Economic Growth

Executive Summary Turkey is staring into an abyss: economic crisis that will morph into political crisis in the June 2023 election cycle. President Erdoğan will pursue populist economic policies and foreign policy adventurism to try to stay in power, leading to negative surprises and “black swan” risks over the coming 9-12 months. While Erdoğan and the ruling party are likely to be defeated in elections, which is good news, investors should not try to front-run the election given high uncertainty. Neither Turkey’s economy and domestic politics nor the global economy and geopolitics warrant a bullish view on Turkish assets. GEOPOLITICAL STRATEGY  Recommendation (TACTICAL) Initiation Date Return LONG JPY/TRY 2022-09-23     Erdoğan’s Net Negative Job Approval Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Bottom Line: The Lira will depreciate further versus the dollar. Both Turkish stocks and local currency bonds merit an underweight stance in an EM basket. EM sovereign credit investors, however, should be neutral on Turkish sovereign credit relative to the EM sovereign credit benchmark. Feature Turkey – now technically Türkiye – is teetering on the verge of a national meltdown. The inflation rate is the fastest in G20 countries, both because of a domestic wage-price spiral and soaring global food and fuel prices. President Recep Tayyip Erdoğan and his Justice and Development Party (AKP) have been in power since 2002, making them highly vulnerable to demands for change in the general election slated for June 18, 2023. Yet Erdoğan is a strongman who won a popular vote to revise the constitution in 2017 and increase his personal power over institutions. His populist Islamist movement is starkly at odds with the country’s traditional elite, including the secular military establishment. Given the poor state of the economy, Erdoğan will likely lose the 2023 election but he could refuse to leave office … or he could win the election and be ousted in a coup d'état, as happened in Turkey in 1960, 1971, and 1980.1 Meanwhile Turkey is beset by foreign dangers – including war in Ukraine and instability in the Middle East. Erdoğan will try to use foreign policy to bolster his popular standing. Turkey has inserted itself in various regional conflicts and could instigate conflicts of its own. While global investors are eager to buy steeply discounted Turkish financial assets ahead of what could be a monumental change in national policy in 2023, the country is extremely unstable. It is a source of “black swan” risks. The best bet is to remain underweight Turkish assets unless and until a pro-market election outcome shakes off the two-decade trend toward economic ruin. Turkish Grand Strategy Turkey is permanently at a crossroads. The land-bridge between Europe and Asia, it is secular and cosmopolitan but also Islamist and traditional. Its past consists of the greatness of empires – Byzantine, Ottoman – while its present consists of a frustrating search for new opportunities in a chaotic regional context. The core of the country consists of the disjointed coastal plains around the Bosporus and Dardanelles straits and the Sea of Marmara, where Istanbul is located. The Byzantine and Ottoman empires were seated on this strategic location at the juncture of the world’s east-west trade. To secure this area, the Turks needed to control the larger Anatolian peninsula – Asia Minor – to prevent roving Eurasian powers from invading, just as they themselves had originally invaded from Central Asia. During times of greatness the Turks could also expand their empire to control the Balkan peninsula and Danube river valley up to Vienna, Crimea and the Black Sea coasts, and the eastern Mediterranean island approaches. During the Ottoman empire’s golden days Turkish power extended all the way into North Africa, Mesopotamia, the Nile river valley, and Mecca and Medina. The empire – and the Islamic Ottoman Caliphate – collapsed in 1924 after centuries of erosion and the catastrophes of World War I. Subsequently Turkey emerged as a secular republic. It adapted to the post-WWII world order by allying with the United States and NATO, in conflict with the Soviet Union which encircled the Turks on all sides. The Russians are longstanding rivals of Turkey, notably in the Black Sea and Crimea, and Stalin wanted to get his hands on the Dardanelles and Bosporus straits. Hence alliance with the US and NATO fulfilled one of the primary demands of Turkish grand strategy: a navy that could defend the straits and Turkish interests in the Black Sea and eastern Mediterranean. The collapse of the Soviet Union seemed to usher in an era of opportunity for Turkey. Turkey benefited from democratization, globalization, and foreign capital inflows. But then America’s wars and crises, Russia’s resurgence, and Middle Eastern instability created a shatter-belt surrounding Turkey, impinging on its national security. In this context of limited foreign policy options, Turkey’s domestic politics coalesced around Erdoğan, the AKP, political Islam, and investment-driven economic growth. Erdoğan and the AKP represent the Anatolian, religious, and Middle Eastern interests in Turkey, as opposed to the maritime, secular, and Euro-centric interests rooted in Istanbul. This point can be illustrated by observing that the poorer interior regions have grown faster than the national average over the period of AKP rule, whereas the more developed coastal regions have tended to lag (Map 1). Voting patterns from the 2018 general election overlap with these economic outcomes. The AKP has steered investment capital into the interior to fund infrastructure and property construction while currency depreciation, rather than productivity enhancement, has merely maintained the status quo with the manufacturing export sector in the coastal regions (Chart 1). Map 1Turkey’s Anatolian Model And The Struggle With The Coasts Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Chart 1Turkey's Export Competitiveness Turkey's Export Competitiveness Turkey's Export Competitiveness Today Turkey faces three distinct obstacles to its geopolitical expansion: Russian aggression: Russia’s resurgence, especially with the seizure of Crimea in 2014 and broader invasion of Ukraine in 2022, threatens Turkey’s interests in the Black Sea and eastern Mediterranean. Turkey must always deal with Russia carefully but over the past 14 years Russia has become belligerent, forcing Turkey to come to terms with Putin while maintaining the NATO alliance. Today Erdoğan tries to mediate the conflict as it does not want to encourage Russian aggression but also does not want NATO to provoke Russia. For instance, Turkey is willing to condone Finland and Sweden joining NATO but only if the West grants substantial benefits to Turkey itself. Ultimately Turkish ties with Russia are overrated. For both economic reasons and grand strategic reasons outlined above, Turkey will cleave to the West (Chart 2). Chart 2Turkey Still Linked To The West Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan ​​​​​ Chart 3Turkish Energy Ties With Russia Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Western liberal hegemony: The EU and NATO foreclosed any Turkish ambitions in Europe. The EU has consolidated with each new crisis while rejecting Turkish membership. This puts limits on Turkish access to European markets and influence in the Balkans. Turkey has guarded its independence jealously against the West. After the Cold War the US expected Turkey to serve American interests in the Middle East and Eurasia. The EU expected it to serve European interests as an energy transit state and a blockade against Middle Eastern refugees. But Turkish interests were often sidelined while its domestic politics did not allow blind loyalty to the West. This led Turkey to push back against the West and cultivate other options, such as deeper economic ties with Russia and China. Turkish dependency on Russian energy is substantial and Turkey has tried to play a mediating role in Russia’s conflict with NATO (Chart 3). Recently Turkey offered to join the Shanghai Cooperation Organization (SCO), a military alliance of Asian powers. However, as with trade, Turkish defense and security ties with the Russo-Chinese bloc are ultimately overrated (Chart 4).  There is room for some cooperation but Turkey is not eager to abandon American military backing in a period in which Russia is threatening to control the Black Sea rim, cut off grain exports arbitrarily, and use tactical nuclear weapons. Chart 4Turkey’s Defense Alliance With The West Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Middle Eastern instability: The Middle East is a potential area for Turkey to increase influence, especially given the AKP’s embrace of political Islam. Turkey benefits from regional economic development and maintains relations with all players. But the region’s development is halting and Turkey is blocked by competitors. The US toppled Iraq in 2003, which strengthened Iran’s regional clout over the subsequent decades. But Iran is not stable and the US has not prevented Iran from achieving nuclear breakout capacity. Turkey cannot abide a nuclear-armed Iran. At the same time, the US continues to support Israel and the Gulf Arab monarchies, which oppose Turkey’s combination of Islam and democratic populism. Russia propped up Syria’s regime in league with Iran, which threatens Turkey’s border integrity. Developments in Syria, Iraq, and Iran have all complicated Turkey’s management of Kurdish militancy and separatism. Kurds make up nearly 20% of Turkey’s population and play a central role in the country’s political divisions. Erdoğan’s Anatolian power base is antagonistic toward the Kurds and regional Kurdish aspirations. China’s strategic rise brings both risks and rewards for Turkey but China is too distant to become the focus of Turkish strategy: China’s dream of reviving the Silk Road across Eurasia harkens back to the glory days of Ottoman power. The Belt and Road Initiative and other investments help to develop Central Asia and the Middle East, enabling Turkey to benefit once again as the middleman in east-west trade (Chart 5). Chart 5Turkey Benefits From East-West Trade Turkey Benefits From East-West Trade Turkey Benefits From East-West Trade But insofar as China’s Eurasian strategy is successful, it could someday impinge on Turkish ambitions, particularly by buttressing Russian and Iranian power. In recent years Erdoğan has experimented with projecting Turkish power in the Middle East (Syria), North Africa (Libya), the Caucasus (Armenia), and the eastern Mediterranean (Cyprus). He cannot project power effectively because of the obstacles outlined above. But he can manipulate domestic and foreign security issues to try to prolong his hold on power. Bottom Line: Boxed in by Russian aggression, western liberal hegemony, and Middle Eastern instability, Turkey cannot achieve its geopolitical ambitions and has concentrated on internal development over the past two decades. However, the country retains some imperial ambitions and these periodically flare up in unpredictable ways as the modern Turkish state attempts to fend off the chaotic forces that loom in the Black Sea, Middle East, North Africa, and Caucasus. The Erdoğan regime is focused on consolidating Anatolian control of Turkey and projecting military power abroad so that the military does not become a political problem for his faction at home. Erdoğan’s Domestic Predicament President Erdoğan has stayed in power for 20 years under the conditions outlined above but he faces a critical election by June 18, 2023 that could see him thrown from power. The result will be extreme political turbulence over the coming nine months until the leadership of the country is settled by hook or by crook. Erdoğan has pursued a strongman or authoritarian leadership style, especially since domestic opposition emerged in the wake of the Great Recession. By firing three central bankers, he has pressured the central bank into running an ultra-dovish monetary policy, producing a 12% inflation rate prior to the Covid-19 pandemic and an 80% inflation rate today. He has also embraced populist fiscal handouts and foreign policy adventurism. Taken together his policies have eroded the country’s political as well as economic stability. From the last general election in 2018 to the latest data in 2022: Real household disposable income  growth has fallen from -7.4% to -18.7% (Chart 6). Chart 6Real Incomes Falling Real Incomes Falling Real Incomes Falling ​​​​​​ Chart 7Turkish Activity Slows Ahead Of Election Turkish Activity Slows Ahead Of Election Turkish Activity Slows Ahead Of Election ​​​​​ The manufacturing PMI has fallen from 49.0 to 47.4 (Chart 7). Consumer confidence has fallen from 92.1 to 72.2 (Chart 8). Chart 8Consumer Confidence: Not Better Off Than At Last Election Consumer Confidence: Not Better Off Than At Last Election Consumer Confidence: Not Better Off Than At Last Election ​​​​​​ Chart 9Erdoğan’s Net Negative Job Approval Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan ​​​​​​ Bad economic news is finally altering public opinion, with polls now shifting against the president and incumbent party: Since the pandemic erupted, Erdoğan’s approval rating has fallen from a peak of 57% to 40% today. Disapproval has Erdoğan’s risen to 54%, leaving him a net negative job approval (Chart 9). Bear in mind that Erdoğan won the election with 52.6% of the vote in 2018, only slightly better than the 51.8% he received in 2014 and well below the 80% that his AKP predecessor received in 2007. Meanwhile the AKP, which never performs as well as Erdoğan himself, has fallen from a 45% support rate to 30% today in parliamentary polls, dead even with the main opposition Republican People’s Party (Chart 10). The AKP won 42.6% of the vote in 2018, down from 49.5% in the second election of 2015, 49.8% in 2011, and 46.6% in 2007. Chart 10Justice And Development Party Neck And Neck With Republican Opposition Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan The gap between Erdoğan and his Republican rivals has narrowed sharply since the global food and fuel price spike began to bite in late 2021 (Chart 11). Chart 11Erdoğan Faces Tough Re-Election Race Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan However, the 2023 election is not straightforward. There are several caveats to the clear anti-incumbent tendency of economic and political data: Soft Economic Landing? The election takes place in nine months, enough time for surprises to salvage Erdoğan’s presidential campaign, given his and his party’s heavily entrenched rule. For example, it is possible – not probable – that Russia will resume energy exports, enabling Europe to recover, and that central banks will achieve a “soft landing” for the global economy. Turkey’s economy would bounce just in time to help the incumbent party. This is not what we expect (see below) but it could happen. Foreign Policy Victories? Erdoğan could achieve some foreign policy victories. He has negotiated a tenuous deal with Russia and Ukraine, along with the UN, to enable grain exports out of Odessa. He could build on this process to negotiate a broader ceasefire in Ukraine. He could also win major concessions from the US and NATO to secure Finnish and Swedish membership in that bloc. If he did he would come off looking like a grand statesman and might just buy another term in office. Unfortunately what is more likely is that Erdoğan will pursue an aggressive foreign policy in an attempt to distract voters from their bread-and-butter woes, only to destabilize Turkey and the region further. Stolen Election? Erdoğan revised the constitution in 2017 – winning 51.4% of the votes in a popular referendum – to give the presidency substantial new powers across the political system. Using these powers he could manipulate the election to produce a favorable outcome or even cling to power despite unfavorable election results. He does not face nearly as powerful and motivated of a liberal establishment as President Trump faced in 2020 or as Brazilian President Jair Bolsonaro faces in 2022. As noted Erdoğan has a contentious relationship with the Turkish military, so while investors cannot rule out a stolen election, they also cannot rule out a military coup in reaction to an attempted stolen election. Thus the election could produce roughly four outcomes, which we rank below from best to worst in terms of their favorability for global investors: 1.  Best Case: Decisive Opposition Victory – 25% Odds – A resounding electoral defeat for the AKP would reverse its unorthodox economic policies in the short term and serve as a lasting warning to future politicians that populism and economic mismanagement lead to political ruin. This outcome would also provide the political capital and parliamentary strength necessary to impose tough reforms and restore a semblance of macroeconomic stability. 2.  Good Case: Narrow AKP Defeat – 50% Odds – A narrow or contested election would produce a weak new government that would at least put a stop to the most inflationary AKP policies. It would improve global investor sentiment around Turkey’s eventual ability to stabilize its economy. The new government would lack the ability to push through structural reforms but it could at least straighten out the affairs of the central bank so as to ensure a cycle of monetary policy tightening, which would stabilize the currency. 3.  Bad Case: Narrow AKP Victory – 15% Odds – A narrow victory would force the AKP to compromise with opposition parties in parliament and pacify social unrest. Foreign adventurism would continue but harmful domestic policies would face obstructionism. 4.  Worst Case: Decisive AKP Victory – 10% Odds – A resounding victory for the ruling party would vindicate Erdoğan and his policies despite their negative economic results, driving Turkey further down the path of authoritarianism, populism, money printing, currency depreciation, and hyper-inflation. He could also be emboldened in his foreign adventurism. Bottom Line: We expect Erdoğan and the AKP to be defeated and replaced. However, Turkey is in the midst of an economic and political crisis and the next 12 months will bring extreme uncertainty. The election could be indecisive, contested, stolen, or overthrown. The aftermath could be chaotic as well as the lead-up. If the AKP stays in power then investors will abandon Turkey and its economy will suffer a historic shock. Therefore investors should underweight Turkey – at least until the next phase in the economic downturn confirms our forecast that the AKP will fall from power. Macro Outlook: Fade The Equity Rally Chart 12Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM The Turkish economy is beset by hyper-inflation. Headline consumer prices are rising at upwards of 80% and core inflation is 65%. Yet Turkish government 10-year bond yields are low and falling: they are down to 11% currently, from a high of 24% at the beginning of the year. Turkish stocks have also outperformed their Emerging Markets counterparts this year in common currency terms even though the lira has been the worst performing EM currency (Chart 12). So, what’s going on in this market? The answer is hidden in the slew of unorthodox policies adopted by the authorities. These measures caused massive distortions in both the economy and the markets. Specifically, late last year, despite very high inflation, the central bank began to cut policy rates encouraging massive loan expansion. As a result, both local currency loans and money supply surged. Which, in turn, completely unhinged inflation (Chart 13). As inflation rose, so did government bond yields. In a bid to keep government borrowing costs low, policymakers changed several bank regulations to force commercial banks to buy government bonds.2  The upshot was that the bond yields stopped tracking inflation and instead began to fall even as inflation skyrocketed. The rampant inflation meant Turkish non-financial firms’ nominal sales skyrocketed. Indeed, sales of all MSCI Turkey non-financials companies have risen by 40% in US dollar terms and 200% in local currency (Chart 14). Chart 13Massive Bank Credit And Money Growth Completely Unhinged The Inflation Massive Bank Credit And Money Growth Completely Unhinged The Inflation Massive Bank Credit And Money Growth Completely Unhinged The Inflation This was at a time when policy rates were being cut. The policy rate has fallen to 12% today from 19% a year earlier. Firms’ local currency real borrowing costs have fallen deeply into negative territory (Chart 15). It helped reduce firms’ costs significantly. Chart 14Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits ​​​​​ Chart 15Policy Rates Are Being Cut Even As The Inflation Reigns Havoc Policy Rates Are Being Cut Even As The Inflation Reigns Havoc Policy Rates Are Being Cut Even As The Inflation Reigns Havoc ​​​​​ Chart 16Wage Costs Have Risen Too, But Not As Much As Inflation Wage Costs Have Risen Too, But Not As Much As Inflation Wage Costs Have Risen Too, But Not As Much As Inflation ​​​​​ Meanwhile, even though wage growth accelerated, it still fell short of inflation, and therefore of nominal sales of the firms (Chart 16). Firms’ wage costs did not rise as much as their prices. All this boosted non-financial firms’ margins. Total profits have risen by 35% in US dollar terms from a year earlier (200% in lira terms). ​​​​​​​ Chart 17The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket ​​​​​​​ On their part, listed financials’ profits have surged by 50% in USD terms and 220% in local currency terms. They benefited both from surging interest income due to rapid loan growth and from massive capital gains on their holding of government securities (see Chart 14 above). All this is reflected in Turkish companies’ earnings per share as well. The spike in EPS has propped up Turkish stocks for past few months. Over the past year, not only have corporate profits and share prices surged, but also house prices have skyrocketed by 170% in local currency terms and 30% in USD terms (Chart 17). In sum, the abnormally low nominal and deeply negative real borrowing costs have produced a money/credit deluge, which has generated a massive inflationary outbreak and has inflated revenues/profits as well as various asset prices. The Lira To Depreciate Further This macro setting is a recipe for a major currency sell-off.  First, Europe – the destination of 90% of Turkish exports – will likely slide into recession over the coming year (Chart 18).  Chart 18A Slowing Europe Will Materially Dent Turkish Growth Too A Slowing Europe Will Materially Dent Turkish Growth Too A Slowing Europe Will Materially Dent Turkish Growth Too A fall in exports will widen Turkey’s current account deficit. Notably, imports will not fall much since the authorities are pursuing easy money policy. Second, the lack of credible macro policies as well as political crisis will assure that foreign capital escapes Turkey. Turkey will find the current account deficit nearly impossible to finance. Third, the country’s net foreign reserves, after adjusting for the central bank’s foreign currency borrowings and commercial banks’ deposits with the central bank, stand at minus 30 billion dollars. In other words, the central bank now has large net US dollar liabilities. As such, it has little wherewithal to defend the currency. There are very high odds that the lira depreciation will accelerate in the months ahead. Fourth, the slew of unorthodox measures taken by the Turkish authorities will encourage banks to buy more government local currency bonds to suppress the government’s borrowing costs. When commercial banks buy government securities from non-banks, they create money “out of thin air.” Hence, the ongoing money supply deluge will continue. This is bearish for the currency. Notably, the economy will likely enter into recession next year – and yet core inflation will stay very high (30% and above). Recent unorthodox bank regulations are meant to encourage a certain kind of lending – loans to farmers, exporters, and small and medium-sized businesses – while discouraging other kinds. Consequently, the overall loan growth will likely slow in nominal terms. There are already signs that credit is decelerating on the margin (Chart 19). Given the very high inflation, slower credit growth will likely lead to a liquidity crunch for many businesses – forcing them to curtail their activity.  Chart 19Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations ​​​​​​ Chart 20Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP ​​​​​​ Indeed, in real terms (deflated by core CPI), local currency loan growth has already slipped into negative territory. This is a bad omen for the overall economy: contracting real loan growth is a harbinger of recession (Chart 20). In short, Turkey is looking into an abyss: a recession amid high inflation (i.e., stagflation) as well as a brewing political crisis (with Erdoğan likely doubling down on unorthodox and populist policies). All this point to another period of a large currency depreciation. While the country will likely change direction to avoid the abyss, investors should wait to allocate capital until after the change in direction is confirmed.    Investment Takeaways The Turkish lira will fall much more vis-à-vis the US dollar in the year ahead. Both Turkish stocks and local currency bonds merit an underweight stance in an EM basket. EM sovereign credit investors, however, should be neutral on Turkish sovereign credit relative to the EM sovereign credit benchmark. Turkey is involved in an economic crisis that will devolve into a political crisis over the election cycle. While Erdoğan and the AKP are likely to fall from power as things stand today, they are heavily entrenched and will be difficult to remove, creating large risks of an indecisive or contested election in 2023 that will increase rather than decrease policy uncertainty and the political risk premium in Turkish assets. As a strongman leader Erdoğan has consolidated political power in his own hands, so there is no one to take the blame for the country’s economic mismanagement – other than foreigners. Hence there is a distinct risk that his foreign policy adventurism will escalate between now and next year, resulting in significant military conflicts or saber-rattling. These will shake out western investors who try to speculate on the likelihood that the election or the military will oust Erdoğan and produce sounder national and economic policies. That outcome is indeed likely but Erdoğan is not going without a fight. Our Geopolitical Strategy also recommends tactically shorting the lira versus the Japanese yen in light of global slowdown, extreme geopolitical risk, and the Bank of Japan’s desire to prevent the yen from falling too far.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Andrija Vesic Consulting Editor Footnotes 1      Sinan Ekim and Kemal Kirişci, “The Turkish constitutional referendum, explained,” Brookings Institution, April 13, 2017, brookings.edu. 2     The central bank replaced an existing 20% reserve requirement ratios for credits with a higher 30% treasury bond collateral requirement. Lenders will have to cut interest rates on commercial loans (except for loans to farmers, exporters, and SMEs). Otherwise, banks will have to maintain additional securities. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary The US inflation surprise increases the odds of both congressional gridlock and recession, which increases uncertainty over US leadership past 2024 and reduces the US’s ability to lower tensions with China and Iran.   Despite the mainstream media narrative, the Xi-Putin summit reinforces our view that China cannot reject Russia’s strategic partnership. The potential for conflict in Taiwan forces China to accept Russia’s overture. For the same reason the US and China cannot re-engage their economies sustainably, even if Biden and Xi somehow manage to reduce tensions after the midterm elections and twentieth national party congress. Russia could reduce oil exports as well as natural gas, intensifying the global energy shock. Ukraine’s counter-offensive and Europe’s energy diversification increase the risk of Russian military and economic failure. The Middle East will destabilize anew and create a new source of global energy supply disruptions. US-Iran talks are faltering as expected. Russian Oil Embargo Could Deliver Global Shock Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Asset Initiation Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 19.1% Bottom Line: Stay long US stocks, defensive sectors, and large caps. Avoid China, Taiwan, eastern Europe, and the Middle East. Feature Several notable geopolitical developments occurred over the past week while we met with clients at the annual BCA Research Investment Conference in New York. In this report we analyze these developments using our geopolitical method, which emphasizes constraints over preferences, capabilities over intentions, reality over narrative. We also draw freely from the many valuable insights gleaned from our guest speakers at the conference.  China Cannot Reject Russia: The Xi-Putin Summit In Uzbekistan Presidents Xi Jinping and Vladimir Putin are meeting in Uzbekistan as we go to press and Putin has acknowledged China’s “questions and concern” about the war in Ukraine.1 They last met on February 4 when Xi gave Putin his blessing for the Ukraine invasion, promising to buy more Russian natural gas and to pursue a “no limits” strategic partnership (meaning one that includes extensive military cooperation). The meeting’s importance is clear from both leaders’ efforts to make it happen. Putin is leaving Russia despite rising domestic criticism over his handling of the Ukraine war and European energy war. Ukraine is making surprising gains in the battlefield, particularly around Kharkiv, threatening Russia’s ability to complete the conquest of Donetsk and the Donbas region. Meanwhile Xi is leaving China for the first time since the Covid-19 outbreak, despite the fact that he is only one month away from the most important political event of his life: the October 16 twentieth national party congress, where he hopes to clinch another five, ten, or fifteen years in power, expand his faction’s grip over the political system, and take over Mao Zedong’s unique title as chairman of the Communist Party. We do not yet know the full outcome of the Uzbek summit but we do not see it as a turning point in which China turns on Russia. Instead the summit reinforces our key point to investors all year: China cannot reject Russia. Russia broke energy ties with Europe and is fighting a proxy war with NATO. The Putin regime has lashed Russia to China’s side for the foreseeable future. China may not have wanted to move so quickly toward an exclusive relationship but it is not in a position to reject Russia’s diplomatic overture and leave Putin out to dry. The reason is that China is constrained by the US-led world order and like Russia is attempting to change that order and carve a sphere of influence to improve its national security. Beijing’s immediate goal is to consolidate power across the critical buffer territories susceptible to foreign interests. It has already consolidated Tibet, Xinjiang, Hong Kong, and to some extent the South China Sea, the critical approach to Taiwan. Taiwan is the outstanding buffer space that needs to be subjugated. Xi Jinping has taken it upon himself to unify China and Taiwan within his extended rule. But Taiwanese public opinion has decisively shifted in favor of either an indefinite status quo or independence. Hence China and Taiwan are on a collision course. Regardless of one’s view on the likelihood of war, it is a high enough chance that China, Taiwan, the US, and others will be preparing for it in the coming years. Chart 1US Arms Sales To Taiwan Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions The US is attempting to increase its ability to deter China from attacking Taiwan. It believes it failed to deter Russia from invading Ukraine – and Taiwan is far more important to US economy and security than Ukraine. The US is already entering discussions with Taiwan and other allies about a package of severe economic sanctions in the event that China attacks – sanctions comparable to those imposed on Russia. The US Congress is also moving forward with the Taiwan Policy Act of 2022, which will solidify US support for the island as well as increase arms sales (Chart 1).2  Aside from China's military preparation – which needs to be carefully reviewed in light of Russia’s troubles in Ukraine and the much greater difficulty of invading Taiwan – China must prepare to deal with the following three factors in the event of war: 1. Energy: China is overly exposed to sea lines of communication that can be disrupted by the United States Navy. Beijing will have to partner with Russia to import Russian and Central Asian resources and attempt to forge an overland path to the Middle East (Chart 2). Unlike Russia, China cannot supply its own energy during a war and its warfighting capacity will suffer if shortages occur or prices spike. 2. Computer Chips: China has committed at least $200 billion on a crash course to build its own semiconductors since 2013 due to the need to modernize its military and economy and compete with the US on the global stage. But China is still dependent on imports, especially for the most advanced chips, and its dependency is rising not falling despite domestic investments (Chart 3). The US is imposing export controls on advanced microchips and starting to enforce these controls on third parties. The US and its allies have cut off Russia’s access to computer chips, leading to Russian shortages that are impeding their war effort.  Chart 2China’s Commodity Import Vulnerability Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Chart 3China's Imports Of Semiconductors China's Imports Of Semiconductors China's Imports Of Semiconductors     3. US Dollar Reserves: China is still heavily exposed to US dollar assets but its access will be cut off in the event of war, just as the US has frozen Russian, Iranian, Venezuelan, and Cuban assets over the years. China is already diversifying away from the dollar but will have to move more quickly given that Russia had dramatically reduced its exposure and still suffered severely when its access to dollar reserves was frozen this year (Chart 4). Where will China reallocate its reserves? To developing and importing natural resources from Russia, Central Asia, and other overland routes. Chart 4China's US Dollar Exposure China's US Dollar Exposure China's US Dollar Exposure Russia may be the junior partner in a new Russo-Chinese alliance but it will not be a vassal. Russia has resources, military power, and regional control in Central Asia that China needs. Of course, China will maintain a certain diplomatic distance from Russia because it needs to maintain economic relations with Europe and other democracies as it breaks up with the United States. Europe is far more important to Chinese exports than Russia. China will play both sides and its companies will develop parallel supply chains. China will also make gestures to countries that feel threatened by Russia, including the Central Asian members of the Shanghai Cooperation Organization (SCO). But the crucial point is that China cannot reject Russia. If the Putin regime fails, China will be diplomatically isolated, it will lose an ally in any Taiwan war, and the US will have a much greater advantage in attempting to contain China in the coming years and decades. Russo-Chinese Alliance And The US Dollar Many investors speculate that China’s diversification away from the US dollar will mark a severe downturn for the currency. This is of course possible, given that Russia and China will form a substantial anti-dollar bloc. Certainly there can be a cyclical downturn in the greenback, especially after the looming recession troughs. But it is harder to see a structural collapse of the dollar as the leading global reserve currency. The past 14 years have shown how global investors react to US dysfunction, Russian aggression, and Chinese slowdown: they buy the dollar! The implication is that a US wage-price spiral, a Russian détente with Europe, and a Chinese economic recovery would be negative for the dollar – but those stars have not yet aligned. Related Report  Geopolitical StrategyThe Geopolitical Consequences Of The Ukraine War The reason China needs to diversify is because it fears US sanctions when it invades Taiwan. Hence reducing its holdings of US treasuries and the dollar signals that it expects war in future. But will other countries rush into the yuan and yuan-denominated bonds if Xi is following in Putin’s footsteps and launching a war of choice, with damaging consequences for the economy? A war over Taiwan would be a global catastrophe and would send other countries plunging into the safe-haven assets, including US assets.   Nevertheless China will diversify and other countries will probably increase their yuan trade over time, just as Russia has done. This will be a cyclical headwind for the dollar at some point. But it will not knock the US off the premier position. That would require a historic downgrade in the US’s economic and strategic capability, as was the case with the United Kingdom after the world wars. China will continue to stimulate the economy after the party congress. A successful Chinese and global economic rebound next year – and a decision to pursue “jaw jaw” with the US and Taiwan rather than “war war” – would be negative for the dollar. Hence we may downgrade our bullish dollar view to neutral on a cyclical basis before long … but not yet and not on a structural basis.  Bottom Line: Favor the US dollar and the euro over the Chinese renminbi and Taiwanese dollar. Underweight Chinese and Taiwanese assets on a structural basis. Ukraine’s Counter-Offensive And A Russian Oil Embargo Ukraine launched a counter-offensive against Russia in September and achieved significant early victories. Russians fell back away from Kharkiv, putting Izyum in Ukrainian hands and jeopardizing Russia’s ability to achieve its war aim of conquering the remaining half of Donetsk province and thus controlling the Donbas region of eastern Ukraine. Russian positions also crumbled west of the Dnieper river, which was always an important limit on Russian capabilities (Map 1). Map 1Status Of Russia-Ukraine War: The Ukrainian Counter-Offensive (September 15, 2022) Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Some commentators, such as Francis Fukuyama in the Washington Post, have taken the Ukrainian counter-offensive as a sign that the Ukrainians will reconquer lost territory and Russia will suffer an outright defeat in this war.3 If Russia cannot conquer the Donbas, its control of the “land bridge” to Crimea will be unsustainable, and it may have to admit defeat. But we are very skeptical. It will be extremely difficult for Ukrainians to drive the Russians out of all of their entrenched positions. US military officials applauded Ukraine’s counter-offensive but sounded a cautious note. The chief problem is that neither President Putin nor the Russian military can afford such a defeat. They will have to double down on the Donbas and land bridge. The war will be prolonged. Ultimately we expect stalemate, which will be a prelude to ceasefire negotiations. But first the fighting will intensify and the repercussions for global economy and markets will get worse. Russia’s war effort is also flagging because Europe is making headway in finding alternatives for Russian natural gas. Russia has cut off flows through the Nord Stream pipeline to Germany, the Yamal pipeline to Poland, and partially to the Ukraine pipeline system, leaving only Turkstream operating normally. Yet EU gas storage is in the middle of its normal range and trending higher (Chart 5).   Chart 5Europe Handling Natural Gas Crisis Well … So Far Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Of course, Europe’s energy supply is still not secure. Cold weather could require more heating than expected. Russia has an incentive to tighten the gas flow further. Flows from Algeria or Azerbaijan could be sabotaged or disrupted (Chart 6). Chart 6Europe’s NatGas Supply Still Not Secure Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Chart 7Europe Tipping Into Recession Anyway Europe Tipping Into Recession Anyway Europe Tipping Into Recession Anyway Russia’s intention is to inflict a recession on Europe so that it begins to rethink its willingness to maintain a long-term proxy war. Recession will force European households to pay the full cost of the energy breakup with Russia all at once. Popular support for war will moderate and politicians will adopt more pragmatic diplomacy. After all they do not have an interest in prolonging the war to the point that it spirals out of control. Clearly the economic pain is being felt, as manufacturing expectations and consumer confidence weaken (Chart 7). Europe’s resolve will not collapse overnight. But the energy crisis can get worse from here. The deeper the recession, the more likely European capitals will try to convince Ukraine to negotiate a ceasefire.   However, given Ukraine’s successes in the field and Europe’s successes in diversification, it is entirely possible that Russia faces further humiliating setbacks. While this outcome may be good for liberal democracies, it is not good for global financial markets, at least not in the short run. If Russia is backed into a corner on both the military and economic fronts, then Putin’s personal security and regime security will be threatened. Russia could attempt to turn the tables or lash out even more aggressively. Already Moscow has declared a new “red line” if the US provides longer-range missiles to Ukraine. A US-Russia showdown, complete with nuclear threats, is not out of the realm of possibility. Russia could also start halting oil exports, as it has threatened to do, to inflict a major oil shock on the European economy. Investors will need to be prepared for that outcome.  Bottom Line: Petro-states have geopolitical leverage as long as global commodity supplies remain tight. Investors should be prepared for the European embargo of Russian oil to provoke a Russian reaction. A larger than expected oil shock is possible given the risk of defeat that Russia faces (Chart 8). Chart 8Russian Oil Embargo Could Deliver Global Shock Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions US-Iran Talks Falter Again This trend of petro-state geopolitical leverage was one of our three key views for 2022 and it also extends to the US-Iran nuclear negotiations, which are faltering as expected. Tit-for-tat military action between Iran and its enemies in the Persian Gulf will pick up immediately – i.e. a new source of oil disruption will emerge. If global demand is collapsing then this trend may only create additional volatility for oil markets at first, but it further constrains the supply side for the foreseeable future. It is not yet certain that the talks are dead but a deal before the US midterm looks unlikely. Biden could continue working on a deal in 2023-24. The Democratic Party is likely to lose at least the House of Representatives, leaving him unable to pass legislation and more likely to pursue foreign policy objectives. The Biden administration wants the Iran deal to tamp down inflation and avoid a third foreign policy crisis at a time when it is already juggling Russia and China. The overriding constraints in this situation are that Iran needs a nuclear weapon for regime survival, while Israel will attack Iran as a last resort before it obtains a nuclear weapon. Yes, the US is reluctant to initiate another war in the Middle East. But public war-weariness is probably overrated today (unlike in 2008 or even 2016) and the US has drawn a hard red line against nuclear weaponization. Iran will retaliate to any US-Israeli aggression ferociously. But conflict and oil disruptions will emerge even before the US or Israel decide to launch air strikes, as Iran will face sabotage and cyber-attacks and will need to deter the US and Israel by signaling that it can trigger a region-wide war. Chart 9If US-Iran Talks Fail, Iraq Will Destabilize Further If US-Iran Talks Fail, Iraq Will Destabilize Further If US-Iran Talks Fail, Iraq Will Destabilize Further Recent social unrest in Iraq, where the nationalist coalition of Muqtada al-Sadr is pushing back against Iranian influence, is only an inkling of what can occur if the US-Iran talks are truly dead, Iran pushes forward with its nuclear program, and Israel and the US begin openly entertaining military options. The potential oil disruption from Iraq presents a much larger supply constraint than the failure to remove sanctions on Iran (Chart 9). A new wave of Middle Eastern instability would push up oil prices and strengthen Russia’s hand, distracting the US and imposing further pain on Europe. It would not strengthen China’s hand, but the risk itself would reinforce China’s Eurasian strategy, as Beijing would need to prepare for oil cutoffs in the Persian Gulf. Iran’s attempts to join the Shanghai Cooperation Organization should be seen in this context. Ultimately the only factor that could still possibly convince Iran not to make a dash for the bomb – the military might of the US and its allies – is the same factor that forces China and Russia to strengthen their strategic bond. The emerging Russo-Chinese behemoth, in turn, acts as a hard constraint on any substantial reengagement of the US and Chinese economies. The US cannot afford to feed another decade of Chinese economic growth and modernization if China is allied with Russia and Central Asia. Of course, we cannot rule out the possibility that the Xi and Biden administrations will try to prevent a total collapse of US-China relations in 2023. If China is not yet ready to invade Taiwan then there is a brief space for diplomacy to try to work. But there is no room for long-lasting reengagement – because the US cannot simply cede Taiwan to China, and hence China cannot reject Russia, and Russia no longer has any options. Bottom Line: Expect further oil volatility and price shocks. Sell Middle Eastern equities. Favor North American, Latin American, and Australian energy producers. Investment Takeaways Recession Risks Rising: The inflation surprise in the US in August necessitates more aggressive Fed rate hikes in the near term, which increases the odds of rising unemployment and recession. US Policy Uncertainty Rising: A recession will greatly increase the odds of US political instability over the 2022-24 cycle and reduce the incentive for foreign powers like Iran or China to make concessions or agreements with the US. European Policy Uncertainty Rising: We already expected a European recession. Russia’s setbacks make it more likely that it will adopt more aggressive military tactics and economic warfare. Chinese Policy Uncertainty Rising: China will continue stimulating next year but its economy will suffer from energy shocks and its stimulus is less effective than in the past. It will likely increase economic and military pressure on Taiwan, while the US will increase punitive measures against China. It is not clear that it will launch a full scale invasion of Taiwan – that is not our base case – but it is possible so investors need to be prepared. Long US and Defensives: Stay long US stocks over global stocks, defensive sectors over cyclicals, and large caps over small caps. Buy safe-havens like the oversold Japanese yen. Long Arms Manufacturers: Buy defense stocks and cyber-security firms. Short China and Taiwan: Favor the USD and EUR over the CNY. Favor US semiconductor stocks over Taiwanese equities. Favor Korean over Taiwanese equities. Favor Indian tech over Chinese tech. Favor Singaporean over Hong Kong stocks. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1     Tessa Wong and Simon Fraser, “Putin-Xi talks: Russian leader reveals China's 'concern' over Ukraine,” BBC, September 15, 2022, bbc.com. 2     US Senate Foreign Relations Committee, “The Taiwan Policy Act of 2022,” foreign.senate.gov. 3    Greg Sargent, “Is Putin facing defeat? The ‘End of History’ author remains confident,” Washington Post, September 12, 2022, washingtonpost.com.                                                                                         Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

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

Listen to a short summary of this report.     Executive Summary Housing Activity Should Start To Stabilize By The End Of The Year Housing Activity Should Start To Stabilize By The End Of The Year Housing Activity Should Start To Stabilize By The End Of The Year Home prices in the US are set to decline, almost certainly in real terms and probably in nominal terms as well. Unlike in past episodes, the impact on construction from a drop in home prices should be limited, given that the US has not seen pervasive overbuilding. The drag on US consumption should also be somewhat muted. In contrast to what happened during the mid-2000s, outstanding balances on home equity lines of credit declined during the pandemic housing boom. US banks are on a strong footing today. This should limit the collateral damage from falling home prices on the financial system. Outside the US, the housing outlook is more challenging. This is especially the case in smaller developed economies such as Canada, Australia, New Zealand, and Sweden. It is also the case in China, where the property market may be on the verge of a Japanese-style multi-decade slide. ​​​​​ Bottom Line: Softening housing markets around the world will weigh on growth. However, against the backdrop of high inflation, that may not be an unambiguously bad thing. We expect global equities to rise into year end, and then retreat in 2023. The Canary in the Coalmine On the eve of the Global Financial Crisis, Ed Leamer delivered a paper at Jackson Hole with the prescient title “Housing IS the Business Cycle.” Leamer convincingly argued that monetary policy primarily operates through the housing market, and that a decline in residential investment is by far the best warning sign of a recession. Table 1 provides supporting evidence for Leamer’s conclusion. It shows that residential investment is not a particularly important driver of GDP growth during non-recessionary quarters but is the only main expenditure component that regularly turns down in the lead-up to recessions. Table 1A Decline In Residential Investment Typically Precedes Recessions The Risks From Housing The Risks From Housing US real residential investment was essentially flat in Q1 but then contracted at an annualized pace of 16% in Q2, shaving 0.83 percentage points off Q2 GDP growth in the process. The Atlanta Fed GDPNow model forecasts that real residential investment will shrink by 22% in Q3, largely reflecting the steep drop in housing starts and home sales observed over the past few months. Chart 1Housing Activity Should Start To Stabilize By The End Of The Year Housing Activity Should Start To Stabilize By The End Of The Year Housing Activity Should Start To Stabilize By The End Of The Year The recent decline in construction activity is a worrying indicator. Nevertheless, there are several reasons to think that the downturn in housing may not herald an imminent recession. First, the lag between when housing begins to weaken and when the economy falls into recession can be quite long. For example, residential investment hit a high of 6.7% of GDP in Q4 of 2005. However, the Great Recession did not start until Q4 of 2007, when residential investment had already receded to 4.2% of GDP. The S&P 500 peaked during the same quarter. Second, recent weakness in housing activity largely reflects the lagged effects of the spike in mortgage rates earlier this year. To the extent that mortgage rates have been broadly flat since April, history suggests that housing activity should start to stabilize by the end of this year (Chart 1). Third, unlike in the mid-2000s, there is no glut of homes in the US today: Residential investment reached 4.8% of GDP last year, about where it was during the late 1990s, prior to the start of the housing bubble (Chart 2). The construction of new homes has failed to keep up with household formation for the past 15 years (Chart 3). As a result, the homeowner vacancy rate stands at 0.8%, the lowest on record (Chart 4). Chart 2Residential Investment Is Well Below Levels Seen During The Housing Bubble Residential Investment Is Well Below Levels Seen During The Housing Bubble Residential Investment Is Well Below Levels Seen During The Housing Bubble Chart 3Home Construction Has Fallen Short Of Household Formation For The Past 15 Years Home Construction Has Fallen Short Of Household Formation For The Past 15 Years Home Construction Has Fallen Short Of Household Formation For The Past 15 Years Chart 4The Homeowner Vacancy Rate Is At Record Lows The Homeowner Vacancy Rate Is At Record Lows The Homeowner Vacancy Rate Is At Record Lows While new home inventories have risen, this mainly reflects an increase in the number of homes under construction. The inventory of finished homes is still 40% below pre-pandemic levels (Chart 5). The inventory of existing homes available for sale is also quite low, which suggests that a rising supply of new homes could be depleted more quickly than in the past. Chart 5While The Number Of Homes Under Construction Increased, The Inventory Of Newly Built And Existing Homes Remains Low While The Number Of Homes Under Construction Increased, The Inventory Of Newly Built And Existing Homes Remains Low While The Number Of Homes Under Construction Increased, The Inventory Of Newly Built And Existing Homes Remains Low Why Was Housing Supply Slow to Rise? In real terms, the Case-Shiller index is now 5% above its 2006 peak (Chart 6). Why didn’t housing construction respond more strongly to rising home prices during the pandemic? Part of the answer is that the memory of the housing bust curtailed the homebuilders’ willingness to expand operations. Supply shortages also limited the ability of homebuilders to construct new homes in a timely fashion. Chart 7 shows that the producer price index for construction materials increased by nearly 50% between January 2020 and July 2022, outstripping the rise in the overall PPI index. Chart 6Real House Prices Are Above Their 2006 Peak Real House Prices Are Above Their 2006 Peak Real House Prices Are Above Their 2006 Peak Chart 7Producer Prices For Construction Materials Shot Up During The Pandemic Producer Prices For Construction Materials Shot Up During The Pandemic Producer Prices For Construction Materials Shot Up During The Pandemic Chart 8Constraints On Home Building Caused The Housing Market To Clear Mainly Through Higher Prices Rather Than Increased Construction The Risks From Housing The Risks From Housing The lack of building materials and qualified construction workers caused the supply curve for housing to become increasingly steep (or, in the parlance of economics, inelastic). To make matters worse, pandemic-related lockdowns probably caused the supply curve to shift inwards, prompting homebuilders to curb output for any given level of home prices. As Chart 8 illustrates, this meant that the increase in housing demand during the pandemic was largely absorbed through higher home prices rather than through increased output.   A Bittersweet Outcome Chart 9Unlike During The Great Recession, Prices For New And Existing Homes Should Fall In Tandem This Time Around Unlike During The Great Recession, Prices For New And Existing Homes Should Fall In Tandem This Time Around Unlike During The Great Recession, Prices For New And Existing Homes Should Fall In Tandem This Time Around The discussion above presents a good news/bad news story about the state of the US housing market. On the one hand, with seasonally-adjusted housing starts now below where they were in January 2020, construction activity is unlikely to fall significantly from current levels. On the other hand, as the supply curve for housing shifts back out, and the demand curve shifts back in towards pre-pandemic levels, home prices are bound to weaken. We expect US home prices to decline, almost certainly in real terms and probably in nominal terms as well. Unlike during the Great Recession, when a wave of foreclosures caused the prices of existing homes to fall more than new homes, the decline in prices across both categories is likely to be similar this time around (Chart 9).   The Impact of Falling Home Prices To what extent will lower home prices imperil the US economy? Beyond the adverse impact of lower prices on construction activity, falling home prices can depress aggregate demand through a negative wealth effect as well as by putting strain on the banking system. The good news is that both these channels are less operative today than they were prior to the GFC. Perhaps because home prices rose so rapidly over the past two years, homeowners did not get the chance to spend their windfall. The personal savings rate soared during the pandemic and has only recently fallen below its pre-pandemic average (Chart 10). Households are still sitting on about $2.2 trillion in excess savings, most of which is parked in highly liquid bank accounts. Outstanding balances on home equity lines of credit actually fell during the pandemic, sinking to a 21-year low of 1.3% of GDP in Q2 2022 (Chart 11). All this suggests that the coming decline in home prices will not suppress consumption as much as it did in the past. Chart 10Household Savings Surged During The Pandemic Household Savings Surged During The Pandemic Household Savings Surged During The Pandemic Chart 11Despite Higher Home Prices, Households Are Not Using Their Homes As ATMs Despite Higher Home Prices, Households Are Not Using Their Homes As ATMs Despite Higher Home Prices, Households Are Not Using Their Homes As ATMs The drop in home prices during the GFC generated a vicious circle where falling home prices led to more foreclosures and fire sales, leading to even lower home prices. Such a feedback loop is unlikely to emerge today. As judged by FICO scores, lenders have been quite prudent since the crisis (Chart 12). The aggregate loan-to-value ratio for US household real estate holdings stands near a low of 30%, down from 45% in the leadup to the GFC (Chart 13). Banks are also much better capitalized than they were in the past (Chart 14). Chart 12FICO Scores For Residential Mortgages Have Improved Considerably Since The Pre-GFC Housing Bubble The Risks From Housing The Risks From Housing Chart 13This Is Not 2007 This Is Not 2007 This Is Not 2007 Chart 14US Banks Are Better Capitalized Than Before The GFC US Banks Are Better Capitalized Than Before The GFC US Banks Are Better Capitalized Than Before The GFC The final thing to note is that home prices tend to fall fairly slowly. It took six years for prices to bottom following the housing bubble, and this was in the context of a severe recession. Thus, the negative wealth effect from falling home prices will probably not become pronounced until 2024 or later. A Grimmer Picture Abroad The housing outlook is more challenging in a number of economies outside of the US. While home prices have increased significantly in the US, they have risen much more in smaller developed economies such as Canada, Australia, New Zealand, and Sweden (Chart 15). My colleague, Jonathan LaBerge, has also argued that overbuilding appears to be more of a problem outside the US (Chart 16). Chart 15Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets Chart 16Canada And Several Other DM Countries Have Overbuilt Homes Since The Global Financial Crisis Canada And Several Other DM Countries Have Overbuilt Homes Since The Global Financial Crisis Canada And Several Other DM Countries Have Overbuilt Homes Since The Global Financial Crisis Chart 17Slightly More Than Half Of Canadians Opted For Variable Rate Mortgages Over The Past 12 Months Slightly More Than Half Of Canadians Opted For Variable Rate Mortgages Over The Past 12 Months Slightly More Than Half Of Canadians Opted For Variable Rate Mortgages Over The Past 12 Months The structure of some overseas mortgage markets heightens housing risks. In Canada, for example, more than half of homebuyers chose a variable-rate mortgage over the last 12 months (Chart 17). At present, about one-third of the total stock of mortgages are variable rate compared to less than 20% prior to the pandemic. Moreover, unlike in the US where 30-year mortgages are the norm, fixed-rate mortgages in Canada typically reset every five years. Thus, as the Bank of Canada hikes rates, mortgage payments will rise quite quickly.   China: Following Japan’s Path? In the EM space, China stands out as having the most vulnerable housing market. The five major cities with the lowest rental yields in the world are all in China (Chart 18). Home sales, starts, and completions have all tumbled in recent months (Chart 19). The bonds of Chinese property developers are trading at highly distressed levels (Chart 20). Chart 18Chinese Real Estate Shows Vulnerabilities… The Risks From Housing The Risks From Housing Chart 19...Activity And Prices Have Been Falling... ...Activity And Prices Have Been Falling... ...Activity And Prices Have Been Falling... Chart 20...And the Bonds of Property Developers Are Trading At Distressed Levels ...And the Bonds of Property Developers Are Trading At Distressed Levels ...And the Bonds of Property Developers Are Trading At Distressed Levels In many respects, the Chinese housing market resembles the Japanese market in the early 1990s. Just as was the case in Japan 30 years ago, Chinese household growth has turned negative (Chart 21). The collapse in the birth rate since the start of the pandemic will only exacerbate this problem. The number of births is poised to fall below 10 million this year, down more than 30% from 2019 (Chart 22). Chart 21China Faces A Structural Decline In The Demand For Housing China Faces A Structural Decline In The Demand For Housing China Faces A Structural Decline In The Demand For Housing Chart 22China's Baby Bust China's Baby Bust China's Baby Bust A few years ago, when inflation was subdued and talk of secular stagnation was all the rage, a downturn in the Chinese property sector would have been a major cause for concern. Things are different today. Global inflation is running high, and to the extent that investors are worried about a recession, it is because they think central banks will need to raise rates aggressively to curb inflation. A weaker Chinese property market would help restrain commodity prices, easing inflationary pressures in the process. As long as the Chinese banking system does not implode – which is highly unlikely given that the major banks are all state-owned – global investors might actually welcome a modest decline in Chinese property investment. Investment Conclusions The downturn in the US housing market suggests that we are in the late stages of the business-cycle expansion. However, given the long lags between when housing begins to weaken and when a recession ensues, it is probable that the US will only enter a recession in 2024. To the extent the stock market typically peaks six months before the outset of a recession, equities may still have further to run, at least in the near term. As we discussed last week, we recommend a neutral allocation on global stocks over a 12-month horizon but would overweight equities over a shorter-term 6-month horizon. In relative terms, the US housing market is more resilient than most other housing markets. We initiated a trade going long Canadian government bonds relative to US bonds on June 30, when the 10-year yield in Canada was 21 basis points above the comparable US yield. Today, the yield on both bonds is almost the same. We expect Canadian bonds to continue to outperform, given the more severe constraints the Bank of Canada faces in raising rates. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on     LinkedIn & Twitter Global Investment Strategy View Matrix The Risks From Housing The Risks From Housing Special Trade Recommendations Current MacroQuant Model Scores The Risks From Housing The Risks From Housing      

Highlights The risk of a US recession has increased sharply over the past several months. We have not yet concluded that a recession over the coming year is inevitable, but substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. The increased risk of a contraction has caused investors to ponder what the next recession might look like. One very important question concerns the likely behavior of short-term interest rates during the next recession, especially if it occurs sooner rather than later. The historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition, there are several arguments pointing to the next US recession being a mild one. For fixed-income investors, the implication is that investors should not overstay their welcome in a long-duration position during the next US recession, and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. Feature Over the past several months, investors have been faced with a sharp increase in the odds of a US recession. Gauging the risk of a recession has featured prominently in our recent reports, and we have concluded, for now, that a US recession over the coming year is not yet inevitable. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Economic expansions do not last forever. This means that the US economy will eventually succumb to a recession at some point over the coming few years. One very important question for investors concerns the likely behavior of short-term interest rates during the next recession, especially if a contraction occurs sooner rather than later. A key aspect of this question is whether the Fed is likely to be forced back towards a zero or negative interest rate policy, and whether it will need to employ asset purchases as part of its stabilization efforts as it has during the last two recessions. If so, long-maturity bond yields are likely to fall significantly during the next recession; if not, investors may be surprised by how modestly long-maturity yields decline. In this report, we examine the historical record of short-term interest rates during recessions and discuss whether the next US recession is likely to be severe or mild. We conclude that the next US recession is more likely to be mild than severe, and that the 10-year Treasury yield is unlikely to fall below 2% during the recession (or fall below this level for very long). In the case of a more severe recession driven by unanchored inflation expectations, the implications would be clearly bearish for bonds. Within a fixed-income portfolio, one conclusion of our analysis is that investors should not overstay their welcome in a long-duration position during the next recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. The Historical Recessionary Path Of Short-Term Interest Rates When projecting how the Fed funds rate is likely to evolve during the next US recession, most investors typically look to the average decline in short-term interest rates during previous recessions as a guide. Based on that approach, Table II-1 highlights that the Fed would likely have to cut rates into negative territory if a recession occurred over the coming 12-18 months, unless it is able to hike interest rates significantly more over the coming year than the market is currently expecting and the FOMC itself is projecting. But in our view, focusing on the historical recessionary decline in interest rates from their peak is not the right approach, because it ignores the fact that recessions typically occur when monetary policy is tight. If a recession occurs within the next 18 months, it will have happened in large part because of a collapse in real wage growth, not just because of the increase in interest rates that has occurred. Chart II-1 highlights that short-term interest rates remain well below potential GDP growth, highlighting that monetary policy would still be easy today – despite the quick pace of increase in short rates – if real wages were growing rather than contracting sharply. In our view, the right approach is to examine how much short-term interest rates have typically fallen during recessions relative to potential or average historical GDP growth. This method captures the degree to which monetary policy easing has typically been required relative to neutral levels to catalyze an economic recovery. Table II-1Based Only On The Historical Decline In Short-Term Interest Rates, The Fed Would Ostensibly Have To Cut Rates Into Negative Territory During The Next Recession September 2022 September 2022 Chart II-1Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Based on this approach, Chart II-2 highlights that the Fed might have to cut the target range for the Fed funds rate to 0-0.25% during the next recession, but there are some examples (like the 1990-1991 recession) that point to a cut to just 0.25-0.5%. The goal of this exercise is not to be specific about the exact level to which the Fed will have to cut the Fed funds rate, but rather whether the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases is likely. Chart II-2The Fed May Have To Cut To Zero During The Next Recession, But Probably Not Into Negative Territory September 2022 September 2022 Structural bond bulls might note that there are five recessions in the post-war era that could potentially point to that outcome based on Chart II-2. However, these episodes involved circumstances that we doubt would be present during the next US recession, especially if one were to emerge over the coming 12-18 months. The 1950s Recessions The recessions of 1953-54 and 1957-58 were fairly sizeable based on the total rise in the unemployment rate, but the monetary policy stance at that time was wildly stimulative in a way that is very unlikely to repeat itself today. In the 1950s, the level of interest rates was still an artifact of WWII (with the Treasury-Fed accord having only been agreed upon in March 1951). Monetary policy was both overly responsive to a period of pent-up disinflation following the initial burst of government spending associated with the Korean war and insufficiently responsive to a strongly positive output gap (Chart II-3). This was meaningfully compounded by a poor understanding of the size of the output gap at that time; the deviation of the unemployment rate from its 10-year average was significantly smaller than its deviation from today’s estimate of NAIRU (Chart II-4). In sum, the economic and monetary policy conditions that existed in the 1950s and that contributed to an interest rate level that was well below the prevailing rate of economic growth do not exist today. As such, we strongly doubt that the Fed’s response to the next US recession would resemble what occurred during that decade. Chart II-3We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s Chart II-4Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates   1973-1975 The recession that began in 1973 occurred because of a huge energy shock that proved to be stagflationary in the true sense of the word. Excluding the 2020 recession, this was the third largest rise in the unemployment rate of any recession since WWII, following 2008/2009 and the 1981/1982 recessions. There are some parallels between this recession and the current economic environment, but the stability of inflation expectations so far does not point to a truly stagflationary outcome. As such, we do not see the 1973-74 recession as a reasonable parallel to today’s environment. In addition, manufacturing employment – which was heavily impacted by the permanent rise in oil prices due to the sector’s energy intensity – stood at 24% of total nonfarm employment in 1973, compared with 8% today. Finally, the weight of food and energy as a share of total consumer spending today is roughly half of what it was during the 1970s (Chart II-5). 2001 Of the five recessions potentially implying that the Fed may have to cut interest rates into negative territory during the next US recession, the 2001 recession is the most relevant parallel to today. It was a modern recession in which the Fed maintained very easy monetary policy for a significant amount of time, in response to concerns about a significant tightening in financial conditions and the impact of prior corporate sector excesses on aggregate demand. The total rise in the unemployment rate during this recession was not very large, but it took some time for the unemployment rate to return to NAIRU. Still, even though this justified a later liftoff, a Taylor rule approach makes it clear that the Fed overstimulated the economy in response to the recession – a view that is reinforced by the enormous rise in household debt that fueled the housing market bubble during that period (Chart II-6). The Fed was very concerned about the negative wealth effects of the bursting of the equity market bubble, which had been caused by a massive decline in the equity risk premium in the second half of the 1990s. These conditions are simply not present today. Chart II-5Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Chart II-6The Fed Clearly Overstimulated In Response To The 2001 Recession The Fed Clearly Overstimulated In Response To The 2001 Recession The Fed Clearly Overstimulated In Response To The 2001 Recession 2008/2009 Chart II-7A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario Chart II-2 highlighted that the Fed would have to cut interest rates to -1% were the 2008/2009 recession to repeat itself, but we judge that to be a totally implausible scenario given the improvement in US household sector balance sheets and financial sector health since the global financial crisis (Chart II-7). As we discuss below, the next US recession is likely to be meaningfully less severe than the 2008/2009 and 2020 recessions, which we believe carries important significance for the path of interest rates and the response of long-maturity bond yields. The bottom line for investors is that, based on the historical experience of rate cuts during recessions, the Fed may end up cutting interest rates back to or close to the zero lower bound in response to the next recession. But the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seems quite unlikely unless the recession is severe, which we do not expect. Will The Next US Recession Be Severe Or Mild? Chart II-8The Most Severe US Recessions Have Had Aggravating Factors That Do Not Appear To Be Present Today September 2022 September 2022 How drastically the Fed will be forced to cut interest rates during the next recession will be driven by its severity. Chart II-8 presents the total rise in the unemployment rate during post-WWII recessions (excluding 2020), in order to gauge whether the factors that have led to severe recessions in the past are likely to be present during the next contraction in output. From our perspective, the most severe US recessions in the post-WWII era have been driven by factors that are very unlikely to repeat themselves in the current environment. We noted above that a repeat of the 2008/2009 recession is a totally implausible scenario, leaving the 1981-1982, 1973-1975, and 1950s recessions as potential severe recession analogues. In three of these four cases we see clear signs of an aggravating factor that we do not (yet) believe will be present during the next US recession. Chart II-9Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s In the 1981-1982 recession, the unemployment rate rose significantly as the Federal Reserve confronted the fact that inflation expectations had become severely unanchored to the upside, causing a persistent wage/price spiral. While unanchored inflation expectations is a risk today, so far the evidence suggests that both households and market participants expect that currently elevated inflation will not persist over the long run (Chart II-9). If inflation expectations do become unanchored to the upside at some point over the coming 12-18 months (or beyond), we are very likely to change our view about the severity of the next recession. However, this would be a bond bearish outcome (at least initially), as it would imply sharply higher yields at both the short and long end of the yield curve in order to tame inflation and re-anchor inflation expectations. As noted above, in the 1973-74 recession, the unexpected and permanent rise in oil prices and outright energy shortages rendered a significant amount of capital and labor uneconomic, which is different than what has been occurring during the pandemic. Were the recent rise in natural gas prices to be permanent and no alternatives available, Europe’s current energy situation would be more reminiscent of the 1973-1974 recession than the pandemic-driven price pressures and supply shortages affecting the US and other developed economies. Chart II-10The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year Finally, while the 1957-58 recession appears to be somewhat of an anomaly driven by a mix of factors, the 1953-54 recession was clearly exacerbated by a sharp slowdown in government spending following the end of the Korean war. It is true that the US is currently experiencing fiscal drag (Chart II-10), but this has occurred against the backdrop of a strong labor market, and IMF forecasts imply that the drag will be significantly smaller over the coming year than what the US is currently experiencing. There are several additional points suggesting that the next US recession will be comparatively mild: Chart II-11The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) Chart II-11 highlights that the milder recessions, those which have seen the unemployment rate rise by less than 3% from their previous low, have generally been the recessions that appear to have simply been triggered by monetary policy becoming tight or nearly tight. This would likely be the case during the next US recession. In the lead up to the 1970, 1990-91, and 2001 recessions, short-term interest rates approached or exceeded either potential growth or the rolling 10-year average growth rate of nominal GDP. The 1960-61 recession stands out slightly as an exception to this rule, in that interest rates were still moderately easy, which is based on our definition of the equilibrium short-term interest rate. But interest rates had risen close to 400 basis points from 1958 to 1960 (suggesting a change in addition to a level effect of interest rates on aggregate demand), and it is notable that the 60-61 recession was the mildest in post-war history, based on the total rise in the unemployment rate. Chart II-12Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession We argued in Section 1 of our report that monetary policy is not currently restrictive on its own, and that the recessionary risk currently facing the US is the result of a combination of the speed of adjustment in interest rates, the fact that real wages have fallen sharply, and the fact that the Fed is determined to see inflation quickly return to target levels. However, what this also highlights is that a recession would likely cause a rise in real wages via a significant slowdown in inflation (at least for a time); this would likely help stabilize aggregate demand and cause a comparatively mild rise in the unemployment rate. While the odds and magnitude of this effect are difficult to quantify, the fact that the labor market has been so tight over the past year and that the participation rate has yet to recover to its pre-pandemic levels suggests that some firms may be reluctant to shed labor during a recession (Chart II-12), suggesting that the total rise in unemployment in the next recession could be relatively small. Finally, Chart II-13 shows that the excess savings that have accumulated over the course of the pandemic, now primarily the result of reduced spending on services, dwarf the magnitude of precautionary savings that were generated in the prior three recessions as a % of GDP. We agree that the savings rate would likely still rise during the next recession, but the existence of excess savings implies that the rise in the savings rate may be surprisingly small – which would, in turn, imply a comparatively mild rise in the unemployment rate. We noted above that the household sector has deleveraged significantly, which is strong evidence against an outsized or long-lasting decline in consumer spending as a possible driver of an above-average rise in the unemployment rate during the next recession. One question that we often receive from clients is whether excessive corporate sector leverage could cause a more severe decline in economic activity once a recession emerges. Chart II-14 illustrates that the answer is “probably not.” The chart presents one estimate of the US nonfinancial corporate sector debt service ratio, based on national accounts data. The chart highlights that the current debt burden for the nonfinancial corporate sector is very low, underscoring that elevated corporate sector debt would not likely act as an aggravating factor driving an outsized rise in the unemployment rate were a recession to occur today. The chart also shows that even if the 10-year Treasury yield were to rise to 4% and corporate bond spreads were to widen in the lead up to a recession, the nonfinancial corporate sector debt service burden would rise to a lower peak than seen in the last three recessions. One key risk to a mild recession view is a scenario in which inflation does not return to or below the Fed’s target during the recession. In that kind of environment, the Fed would not likely cut interest rates to as low a level as they have in the past relative to potential growth. But the historical record is clear that recessions cause a deceleration in inflation, and if a recession emerges over the coming 12-18 months it will likely happen after supply-side and pandemic-related disinflation has already occurred. That means that inflation is likely to move back to or below the Fed’s target in a recessionary environment. We should note that this assessment differs somewhat from the scenario described by my former colleague Martin Barnes, who wrote a guest report on inflation published in our July Bank Credit Analyst.1 Chart II-13Today’s Pandemic-Related Excess Savings Dwarf Precautionary Savings During The Prior Three Recessions September 2022 September 2022 Chart II-14US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment   Long-Maturity Bond Yields And The Next US Recession What does our analysis imply for long-maturity bond yields and the duration call over the coming few years? In order to judge what is likely to happen to long-maturity bond yields in a recession scenario over the coming 12-18 months, we first project the fair value of the 5-year Treasury yield based on the following hypothetical circumstances: The onset of recession in March 2023 and a peak in the Fed funds rate at a target range of 3.75-4%. A recession duration of eight months, over which time the Fed steadily cuts the policy rate to 0-0.25%. An initial Fed rate hike in September 2024, nine months following the end of the recession, consistent with a relatively short return of the unemployment rate to NAIRU as an expansion takes hold. A rate hike pace of eight quarter-point hikes per year, with the Fed again raising rates to a peak of 4% A longer-term average Fed funds rate of 3%, which we regard as a low estimate. Chart II-15The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario Chart II-15 highlights the fair value path for the 5-year Treasury yield in this scenario. Not surprisingly, the fair value today is lower than the current level of the 5-year yield, highlighting that a shift to a long duration stance will be warranted at some point over the coming year if the US economy enters a non-technical, typical income-statement recession. However, the chart also highlights that a long duration position is not likely to be warranted for very long, given that the lowest level of the 5-year fair value path is substantially higher than it was in 2020 and 2021 and is also higher than its 10-year average. Chart II-16 reveals the importance of forecasting the near-term path of interest rates when predicting the likely behavior of long-maturity bond yields. Even though near- and long-term interest rate expectations should be at least somewhat differentiated, the chart highlights that the real 5-year/5-year forward Treasury yield is very closely explained by the real 5-year Treasury yield and a 3-year lag of our adaptive inflation expectations model (which is highly consistent with BCA’s Golden Rule of bond investing framework). Chart II-16 shows that long-maturity bond yields should be higher than they are based on the current level of real 5-year yields and lagged inflation expectations, underscoring the point that we made in Section 1 of our report that significant upside risk exists for long-maturity bond yields in a non-recessionary outcome over the coming year. In a recessionary outcome, it is clear that bond yields will fall as the Fed cuts interest rates, as Chart II-15 demonstrated. But, Chart II-17 highlights that during recessions, there is little precedent for a negative 5-10 yield curve slope outside of the context of the persistently high inflation environment of the late 1960s and 1970s. Applying that template to the fair value path that we showed in Chart II-15 suggests that the 10-year Treasury yield will not fall below 2% during the next recession. As we noted in our August report,2 a 10-year Treasury yield decline to 2% would result in significant performance for long-maturity bonds, but it would not end the structural bear market in bonds that began two years ago – a fact that we suspect would be very surprising to bond-bullish investors. Chart II-165-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward 5-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward 5-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward Chart II-17There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession It is true that bond yields may deviate from the fair value levels shown in Chart II-15 if investors expect a different outcome for the path of the Fed funds rate than we described. However, it is worth noting that changes in our assumed post-recession peak Fed funds rate and the long-term average do not substantially change the outcome shown in Chart II-15. If investors instead assume that the Fed funds rate will peak at 3% during the next expansion, that lowers the fair value path for the 5-year yield by approximately 5 basis points. Changing the long-term average Fed funds rate to 2.4%, the Fed’s current neutral rate expectation, would reduce it by about 25 basis points. These levels would still be significantly above the lows reached in 2011-2013 and in 2020, underscoring that the length of the recession and the speed at which the Fed begins to raise interest rates will be far more important determinants of the path of US Treasury yields. We strongly suspect that investors will recognize that a comparatively mild recession will not result in the same hyper-accomodative monetary policy stance that occurred during the past two recessions, implying that long-maturity bond yields will have less downside during the next recession than may be currently recognized. Investment Conclusions As we have presented, the historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition to this, there are several arguments pointing to the next US recession being a mild one. In a mild recession scenario, we doubt that the 10-year Treasury yield would fall below 2%, or fall below this level for very long. For fixed-income investors, while bond yields will fall for a time if a recession emerges, the implication is that investors should not overstay their welcome in a long-duration position during the recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. We noted in our July report that if a recession occurred within the coming 6-12 months, that the S&P 500 would likely fall to 3100, even if the recession were average. A mild recession may see the S&P 500 decline less severely than this, but stocks are still likely to incur significant losses during the next recession unless investors price in a much shallower path for short-term interest rates than we believe will be warranted. As noted in Section 1 of our report, we have not yet concluded that a US recession is inevitable over the coming 6-12 months. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Additional changes to our recommended cyclical allocation may thus occur over the coming few months, in response to incoming data, our assessment of the likely implications for monetary policy, and the response of long-maturity government bond yields. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1  Please see The Bank Credit Analyst "Inflation Whipsaw Ahead," dated June 30, 2022, available at bca.bcaresearch.com 2  Please see The Bank Credit Analyst "August 2022," dated July 28, 2022, available at bca.bcaresearch.com

Highlights The odds of a Goldilocks outcome for the US economy increased somewhat in August, but the risks of a US recession over the coming year remain quite elevated. We continue to recommend that investors stay neutrally positioned towards equities within a global multi-asset portfolio. The disinflationary impulse from the July US CPI report is less compelling than it seems, in that it appears to have been mostly driven by declining energy prices. It is far from clear that energy prices will continue to decline over the coming months and are, in fact, likely to rise even if an Iranian deal takes place. This implies that investors may have jumped the gun in pricing in substantial disinflation and sharply higher odds of a Goldilocks economic outcome. The OIS curve is implying a reasonable path for the Fed funds rate for the remainder of this year, but it is too low 12 months from now based on the Fed’s median rate expectation for year-end 2023. This suggests that a further upward adjustment in the OIS curve is likely warranted, and that a modestly short duration stance is appropriate. Investors believe that the rate hike path priced into the OIS curve would not be recessionary, because short-term inflation expectations are pricing in a very substantial slowdown in headline inflation. From the perspective of market participants, this would both raise the recessionary threshold for interest rates (via stronger real wages) and could potentially allow the Fed to reduce interest rates closer to its (very likely wrong) estimate of neutral. We agree that the odds of a recession will decline if headline inflation does fall below 4% over the coming year, but it is not yet clear that this will occur. And if it does, the resulting improvement in real wages would ultimately allow the Fed to raise interest rates to a higher level before short-circuiting the economic expansion. As such, we expect real long-maturity government bond yields to rise meaningfully in a scenario where real wages recover significantly and a recession is avoided, which will put heavy pressure on equity multiples. This underscores that stock prices face risks in both a recessionary and non-recessionary environment. There are arguments pointing to a decline in the dollar beyond the near term, even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. Stay neutral for now, but look for opportunities to short the dollar beyond the coming few months. Jumping The Gun On Goldilocks The odds of a Goldilocks outcome for the US economy over the coming six to nine months increased somewhat in August. The July CPI report presented some evidence of supply-side and pandemic-related disinflation (Chart I-1), and we saw more resilient manufacturing production in the US – even after excluding the automotive sector – than many manufacturing indicators have been indicating (Chart I-2). In addition, the regional Fed manufacturing index in the especially manufacturing-sensitive state of Pennsylvania surprised significantly to the upside in July, although this was at least somewhat offset by a collapse in the New York and Dallas Fed’s general business conditions indexes (Chart I-3). Chart I-1There Is Now Some Evidence Of Supply-Side & Pandemic-Related Disinflation In The US There Is Now Some Evidence Of Supply-Side & Pandemic-Related Disinflation In The US There Is Now Some Evidence Of Supply-Side & Pandemic-Related Disinflation In The US Chart I-2US Manufacturing Production Has Been More Resilient Than Surveys Would Have Suggested US Manufacturing Production Has Been More Resilient Than Surveys Would Have Suggested US Manufacturing Production Has Been More Resilient Than Surveys Would Have Suggested Against the backdrop of significant recessionary risks, and a debate about whether negative growth in the first half of the year already constitutes a recession in the US, these developments have been positive. The Atlanta Fed’s GDPNow model is pointing to positive (albeit below-trend) growth of 1.4% in Q3, which is consistent with consensus forecasts. The Atlanta Fed’s model is also forecasting the strongest real consumption growth since Q4 2021 (Chart I-4). Equity investors responded to incrementally lower recession odds and a slower pace of inflation by bidding up the S&P 500 from roughly 3800 at the beginning of July to over 4200 in August. Chart I-3Mixed Messages From The Regional Fed Indicators Mixed Messages From The Regional Fed Indicators Mixed Messages From The Regional Fed Indicators Chart I-4The Atlanta Fed GDPNow Model Is Pointing To Positive Growth And Resilient Consumption In Q3 September 2022 September 2022   However, several other developments over the past month continue to highlight that the risks of a US recession over the coming year are quite elevated, which supports our recommendation that investors stay neutrally positioned towards equities within a global multi-asset portfolio: The August flash PMIs were fairly negative, especially for the services sector. The August flash S&P Global manufacturing PMI rose in Germany, but it fell in the US, France, and the UK. Services PMIs declined significantly in all four countries, especially in the US where survey participants noted that “hikes in interest rates and inflation dampened customer spending as disposable incomes were squeezed.” Survey respondents also noted that “new orders contracted at the steepest pace for over two years, as companies highlighted greater client hesitancy in placing new work.” Chart I-5The Conference Board's LEI Is Very Weak The Conference Board's LEI Is Very Weak The Conference Board's LEI Is Very Weak The Conference Board’s leading economic indicator dropped for a fifth month in a row in July, which has always been associated with a US recession (based on the indicator’s current construction). Chart I-5 highlights that the indicator’s market-based and real economy components are both very weak, and that the Conference Board’s coincident indicator has now fallen below its 12-month moving average. While the Philly Fed manufacturing index picked up in July, the new orders component of the regional Fed manufacturing PMIs broadly sank further into contractionary territory (Chart I-6). Chart I-6The Regional Fed New Orders Components Are Very Weak The Regional Fed New Orders Components Are Very Weak The Regional Fed New Orders Components Are Very Weak The Atlanta Fed model shown in Chart I-4 is pointing to a second quarter of negative growth from real residential investment, a component of GDP that reliably peaks in advance of economic contractions.1 Job openings are now pointing to a potential rise in unemployment. The relationship between job openings and unemployment is currently subject to heavy debate, as discussed in a recent report by my colleague Ryan Swift.2 However, abstracting from a theoretical discussion about movements along or shifts in the Beveridge curve, investors should note that the empirical record is fairly clear – Chart I-7 highlights that falling job vacancies occurred alongside a significant rise in the level of unemployment during the last two recessions. We acknowledge that the relationship has seen some deviations since 2018/2019, so this may highlight that a larger decline in job openings will be required for unemployment to trend higher. A 10% rise in the level of unemployment relative to its 12-month moving average has always been associated with a recession, implying that a sustained decline in job openings to 10M or lower would represent a likely recessionary signal – even if that recession proves to be a mild one (see Section 2 of this month’s report). Chart I-7Declining Job Openings Are Pointing To Potentially Higher Unemployment Declining Job Openings Are Pointing To Potentially Higher Unemployment Declining Job Openings Are Pointing To Potentially Higher Unemployment Table I-1 highlights that the disinflationary impulse from the July CPI report is less compelling than it seems, in that it appears to have been mostly driven by declining energy prices (particularly gasoline and fuel oil). Outside of the clear impact that falling fuel prices had on airline fares, there is not yet compelling evidence that core inflation is decelerating due to easing supply-side and pandemic-related effects, or due to slowing demand. As we will discuss below, it is far from clear that energy prices will continue to decline over the coming months and are, in fact, likely to rise even if an Iranian deal takes place. This implies that investors may have jumped the gun in pricing in substantial disinflation and sharply higher odds of a Goldilocks economic outcome. Table I-1The Disinflationary Impulse From The July CPI Report Is Less Compelling Than It Seems September 2022 September 2022 Inflation And The Fed As we discuss in Section 2 of our report, recessions occur because monetary policy becomes tight, a significant non-policy shock to aggregate demand or supply occurs, or some combination of both develops. We do not believe that monetary policy is currently restrictive on its own (Chart I-8), and we have not yet concluded that a US recession is inevitable. But when combined with the speed of adjustment in interest rates, the fact that real wages have fallen sharply (Chart I-9), and the fact that the Fed is determined to see inflation quickly return to target levels, it is clear that the odds of a recession over the coming 12-18 months remain elevated. Chart I-8Absent Declining Real Wages, The Current Level Of Interest Rates Would Not Be Restrictive Absent Declining Real Wages, The Current Level Of Interest Rates Would Not Be Restrictive Absent Declining Real Wages, The Current Level Of Interest Rates Would Not Be Restrictive Chart I-9But Real Wages Are Declining, And The Pace Of Tightening Has Been Extraordinarily Rapid But Real Wages Are Declining, And The Pace Of Tightening Has Been Extraordinarily Rapid But Real Wages Are Declining, And The Pace Of Tightening Has Been Extraordinarily Rapid Many investors do not appear to fully appreciate the fact that the Fed will continue to tighten policy until it sees clear and unequivocal signs that inflation is easing. Importantly, the minutes of the July FOMC meeting highlighted that this is likely to be true even if unambiguous signs of easing supply-side and pandemic-related inflation present themselves. During the July meeting, FOMC participants noted that “though some inflation reduction might come through improving global supply chains or drops in the prices of fuel and other commodities, some of the heavy lifting would also have to come by imposing higher borrowing costs on households and businesses”. They also emphasized that “a slowing in aggregate demand would play an important role in reducing inflation pressures”. The upshot is that the Fed was aware before the July CPI report that energy-related inflation might fall, but also understood that they would still have to tighten enough to slow aggregate demand to reduce underlying inflationary pressures. It is true that investors are pricing in additional rate hikes from the Fed, but there are two caveats for investors to consider. The first is that while the OIS curve is implying a reasonable path for the Fed funds rate for the remainder of this year, it is too low 12 months from now based on the Fed’s median rate expectation for year-end 2023 (Chart I-10). This suggests that a further upward adjustment in the OIS curve is likely warranted. Second, and more importantly, investors appear to be making the assumption that the rate hikes already built into the OIS curve will not be recessionary. Investors are making this assumption because short-term inflation expectations are pricing in a very substantial slowdown in headline inflation (Chart I-11), which would both raise the recessionary threshold for interest rates (via stronger real wages) and could potentially allow the Fed to reduce interest rates closer to its (very likely wrong) estimate of neutral. Chart I-10A Further Upward Adjustment In The OIS Curve Is Likely Warranted A Further Upward Adjustment In The OIS Curve Is Likely Warranted A Further Upward Adjustment In The OIS Curve Is Likely Warranted Chart I-11Short-Term Inflation Expectations Are Pricing In A Massive Deceleration In Headline Inflation Short-Term Inflation Expectations Are Pricing In A Massive Deceleration In Headline Inflation Short-Term Inflation Expectations Are Pricing In A Massive Deceleration In Headline Inflation We agree with investors that the odds of a recession will decline significantly, ceteris paribus, if headline inflation does drop below 4% over the coming year. But we noted above that it is not yet clear that this will occur. In addition, we disagree with investors that this would result in a reduction in short-term interest rates, because this belief is based on the view that monetary policy is currently in restrictive territory even without the negative impact of sharply lower real wages. Absent the negative real wage effect, our view is that monetary policy would still be stimulative at current interest rates, which is why we believe that the 2023 portion of the OIS curve is too dovish in a non-recessionary scenario. The Outlook for Stocks The equity market rally that began in early July has been based on the assumption that significant supply-side and pandemic-related disinflation is now a fait accompli. If it is, then the odds of a recession over the coming year are indeed meaningfully lower, and the risk to corporate profits is less than feared. We noted above that investors may have jumped the gun in pricing in substantial disinflation and sharply lower odds of a US recession. But even in a scenario in which the odds of recession do come in significantly, stocks still face risks from a significant rise in real bond yields. Chart I-12Long-Maturity TIPS Yields Would Likely Rise In A Non-Recessionary Scenario, Compressing Equity Multiples Long-Maturity TIPS Yields Would Likely Rise In A Non-Recessionary Scenario, Compressing Equity Multiples Long-Maturity TIPS Yields Would Likely Rise In A Non-Recessionary Scenario, Compressing Equity Multiples Investors have been focused on very elevated inflation as the driver of both rising inflation expectations and rising real bond yields, and have assumed that a meaningful slowdown in inflation (as forecast by short-term measures of inflation expectations) implies that the Fed funds rate will return to the Fed’s estimate of neutral. This belief, along with a lower projected Fed funds rate in 2024 than 2023 in the FOMC’s participant forecasts, is the basis for the 2023 “pivot” currently priced into the OIS curve. Given that the Fed funds rate has already reached the Fed’s neutral rate estimate, there is a meaningful chance that this estimate will be revised upwards by the Fed or challenged by investors if economic activity improves in response to a decline in inflation and a corresponding rise in real wages. Such a scenario would highlight to investors that the Fed’s estimate of neutral is likely too low, which would imply a significant increase in real 10-year TIPS yields (which are currently 160 basis points below their pre-2008 average). Chart I-12 highlights the impact that a rise in real long-maturity bond yields could have on equities, even in a non-recessionary scenario where 12-month forward earnings per share grows 8% over the coming year. A rise in 10-year TIPS yields to 1.5% by the middle of 2023 would cause a 16% contraction in the 12-month forward P/E ratio and a 10% decline in stock prices, assuming an unchanged 12-month forward equity risk premium (ERP). It is possible that the ERP could decline in a rising bond yield scenario. Chart I-13 highlights that the ERP is indeed negatively correlated with real bond yields (in part due to the methods that we use to calculate it). The counterpoint is that there are a number of risks that equity investors should be compensated for today that did not exist in the late 1990s or early 2000s, especially the risks of populist policies in many advanced economies and major geopolitical events (as Russia’s invasion of Ukraine recently highlighted). Chart I-14 illustrates that, since 1960, a long-term version of the equity risk premium, calculated using trailing earnings and our adaptive expectations proxy to deflate long-maturity bond yields, has been fairly well explained by the Misery Index (the sum of the unemployment and headline inflation rates). However, the chart also shows that the ERP has been structurally higher over the past decade than the Misery Index would have predicted. It is unclear if this is due to a riskier environment or the negative ERP/real yield correlation that we noted. Chart I-13The Equity Risk Premium Could Come Down As Bond Yields Rise, But That Is Not Guaranteed The Equity Risk Premium Could Come Down As Bond Yields Rise, But That Is Not Guaranteed The Equity Risk Premium Could Come Down As Bond Yields Rise, But That Is Not Guaranteed Chart I-14A Structurally Higher ERP Over The Past Decade Could Represent Needed Compensation For Structural Risks A Structurally Higher ERP Over The Past Decade Could Represent Needed Compensation For Structural Risks A Structurally Higher ERP Over The Past Decade Could Represent Needed Compensation For Structural Risks The conclusion is that investors do not yet appear to have a basis to bet on a declining ERP in a rising bond yield environment, underscoring that even a non-recessionary scenario poses a risk to stock prices. It is worth noting that this second risk facing stocks has essentially been caused by the Fed because of its maintenance of a very low neutral rate estimate that we feel is no longer economically justified. Bond Market Prospects Chart I-15Investors Should Stay Modestly Short Duration, For Now Investors Should Stay Modestly Short Duration, For Now Investors Should Stay Modestly Short Duration, For Now Over the past few months, the Bank Credit Analyst service has continued to recommend that investors maintain a modestly short duration stance even as we recommended reducing equity exposure. The recent rise in the 10-year Treasury yield back to 3% has validated that view (Chart I-15), and reinforces our view that there is significant upside risk to long-maturity bond yields in a non-recessionary scenario. Our expectation that the Fed will raise interest rates to a higher level over the next year than the OIS curve is currently discounting also argues for a modestly short stance, based on BCA’s “Golden Rule” framework. The “Golden Rule” states that investors should set their overall bond portfolio duration based on how their own 12-month fed funds rate expectations differ from the expectations that are priced into the market. As we detail in Section 2 of our report, the Fed has always cut interest rates in response to a recession in the post-WWII environment, so we would certainly recommend a long duration stance if a recession emerges. But given our view that a recession is still a risk rather than a likely event, we feel that a modestly short duration stance is currently appropriate. Chart I-16US Corporate Bond Value Has Improved, But Not Enough To Trump The Cycle US Corporate Bond Value Has Improved, But Not Enough To Trump The Cycle US Corporate Bond Value Has Improved, But Not Enough To Trump The Cycle As noted above in our discussion of the risks facing stock prices in a non-recessionary scenario, falling inflation that is not associated with a recession will ironically be a bearish signal for long-maturity bonds, because it means that the Fed will have greater capacity to raise interest rates without ending the recovery. The short end of the yield curve could be flat or move modestly lower in response to a significant easing in inflation, but the long end of the curve would be at serious risk of moving higher. We are thus very likely to recommend a short duration stance in response to solid evidence of true supply-side and pandemic-related disinflation, assuming it emerges outside of the context of a recession. Within the credit space, the rise in US corporate bond spreads since the start of the year has meaningfully improved the value of investment- and speculative-grade corporate bonds (Chart I-16), but not so much that it justifies a positive stance towards these assets relative to government bonds given the risks facing the US economy. We continue to recommend an underweight stance towards investment-grade and a neutral stance towards speculative-grade within a fixed-income portfolio. The Outlook For Energy Prices Chart I-17The EU's Oil Embargo Will Cause Russian Oil Production To Tank The EU's Oil Embargo Will Cause Russian Oil Production To Tank The EU's Oil Embargo Will Cause Russian Oil Production To Tank The likely path of commodity prices, particularly that of oil, is an extremely important determinant of whether the US is likely to experience a recession over the coming year. We are among those who have downplayed the significance of oil price shocks in driving contractions in economic output over the past two decades,3 but the current situation is unique given the role that very elevated inflation has played in driving real wages lower. In a recent Strategy Report from our Commodity & Energy Strategy service, my colleague Robert P. Ryan underscored the impact that the European Union’s embargo of Russian oil will likely have on the energy market. If fully implemented, ~ 2.3mm barrels/day of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. EU, UK and US shipping insurance and reinsurance sanctions are also scheduled to be implemented in December, which means that “surplus” Russian oil production cannot be fully reoriented to other countries. Chart I-17 presents the likely impact on Russia’s crude oil output, namely a ~ 2mm barrels/day decline in oil output by the end of next year – nearly equal to the amount of oil set to be embargoed. Our base case view remains that supply and demand in the oil market will remain relatively balanced going into the winter, but the removal from the market of Russian oil production because of the various EU embargoes – even if it is offset by the return of 1mm b/d of Iranian exports on the back of a deal with the US – will ultimately push crude oil prices higher and inventories lower (Chart I-18). The price impact of this event could happen earlier than the immediate supply/demand balance would suggest, if investors have not fully priced in the extent of the decline in Russian oil production that our commodity team is forecasting. Our commodity team’s forecast serves as an important reminder that the economic consequences of Russia’s invasion of Ukraine may not be fully behind us. It also highlights that the recent disinflation observed in the US, which was mostly driven by lower energy prices in July, may not be sustained. Chart I-19 highlights what could happen to US gasoline prices based on the path for oil shown in Chart I-18, and how that forecast is sharply at odds with the current gasoline futures curve. Chart I-20 highlights that US gasoline stocks are currently below their 5-year average; the last time this occurred was in Q1 2021, which was an environment of rising gasoline prices to levels that were higher than what would usually be implied by crude oil prices. Chart I-18Oil Prices Are More Likely To Rise Than Fall Oil Prices Are More Likely To Rise Than Fall Oil Prices Are More Likely To Rise Than Fall Chart I-19Higher Oil Prices Would Cause Gasoline Prices To Deviate Significantly From Market Expectations Higher Oil Prices Would Cause Gasoline Prices To Deviate Significantly From Market Expectations Higher Oil Prices Would Cause Gasoline Prices To Deviate Significantly From Market Expectations Chart I-20Gasoline Stocks Are Low In The US, Underscoring The Upside Risk To Prices Gasoline Stocks Are Low In The US, Underscoring The Upside Risk To Prices Gasoline Stocks Are Low In The US, Underscoring The Upside Risk To Prices The upshot is that our commodity team expects oil prices to move higher over the coming 6-12 months, under the assumption that the EU’s embargo against Russian oil moves forward as announced. This poses a clear threat to imminent supply-side and pandemic-related disinflation, and underscores the risks to a Goldilocks economic outcome over the coming few months. The Dollar: Value, Technical Conditions, And The Cycle Chart I-21The Dollar Is Reliably Countercyclical, But It Has Registered Outsized Gains Over The Past Year The Dollar Is Reliably Countercyclical, But It Has Registered Outsized Gains Over The Past Year The Dollar Is Reliably Countercyclical, But It Has Registered Outsized Gains Over The Past Year The US dollar moved higher over the past month, after first retreating from its mid-July high for the year. We tempered our view about the likelihood of a falling dollar over the near term in last month’s report, but from a bigger picture perspective we have been surprised by the degree of dollar strength this year. The US dollar is a reliably countercyclical currency, so clearly some of the dollar’s strength has been the result of weakness in risky asset prices (Chart I-21). But the bottom panel of Chart I-21 highlights that the broad trade-weighted dollar has performed even better over the past year than returns to the S&P 500 would have implied, underscoring that the magnitude of the dollar’s strength has been atypical. The last two times that the US dollar performed substantially better than the trend in risky assets would have implied were in 2012 and 2015, years in which euro area breakup risk was a driving force in markets. Alongside the fact that EURUSD has fallen below parity and USDEUR has outperformed even more than the broad trade-weighted dollar has, “excess” dollar returns point strongly to Europe’s energy woes in the aftermath of Russia’s invasion of Ukraine as the key driver of outsized broad dollar strength. Chart I-22 highlights that European natural gas prices have exceeded the level that we had forecasted would occur in a complete cutoff scenario, meaning that Europe’s energy crunch is likely happening now, rather than in the winter. However, even considering the negative economic outlook facing the euro area, there are arguments pointing to a decline in the dollar beyond the near term – even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. First, Chart I-23 highlights that EURUSD has undershot what the trend in relative real interest rates would suggest, which has historically led changes in the euro. This implies that the euro has declined partly because of the introduction of a sizeable risk premium, which may dissipate after the winter. Chart I-22The Euro Has Been Heavily Impacted By Europe's Energy Crunch The Euro Has Been Heavily Impacted By Europe's Energy Crunch The Euro Has Been Heavily Impacted By Europe's Energy Crunch Chart I-23EURUSD Has Undershot What The Trend In Relative Real Interest Rates Would Suggest EURUSD Has Undershot What The Trend In Relative Real Interest Rates Would Suggest EURUSD Has Undershot What The Trend In Relative Real Interest Rates Would Suggest Second, Chart I-24 highlights that the US dollar is extremely overbought and is technically extended to a point that has historically been associated with reversals in the broad dollar trend. Finally, Chart I-25 highlights that the US dollar is extraordinarily expensive based on our valuation models, underscoring that an eventual decline in the dollar may be quite severe. We agree that valuation is not usually an effective market timing tool, but investors should place a greater weight on valuation measures as they are stretched further. Based either on our models or a more traditional PPP approach, the degree of US dollar overvaluation is extreme – arguing for a bearish bias on a 6-12 month timeline barring an unambiguous move towards recession in the US. Chart I-24US Dollar And Indicator The US Dollar Is Heavily Overbought US Dollar And Indicator The US Dollar Is Heavily Overbought US Dollar And Indicator The US Dollar Is Heavily Overbought Chart I-25The US Dollar Is Extremely Expensive The US Dollar Is Extremely Expensive The US Dollar Is Extremely Expensive         Investment Conclusions Considering the economic developments over the past month and the reaction of financial markets, the takeaway for investors seems clear. Market participants have eagerly shifted towards the Goldilocks economic and financial market outcome, based on (so far) incomplete evidence of supply-side and pandemic-related disinflation that has predominantly been driven by declining energy prices. Given significant potential upside risks to oil and US gasoline prices over the coming few months, investors should wait for more durable signs of significant disinflation before downgrading the odds of a US recession over the coming year. We would certainly recommend cutting global equity exposure to underweight were we to determine that the US is likely to experience an imminent recession, but the avoidance of a recession does not necessarily suggest that an overweight stance is warranted. Sharply lower inflation would reduce the odds of a recession, but it would also raise real wages and would ultimately allow the Fed to raise interest rates to a higher level before short-circuiting the economic expansion. As such, we expect real long-maturity government bond yields to rise meaningfully in a scenario where real wages recover significantly and a recession is avoided, which will put meaningful pressure on equity multiples. Barring a decline in the equity risk premium, US stocks could face a loss on the order of 10% over the coming year in such a scenario (even under the assumption of positive earnings growth), reinforcing our view that a neutral stance towards global equities is currently appropriate. In addition to a neutral global asset allocation stance, we recommend that investors maintain a neutral regional equity position and a neutral stance towards cyclicals versus defensives, although we do recommend a modest overweight towards value stocks given our view that a modestly short duration stance is appropriate. Although we recommend a neutral stance towards USD over the next few months, we also see ample scope for a decline in the dollar beyond the near term – even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. We believe that there are upside risks to energy prices, which our Commodity & Energy Strategy service recommends playing via the iShares GSCI Commodity Dynamic Roll Strategy (COMT) ETF. As a final point, we remain cognizant of the fact that financial markets rarely trend sideways over 6-to-12 month periods. We continue to regard a neutral global asset allocation stance as a temporary stepping stone either to a further downgrade of risky assets to underweight, or to an increase in risky asset exposure back to a high-conviction overweight. The latter is still possible, especially if we see unequivocal signs of a substantial and broad-based slowdown in the US headline inflation rate, and if long-maturity real bond yields are well-behaved in response or if we see clear signs of a declining equity risk premium. Thus, investors should note that additional changes to our recommended cyclical allocation may occur over the coming few months, in response to incoming data, our assessment of the likely implications for monetary policy, and the response of long-maturity government bond yields.   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst August 25, 2022 Next Report: September 29, 2022 II. The Fed Funds Rate, Bond Yields, And The Next US Recession The risk of a US recession has increased sharply over the past several months. We have not yet concluded that a recession over the coming year is inevitable, but substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. The increased risk of a contraction has caused investors to ponder what the next recession might look like. One very important question concerns the likely behavior of short-term interest rates during the next recession, especially if it occurs sooner rather than later. The historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition, there are several arguments pointing to the next US recession being a mild one. For fixed-income investors, the implication is that investors should not overstay their welcome in a long-duration position during the next US recession, and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. Over the past several months, investors have been faced with a sharp increase in the odds of a US recession. Gauging the risk of a recession has featured prominently in our recent reports, and we have concluded, for now, that a US recession over the coming year is not yet inevitable. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Economic expansions do not last forever. This means that the US economy will eventually succumb to a recession at some point over the coming few years. One very important question for investors concerns the likely behavior of short-term interest rates during the next recession, especially if a contraction occurs sooner rather than later. A key aspect of this question is whether the Fed is likely to be forced back towards a zero or negative interest rate policy, and whether it will need to employ asset purchases as part of its stabilization efforts as it has during the last two recessions. If so, long-maturity bond yields are likely to fall significantly during the next recession; if not, investors may be surprised by how modestly long-maturity yields decline. In this report, we examine the historical record of short-term interest rates during recessions and discuss whether the next US recession is likely to be severe or mild. We conclude that the next US recession is more likely to be mild than severe, and that the 10-year Treasury yield is unlikely to fall below 2% during the recession (or fall below this level for very long). In the case of a more severe recession driven by unanchored inflation expectations, the implications would be clearly bearish for bonds. Within a fixed-income portfolio, one conclusion of our analysis is that investors should not overstay their welcome in a long-duration position during the next recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. The Historical Recessionary Path Of Short-Term Interest Rates When projecting how the Fed funds rate is likely to evolve during the next US recession, most investors typically look to the average decline in short-term interest rates during previous recessions as a guide. Based on that approach, Table II-1 highlights that the Fed would likely have to cut rates into negative territory if a recession occurred over the coming 12-18 months, unless it is able to hike interest rates significantly more over the coming year than the market is currently expecting and the FOMC itself is projecting. But in our view, focusing on the historical recessionary decline in interest rates from their peak is not the right approach, because it ignores the fact that recessions typically occur when monetary policy is tight. If a recession occurs within the next 18 months, it will have happened in large part because of a collapse in real wage growth, not just because of the increase in interest rates that has occurred. Chart II-1 highlights that short-term interest rates remain well below potential GDP growth, highlighting that monetary policy would still be easy today – despite the quick pace of increase in short rates – if real wages were growing rather than contracting sharply. In our view, the right approach is to examine how much short-term interest rates have typically fallen during recessions relative to potential or average historical GDP growth. This method captures the degree to which monetary policy easing has typically been required relative to neutral levels to catalyze an economic recovery. Table II-1Based Only On The Historical Decline In Short-Term Interest Rates, The Fed Would Ostensibly Have To Cut Rates Into Negative Territory During The Next Recession September 2022 September 2022 Chart II-1Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Based on this approach, Chart II-2 highlights that the Fed might have to cut the target range for the Fed funds rate to 0-0.25% during the next recession, but there are some examples (like the 1990-1991 recession) that point to a cut to just 0.25-0.5%. The goal of this exercise is not to be specific about the exact level to which the Fed will have to cut the Fed funds rate, but rather whether the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases is likely. Chart II-2The Fed May Have To Cut To Zero During The Next Recession, But Probably Not Into Negative Territory September 2022 September 2022 Structural bond bulls might note that there are five recessions in the post-war era that could potentially point to that outcome based on Chart II-2. However, these episodes involved circumstances that we doubt would be present during the next US recession, especially if one were to emerge over the coming 12-18 months. The 1950s Recessions The recessions of 1953-54 and 1957-58 were fairly sizeable based on the total rise in the unemployment rate, but the monetary policy stance at that time was wildly stimulative in a way that is very unlikely to repeat itself today. In the 1950s, the level of interest rates was still an artifact of WWII (with the Treasury-Fed accord having only been agreed upon in March 1951). Monetary policy was both overly responsive to a period of pent-up disinflation following the initial burst of government spending associated with the Korean war and insufficiently responsive to a strongly positive output gap (Chart II-3). This was meaningfully compounded by a poor understanding of the size of the output gap at that time; the deviation of the unemployment rate from its 10-year average was significantly smaller than its deviation from today’s estimate of NAIRU (Chart II-4). In sum, the economic and monetary policy conditions that existed in the 1950s and that contributed to an interest rate level that was well below the prevailing rate of economic growth do not exist today. As such, we strongly doubt that the Fed’s response to the next US recession would resemble what occurred during that decade. Chart II-3We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s Chart II-4Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates   1973-1975 The recession that began in 1973 occurred because of a huge energy shock that proved to be stagflationary in the true sense of the word. Excluding the 2020 recession, this was the third largest rise in the unemployment rate of any recession since WWII, following 2008/2009 and the 1981/1982 recessions. There are some parallels between this recession and the current economic environment, but the stability of inflation expectations so far does not point to a truly stagflationary outcome. As such, we do not see the 1973-74 recession as a reasonable parallel to today’s environment. In addition, manufacturing employment – which was heavily impacted by the permanent rise in oil prices due to the sector’s energy intensity – stood at 24% of total nonfarm employment in 1973, compared with 8% today. Finally, the weight of food and energy as a share of total consumer spending today is roughly half of what it was during the 1970s (Chart II-5). 2001 Of the five recessions potentially implying that the Fed may have to cut interest rates into negative territory during the next US recession, the 2001 recession is the most relevant parallel to today. It was a modern recession in which the Fed maintained very easy monetary policy for a significant amount of time, in response to concerns about a significant tightening in financial conditions and the impact of prior corporate sector excesses on aggregate demand. The total rise in the unemployment rate during this recession was not very large, but it took some time for the unemployment rate to return to NAIRU. Still, even though this justified a later liftoff, a Taylor rule approach makes it clear that the Fed overstimulated the economy in response to the recession – a view that is reinforced by the enormous rise in household debt that fueled the housing market bubble during that period (Chart II-6). The Fed was very concerned about the negative wealth effects of the bursting of the equity market bubble, which had been caused by a massive decline in the equity risk premium in the second half of the 1990s. These conditions are simply not present today. Chart II-5Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Chart II-6The Fed Clearly Overstimulated In Response To The 2001 Recession The Fed Clearly Overstimulated In Response To The 2001 Recession The Fed Clearly Overstimulated In Response To The 2001 Recession 2008/2009 Chart II-7A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario Chart II-2 highlighted that the Fed would have to cut interest rates to -1% were the 2008/2009 recession to repeat itself, but we judge that to be a totally implausible scenario given the improvement in US household sector balance sheets and financial sector health since the global financial crisis (Chart II-7). As we discuss below, the next US recession is likely to be meaningfully less severe than the 2008/2009 and 2020 recessions, which we believe carries important significance for the path of interest rates and the response of long-maturity bond yields. The bottom line for investors is that, based on the historical experience of rate cuts during recessions, the Fed may end up cutting interest rates back to or close to the zero lower bound in response to the next recession. But the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seems quite unlikely unless the recession is severe, which we do not expect. Will The Next US Recession Be Severe Or Mild? Chart II-8The Most Severe US Recessions Have Had Aggravating Factors That Do Not Appear To Be Present Today September 2022 September 2022 How drastically the Fed will be forced to cut interest rates during the next recession will be driven by its severity. Chart II-8 presents the total rise in the unemployment rate during post-WWII recessions (excluding 2020), in order to gauge whether the factors that have led to severe recessions in the past are likely to be present during the next contraction in output. From our perspective, the most severe US recessions in the post-WWII era have been driven by factors that are very unlikely to repeat themselves in the current environment. We noted above that a repeat of the 2008/2009 recession is a totally implausible scenario, leaving the 1981-1982, 1973-1975, and 1950s recessions as potential severe recession analogues. In three of these four cases we see clear signs of an aggravating factor that we do not (yet) believe will be present during the next US recession. Chart II-9Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s In the 1981-1982 recession, the unemployment rate rose significantly as the Federal Reserve confronted the fact that inflation expectations had become severely unanchored to the upside, causing a persistent wage/price spiral. While unanchored inflation expectations is a risk today, so far the evidence suggests that both households and market participants expect that currently elevated inflation will not persist over the long run (Chart II-9). If inflation expectations do become unanchored to the upside at some point over the coming 12-18 months (or beyond), we are very likely to change our view about the severity of the next recession. However, this would be a bond bearish outcome (at least initially), as it would imply sharply higher yields at both the short and long end of the yield curve in order to tame inflation and re-anchor inflation expectations. As noted above, in the 1973-74 recession, the unexpected and permanent rise in oil prices and outright energy shortages rendered a significant amount of capital and labor uneconomic, which is different than what has been occurring during the pandemic. Were the recent rise in natural gas prices to be permanent and no alternatives available, Europe’s current energy situation would be more reminiscent of the 1973-1974 recession than the pandemic-driven price pressures and supply shortages affecting the US and other developed economies. Chart II-10The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year Finally, while the 1957-58 recession appears to be somewhat of an anomaly driven by a mix of factors, the 1953-54 recession was clearly exacerbated by a sharp slowdown in government spending following the end of the Korean war. It is true that the US is currently experiencing fiscal drag (Chart II-10), but this has occurred against the backdrop of a strong labor market, and IMF forecasts imply that the drag will be significantly smaller over the coming year than what the US is currently experiencing. There are several additional points suggesting that the next US recession will be comparatively mild: Chart II-11The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) Chart II-11 highlights that the milder recessions, those which have seen the unemployment rate rise by less than 3% from their previous low, have generally been the recessions that appear to have simply been triggered by monetary policy becoming tight or nearly tight. This would likely be the case during the next US recession. In the lead up to the 1970, 1990-91, and 2001 recessions, short-term interest rates approached or exceeded either potential growth or the rolling 10-year average growth rate of nominal GDP. The 1960-61 recession stands out slightly as an exception to this rule, in that interest rates were still moderately easy, which is based on our definition of the equilibrium short-term interest rate. But interest rates had risen close to 400 basis points from 1958 to 1960 (suggesting a change in addition to a level effect of interest rates on aggregate demand), and it is notable that the 60-61 recession was the mildest in post-war history, based on the total rise in the unemployment rate. Chart II-12Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession We argued in Section 1 of our report that monetary policy is not currently restrictive on its own, and that the recessionary risk currently facing the US is the result of a combination of the speed of adjustment in interest rates, the fact that real wages have fallen sharply, and the fact that the Fed is determined to see inflation quickly return to target levels. However, what this also highlights is that a recession would likely cause a rise in real wages via a significant slowdown in inflation (at least for a time); this would likely help stabilize aggregate demand and cause a comparatively mild rise in the unemployment rate. While the odds and magnitude of this effect are difficult to quantify, the fact that the labor market has been so tight over the past year and that the participation rate has yet to recover to its pre-pandemic levels suggests that some firms may be reluctant to shed labor during a recession (Chart II-12), suggesting that the total rise in unemployment in the next recession could be relatively small. Finally, Chart II-13 shows that the excess savings that have accumulated over the course of the pandemic, now primarily the result of reduced spending on services, dwarf the magnitude of precautionary savings that were generated in the prior three recessions as a % of GDP. We agree that the savings rate would likely still rise during the next recession, but the existence of excess savings implies that the rise in the savings rate may be surprisingly small – which would, in turn, imply a comparatively mild rise in the unemployment rate. We noted above that the household sector has deleveraged significantly, which is strong evidence against an outsized or long-lasting decline in consumer spending as a possible driver of an above-average rise in the unemployment rate during the next recession. One question that we often receive from clients is whether excessive corporate sector leverage could cause a more severe decline in economic activity once a recession emerges. Chart II-14 illustrates that the answer is “probably not.” The chart presents one estimate of the US nonfinancial corporate sector debt service ratio, based on national accounts data. The chart highlights that the current debt burden for the nonfinancial corporate sector is very low, underscoring that elevated corporate sector debt would not likely act as an aggravating factor driving an outsized rise in the unemployment rate were a recession to occur today. The chart also shows that even if the 10-year Treasury yield were to rise to 4% and corporate bond spreads were to widen in the lead up to a recession, the nonfinancial corporate sector debt service burden would rise to a lower peak than seen in the last three recessions. One key risk to a mild recession view is a scenario in which inflation does not return to or below the Fed’s target during the recession. In that kind of environment, the Fed would not likely cut interest rates to as low a level as they have in the past relative to potential growth. But the historical record is clear that recessions cause a deceleration in inflation, and if a recession emerges over the coming 12-18 months it will likely happen after supply-side and pandemic-related disinflation has already occurred. That means that inflation is likely to move back to or below the Fed’s target in a recessionary environment. We should note that this assessment differs somewhat from the scenario described by my former colleague Martin Barnes, who wrote a guest report on inflation published in our July Bank Credit Analyst.4 Chart II-13Today’s Pandemic-Related Excess Savings Dwarf Precautionary Savings During The Prior Three Recessions September 2022 September 2022 Chart II-14US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment   Long-Maturity Bond Yields And The Next US Recession What does our analysis imply for long-maturity bond yields and the duration call over the coming few years? In order to judge what is likely to happen to long-maturity bond yields in a recession scenario over the coming 12-18 months, we first project the fair value of the 5-year Treasury yield based on the following hypothetical circumstances: The onset of recession in March 2023 and a peak in the Fed funds rate at a target range of 3.75-4%. A recession duration of eight months, over which time the Fed steadily cuts the policy rate to 0-0.25%. An initial Fed rate hike in September 2024, nine months following the end of the recession, consistent with a relatively short return of the unemployment rate to NAIRU as an expansion takes hold. A rate hike pace of eight quarter-point hikes per year, with the Fed again raising rates to a peak of 4% A longer-term average Fed funds rate of 3%, which we regard as a low estimate. Chart II-15The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario Chart II-15 highlights the fair value path for the 5-year Treasury yield in this scenario. Not surprisingly, the fair value today is lower than the current level of the 5-year yield, highlighting that a shift to a long duration stance will be warranted at some point over the coming year if the US economy enters a non-technical, typical income-statement recession. However, the chart also highlights that a long duration position is not likely to be warranted for very long, given that the lowest level of the 5-year fair value path is substantially higher than it was in 2020 and 2021 and is also higher than its 10-year average. Chart II-16 reveals the importance of forecasting the near-term path of interest rates when predicting the likely behavior of long-maturity bond yields. Even though near- and long-term interest rate expectations should be at least somewhat differentiated, the chart highlights that the real 5-year/5-year forward Treasury yield is very closely explained by the real 5-year Treasury yield and a 3-year lag of our adaptive inflation expectations model (which is highly consistent with BCA’s Golden Rule of bond investing framework). Chart II-16 shows that long-maturity bond yields should be higher than they are based on the current level of real 5-year yields and lagged inflation expectations, underscoring the point that we made in Section 1 of our report that significant upside risk exists for long-maturity bond yields in a non-recessionary outcome over the coming year. In a recessionary outcome, it is clear that bond yields will fall as the Fed cuts interest rates, as Chart II-15 demonstrated. But, Chart II-17 highlights that during recessions, there is little precedent for a negative 5-10 yield curve slope outside of the context of the persistently high inflation environment of the late 1960s and 1970s. Applying that template to the fair value path that we showed in Chart II-15 suggests that the 10-year Treasury yield will not fall below 2% during the next recession. As we noted in our August report,5 a 10-year Treasury yield decline to 2% would result in significant performance for long-maturity bonds, but it would not end the structural bear market in bonds that began two years ago – a fact that we suspect would be very surprising to bond-bullish investors. Chart II-165-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward 5-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward 5-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward Chart II-17There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession It is true that bond yields may deviate from the fair value levels shown in Chart II-15 if investors expect a different outcome for the path of the Fed funds rate than we described. However, it is worth noting that changes in our assumed post-recession peak Fed funds rate and the long-term average do not substantially change the outcome shown in Chart II-15. If investors instead assume that the Fed funds rate will peak at 3% during the next expansion, that lowers the fair value path for the 5-year yield by approximately 5 basis points. Changing the long-term average Fed funds rate to 2.4%, the Fed’s current neutral rate expectation, would reduce it by about 25 basis points. These levels would still be significantly above the lows reached in 2011-2013 and in 2020, underscoring that the length of the recession and the speed at which the Fed begins to raise interest rates will be far more important determinants of the path of US Treasury yields. We strongly suspect that investors will recognize that a comparatively mild recession will not result in the same hyper-accomodative monetary policy stance that occurred during the past two recessions, implying that long-maturity bond yields will have less downside during the next recession than may be currently recognized. Investment Conclusions As we have presented, the historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition to this, there are several arguments pointing to the next US recession being a mild one. In a mild recession scenario, we doubt that the 10-year Treasury yield would fall below 2%, or fall below this level for very long. For fixed-income investors, while bond yields will fall for a time if a recession emerges, the implication is that investors should not overstay their welcome in a long-duration position during the recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. We noted in our July report that if a recession occurred within the coming 6-12 months, that the S&P 500 would likely fall to 3100, even if the recession were average. A mild recession may see the S&P 500 decline less severely than this, but stocks are still likely to incur significant losses during the next recession unless investors price in a much shallower path for short-term interest rates than we believe will be warranted. As noted in Section 1 of our report, we have not yet concluded that a US recession is inevitable over the coming 6-12 months. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Additional changes to our recommended cyclical allocation may thus occur over the coming few months, in response to incoming data, our assessment of the likely implications for monetary policy, and the response of long-maturity government bond yields. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts In contrast to the recent rally in equities, BCA’s equity indicators continue to paint a bearish outlook for stock prices. Our Monetary, Technical, and Speculative indicators have stopped falling, but they remain very weak. Meanwhile, the recent rally has pushed our valuation indicator back towards a level indicating stocks are considerably overvalued. While it is still a risk and not yet a likely event, the odds of a US recession over the next 12 months remain elevated. We maintain a neutral stance for stocks versus bonds over the coming year. Forward earnings are no longer being revised up, but bottom-up analysts’ expectations for earnings are likely still too optimistic. Although earnings growth will be positive over the coming year if a US recession is avoided, it will be in the mid-to-low single-digits given ongoing pressure on profit margins. Within a global equity portfolio, we maintain a neutral stance on cyclicals versus defensives, small caps versus large, and a neutral stance on regional equity allocation. We recommend a modest overweight towards value versus growth stocks, given our recommendation of a modestly short duration stance within a global fixed-income portfolio. Commodity prices have stopped falling, and our composite technical indicator now highlights that commodities are oversold. Our base-case view is that oil prices are likely to rise over the coming 12-months, barring a US recession. Global food prices have come down in the wake of deal between Russia and Ukraine to allow the latter to resume its agricultural exports. But the recent surge in European natural gas prices suggests that global food inflation may remain elevated, given that natural gas is used in the production of fertilizer. Ongoing weakness in the Chinese property market argues for a neutral stance towards industrial metals, until compelling signs of a more aggressive policy response emerge. US and global LEIs have now fallen into negative territory, underscoring that the risk of a global recession is elevated. Some indicators are easing back towards positive territory, such as our global LEI Diffusion Index and our US Financial Conditions Index, but it is not yet clear if they are heralding a reacceleration in economic activity or merely a less intense pace of decline. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators Chart III-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Footnotes 1     Please see The Bank Credit Analyst "Is The US Housing Market Signaling An Imminent Recession?" dated May 26, 2022, available at bca.bcaresearch.com 2     Please see US Bond Strategy "The Great Soft Landing Debate," dated August 2, 2022, available at usbs.bcaresearch.com 3    Please see The Bank Credit Analyst "April 2022," dated March 31, 2022, available at bca.bcaresearch.com 4    Please see The Bank Credit Analyst "Inflation Whipsaw Ahead," dated June 30, 2022, available at bca.bcaresearch.com 5    Please see The Bank Credit Analyst "August 2022," dated July 28, 2022, available at bca.bcaresearch.com

Executive Summary US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins China needs lower interest rates and a weaker currency to battle deflationary pressures. In the US, the main problem is elevated inflation. This heralds higher interest rates and a stronger currency. Hence, the Chinese yuan will depreciate against the greenback. When the RMB weakens versus the US dollar, commodity prices usually fall, and EM currencies and asset prices struggle. Faced with surging unit labor costs, US companies will continue to raise their prices to protect their profit margins and profitability. This will lead to one of the following two possible scenarios in the months ahead. Scenario 1: If customers are willing to pay considerably higher prices, nominal sales will remain robust, profits will not collapse, and a recession is unlikely. However, this also implies that the Fed will have to tighten policy by more than what is currently priced in by markets. Scenario 2: If customers push back against higher prices and curtail their purchases, then the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink, and their profits will plunge.  In both scenarios, the outlook for stocks is poor. However, one key difference is that scenario 1 is bearish for US Treasurys while scenario 2 is bond bullish. Bottom Line: On the one hand, the US has a genuine inflation problem. The upshot is that the Fed cannot pivot too early. The Fed’s hawkish rhetoric will support the US dollar. A strong greenback is bad for EM financial markets. On the other hand, the Chinese economy and global trade are experiencing deflation/recession dynamics. Cyclical assets underperform and the US dollar generally appreciates in this environment. This is also a toxic backdrop for EM financial markets.   Financial markets have been caught in contradictions. The reason is that investors cannot decide if the global economy is heading into a recession with deflationary forces prevailing, or whether a goldilocks economy or a period of inflation or stagflation will emerge in the foreseeable future. There are also plenty of contradictory data to support all the above scenarios.  As such, financial markets are volatile, swinging wildly as market participants absorb new economic data points. The S&P 500 index has rebounded from its 3-year moving average, which had previously served as a major support (Chart 1). Yet, the rebound has faltered at its 200-day moving average. Its failure to break decisively above this 200-day moving average entails that a new cyclical rally is not yet in the cards. Chart 1The S&P 500 Is Stuck Between Technical Resistance And Support Lines The S&P 500 Is Stuck Between Technical Resistance And Support Lines The S&P 500 Is Stuck Between Technical Resistance And Support Lines The S&P 500 index will remain between these resistance and support lines until investors make up their minds about the economic outlook. The EM equity index has been unable to rebound strongly alongside US stocks. A major technical support that held up in the 1998, 2001, 2002, 2008, 2015 and 2020 bear markets is about 15% below the current level (Chart 2). Hence, we recommend that investors remain on the sidelines of EM stocks. Chart 2EM Share Prices Are Still 15% Above Their Long-Term Technical Support Level EM Share Prices Are Still 15% Above Their Long-Term Technical Support Level EM Share Prices Are Still 15% Above Their Long-Term Technical Support Level BCA’s Emerging Markets Strategy team’s macro themes and views remain as follows: Related Report  Emerging Markets StrategyCharts That Matter In China, the main economic risk is deflation and the continuation of underwhelming economic growth. Core and service consumer price inflation are both below 1% and property prices are deflating. Falling prices amid high debt levels is a recipe for debt deflation. We discussed the government’s stimulus – including measures enacted for the property market – in the August 11 report. The latest announcement about the RMB 1 trillion stimulus does not change our analysis. In fact, we expected an additional RMB 1.5 trillion in local government bond issuance for the remainder of the current year. Yet, the government authorized only an additional RMB 0.5 trillion. This is substantially below what had been expected by analysts and commentators in recent months.   In Chinese and China-related financial markets, a recession/deflation framework remains appropriate. Onshore interest rates will drop further, the yuan will depreciate more, and Chinese stocks and China related plays will continue experiencing growth/profit headwinds. Meanwhile, the US economy has been experiencing stagflation this year. Chart 3 shows that even though the nominal value of final sales has expanded by 8-10%, sales and output have stagnated in real terms (close to zero growth). Hence, nominal sales and corporate profits have so far held up because companies have been able to raise prices by 8-9.5% (Chart 4). Is this bullish for the stock market? Not really. Chart 3US Stagflation: Strong Nominal Growth, But Small In Real Terms US Stagflation: Strong Nominal Growth, But Small In Real Terms US Stagflation: Strong Nominal Growth, But Small In Real Terms Chart 4US Corporate Profits Have Held Up Because Of Pricing Power/Inflation US Corporate Profits Have Held Up Because Of Pricing Power/Inflation US Corporate Profits Have Held Up Because Of Pricing Power/Inflation The fact that companies have been able to raise their selling prices at this rapid pace implies that the Fed cannot stop hiking rates. Besides, US wages and unit labor costs are surging (Chart 9 below). The implication is that inflation will be entrenched and core inflation will not drop quickly and significantly enough to allow the Fed to pivot anytime soon. Overall, US economic data releases have been consistent with our view that although real growth is slowing, the US economy is experiencing elevated inflations, i.e., a stagflationary environment. Critically, wages and inflation lag the business cycle and are also very slow moving variables. Hence, US core inflation will not drop below 4% quickly enough to provide relief for the Fed and markets. Is a US recession imminent? It depends. One thing we are certain of is that faced with surging unit labor costs, US companies will attempt to raise their prices to protect their profit margins and profitability. Our proxy for US corporate profit margins signals that they are already rolling over (Chart 5). Hence, business owners and CEOs will attempt to raise selling prices further. Chart 5US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins This will lead to one of two possible scenarios for the US economy in the months ahead. Scenario 1: If customers (households and businesses) are willing to pay considerably higher prices, nominal sales will remain very robust, and profits will not collapse, reducing the likelihood of a recession. Yet, this means that inflation will become even more entrenched, and employees will continue to demand higher wages. A wage-price spiral will persist. The Fed will have to raise rates much more than what is currently priced in financial markets. This is negative for US share prices. Scenario 2: If customers push back against higher prices and curtail their purchases, output volume will relapse, i.e., the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink (prices received will rise much less than unit labor costs) and profits will plunge.  Suffering a profit squeeze, companies will lay off employees, wage growth will decelerate, and high inflation will be extinguished. In this scenario, bond yields will drop significantly but plunging corporate profits will weigh on share prices. We are not certain which of these two scenarios will prevail: it is hard to determine the point at which US consumers will push back against rising prices. Nevertheless, it is notable that in both scenarios, the outlook for stocks is poor.   Finally, as we have repeatedly written, global trade is about to contract. Charts 10-18 below elaborate on this theme. This is disinflationary/recessionary. Investment Conclusions On the one hand, the Chinese economy and global trade are experiencing deflation/recession dynamics. Cyclical assets struggle and the US dollar does well in this environment. This constitutes a toxic backdrop for EM financial markets. On the other hand, the US has a genuine inflation problem. The upshot is that the Fed cannot pivot too early. The Fed’s hawkish rhetoric will support the US dollar. A strong greenback is also bad for EM financial markets. Thus, we do not see any reason to alter our negative view on EM equities, credit and currencies. Investors should continue underweighting EM in global equity and credit portfolios. Local currency bonds offer value, but further currency depreciation and more rate hikes remain a risk to domestic bonds. We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN and IDR. In addition, we recommend shorting HUF vs. CZK, KRW vs. JPY, and BRL vs. MXN.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Messages From Various US High-Beta / Cyclical Stock Prices US high-beta consumer discretionary, industrials, tech and early cyclical stocks have not yet broken out. The rebounds in high-beta tech and industrials have been rather muted. We are watching these and many other market signs and technical indicators to gauge if the recent rebounds can turn into a cyclical bull market. Chart 6 Messages From Various US High-Beta / Cyclical Stock Prices Messages From Various US High-Beta / Cyclical Stock Prices Chart 7 Messages From Various US High-Beta / Cyclical Stock Prices Messages From Various US High-Beta / Cyclical Stock Prices Falling Global Trade + Sticky US Inflation = US Dollar Overshot On the one hand, US household spending on goods ex-autos is already contracting and will drop further. The same is true for EU demand. The reasons are excessive consumption of goods over the past two years and shrinking household real disposable income. As a result, global trade is set to shrink, which is positive for the US dollar. On the other hand, surging US unit labor costs entail that core CPI will be very sticky at levels well above the Fed’s target. Hence, the Fed will likely maintain its hawkish bias for now, which is also bullish for the greenback. In short, the US dollar will continue overshooting.  Chart 8 Falling Global Trade + Sticky US Inflation = US Dollar Overshot Falling Global Trade + Sticky US Inflation = US Dollar Overshot Chart 9 Falling Global Trade + Sticky US Inflation = US Dollar Overshot Falling Global Trade + Sticky US Inflation = US Dollar Overshot Chinese Exports Will Contract, And Imports Will Fail To Recover Chinese export volume growth has come to a halt. Shrinking imports of inputs used for re-export (imports for processing trade) are pointing to an imminent contraction in the mainland’s exports. Further, Chinese import volumes have been contracting for the past 12 months. The value of imports has not plunged only because of high commodity prices. As commodity prices drop, import values will converge to the downside with import volumes. This is negative for economies/industries selling to China. Chart 10 Chinese Exports Will Contract, And Imports Will Fail to Recover Chinese Exports Will Contract, And Imports Will Fail to Recover Chart 11 Chinese Exports Will Contract, And Imports Will Fail to Recover Chinese Exports Will Contract, And Imports Will Fail to Recover Global Manufacturing / Trade Downtrend Is Intact China buys a lot of inputs from Taiwan that are used in its exports. That is why the mainland’s imports from Taiwan lead the global trade cycle. This is presently heralding a considerable deterioration in global trade.  In addition, falling freight rates and depreciating Emerging Asian (ex-China) currencies are all currently pointing to a further underperformance of global cyclicals versus defensive sectors. Chart 12 Global Manufacturing / Trade Downtrend Is Intact Global Manufacturing / Trade Downtrend Is Intact Chart 13 Global Manufacturing / Trade Downtrend Is Intact Global Manufacturing / Trade Downtrend Is Intact Chart 14 Global Manufacturing / Trade Downtrend Is Intact Global Manufacturing / Trade Downtrend Is Intact Taiwan Is A Canary In A Coal Mine Taiwanese manufacturing companies have seen their export orders plunge and their customer inventories surge. This has occurred in its overall manufacturing and semiconductor companies.  This corroborates our thesis that global export volumes will contract in the coming months. Chart 15 Taiwan Is A Canary In A Coal Mine Taiwan Is A Canary In A Coal Mine Chart 16 Taiwan Is A Canary In A Coal Mine Taiwan Is A Canary In A Coal Mine Korean Exporters Are Struggling Korean export companies are experience the same dynamics as their Taiwanese peers. Semiconductor prices and sales are falling hard in Korea. Export volume growth has come to a halt and will soon shrink. Chart 17 Korean Exporters Are Struggling Korean Exporters Are Struggling Chart 18 Korean Exporters Are Struggling Korean Exporters Are Struggling EM Equities: Cheap And Unloved? The EM cyclically adjusted P/E (CAPE) ratio has fallen to one standard deviation below its mean. Based on this measure, EM stocks are currently as cheap as they were at their bottoms in 2020, 2015 and 2008. EM share prices in USD deflated by US CPI are now at two standard deviations below their long-term time-trend. This is as bad as it got when EM stocks bottomed in the previous bear markets. The reason for EM stocks poor performance and such “cheapness” is corporate profits. EM EPS in USD has been flat, i.e., posting zero growth in the past 15 years. Besides, EM narrow money (M1) growth points to further EM EPS contraction in the months ahead. Chart 19 EM Equities: Cheap And Unloved? EM Equities: Cheap And Unloved? Chart 20 EM Equities: Cheap And Unloved? EM Equities: Cheap And Unloved? Chart 21 EM Equities: Cheap And Unloved? EM Equities: Cheap And Unloved? Chart 22 EM Equities: Cheap And Unloved? EM Equities: Cheap And Unloved? Commodity Prices Remain At Risk China needs lower interest rates and a weaker currency to battle deflationary pressures. In the US, the problem is inflation, which heralds higher interest rates and a stronger currency to fight rising prices. Hence, the yuan will depreciate versus the greenback. When the RMB depreciates versus the US dollar, commodity prices usually fall. Further, commodity currencies (an average of AUD, NZD and CAD) continue drafting lower. This indicator correlates with commodity prices and also presages further relapse in resource prices. Chart 23 Commodity Prices Remain At Risk Commodity Prices Remain At Risk Chart 24 Commodity Prices Remain At Risk Commodity Prices Remain At Risk Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chinese crude oil imports have been contracting for almost a year. Global (including US) demand for gasoline has relapsed. Meantime, Russia’s oil and oil product exports have fallen only by a mere 5% from their January level. This explains why oil prices have recently fallen. Oil lags business cycles: its consumption will shrink as global growth downshifts. However, geopolitics remain a wild card. Hence, we are uncertain about the near-term outlook for oil prices. That said, oil has made a major top and any rebound will fail to last much longer or push prices above recent highs. Chart 25 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chart 26 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chart 27 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chart 28 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations What Is Next For The Chinese RMB? The Chinese yuan will continue depreciating versus the US dollar. China needs lower interest rates and a weaker currency to battle deflationary pressures. While currency is moderately cheap, exchange rates tend to overshoot/undershoot and can remain cheap/expensive for a while. The CNY/USD has technically broken down. Interestingly, the periods of RMB depreciation coincide with deteriorating global US dollar liquidity and, in turn, poor performance by EM assets and commodities. Chart 29 What Is Next For The Chinese RMB? What Is Next For The Chinese RMB? Chart 30 What Is Next For The Chinese RMB? What Is Next For The Chinese RMB? Chart 31 What Is Next For The Chinese RMB? What Is Next For The Chinese RMB? Stay Put On Chinese Equities Odds are rising that Chinese platform companies will likely be delisted from the US as we have argued for some time. Hence, international investors will continue dampening US-listed Chinese stocks. The outlook for China’s economic recovery and profits is downbeat. This will weigh on non-TMT stocks and A shares. Within the Chinese equity universe, we continue to recommend the long A-shares / short Investable stocks strategy, a position we initiated on March 4, 2021. Chart 32 Stay Put On Chinese Equities Stay Put On Chinese Equities Chart 33 Stay Put On Chinese Equities Stay Put On Chinese Equities Chart 34 Stay Put On Chinese Equities Stay Put On Chinese Equities Chart 35 Stay Put On Chinese Equities Stay Put On Chinese Equities Messages For Stocks From Corporate Bonds Historically, rising US and EM corporate bond yields led to a selloff in US and EM share prices, respectively. Corporate bond yields are the cost of capital that matters for equities. Unless US and EM corporate bond yields start falling on a sustainable basis, their share prices will struggle. Corporate bond yields could increase because of either rising US Treasury yields or widening credit spreads. Chart 36 Messages For Stocks From Corporate Bonds Messages For Stocks From Corporate Bonds Chart 37 Messages For Stocks From Corporate Bonds Messages For Stocks From Corporate Bonds EM Currencies And Fixed-Income: An Unfinished Adjustment The profiles of EM FX and credit spreads suggest that their adjustment might not be complete. We expect further EM currency depreciation and renewed EM credit spread widening. EM domestic bond yields have risen significantly and offer value. However, if and as US TIPS yields rise and/or EM currencies continue to depreciate, local bond yields are unlikely to fall. To recommend buying EM local bonds aggressively, we need to change our view on the US dollar. Chart 38 EM Currencies And Fixed-Income: An Unfinished Adjustment EM Currencies And Fixed-Income: An Unfinished Adjustment Chart 39 EM Currencies And Fixed-Income: An Unfinished Adjustment EM Currencies And Fixed-Income: An Unfinished Adjustment Chart 40 EM Currencies And Fixed-Income: An Unfinished Adjustment EM Currencies And Fixed-Income: An Unfinished Adjustment Chart 41 EM Currencies And Fixed-Income: An Unfinished Adjustment EM Currencies And Fixed-Income: An Unfinished Adjustment   Footnotes Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Executive Summary We continue to recommend overweighting risk assets in multi-asset portfolios over the next six months because we believe financial markets have prematurely priced in too much pessimism. Against a particularly uncertain macroeconomic backdrop, we think all investors should have reduced conviction in their views. Asking how one could be getting it wrong is especially relevant today. We identify seven prominent risks to our view, with unanchored inflation expectations and consumer retrenchment posing the biggest threats to our risk-friendly recommendations. The former would imply economic overheating that would prompt the Fed to squash the expansion; the latter would herald a period of insufficient growth. Inflation Expectations Are Still Contained Inflation Expectations Are Still Contained Inflation Expectations Are Still Contained Bottom Line: We are on the alert for several ways our glass-half-full view could be disappointed but none of them has yet emerged. We continue to recommend positioning a portfolio in line with it. Feature We will be taking our summer vacation this week and will not publish next Monday, August 29th. We will resume our regular publication schedule on September 5th. Chart 1Overdone Overdone Overdone We held our quarterly webcast last week, in which we reiterated three main points that will be familiar to US Investment Strategy readers. One, the demise of the American consumer has been greatly exaggerated. Two, monetary policy works with a lag. Three, stubbornly high inflation will bring about the end of the expansion and the bull markets in equities and credit, but not just yet. Those points reinforce our view that equities and credit will outperform Treasuries and cash over the rest of the year and place us at the more bullish end of the continuum inside and outside of BCA for the near term, though we are much more circumspect about the prospect for risk assets over the next twelve months and beyond. We also spent some time digging into the reasons that we are more constructive than the average bear. Those reasons largely revolved around the idea that financial markets prematurely discounted the negative effects that will follow sometime after the Fed flips monetary policy settings from easy to tight. After tightening sharply over the first half of the year (Chart 1, top panel), we think financial conditions are due for a break as Treasury yields settle into a well-defined range (Chart 1, second panel), credit spreads consolidate their retracement after sharply widening (Chart 1, third panel), the S&P 500 finds a footing and retraces more of its first half losses (Chart 1, fourth panel) and the dollar, cooling off after a torrid run (Chart 1, bottom panel), prepares to weaken over the intermediate term. We did not have time to answer all the questions from the webcast Q&A before the hour was up and we spent much of the week replying to them over email. Several of the questions asked what we are most worried about, or which indicators are most likely to signal that we are getting the outlook wrong. We ask ourselves these questions continuously and they are an ideal way to conclude a gathering like last Monday’s. Although we didn’t get to address them live, examining the biggest risks to our view as a coda in this week's bulletin is the next best thing. Risk #1: Unanchored Inflation Expectations We view a breakout in inflation expectations as the biggest risk to our view. If households, businesses and investors were to expect that inflation would inflect meaningfully higher over the long term, they would adjust their behavior in ways that could make high inflation beget still higher inflation. The ensuing self-reinforcing cycle would become much more difficult for the Fed to break and would presumably involve a stark repricing of Treasury securities and risk assets. Related Report  US Investment StrategyRisks To Our View We have been warily monitoring inflation expectations over the near term (0-2 years, top panel in Charts 2 and 3), the intermediate term (3-5 years, middle panel) and the long term (6-10 years, bottom panel), as has the Fed. We have become increasingly emboldened by the stability of the intermediate- and long-term series, even in the face of the highest measured inflation in 40-plus years. Now that near-term expectations have rolled over, some of the risk that elevated current inflation will begin to bleed into long-run expectations is fading. We remain relieved that businesses, investors and consumers (Chart 4) have not yet assumed high inflation will persist but if longer-run inflation expectations threaten to become unanchored, we will abandon our constructive take on the economy and risk assets. Chart 2High Reported Inflation ... High Reported Inflation ... High Reported Inflation ... ​​​​​​ Chart 3... Has Yet To Translate Into ... ... Has Yet To Translate Into ... ... Has Yet To Translate Into ... ​​​​​​ Chart 4... Meaningfully Higher Long-Run Inflation Expectations ... Meaningfully Higher Long-Run Inflation Expectations ... Meaningfully Higher Long-Run Inflation Expectations Risk #2: A Renewed COVID Breakout The other risks are not as significant as unmoored inflation expectations but they are meaningful nonetheless. A renewed COVID breakout that imposed the de facto equivalent of rolling blackouts in production and transportation would partially undo the supply chain improvements that have helped relieve some of the upward pressure on goods inflation while hampering global growth. That could have the doubly negative impact of squeezing S&P 500 earnings while rekindling inflation pressures, nudging the US and global economies toward stagflation. Effective vaccinations and treatments have rendered COVID little more than a nuisance in the States (Chart 5) and other developed nations, but if the pandemic surges back to life elsewhere in the world, we would have to reconsider our more constructive take. Chart 5Initially A Scourge, COVID Is Now An Annoyance Initially A Scourge, COVID Is Now An Annoyance Initially A Scourge, COVID Is Now An Annoyance Risk #3: Geopolitical Pressures Our in-house geopolitical experts were among the first to sound the alarm on Ukraine early in the year. A worsening of the conflict there, or anything that imperils Europe’s access to energy supplies or further restricts global supplies of grain, will also cloud the picture for risk assets. Our geopolitical team has long viewed the Taiwan Strait as a potential major geopolitical flashpoint and a sharp increase in Sino-American tensions would make us reconsider our thesis as well. Our in-house team warns that Iran could be another source of instability and we will have to remain aware of the potential for geopolitics to throw a wrench into otherwise neutral-to-bullish macro conditions. Risk #4: US Consumers Lose Their Nerve Though we haven’t tried to rank the risks beyond a breakout in inflation expectations, a big pickup in the savings rate is the second largest risk on our list. If households reverse field and start saving their disposable income at a rate above their post-crisis/pre-pandemic average (Chart 6), it would signal that their aggregate consumption decisions were beginning to match their gloomy responses to confidence surveys. That would erode our conviction that they will deploy their excess pandemic savings to keep consumption – and the US economy – expanding near its trend rate. If consumers begin to circle the wagons in paradox-of-thrift fashion, it would present a nearly insurmountable obstacle for our thesis. Chart 6A Massive Savings Cushion To Support Consumption ... A Massive Savings Cushion To Support Consumption ... A Massive Savings Cushion To Support Consumption ... Risk #5: Consumer Credit Deterioration As SIFI bank executives noted in last month’s second quarter earnings calls, consumer credit has performed spectacularly well. Credit card net charge-offs are hovering at all-time lows, mortgage foreclosure rates are microscopic, and the only signs of stress have emerged, faintly, at the lowest ends of the wealth and income distributions. The very gentle softening in consumer credit that lenders have seen so far (Chart 7) could turn into something more worrisome if inflation fails to moderate and/or the jobs market goes south. If consumer credit begins palpably deteriorating, it would signal that the excess savings buffer does not offer as much protection as we thought. Chart 7... And Consumer Credit Risks To Our View (Again) Risks To Our View (Again) Risk #6: A Softening Labor Market Chart 8Still A Lot Of Help Wanted Still A Lot Of Help Wanted Still A Lot Of Help Wanted An extremely robust labor market has helped solidify our conviction that a sizable moat protects the US economy from unwelcome near-term surprises. Despite evident deceleration in growth over the first half of the year, net payrolls have continued to grow at a rapid clip and ongoing demand for additional hires (Chart 8) remains strong. The labor market could soften more rapidly than it has so far or than we project it will in the near term. Risk assets’ window for outperformance will shorten the faster the labor demand moat shrinks. Risk #7: Technical Support Could Prove Fleeting We have been further encouraged by the ease with which the S&P 500 sliced through resistance around 4,175 on its second try last week and has remained above that level (Chart 9). We see 4,175 providing tactical support to the index, limiting its near-term downside. If the support were to fail a test, we will be forced to re-evaluate US equities’ near-term risk-reward profile. Chart 9The S&P 500 Appears To Have Some Near-Term Technical Support Risks To Our View (Again) Risks To Our View (Again) A client alerted us last week to a longer-term technical pattern that might serve to put a bottom under equities. Since 1950, no bear market has made new lows after retracing at least 50% of its decline. We explored the pattern beginning with the November 1968-May 1970 bear market and found that tests of the 50% retracement level were few and far between. The bear market action of the last 50-plus years by no means guarantees that the S&P 500 will encounter difficulty punching back through the 50% threshold (4,231.67) it crossed on Friday August 12th, but the index has gathered some positive technical omens during its two-month rally. Investment Implications There is no shortage of potential risks right now and we reiterate our heightened vigilance. Investors must contend with the combination of a once-in-a-century global pandemic, the unprecedented fiscal and monetary responses to its outbreak, the first major cross-border war in Europe since 1945 and four-decade highs in inflation across major developed economies. Our conviction levels are lower than normal and our inherent compulsion to ask where we could be getting it wrong now verges on paranoia. Though we are continuously looking over our shoulder, we are comforted by nearly unanimous glass-half-empty sentiment. We still believe that it won’t take much for corporate earnings and the economy to surprise to the upside. The latest iteration of the Bank of America Merrill Lynch portfolio manager survey revealed that sentiment is no longer “apocalyptically bearish,” but we still expect that relative performance pressures will prod many bearishly positioned managers to cover their risk asset underweights. We remain constructive on risk assets over the next six months, though we will likely take some chips off the table if the S&P 500 rallies into the 4,500-to-4,600 range as we expect. It is a core part of our process to seek out information that may invalidate our hypotheses and we don’t even have to venture beyond the confines of BCA to gather it right now. Our differences with our colleagues are not as large as they might seem in our daily BCA Live and Unfiltered live stream, however, as they boil down to timing. We are neutral-to-bearish twelve months out, as we anticipate another equity bear market will begin around the second half of next year once it becomes apparent that the FOMC will not stand down from its 2% inflation goal. We simply think there’s money to be made from the long side in the interim.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (August 16 at 10:00 AM EDT, 15:00 PM BST, 16:00 PM CEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist Treasury Index Returns Spread Product Returns

Listen to a short summary of this report.     Executive Summary Chart 1The Dollar Has Broken Below The First Line Of Support The Dollar Has Broken Before The First Line Of Support The Dollar Has Broken Before The First Line Of Support The softer CPI print in the US boosted growth plays and pushed the DXY index below its 50-day moving average (Feature Chart). This suggests CPI numbers will remain the most important print for currency markets in the coming weeks and months. If US inflation has peaked, then the market will price a less aggressive path for Fed interest rates, which will loosen support for the dollar. At the same time, other G10 central banks are still seeing accelerating inflation. This will keep them on a tightening path. This puts the DXY in a tug of war. On the downside, the Fed could turn less hawkish. On the other hand, currencies such as the EUR, GBP and even SEK face high inflation but deteriorating growth. This will depress real rates. Within this context, the most attractive currencies are those with relatively higher real rates, and a real prospect of a turnaround in growth. NOK and AUD stand out as potential candidates. Our short EUR/JPY trade has been performing well in this context. Stick with it.  RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short EUR/JPY 141.20 2022-07-21 3.29 Bottom Line: Our recommended strategy is a neutral dollar view over the next three months, until it becomes clear inflation has peaked and global growth has bottomed. Feature The DXY index peaked at 108.64 on July 14 and has dropped to 105.1 as we go to press. There have been two critical drivers of this move. First, the 10-year US Treasury yield has fallen from 3.5% to 2.8%. With this week’s all important CPI release, which showed a sharp deceleration in the headline measure, bond yields may well stabilize at current levels for a while. Second, the drop in energy prices has boosted the JPY, SEK and EUR, which are heavily dependent on imported energy. Related Report  Foreign Exchange StrategyA Montreal Conversation On FX Markets Another development has been happening in parallel – as US inflation upside surprises have crested, so has the US price impulse relative to its G10 counterparts (Chart 1). To the extent that this eases market pricing of a hawkish Fed (relative to other G10 central banks), it will continue to diminish upward pressure on the dollar. Much will depend on the incoming inflation prints both in the US, and abroad. With the DXY having broken below its 50-day moving average, the next support level is at 103.6. This is where the 100-day moving average lies, which the dollar tested twice this year before eventually bouncing higher (Chart 2). The next few sections cover the important data releases over the last month in our universe of G10 countries, and implications for currency strategy. What is clear is that most foreign central banks are committed to their tightening campaign, which argues for a neutral stance towards the DXY for now. Chart 1US Inflation Momentum Has Rolled Over US Inflation Momentum Has Rolled Over US Inflation Momentum Has Rolled Over Chart 2The Dollar Has Broken Below The First Line Of Support The Dollar Has Broken Below The First Line Of Support The Dollar Has Broken Below The First Line Of Support US Dollar: Consolidation Chart 3The Conditions For A Fed Hike Remain In Place The Conditions For A Fed Hike Remain In Place The Conditions For A Fed Hike Remain In Place The dollar DXY index is up 10% year to date. Over the last month, the DXY index is down 2.1% (panel 1). Incoming data continues to make the case for a strong dollar. Job gains are robust. In June, the US added 372K jobs. The July release was even stronger at 528K jobs. This pushed the unemployment rate to a low of 3.5% (panel 2). Wages continue to soar. Average hourly earnings came in at 5.2% year-on-year in July. The Atlanta Fed wage growth tracker continues to edge higher across all income cohorts (panel 3). The June CPI print was above expectations at 9.1% for headline, with core at 5.9%. The July print for headline that came out this week was 8.5%, below expectations of 8.7%. At 5.9%, the core measure is still well above the Fed’s target (panel 4). June retail sales remained firm, but consumer sentiment continues to weaken. While the University of Michigan current conditions index increase from 53.8 to 58.1 in June, this is well below the January 2020 level of 115. Correspondingly, the Conference Board consumer confidence index fell from 98.7 to 95.7 in July. On June 17, the Fed increased interest rates by 75bps, as expected. The US entered a second consecutive quarter of GDP growth contraction in Q2, falling by an annualized 0.9%. The ISM manufacturing index was flat in July suggesting Q3 GDP is not starting on a particularly strong foot. The Atlanta Fed Q3 GDP growth tracker is, however, printing 2.5%. Unit labor costs are soaring, rising 10.8% in Q2. This is sapping productivity growth, which fell 4.6% in Q2.  The key for the dollar’s outlook is the evolution of US inflation and the labor market. For now, inflation remains sticky, and wages are rising. Meanwhile, labor market conditions remain robust. This will keep the Fed on a tightening path in the near term. We initially went short the DXY index but were stopped out. We remain neutral in the short term, though valuation keeps us bearish over a long-term horizon. The Euro: A European Hard Landing Chart 4The Euro Is At Recession Lows The Euro Is At Recession Lows The Euro Is At Recession Lows The euro is down 9.2% year to date. Over the last month, the euro is up 2.7%, having faced support a nudge below parity. Incoming data continues to suggest weak economic conditions, with a stagflationary undertone: The ZEW Expectations Survey for July was at -51.1, the lowest reading since 2011 (panel 1). The current account remains in a deficit, at -€4.5bn in May. Consumer confidence continues to plunge. The July reading of -27 is the worst since the 2020 Covid-19 crisis (panel 2). Despite the above data releases, the ECB surprised markets by raising rates 50bps. CPI continues to surprise to the upside. The preliminary CPI print for July came in at 8.9%, well above the previous 8.6% print. PPI in the euro area was at 35.8% in June, a slight decline from the May reading (panel 3). The German Ifo business expectations index fell to 80.3 in July. Historically, that has been consistent with a manufacturing PMI reading of 45 (panel 4). The Sentix confidence index stabilized in August but remains very weak at -25.2. This series tends to be trending, having peaked in July last year. We will see if the next few months continue to show stabilization. The ECB mandate dictates that it will continue to fight soaring inflation. As such, it may have no choice but to generate a Eurozone-wide recession. This is the key risk for the euro since it could push EUR/USD below parity again. We continue to sell the EUR/JPY cross. In a risk-off environment, EUR/JPY will collapse. In a risk-on environment, like this week, the yen can still benefit since it is oversold. Meanwhile, investors remain overwhelmingly bearish (panel 5). The Japanese Yen: Quite A Hefty Rally Chart 5Some Green Shoots In Japan Some Green Shoots In Japan Some Green Shoots In Japan The Japanese yen is down 13.4% year-to-date, the worst performing G10 currency (panel 1). Over the last month, the yen is up 3.3%. Incoming data in Japan has been worsening as the rising number of Covid-19 cases is hitting mobility and economic data. According to the Eco Watcher’s survey, sentiment among small and medium-sized Japanese firms deteriorated in July. Current conditions fell from 52.9 to 43.8. The outlook component also declined from 47.6 to 42.8. Machine tool order momentum, one of our favorite measures of external demand, continues to slow. Peak growth was at 141.9% year-on-year in May last year. The preliminary reading from July was at 5.5% (panel 2). Labor cash earnings came in at 2.2% year-on-year, a positive sign. Household spending also rose 3.5%. Rising wages could keep inflation momentum rising in Japan (panel 3). On that note, the Tokyo CPI report for July was also encouraging, with an increase in the core-core measure from 1% to 1.2%. The Tokyo CPI tends to lead nationwide measures. The labor market remains robust. Labor demand exceeds supply by 27%. The Bank of Japan kept monetary policy on hold on July 20th, a policy move that makes sense given incoming data. The BoJ still views a large chunk of inflation in Japan as transitory. For inflation to pick up, wages need to rise. While they are rising, inflation expectations remain well anchored, suggesting little rationale for the BoJ to shift (panel 4). That said, the yen is extremely cheap after being the best short this year (panel 5).  British Pound: Coiled Spring Below 1.20? Chart 6Cable Is Vulnerable Cable Is Vulnerable Cable Is Vulnerable The pound is down 9.8% year to date. Over the last month, the pound is up by 2.5%. Sterling broke below a soft floor of 1.20, but quickly bounced back and is now sitting at 1.22, as sentiment picked up (panel 1). We find the UK to have an even bigger stagflation problem than the eurozone. CPI came in at 9.4% in June. The RPI came in at 11.8%. PPI was at 24%. All showed an acceleration from the month of May (panel 2). Nationwide house price inflation has barely rolled over unlike other markets, increasing from 10.7% in June to 11% in July. The Rightmove national asking price was 9.3% higher year-on-year in July, compared to 9.7% in June (panel 3). Meanwhile, mortgage approvals have been in steady decline over the last two years, which points toward stagflation. Retail sales excluding auto and fuel fell 5.9% year-on-year in June, the weakest reading since the Covid-19 crisis. Consumer confidence is lower than in 2020 (panel 4). Trade data continues to be weak, which has dipped the current account towards decade lows (panel 5). The external balance is the biggest driver of the pound, given the huge deficit. The above environment has put the BoE in a stagflationary quagmire. Last week, they raised rates by 50 bps suggesting inflation is a much more important battle than growth. Politically, the resignation of Prime Minister Boris Johnson, and broader difficulties for the Conservative Party, is fueling sterling volatility. We are maintaining our long EUR/GBP trade as a bet that at 1.03, the euro has priced in a recession (well below the 2020 lows), but sterling has not. On cable, 1.20 will prove to be a long-term floor but it will be volatile in the short term.  Australian Dollar: A Contrarian Play Chart 7Relatively Solid Domestic Conditions In Australia Relatively Solid Domestic Conditions In Australia Relatively Solid Domestic Conditions In Australia The AUD is down 2.3% year-to-date. Over the last month, the AUD is up 5.3%. AUD is fast approaching its 200-day moving average. If that is breached, it could signal that the highs of this year, above 76 cents, are within striking distance (panel 1). Inflation is accelerating in Australia. In Q2, the inflation reading was 6.1%, while the trimmed-mean and weighted-median measures were above the central bank’s 1-3% band (panel 2). As a result, the RBA stated the benchmark rate was “well below” the neutral rate. It increased rates by an additional 50bps in August, lifting the official cash rate to 1.85%. Further rate increases are likely. There are a few reasons for this. First, labor market conditions are the most favorable in decades. In June, unemployment reached 3.5%, its lowest level in 50 years, against a consensus of 3.8% (panel 3). The participation rate also increased to 66.8% in June from 66.7%, which has pushed the underutilization rate to multi-decade lows (panel 4). Despite this, consumer confidence continued its decline in August, dropping to 81.2 from 83.8. A pickup in Covid-19 cases and high consumer prices are the usual suspects. Beyond the labor market, monetary policy seems to be having the desired effect. Demand appears to be slowing as retail sales grew 0.2% month-on-month in June from 0.9%. Home loan issuance declined by 4.4% in June, driven by a 6.3% decline in investment lending. House price growth continued to decline in July, particularly in densely populated regions like Sydney and Melbourne. The manufacturing sector remains strong, with July PMI coming in at 55.7, suggesting the RBA might just be achieving a soft landing in Australia.  The external environment was largely favorable for the AUD in June, as the trade balance increased substantially by A$17.7bn with commodities rallying early in the month. However, commodity prices are rolling over. The price of iron for example, is down 24% from its peak in June. This will likely weigh on the trade balance going forward (panel 5). A weakening external environment are near-term headwinds for the AUD, but we will be buyers on weakness (panel 6).  New Zealand Dollar: Least Preferred G10 Currency Chart 8Near-Term Risks To NZD Near-Term Risks To NZD Near-Term Risks To NZD The NZD is down 6.1% this year. Over the last month, it is up 5% (panel 1). The Reserve Bank of New Zealand raised its official cash rate (OCR) in July by 50bps to 2.5%, in line with market expectations. Policymakers maintained their hawkish stance and guided towards increased tightening until monetary conditions can bring inflation within its target range of 1-3%. Inflation rose in Q2 to 7.3% from a 7.1% forecast, largely driven by rising construction and energy prices (panel 2). As of the latest data, monetary policy appears to be continuing to have the desired effect on interest rate sensitive parts of the economy. REINZ home sales declined 38.1% year-on-year in June. Home price growth continues to roll over (panel 3). The external sector continues to slow. Dairy prices, circa 20% of exports, saw a 12% drop in early August after remaining flat in July. The 12-month trailing trade balance remains in deficit. This is most likely due to a substantial slowdown in Chinese economic activity, given that China is an important trade partner with New Zealand. What is important is that the RBNZ’s “least regrets” approach seems to be working. Despite a cooling economy, sentiment seems to be stabilizing. ANZ consumer confidence improved to 81.9 in July from 80.5. Business confidence also improved to -56.7 from -62.6 (panel 4). Ultimately, the NZD is driven by terms of trade, as well as domestic conditions (panels 1 and 5). Thus, short-term headwinds from a deteriorating external sector do not make us buyers of the currency for now, though a rollover in the dollar will help the kiwi.  Canadian Dollar: Lower Oil, Hawkish BoC Chart 9The BoC Will Stay On A Hawkish Path The BoC Will Stay On A Hawkish Path The BoC Will Stay On A Hawkish Path The CAD is down 1.2% year to date. Over the last month, it is up 1.8%. The Canadian dollar did not fully catch up to oil prices on the upside. Now that crude is rolling over, CAD remains vulnerable, unless the dollar continues to stage a meaningful decline (panel 1). Canadian data has been rather mixed over the last month. For example: There have been two consecutive months of job losses. This is after a string of positive job reports. In July, Canada lost 31K jobs. In June, it lost 43K. The reasons have been mixed, from women dropping out of the labor force, to lower youth participation (the participation rate fell), but this is a trend worth monitoring (panel 2). CPI growth remains elevated and is accelerating both on headline and core measures(panel 3). Building permits and housing starts have started to roll over, as house price inflation continues to lose momentum. June housing starts were at 274K from 287.3K. June building permits also fell 1.5% month-on-month though annual inflation is still outpacing house price growth (panel 4). The Canadian trade balance is improving, hitting a multi-year high of C$5.05 bn in June. This has eased the need for foreign capital inflows. The BoC raised rates 100bps in July, the biggest interest rate increase in one meeting among the G10. Unless the labor market continues to soften, the BoC will continue to focus on inflation, which means more rate hikes are forthcoming. The OIS curve is pricing a peak BoC rate of 3.6% in 9 months (panel 5). Two-year real rates are still higher in the US compared to Canada. And the loonie has lost the tailwind from strong WCS oil prices. As such, unless the dollar softens further, the loonie will remain in a choppy trading pattern like most of this year.  Swiss Franc: A Safe Haven Chart 10The Franc Will Remain Strong Against The Euro For Now The Franc Will Remain Strong Against The Euro For Now The Franc Will Remain Strong Against The Euro For Now CHF is down 3.2% year-to-date and up 4.3% in the past month. The Swiss franc has been particular strong against the euro, with EUR/CHF breaching parity (panel 1). Switzerland remains an island of relative economic stability in the G10. Although slowing, the manufacturing PMI was a healthy 58 in July. The trade surplus was up to CHF 2.6bn in June, despite a strong franc. While most European countries are preparing for a tough winter with energy rationing, prospects for Switzerland, which derives only 13% of its electricity from natural gas, look more favorable.  Still, as a small open economy, Switzerland is feeling the impact of global growth uncertainty. The KOF leading indicator dropped to 90.1 in August with a sharp decline in the manufacturing component. This broader measure suggests the relative resilience of the manufacturing sector might not last long (panel 2). Consumer confidence also fell to the lowest level since the onset of the pandemic. Swiss headline inflation stabilized at 3.4% in July. The core measure rose slightly to the SNB’s 2% target (panel 3). The UBS real estate bubble index rose sharply in Q2, suggesting inflation is not only an imported problem. Labor market conditions also remain tight, with the unemployment rate at 2%, a two-decade low. The SNB will continue to embrace currency strength while inflation risks persist (panel 4), as can be seen by the decline in sight deposits and FX reserves (panel 5). The market is still pricing in another 50 bps hike in September although August inflation data that comes out before the meeting will likely be critical for that decision. CHF is one of the most attractive currencies in our ranking. Despite the recent outperformance, CHF is still down year-to-date against the dollar. A rise in safe-haven demand, and a possible energy crunch in winter will be supportive, especially against the euro.  Norwegian Krone: Oil Fields Are A Jewel Chart 11NOK Will Reap Dividends From Energy Exports NOK Will Reap Dividends From Energy Exports NOK Will Reap Dividends From Energy Exports NOK is down 7.4% year-to-date and up 7.1% over the last month. It is also up 4.2% versus the euro, despite softer oil prices (panel 1). Inflation in Norway continues to accelerate. In July, CPI grew 6.8% year-on-year, above the market consensus and the Norges Bank’s forecast. Underlying inflation jumped sharply to an all-time high of 4.5%, compared to the Bank’s 3.2% forecast made just over a month ago (panel 2). These figures are adding pressure on the central bank to increase the pace of interest rate hikes, with 50bps looking increasingly likely at the meetings in August and September. NOK jumped on the inflation news. The housing market is starting to show signs of slowing with prices down 0.2% on the month in July, the first decrease since December. This, together with household indebtedness (panel 3), makes the task of policy calibration challenging. Our bias is that a persistently tight labor market and strong wage growth (panel 4) will allow the bank to focus on inflation. Economic activity remains robust in Norway but is softening. The manufacturing PMI fell to 54.6 in July, while industrial production was down 1.7% month-over-month in June. Consumer demand remains frail with retail sales and household consumption flat in June from the previous month. On a more positive note, trade surplus remains near record levels and is likely to stay elevated as high European demand for Norwegian energy is likely to last at least through the winter (panel 5). As global risk sentiment picked up, the krone became the best performing G10 currency over the past month. If the risk appetite reverses, the currency is likely to feel some turbulence. Swedish Krona: Cheap, But No Catalysts Yet Chart 12SEK = EUR On Steroids SEK = EUR On Steroids SEK = EUR On Steroids SEK is down 10% year-to-date and up 5.6% over the past month. The vigorous rebound highlights just how oversold the Swedish krona is (panel 1). The Swedish economy grew 1.4% in Q2 from the previous three months, rebounding from a 0.8% contraction in the first quarter. This is impressive, given high energy prices and a slowdown in global economic activity. Going forward, growth is likely to slow. In July, the services and manufacturing PMIs declined, and consumer confidence fell sharply to the lowest reading in almost 30 years. Retail sales were down 1.2% month-on-month in June. The housing market is also feeling the pain of rising borrowing costs (panel 2). The Riksbank’s latest estimate sees a 16% decline in prices by the end of next year.  For now, inflation is still accelerating in Sweden. CPIF, the Riksbank’s preferred measure, increased from 7.2% to 8.5% in June. Headline inflation rose from 7.3% to 8.7% (panel 3). Headline inflation is likely to decline in July, given the drop in the price component of the PMIs, but inflation will remain well above target. This will keep real rates weak (panel 4). This suggests that the Riksbank is facing the same conundrum as the ECB: accelerate policy tightening and tip the economy towards recession or remain accommodative and risk inflation becoming more entrenched. Our bias is that the Riksbank is likely to frontload rate hikes as currently priced in the OIS curve, with a 50 bps hike in September, ahead of major labor union wage negotiations (panel 5). Much like the NOK, the Swedish krona rebounded strongly in the past month on global risk-on sentiment. Fundamentally, the krona remains more vulnerable to external shocks due to higher energy dependency and a strong dollar. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Artem Sakhbiev Research Associate artem.sakhbiev@bcaresearch.com Thierry Matin Research Associate thierry.matin@bcaresearch.com   Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary