Financial Markets

Executive Summary The Efficient Market Hypothesis (EMH) is flawed. This Holy Grail of financial economics assumes that investors are a homogenous bunch with identical investment horizons, when the reality is that investors have a wide spectrum of time horizons. The alternative but less well-known Fractal Market Hypothesis (FMH) recognizes that investors with different time horizons interpret the same facts and information differently. The key conclusion of the FMH is that when the different investment horizons are all active in the market, the price reflects all available information, meaning that the market is efficient, liquid, and stable. But when the different investment horizons start to converge and coalesce, the market becomes inefficient, illiquid, and vulnerable to a trend reversal. Using the FMH over the past six months, 5 structured recommendations were closed in profit: Short ILS/GBP, Short Coffee versus Cocoa, Short World Basic Resources versus Market, Long EUR/CHF, and Short Semiconductors versus Tech. Against this, 3 structured recommendations were closed in loss: Short Nickel versus Silver, Long Polish Bonds versus US Bonds, and Short World Semiconductors versus Biotech. Within the 10 open trades, 3 are in healthy profit, 4 are flat, and 3 are in loss. The Efficient Market Hypothesis Does Not Describe The Truth; The Fractal Market Hypothesis Does Fractal Trading Update - June 2022 Fractal Trading Update - June 2022 Bottom Line: As few investors are aware of the Fractal Market Hypothesis, it gives a competitive advantage to those that use it to identify potential trend reversals. Feature For nations and societies, disagreement and conflict are unhealthy. But for financial markets, the opposite is true – it is the lack of disagreement and conflict that is unhealthy. This is because the market needs disagreement to generate liquidity, the ability to trade quickly and in large volume without destabilizing the market price. If I want to buy a share, then somebody must sell me that share. It follows that I and the seller must disagree about the attractiveness of the share at the current price. Likewise, if I and like-minded individuals want to buy ten million shares, it follows that lots of market participants must disagree with us. If lots of market participants do not disagree with us, there will be insufficient liquidity to complete the transaction without a price change. And if too many people are engaged in groupthink, the price change could be extreme. Markets Become Inefficient When There Is Not Enough Disagreement How can there be major disagreement about the attractiveness of an investment when we all have access to the same facts and information? According to the Efficient Market Hypothesis (EMH) there cannot be, because asset prices always reflect all available information.1   Unfortunately, the Efficient Market Hypothesis is flawed. This Holy Grail of financial economics assumes that investors are a homogenous bunch with identical investment horizons, when the reality is that investors have a wide spectrum of time horizons – ranging from the milliseconds of momentum-driven high-frequency trading (HFT) to the decades of a value-driven pension fund. The market is efficient only when a wide spectrum of investment horizons is setting the price, signified by the market having a rich fractal structure. The alternative but less well-known Fractal Market Hypothesis (FMH) recognizes the reality of different time horizons. Crucially, the FMH acknowledges that investors with different time horizons interpret the same facts and information differently. In other words, they disagree (Box I-1). Box 1-1The Efficient Market Hypothesis Does Not Describe The Truth; The Fractal Market Hypothesis Does Fractal Trading Update - June 2022 Fractal Trading Update - June 2022 For example, the momentum-based high frequency trader might interpret a sharp one-day sell-off as a sell signal, but the value-based pension fund might interpret the same information as a buying opportunity. This disagreement will create liquidity without requiring a big price adjustment. Thereby it also fosters market stability. The key conclusion of the Fractal Market Hypothesis is that when the different investment horizons are all active in the market, the price does reflect all available information, meaning that the market is efficient, liquid, and stable. But when the different investment horizons start to converge and coalesce, the market becomes inefficient, illiquid, and vulnerable to a trend reversal. Buy and sell orders will no longer match without a price change, possibly extreme. Can we measure the loss of efficiency in a specific investment, and thereby anticipate a potential trend reversal? The answer is yes, by monitoring its fractal dimension, using the expression in the Appendix. Although many readers may find the concept of a fractal dimension intimidating, the idea is simple and intuitive. It just measures the complexity – or information content – in an object or structure. Thereby, when an investment’s fractal dimension reaches its lower limit, it warns that the information content of longer-term investors is missing from the price.  When the longer-term investors do ultimately re-enter the price setting process, the question is: will they endorse the recent trend because of some major change in the fundamentals – such as the start of the Russia/Ukraine war? Or will they reject it, as an unjustified deviation from a fundamental anchor. In most cases, it is the latter: a rejection and a trend reversal. As few investors are aware of the Fractal Market Hypothesis, it gives a competitive advantage to those that use it to identify potential trend reversals. Fractal Trading Update Using the Fractal Market Hypothesis over the past six months, 5 structured recommendations were closed in profit: Short ILS/GBP, Short Coffee versus Cocoa, Short World Basic Resources versus Market, Long EUR/CHF, and Short Semiconductors versus Tech. A fragile fractal structure warns of a crowded trade. One structured recommendation was closed flat: Short Personal Goods versus Consumer Services. Against this, 3 structured recommendations were closed in loss: Short Nickel versus Silver, Long Polish Bonds versus US Bonds, and Short World Semiconductors versus Biotech. Within the 10 open trades, 3 are in healthy profit, 4 are flat, and 3 are in loss. As for the unstructured recommendations, for which we do not define profit targets or expiry dates, we are pleased to report that out of 31 recommendations, only 2 failed to experience a countertrend reversal. Wins 1) November 18th: Short ILS/GBP Achieved its profit target of 4.2 percent. 2) November 25th: Short Coffee versus Cocoa (Chart I-1) Achieved almost half of its 30 percent profit target at expiry. Chart I-1Fractal Analysis Correctly Predicted A Reversal In Coffee Versus Cocoa Fractal Analysis Correctly Predicted A Reversal In Coffee Versus Cocoa Fractal Analysis Correctly Predicted A Reversal In Coffee Versus Cocoa 3) January 20th: Short World Semiconductors versus Tech (Chart I-2) Achieved its profit target of 6 percent. Chart I-2Fractal Analysis Correctly Predicted A Reversal In World Semiconductors Versus Technology Fractal Analysis Correctly Predicted A Reversal In World Semiconductors Versus Technology Fractal Analysis Correctly Predicted A Reversal In World Semiconductors Versus Technology 4) March 10th: Long EUR/CHF Achieved its profit target of 3.6 percent. 5)  April 14th: Short World Basic Resources versus Market (Chart I-3) Achieved its profit target of 11.5 percent. Chart I-3Fractal Analysis Correctly Predicted A Reversal In World Basic Resources Versus Market Fractal Analysis Correctly Predicted A Reversal In World Basic Resources Versus Market Fractal Analysis Correctly Predicted A Reversal In World Basic Resources Versus Market In addition, Short World Personal Goods versus Consumer Services which was opened on December 9th reached a high-water mark of 10.5 percent but expired flat. Losses 1) December 2nd: Short World Semiconductors versus Biotech Hit its stop loss of 9.5 percent. 2) January 13th: Long Poland versus US: 10-Year Government Bonds Reached a high-water mark of 3.7 percent, but then reversed to hit its stop loss of 8 percent. In the current geopolitical crisis, Poland has been a casualty due to its lengthy border with Ukraine. 3) February 3rd: Short Nickel versus Silver (Chart I-4) Hit its stop loss at 20 percent following an explosive short-squeeze rally in the Nickel price. Chart I-4Nickel's Short-Squeeze Rally Forced A Price Trend Prolongation Nickel's Short-Squeeze Rally Forced A Price Trend Prolongation Nickel's Short-Squeeze Rally Forced A Price Trend Prolongation Open Trades 1) January 27th: Long MSCI Korea versus All-Country World (Chart I-5) Open, in profit, having reached a high-water mark of 6 percent (versus an 8 percent target). Chart I-5Fractal Analysis Correctly Predicted A Rebound In Korea Versus All-Country World Fractal Analysis Correctly Predicted A Rebound In Korea Versus All-Country World Fractal Analysis Correctly Predicted A Rebound In Korea Versus All-Country World 2) February 24th: Long US Biotech versus US Tech Open, in profit, having reached a high-water mark of 10.5 (versus a 17.5 percent target). 3) March 3rd: Short World Banks versus Consumer Services Reached a high-water mark of 7.3 percent (versus a 12 percent target), but then reversed and is in loss. 4) March 24th: Long 5-Year T-bond Open, in modest loss. 5) April 7th: Short World Non-Life Insurance versus Homebuilders (Chart I-6) Open, in profit having reached a high-water mark of 12.4 percent (versus a 14 percent target). Chart I-6Fractal Analysis Correctly Predicted A Reversal In World Non-Life Insurance Versus Homebuilders Fractal Analysis Correctly Predicted A Reversal In World Non-Life Insurance Versus Homebuilders Fractal Analysis Correctly Predicted A Reversal In World Non-Life Insurance Versus Homebuilders 6) April 7th: Long JPY/CHF Reached a high-water mark of 3.4 percent versus a 4 percent target, but then reversed into modest loss. This suggests that the trade needed a narrower profit target. 7) April 28th: Short High Dividend ETF versus US 10-Year T-bond Open, in modest loss, having reached a high-water mark of 2.9 percent (versus a 6 percent target). 8) May 19th: Short FTSE 100 versus STOXX Europe 600 Open, and flat. 9) June 2nd: Long JPY/USD (Chart I-7) Open, and flat. Chart I-7The Sell-Off In JPY/USD Has Reached A Potential Turning Point The Sell-Off In JPY/USD Has Reached A Potential Turning Point The Sell-Off In JPY/USD Has Reached A Potential Turning Point 10) June 2nd: Short Australia Basic Resources versus World Market (Chart I-8) Open, and flat. Chart I-8The Australian Basic Resources Sector Is Vulnerable To Reversal The Australian Basic Resources Sector Is Vulnerable To Reversal The Australian Basic Resources Sector Is Vulnerable To Reversal   Our full watchlist of 29 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Appendix: Calculating The Fractal Dimension Of A Financial Market Fractal Trading Update - June 2022 Fractal Trading Update - June 2022 Chart 1AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 2Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Chart 3Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 4US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 5BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 6Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Chart 7CNY/USD Has Reversed CNY/USD Has Reversed CNY/USD Has Reversed Chart 8CAD/SEK Is Vulnerable To Reversal CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 9Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 10The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 11The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 12FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 13Netherlands Underperformance Vs. Switzerland Is Ending Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 14The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 15The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 16Food And Beverage Outperformance Exhausted Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 18The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 19A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 21Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 22Cotton Versus Platinum Is Reversing Cotton Versus Platinum Is Reversing Cotton Versus Platinum Is Reversing Chart 23Switzerland's Outperformance Vs. Germany Has Ended Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Chart 24The Rally In USD/EUR Has Ended The Rally In USD/EUR Has Ended The Rally In USD/EUR Has Ended Chart 25The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 26A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 27Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Chart 28US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 29GBP/USD At A Turning Point GBP/USD At A Turning Point GBP/USD At A Turning Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Hadi Elzein Research Associate hadi.elzein@bcaresearch.com Footnotes 1  Strictly speaking, the EMH assumes there is some disagreement, but that this disagreement is random and follows a standard Gaussian (bell-curve) distribution. Therefore, the EMH assumes that a share price just follows a random walk until new (unpredictable) fundamental information arrives. Fractal Trades Fractal Trading Update - June 2022 Fractal Trading Update - June 2022 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Chinese Infrastructure Investment Growth: A Slowdown Ahead Chinese Infrastructure Investment Growth: A Slowdown Ahead Chinese Infrastructure Investment Growth: A Slowdown Ahead Despite the authorities’ push, China’s infrastructure1  investment nominal growth2 will likely slow from the current rate of 8% to 1-3% in 2022H2, on a year-over-year basis.   Funding shortages will limit local governments’ capability to invest in traditional infrastructure fixed-asset investment (FAI), which will likely grow by only 1-2% in 2022H2. We expect China’s cheap green loans to support a 10-15% growth in tech infrastructure spending in the second half of this year. However, the scale of China’s tech infrastructure investment is too small in absolute terms to offset the weakness in traditional infrastructure spending.  Tech infrastructure plays will likely outperform traditional infrastructure plays in the long term as China continues its efforts to peak carbon emissions before 2030 and reach carbon neutrality before 2060. As new infrastructure investment will accelerate in the coming years, we are positive on the sectors of NEV and NEV charging poles. Given the still-high valuation of the sector and mounting downward pressure that the Chinese economy is currently facing, we look to buy these sectors at a better price entry point. Bottom Line: China’s infrastructure investment growth will likely slow from the current 8% rate to 1-3% in 2022H2 due to funding constraints and a shrinking pool of profitable infrastructure projects. Feature Infrastructure investment growth in China accelerated to 8% (nominal) in the first four months of this year (Chart 1, top panel). The authorities demanded that local governments execute infrastructure projects sooner and faster to offset the strong headwinds to the economy from COVID restrictions and continued property downturn. Nonetheless, China’s infrastructure investment growth will likely slow from the current annual rate (YoY) of 8% to 1-3% in 2022H2 due to funding constraints and a lack of financially feasible projects, bringing the whole year’s growth to slightly below 4%.  Although a 4% YoY growth in infrastructure investment this year would be an improvement from the 0.4% YoY contraction in 2021, it is far below the 12% average rate of infrastructure spending growth over the past decade (Chart 1). Moreover, we estimate that traditional infrastructure investment, which accounts for 95% of China’s total infrastructure spending, will only grow by 1-2% in 2022H2 (Chart 2, top panel). Chart 1Chinese Infrastructure Investment: Moderate Growth In 2022H2 Chinese Infrastructure Investment: Moderate Growth In 2022H2 Chinese Infrastructure Investment: Moderate Growth In 2022H2 Chart 2Investment Growth In 2022H2: Deceleration In Traditional Infrastructure While Acceleration In Tech Infrastructure Investment Growth In 2022H2: Deceleration In Traditional Infrastructure While Acceleration In Tech Infrastructure Investment Growth In 2022H2: Deceleration In Traditional Infrastructure While Acceleration In Tech Infrastructure For the tech infrastructure, we are more positive as building cutting-edge tech infrastructure– including 5G networks, data centers, artificial intelligence (AI) and Internet of Things (IoT) – has become a top development priority for China. With supportive policies and cheap green loans, we expect a 10-15% YoY growth in Chinese tech infrastructure in 2022H2 (Chart 2, bottom panel). However, the scale of China’s tech infrastructure investment is too small in absolute terms to offset the weakness in traditional infrastructure spending. After all, tech infrastructure currently only accounts for about 5% of the total Chinese nominal infrastructure FAI (Chart 3). Chart 3Breaking Down Chinese Infrastructure Investment China's Infrastructure Push: How Much Upside? China's Infrastructure Push: How Much Upside? Tech infrastructure plays will likely outperform their traditional infrastructure counterparts in the long term as China continues its efforts to peak carbon emissions before 2030 and reach carbon neutrality before 2060. As new infrastructure investment will accelerate in the coming years, we are positive on the sectors of NEV and NEV charging poles. Yet, considering China’s economy is still facing downward pressure and the sector’s valuations are still high, we look to buy these sectors at a better price entry point. Funding Constraints The recent strong rebound in Chinese infrastructure investment was mainly driven by a massive frontload of local government special purpose bond (SPB) sales, as well as funding from last year’s SPB proceeds – both funding resources will not sustain into the second half of this year.   According to the data from the Ministry of Finance, in the first five months of 2022, special bond issuance has already reached 2.03 trillion RMB, significantly higher than the 1.2 trillion RMB issued during the same period last year. In addition, there has been an estimated 1.2 trillion unused SPB proceeds from 2021 that have been carried over to 2022 to fund infrastructure spending. However, such a boost in local government funding of infrastructure investment is unsustainable. We expect Chinese infrastructure investment growth to fall back to the 1-3% range in 2022H2 due to limited financial availability and a shrinking pool of infrastructure projects. Chart 4 shows the breakdown of the major funding sources of Chinese infrastructure investment. Most of them are likely to face considerable constraints over the next six months. Chart 4Major Funding Sources Of Chinese Infrastructure Investment China's Infrastructure Push: How Much Upside? China's Infrastructure Push: How Much Upside? (1) Less Revenues Chinese local governments face tremendous shortfalls of cash, which will impede their ability to meet their nearly 30% contribution to overall infrastructure funding: Land sales by local governments contribute nearly 90% of government-managed funds (GMF3). The latter's revenues, excluding proceeds from SPB issuance, account for 16% of overall infrastructure funding. The deep contraction in home sales has depressed real estate developers’ land purchases, which has considerably reduced local government revenues (Chart 5). This will curb the ability of local governments to finance their infrastructure projects through GMFs. Although we expect a moderate rebound in property sales over the next six months from very depressed levels in recent months, the improvement in local government land sales will likely be very limited as real estate developers are still overleveraged and under severe funding constraints.   In addition to the slump in land sales, tax cuts for corporates and low-income households are also eroding local government revenues, and COVID-related expenses add to spending needs. Shrinking corporate profits will also pose downward risks to the tax revenues of local governments (Chart 6). Chart 5Government-Managed Funds: Headwinds From Falling Land Sales Government-Managed Funds: Headwinds From Falling Land Sales Government-Managed Funds: Headwinds From Falling Land Sales Chart 6Declining Government Tax##br## Revenues Declining Government Tax Revenues Declining Government Tax Revenues   The general budget of local governments,4 which contributes to about 14% of overall infrastructure financing, is extremely tight this year. In the first four months of the year,  revenues of local governments fell by about 18% from the same period last year, while their expenditures increased by 5%. As a result, the general government’s fiscal deficit will likely exceed both the 2.8% target set for this year and the 3.2% fiscal deficit of last year (Chart 7).   Chart 7Government General Budget: Large Deficit Government General Budget: Large Deficit Government General Budget: Large Deficit (2) Less SPB Available In H2 Chart 8Local Government Special Bond Issuance Will Decrease In 2022H2 Local Government Special Bond Issuance Will Decrease In 2022H2 Local Government Special Bond Issuance Will Decrease In 2022H2 Local government SPB issuance, which is used exclusively to fund infrastructure projects, has been another major source of financing for domestic infrastructure projects since 2016 (Chart 8).    As local governments frontloaded 56% of their 2022 SPB quota in the first five months of this year, they will have less fiscal support from SPBs in 2022H2. As net local government SPB issuance made up about 16% of overall infrastructure FAI on average in the past three years, there is quite a financing gap to be filled in 2022H2. (3) Contracting Domestic Loan Demand Domestic loans contribute to about 20% of overall infrastructure financing, with 14% from regular non-household medium-long-term (MLT) lending, and another 6% from domestic green loans. Infrastructure projects are generally long-term investments in nature and hence often require MTL loans. Presently, the impulse of non-household MLT lending is contracting (Chart 9). While not all MLT loans are used for infrastructure, sluggish MLT lending also reflects corporates’ reluctance to borrow for and invest in infrastructure projects. Strong economic headwinds due to COVID-induced lockdowns and the slumping property market, mounting local government debt, and low returns on infrastructure projects will continue to curb corporates’ demand for bank loans to fund infrastructure projects, particularly from the private sector. The “green loans”,5 which are used for but not limited to new energy infrastructure projects, will continue to grow strongly in 2022H2. In 2021, the increase in green loans for infrastructure was 1.64 trillion RMB, or a 62% increase from the previous year. In 2022, we expect new green loans could rise 50%-80% to 2.5-3 trillion RMB, with an increase of 0.6-1.1 trillion RMB in new green loans in the second half of the year. While green loans will help support the overall infrastructure investment, given their small size (green loans accounted for about 8% of China’s total infrastructure investment in 2021), they will unlikely fully offset the shortfall from other financing sources this year (Chart 10). Chart 9Sluggish Medium/Long-Term Bank##br## Lending Sluggish Medium/Long-Term Bank Lending Sluggish Medium/Long-Term Bank Lending Chart 10Green Loans: Strong Growth In 2022H2 But Still Small Amount Relative To Overall Infrastructure Investment Green Loans: Strong Growth In 2022H2 But Still Small Amount Relative To Overall Infrastructure Investment Green Loans: Strong Growth In 2022H2 But Still Small Amount Relative To Overall Infrastructure Investment In the long run, though, to reach peak carbon emissions by 2030 and carbon neutrality by 2060, China will continue to lean heavily on its banking system to accelerate green projects and infrastructure investment. (4) Public-Private Partnerships (PPP) Since 2014, PPPs have become an important financing model for Chinese local governments to fund infrastructure investments. However, to control rising local government leverage, the central government has tightened regulations on PPP projects since early 2018. Heightened scrutiny has resulted in a sharp deceleration in both PPP investment and overall infrastructure investment growth. Consequently, PPP contributions to total infrastructure FAI have been consistently declining, from over 30% in 2017 to about 4% currently (Chart 11). So far this year, the amount of signed and implemented PPP investments has been falling. While the private sector’s propensity to invest has been extremely weak, a shrinking pool of profitable infrastructure projects could be another contributing factor. The number of projects – which are in the preparation stage in the national total project entries – has been falling from its peak of 2,550 in June 2017 to only 465 in March 2022 (Chart 12). Chart 11Public-Private Partnerships Funding: Limited Growth In 2022H2 Public-Private Partnerships Funding: Limited Growth In 2022H2 Public-Private Partnerships Funding: Limited Growth In 2022H2 Chart 12A Shrinking Pool Of Public-Private Partnership##br## Projects A Shrinking Pool Of Public-Private Partnership Projects A Shrinking Pool Of Public-Private Partnership Projects (5) Other Funding Sources Local government financing vehicles (LGFV) and shadow bank borrowing were major financing sources prior to 2018. However, following the 2017/2018 financial de-risking and anticorruption campaign, local governments have scaled back their shadow bank activities significantly. Shadow banking remains in deep contraction (Chart 13). We expect only a modest pick-up in LGFV leveraging during the rest of the year, given that both the anticorruption campaign and a reshuffling of local government officials are ongoing. Chart 13Shadow Banking Will Remain In Deep Contraction Shadow Banking Will Remain In Deep Contraction Shadow Banking Will Remain In Deep Contraction In addition, policy banks could sell special sovereign bonds to help fund domestic infrastructure projects. For example, in a recent State Council meeting, Premier Li Keqiang requested policy banks to provide 800 billion RMB ($120 billion) in funding for infrastructure projects. An 800-billion-RMB additional funding, if fully invested, would only add about 0.4% growth to this year’s infrastructure spending. Bottom line: Due to funding constraints and a shrinking pool of profitable infrastructure projects, China’s infrastructure investment growth rate will likely slow from the current 8% pace to 1-3% in 2022H2. Infrastructure Investment Focus: Shifting From Traditional To New Chart 14China Is Shifting Its Focus Away From Traditional Infrastructure Development… China Is Shifting Its Focus Away From Traditional Infrastructure Development... China Is Shifting Its Focus Away From Traditional Infrastructure Development... The pace of new infrastructure (including but not limited to tech infrastructure) is set to accelerate both cyclically (in the next 6 to 12 months) and structurally (in the next 3 to 5 years), while traditional infrastructure investment growth will slow. However, over a cyclical time horizon, infrastructure investment in new economy sectors is too small to offset the weakness in spending in traditional sectors. Decelerating Investment In Traditional Infrastructure In 2022H2 And Beyond Chart 14 shows the real growth rate of railways, highways and airports has all dropped to below 3% last year. Correspondingly, investment in transport infrastructure only grew 1.4% in 2020 and 1.6% in 2021, a distinctly slower pace from 3.9% in 2018 and 3.4% in 2019. Similar growth deceleration has also occurred in the Water Conservancy, Environment & Utility Management sector. Investment growth in nominal terms this sector fell from 3.3% in 2018 and 2.9% in 2019 to 0.2% in 2020 and saw a 1.2% contraction in 2021. Most Chinese cities with large populations and/or high population density have already upgraded their sewer system in recent years and, therefore, localities have only been maintaining rather than upgrading these systems. The Water Conservancy, Environment & Utility Management sector and the Transport, Storage and Postal Service sector together account for the lion’s share (78%) of total infrastructure investment. A growth deceleration in these two sectors will likely lead to slower growth in overall infrastructure investment, compared with the first four months of this year, when both sectors grew by 7.2% and 7.4%, respectively, in nominal terms. Accelerating Investment In New Infrastructure In 2022H2 And Beyond Chart 15...To New Infrastructure Development ...To New Infrastructure Development ...To New Infrastructure Development Investment in new economy sectors–such as Electricity, Gas & Water Production and Supply, which currently accounts for about 18% of overall infrastructure investment–will remain strong in 2022H2. Investment in the subsector of ultra-high-voltage electricity transmission (UHV electricity transmission) and smart grid, as well as new electricity infrastructure, such as wind and solar power, will also continue to accelerate. The construction of 5G base stations will grow strongly in the coming years but may see a moderation in growth this year. Network operators such as China Mobile, China Unicom and China Telecom plan to build about 600,000 5G base stations, slightly lower than last year’s 650,000. The construction of new electric vehicle (NEV) charging poles accelerated because of a significant increase in NEV sales (Chart 15). Elevated oil prices and technology improvement in NEV performance have boosted NEV sales in China. As such, investment growth in NEV charging infrastructure is set to rise in the coming years. Bottom line: China’s investment focus is shifting from traditional infrastructure to new economy infrastructure. As such, we expect new infrastructure investment in tech and green energy to rise at the expense of traditional infrastructure (Chart 16). Chart 16"Green Investment" Is Rising, “Dirty Thermal” Investment Is Falling China's Infrastructure Push: How Much Upside? China's Infrastructure Push: How Much Upside? Investment Implications The infrastructure sector accounts for about 10-15% of China’s total steel consumption and about 30-40% of cement consumption (Chart 17). Chart 17A Slowdown In Chinese Infrastructure Spending Will Weigh On Steel And Cement Prices A Slowdown In Chinese Infrastructure Spending Will Weigh On Steel And Cement Prices A Slowdown In Chinese Infrastructure Spending Will Weigh On Steel And Cement Prices We expect China’s infrastructure investment, particularly in traditional sectors like highway construction, to slow in the second half of the year. As such, steel prices are at risk of falling further. Moreover, sluggish construction activity in property markets will be a drag on steel prices (Chart 18). Slower growth in traditional infrastructure investment in the next six months, as well as structurally will pose downward pressures on the performance of both global and Chinese onshore machinery stocks (Chart 19). Chart 18Dismal Property Markets Will Be A Drag On##br## Steel Prices Dismal Property Markets Will Be A Drag On Steel Prices Dismal Property Markets Will Be A Drag On Steel Prices Chart 19Slower Growth In Traditional Infrastructure Investment Will Weigh On Global/Chinese Machinery Stocks Slower Growth In Traditional Infrastructure Investment Will Weigh On Global/Chinese Machinery Stocks Slower Growth In Traditional Infrastructure Investment Will Weigh On Global/Chinese Machinery Stocks Chart 20Look To Buy NEV Stocks Look To Buy NEV Stocks Look To Buy NEV Stocks We are positive on China’s NEV sector’s structural outlook and stock performance, based on an acceleration in new economy infrastructure investment in the coming years. However, the near-term outlook on the sector’s stock performance is neutral at best. The sector’s valuations are high, considering China’s economy is still facing downward pressure due to a faltering property market, sluggish household income growth and consumption, falling export demand, as well as heightened risks of further COVID-induced lockdowns. NEV stocks will likely have more shakeouts in the coming six months before any sustainable uptrend. Hence, we look to buy these sectors at a better price entry point (Chart 20).   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes 1  Including both traditional infrastructure and tech infrastructure. For the purposes of this report, the composition of “infrastructure” includes “traditional infrastructure” and “tech infrastructure.” The “traditional infrastructure” comprises three categories – (1) Transport, Storage and Postal Service; (2) Water Conservancy, Environment & Utility Management; and (3) Electricity, Gas & Water Production and Supply. 2 Please note that all growth rates in this report are nominal growth rates. 3 According to the country’s Budget Law, the GMF budget refers to the budget for revenues and expenditures for the funds raised for specific developmental objectives. In brief, GMFs constitute de-facto off-balance-sheet government revenues and spending. 4 The general budget of local governments covers local governments’ day-to-day operation as well as local infrastructure development (mainly in four categories: Environment Protection,  Urban & Rural Community Affairs, and Affairs of Agriculture, Forest  & Irrigation and Transportation). In contrast, the government-managed funds (GMF) excluding proceeds from SPB issuance finances the big ang national-level important infrastructure projects. 5 Last November, the People’s Bank of China (PBoC) launched a carbon emission reduction facility (CERF) to offer low interest loans to financial institutions that help firms cut carbon emissions. The targeted green lending program will provide 60% of loan principals made by financial institutions for carbon emission cuts at a one-year lending rate of 1.75%. The funding will be available retroactively after the loans are made, and can be rolled over twice. Strategic Themes Cyclical Recommendations

Listen to a short summary of this report.       Executive Summary Chinese Stocks Are Relatively Cheap Chinese Stocks Are Relatively Cheap Chinese Stocks Are Relatively Cheap The Chinese economy faces a trifecta of economic woes: 1) The threat of renewed Covid lockdowns; 2) Cooling export demand; 3) A floundering housing market. Trying to reflate the Chinese housing bubble would only damage the long-term prospects of China’s economy. A much better option would be to adopt measures that boost disposable income. Not only would this help offset the drag from slowing export growth and a negative housing wealth effect, but it would also take some of the sting out of China’s zero-Covid policy. With the Twentieth Party Congress slated for later this year, the political incentive to shower the economy with cash will only intensify. Chinese equities are trading at only 10-times forward earnings and about 1-times sales. A significant upward rating for equity valuations is likely if the government adopts broad-based income-support measures. Go long the iShares MSCI China ETF ($MCHI) as a tactical trade. Bottom Line: China faces a number of economic woes, but these are fully discounted by the market. What has not been discounted is a broad-based stimulus program focused on income-support measures.   Dear Client, I will be visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi next week. No doubt, the outlook for oil prices will feature heavily in my discussions. I will brief you on any insights I learn in my report on June 17. In the meantime, I am pleased to announce that Matt Gertken, BCA’s Chief Geopolitical Strategist, will be the guest author of next week’s Global Investment Strategy report. Best regards, Peter Berezin Chief Global Strategist Triple Threat The Chinese economy faces a trifecta of economic woes: 1) The threat of renewed Covid lockdowns; 2) Cooling export demand; 3) A floundering housing market. Let us discuss each problem in turn.   Problem #1: China’s Zero-Covid Policy in the Age of Omicron Chart 1China’s Lockdown Index Remains Elevated China: A Trifecta Of Economic Woes China: A Trifecta Of Economic Woes China was able to successfully suppress the virus in the first two years of the pandemic. However, the emergence of the Omicron strain is challenging the government’s commitment to its zero-Covid policy. The BA.2 subvariant of Omicron is 50% more contagious than the original Omicron strain and about 4-times more contagious than the Delta strain. While 89% of China’s population has been fully vaccinated, the number drops off to 82% for those above the age of 60. And those who are vaccinated have been inoculated with vaccines that appear to be largely ineffective against Omicron. Keeping a virus as contagious as measles at bay in a population with little natural or artificial immunity is exceedingly difficult. While the authorities are starting to relax restrictions in Shanghai, China’s Effective Lockdown Index remains at elevated levels (Chart 1). A number of domestically designed mRNA vaccines are in phase 3 trials. However, it is not clear how effective they will be. Shanghai-based Fosun Pharma has inked a deal to distribute 100 million doses of Pfizer’s vaccine, but so far neither it nor Moderna’s vaccine have been approved for use. Our working assumption is that China will authorize the distribution of western-made mRNA vaccines later this year if its own offerings prove ineffectual. The Chinese government has already signed a deal to manufacture a generic version of Pfizer’s Paxlovid, which has been shown to cut the risk of hospitalization by 90% if taken within five days of the onset of symptoms. In the meantime, the authorities will continue to play whack-a-mole with Covid. Investors should expect more lockdowns during the remainder of the year.   Problem #2: Weaker Export Growth China’s export growth slowed sharply in April, with manufacturing production contracting at the fastest rate since data collection began. Activity appears to have rebounded somewhat in May, but the new export orders components of both the official and private-sector manufacturing PMIs still remain below 50 (Chart 2). Part of the export slowdown is attributable to lockdown restrictions. However, weaker external demand is also a culprit, as evidenced by the fact that Korean export growth — a bellwether for global trade — has decelerated (Chart 3).  Chart 2China’s Export Growth Has Rolled Over China's Export Growth Has Rolled Over China's Export Growth Has Rolled Over Chart 3Softer Export Growth Is Not A China-Specific Phenomenon Softer Export Growth Is Not A China-Specific Phenomenon Softer Export Growth Is Not A China-Specific Phenomenon Spending in developed economies is shifting from manufactured goods to services. Retail inventories in the US are now well above their pre-pandemic trend, suggesting that the demand for Chinese-made goods will remain subdued over the coming months (Chart 4). The surge in commodity prices is only adding to Chinese manufacturer woes. Input prices rose 10% faster than manufacturing output prices over the past 12 months. This is squeezing profit margins (Chart 5). Chart 4Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Chart 5Surging Input Costs Are Weighing On The Profits Of Chinese Commodity Users Surging Input Costs Are Weighing On The Profits Of Chinese Commodity Users Surging Input Costs Are Weighing On The Profits Of Chinese Commodity Users A modest depreciation in the currency would help the Chinese export sector. However, after weakening from 6.37 in April to 6.79 in mid-May, USD/CNY has moved back to 6.66 on the back of the recent selloff in the US dollar. Chart 6The RMB Tends To Weaken When EUR/USD Is Rising The RMB Tends To Weaken When EUR/USD Is Rising The RMB Tends To Weaken When EUR/USD Is Rising We expect the dollar to weaken further over the next 12 months as the Fed tempers its hawkish rhetoric in response to falling inflation. Chart 6 shows that the trade-weighted RMB typically strengthens when EUR/USD is rising. Chester Ntonifor, BCA’s Chief Currency Strategist, expects EUR/USD to reach 1.16 by the end of the year.   Problem #3: Flagging Property Market Chinese housing sales, starts, and completions all contracted in April (Chart 7). New home prices dipped 0.2% on a month-over-month basis, and are up just 0.7% from a year earlier, the smallest gain since 2015. The percentage of households planning to buy a home is near record lows (Chart 8). Chart 7The Chinese Property Market Has Been Cooling The Chinese Property Market Has Been Cooling The Chinese Property Market Has Been Cooling Chart 8Intentions To Buy A House Have Declined Intentions To Buy A House Have Declined Intentions To Buy A House Have Declined China’s property developers are in dire straits. Corporate bonds for the sector are, on average, trading at 48 cents on the dollar (Chart 9). Goldman Sachs estimates that the default rate for property developers will reach 32% in 2022, up from their earlier estimate of 19%. The government is trying to prop up housing demand. The PBoC lowered the 5-year loan prime rate by 15 bps on May 20th, the largest such cut since 2019. The authorities have dropped the floor mortgage rate to a 14-year low of 4.25%. They have also taken steps to make it easier for property developers to issue domestic bonds. BCA’s China strategists believe these measures will foster a modest rebound in the property market in the second half of this year. However, they do not anticipate a robust recovery – of the sort experienced following the initial wave of the pandemic – due to the government’s continued adherence to the “three red lines” policy.1 China is building too many homes. While residential investment as a share GDP has been trending lower, it is still very high in relation to other countries. China’s working-age population is now shrinking, which suggests that housing demand will contract over the coming years (Chart 10). Chart 9Chinese Property Developer Bonds Are Trading At Distressed Levels Chinese Property Developer Bonds Are Trading At Distressed Levels Chinese Property Developer Bonds Are Trading At Distressed Levels Chart 10Shrinking Working-Age Population Implies Less Demand For Housing Shrinking Working-Age Population Implies Less Demand For Housing Shrinking Working-Age Population Implies Less Demand For Housing Chinese real estate prices are amongst the highest anywhere. The five biggest cities in the world with the lowest rental yields are all in China (Chart 11). The entire Chinese housing stock is worth nearly $100 trillion, making it the largest asset class in the world. As such, a decline in Chinese home prices would generate a sizable negative wealth effect. Chart 11Chinese Real Estate Is Expensive China: A Trifecta Of Economic Woes China: A Trifecta Of Economic Woes A Silver Bullet? Trying to reflate the Chinese housing bubble would only damage the long-term prospects of China’s economy. Luckily, one does not need to fill a leaky bucket through the same hole the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs in declining sectors will eventually find new jobs in other sectors. China needs to reorient its economy away from its historic reliance on investment and exports towards consumption. The easiest way to do that is to adopt measures that boost disposable income, which has slowed of late (Chart 12). Not only would this help offset the drag from slowing export growth and a negative housing wealth effect, but it would also take some of the sting out of China’s zero-Covid policy. The authorities have not talked much about pursuing large-scale income-support measures of the kind adopted by many developed economies during the pandemic. As a result, market participants have largely dismissed this possibility. Yet, with the Twentieth Party Congress slated for later this year, the political incentive to shower the economy with cash will only intensify. Chinese equities are trading at only 10-times forward earnings and about 1-times sales (Chart 13). A significant upward rating for equity valuations is likely if the government adopts broad-based income-support measures. As we saw in the US and elsewhere, stimulus cash has a habit of flowing into the stock market; and with real estate in the doldrums, equities may become the asset class of choice for many Chinese investors. With that in mind, we are going long the iShares MSCI China ETF ($MCHI) as a tactical trade. Chart 12Disposable Income Growth Has Been Trending Lower Disposable Income Growth Has Been Trending Lower Disposable Income Growth Has Been Trending Lower Chart 13Chinese Stocks Are Relatively Cheap Chinese Stocks Are Relatively Cheap Chinese Stocks Are Relatively Cheap At a global level, a floundering Chinese property market would have been a cause for grave concern in the past, as it would have represented a major deflationary shock. Times have changed, however. The problem now is too much inflation, rather than too little. To the extent that reduced Chinese investment injects more savings into the global economy and knocks down commodity prices, this would be welcomed by most investors. China’s economy may be heading for a “beautiful slowdown.” Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn Twitter   Footnotes   1      The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. View Matrix China: A Trifecta Of Economic Woes China: A Trifecta Of Economic Woes Special Trade Recommendations Current MacroQuant Model Scores China: A Trifecta Of Economic Woes China: A Trifecta Of Economic Woes

Executive Summary Return Of The 'Pocketbook Voter' Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign President Biden’s pledge to fight inflation ahead of the midterm elections got a boost with the Gulf Arab states pledging to increase oil production in July and August. Yet OPEC’s action should not be overrated. The Saudis are not clearly bailing out Biden … at least not yet. Biden’s other inflation-fighting tools are also limited. The Fed will hike rates, which will weigh on inflation, at least in the short run. A short-term moderation in inflation will cause big shifts in financial markets. It will not save the midterms for Democrats, but gridlock is disinflationary so the effect is the same. Inflation risks will persist over the long run.   Recommendation (Cyclical) Inception Level Inception Date Return Small Vs. Large Cap Energy 0.6485 26-JAN-22 14.2% Oil And Gas Transportation And Storage Vs. S&P 500 0.0527 30-MAR-22 16.5% Bottom Line: Expect inflation to moderate in the short run. Oil prices will be volatile. Book a 14% profit on small cap versus large cap energy stocks and a 16.5% profit on the oil and gas transportation sub-sector relative to the broad market. Feature President Biden kicked off the summer – and the midterm election campaign – by defending his record thus far and pledging a three-pronged strategy to fight inflation. His options are limited but he received a boost from OPEC right off the bat. The bottom line is that disinflationary pressures are emerging. These include congressional gridlock, which is likely to return in January 2023. Biden’s policies will not save his party from a defeat in the midterms but moderating inflation will have huge investment consequences. Biden’s Three-Pronged Plan Consumer confidence is hurting while inflation eats away at real wage growth for Americans (Chart 1). Confidence is 14% higher than when Biden took office but 17.5% lower than when it peaked in June 2021. The latest survey from the Conference Board showed another decrease in May. This is foul weather for a ruling party that already stands to suffer a major check on its power when voters go to the polls in the fall. Biden’s approval rating is likely to stabilize but only at the current low level of 41.4%. Voters are focusing on the economy more than other issues like health care, the environment, or foreign affairs (Chart 2). Chart 1Consumer Confidence And Real Wages Tumble Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Chart 2Return Of The 'Pocketbook Voter' Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign In the Wall Street Journal Biden laid out his party’s election pitch.1 First, he argued that the US economy is transitioning from rapid recovery to stable growth – i.e. that it is not going into recession. That would be good, but a recession is possible and the slowdown is politically deadly: Household Savings: Aggregate household savings have risen from $1Tn in 2019 to $3.9Tn today, which Biden cited as evidence of improving financial security. The problem is that inequality skews the picture and the average American is unlikely to feel secure. Low and middle income earners have depleted their savings or seen only a small increase (Chart 3). The Biden administration failed to improve inequality as promised while the uneven economic recovery means that lower-paid Americans do not have as much ability to buffer spending as the aggregate savings imply. They will be unhappy in November. Chart 3Normal Households No Longer Flush With Savings Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Jobs And Wages: Biden highlighted the role of his economic stimulus in lowering unemployment and argued that Americans have better paying jobs. But inflation has eroded real wages and incomes, as highlighted in Chart 1 above. Business Investment: Biden argued that business investment is brisk. But sentiment is turning. New orders of core capital goods have rolled over and capex intentions are falling (Chart 4). Manufacturing Comeback: Biden also touted the US manufacturing comeback, claiming that factory jobs are growing at fastest rate in 30 years. But again the tide is shifting against him, with the employment component of manufacturing purchasing manager indexes now signaling contraction (Chart 5). Biden, like Presidents Trump and Obama, has invested heavily in the “Buy America” re-industrialization narrative, so this trend is threatening. Chart 4Business Investment Setback Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Chart 5Manufacturing Employment Weakening Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign A recession may indeed be avoided but the risk will not go away in time for the election. A recent study showed that at today’s extremely high level of inflation and extremely low level of unemployment, the odds of recession range from 60%-70% over the next 12-24 months.2 Second, Biden promised voters that he will fight inflation with all the powers of the White House. He laid out a three-pronged approach. However, his options are fairly limited and voters will not change their minds easily over the next five months: The Fed will hike rates: Biden argued that it is the Fed’s job to fight inflation and he will not interfere with rate hikes. While Biden offered admirable verbal support for an independent and non-partisan central bank, the truth is that real interest rates have not been this low since the highly politicized Fed chairmanship of Arthur Burns (Chart 6). While Biden has no reason to discourage rate hikes at the moment, he may change his tune as rates rise, growth slows, and the presidential election approaches. So may Powell, but by then it may be too late. In short, the Fed will hike, which will weigh on inflation, but it will not help Biden win voters this fall or avoid a recession by 2024. Congress will expand capacity: Biden argued that the bipartisan infrastructure bill that he signed into law and his other legislative proposals will boost the supply side of the economy. We are moderately optimistic about Congress’s ability to pass a party-line reconciliation bill that provides subsidies for the energy sector. This could pass under the consensus-building rubric of fighting Russia and climate change at the same time. But this measure, along with Biden’s Housing Supply Action Plan, child care and elderly care subsidies, and other proposals often look more like demand-side stimulus than supply-side reforms. They would fan inflation by increasing government spending and budget deficits. Moreover the administration cannot fix broken supply chains while China remains subject to strict Covid-19 lockdowns (Chart 7). In short, Congress may pass a reconciliation bill but it would be mildly stimulating for the economy (i.e. inflationary) and none of the supply-side improvements would reduce inflation in time for the midterms. Chart 6Biden Doesn't Need To Interfere With The Fed Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Chart 7Supply Snarls Will Continue While China Struggles With Covid Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign The budget deficit will fall: Biden argued that budget consolidation will reduce inflation, pointing to this year’s estimated $1.7 trillion drop in the budget deficit and arguing that the deficit is falling lower than pre-pandemic levels. He also argued that robust tax revenues from the economic recovery justified his previous fiscal stimulus (the American Rescue Plan Act). However, the budget is merely normalizing from extreme pandemic heights – there have obviously not been any long-term fiscal reforms (Chart 8). If Congress passes a reconciliation bill then Biden may succeed at passing a minimum corporate tax, which would mark an important success. But while the fiscal drag is negative for inflation, it is also negative for the economy this year and for Biden’s party in the midterms, and long-term budget trends are inflationary. Chart 8No Sign Of Budget Control Over Long Run – Budget Deficits Are Inflationary Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign The takeaway is that the Fed’s actions are disinflationary. Congress may or may not pass a climate bill before the election, but if it does, the budget deficit will be the same or larger and the economy will be the same or slightly stimulated. In brief Biden’s anti-inflation plan is to avoid interfering at the Fed. Extremely low unemployment will not save Biden and the Democrats this election season, any more than it saved Trump and the Republicans in 2018 (Chart 9). The Fed will rein in inflation at least in the short run. The election will lead to gridlock, which will freeze fiscal policy. Bottom Line: Inflation expectations will moderate but not because of any supply-side reform or fiscal consolidation coming from the Biden administration this year. Chart 9Low Unemployment Will Not Save Democrats Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Will Biden Ease Russian Energy Tensions? No. Biden’s other avenues for reducing inflation – not addressed in his editorial – lie in the foreign policy realm. The Biden administration is turning toward foreign policy as gridlock settles over Capitol Hill. Biden’s foreign policy will be insular, reactive, and focused on the midterm elections. Could Biden facilitate ceasefire talks in Ukraine so as to ease energy pressures stemming from Russia? The short answer is no. Biden imposed an oil embargo on Russia and ultimately agreed to the EU’s embargo. Biden can afford to run large risks with Russia this year because a larger confrontation or crisis with Russia would not hurt the Democrats in the midterm elections. Indeed the best hope for the Democrats is to recreate the 1962 congressional election, when John F. Kennedy stared down Soviet leader Nikita Krushchev in the Cuban Missile Crisis in October just before the election. Kennedy’s Democrats lost four seats in the House, gained four in the Senate, and kept control of both. Biden’s approval rating is nowhere near Kennedy’s but his party’s outlook is bad enough that he may be willing to run the risk of a crisis that could lead to a favorable rally-around-the-flag effect in the fall (Chart 10). Biden’s clearance this week of the highly mobile artillery rocket system for Ukraine – despite the risk that Ukrainians would launch attacks into Russian territory – underscores this point. Bottom Line: Biden will not ease tensions with Russia ahead of the midterm to try to reduce energy prices. Chart 10Biden Can Risk A Bigger Russia Crisis Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Will Biden Lower China Tariffs? No. What about China – will Biden ease the Trump administration’s tariffs on China to reduce inflation before the midterm election? Treasury Secretary Janet Yellen has repeatedly signaled support for this idea. The Trump administration marked a historic increase in US tariffs and the Biden administration has so far offered relief only for US allies (Chart 11). Again the short answer is no. Protectionist sentiment will prevail during midterm election season and US voters have turned decisively unfavorable toward China in recent years (Chart 12). The China tariffs have not been the driver for US inflation so tariff relief would bring minimal price relief while exacting a high political cost of making Biden look weak, wishy-washy on his pro-democracy values, and (according to Republicans) corrupt. Biden would be offering unilateral benefits to China without gaining Chinese trade concessions. Chart 11Biden Keeps Trump's Tariffs On China Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Chart 12Protectionist Sentiment To Prevail Amid Midterms Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Recently the Biden administration gave some indications of where it stands on China policy. Biden visited US allies in Asia Pacific and provoked China over the Taiwan Strait. Secretary of State Antony Blinken unveiled the administration’s comprehensive China policy and declared that the US would remain focused on China as the “most serious long-term challenge” despite Russia’s open belligerence in Europe.3 On paper, US-China trade relations do not look that bad. While China is falling short of its Phase One trade deal import promises, the truth is that a global recession intervened – and those promises were made under duress when the US slapped sweeping sanctions on Chinese exports. The commodity trade is booming, as is to be expected amid global energy shortages (Chart 13). The problem is that neither the US nor China has the domestic political capital to offer structural concessions in the short run, while both sides are girding for a century-long power struggle over the long run. Supply insecurity will result in the commodity trade suffering as a vast global substitution effect takes place. This is due to Russia’s energy breakup with Europe, growing Russia-China trade linkages, and ongoing US-China tensions. Global trade and US-China trade are set to slow, while China’s surge in energy imports from the US will abate for reasons of state security. Chart 13US-China Trade Faces Strategic Limits Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Bottom Line: No reduction in US tariffs on China is likely. Any reduction will have minimal macroeconomic effects and will be replaced by other punitive measures, given the underlying strategic competition and protectionist election politics. Meanwhile China’s “Zero Covid” policy will weigh on trade ties and sustain price pressures in the short run, as mentioned. Will Biden Lift Iran Sanctions? Probably Not. What about the Middle East? Can Biden convince the core OPEC states to pump more oil in lieu of Russian production? Or can Biden lift sanctions on Iran to undercut soaring gasoline prices? On this front Biden received welcome news on June 2 when Gulf Arab states promised to increase production by 638,000 barrels per day in July and August, up from an expected 430,000. At the same time news broke that Biden will visit Saudi Arabia, including potentially Crown Prince Mohammed bin Salman (MBS), and other Gulf partners sometime in June. There is not yet a clear understanding between Biden and MBS but it is possible that one will develop. The trigger for OPEC’s declaration is the EU oil embargo on Russia. EU is finalizing an embargo on 90% of oil imports – everything except the oil flowing through the Southern Druzhba pipeline to land-locked eastern European states. The embargo will impair Russian energy production: it could fall by as much as 2-3 million barrels per day, distribution interruptions will occur as Russia transitions to Asian buyers, and Russia’s long-term production capacity could be damaged. The result could be a destabilizing price spike. While the core OPEC states have just enough spare capacity to cover that gap in theory (Chart 14), they will not want to commit all spare capacity at once. Chart 14OPEC Spare Capacity Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign There is still a lot of uncertainty about how rapidly the embargo will be enforced, how much Russian production will suffer, whether the OPEC states will meet these new production increases (all except Saudi have been falling short), and what will be the OPEC policy beyond August. But for now it is clear that the Gulf Arab states are helping the US and EU by signaling some extra supplies at a critical time. The Gulf Arabs benefit from high oil prices and have previously ignored the G7’s pleas to increase production. But they also need to prolong the business cycle – a cycle-killing price shock from Russia is not in their interest. They are interested in keeping up revenues, maintaining domestic stability, and maintaining their position as the gatekeepers of the global oil supply and price. Secondarily, they are interested in maintaining close relations with the US, which guarantees their national security. OPEC supply easing at this juncture is obviously beneficial to Biden ahead of the US midterm election in November. But there is not yet an understanding on this front because the US is also negotiating to rejoin the 2015 nuclear agreement with Iran, which Saudi Arabia and the Gulf states oppose. Biden’s trip to the Gulf suggests that nothing is settled yet. The OPEC production increase is not proof alone that the US is breaking off talks with Iran. If the Gulf states thought the US were going to strike a deal with Iran, they might produce more oil to preempt the deal and grab more market share, which is what they did in 2014 in advance of the original 2015 US-Iran nuclear deal. The Saudis do not want US shale producers and Iranian exporters to form an unholy alliance that steals market share and compromises Saudi security. Still, we expect the US-Iran deal to fall apart. The Biden administration does not have a unified international coalition to enforce sanctions on Iran. Nor does it have the political capital or longevity to give Iran credible security guarantees that would convince it to freeze its nuclear program. Recent events support our view. The UN atomic watchdog says that Iran’s stockpile of highly enriched uranium has risen by 30% in three months. Meanwhile the US seized an Iranian tanker off Greece, Iran seized two Greek tankers, and Greece warned about dangers to shipping in the Persian Gulf. To develop a better understanding between Biden and MBS, the US needs to assure the Saudis that it will not renew the deal with Iran. The Saudis will not provide oil at Biden’s whim but they may provide if they have satisfaction that the US will scrap the deal, or otherwise compensate them, such as through increased defense assistance (which Biden threatened to cut off when he entered office). Investors should expect OPEC to fall short of its current promises – and yet to try to provide the minimum production increases necessary to prevent a destabilizing oil spike. OPEC’s interest is to make a windfall for as long as possible, which means not killing the cycle out of greed. This policy could be positive for oil prices after the immediate downward price adjustment. But for now investors should merely expect oil volatility as the EU’s embargo enforcement, Russian retaliation, Russian oil production, OPEC implementation, and US sanctions on Iran are all up in the air. A successful US-Iran deal would deepen the drop in oil prices. But odds are 60/40 that that deal will fail, leading to an escalation of tensions in the Middle East. Biden will have to underscore the US’s red line against Iranian nuclear weaponization. Oil supply disruptions will increase in frequency across the region. Bottom Line: OPEC has given Biden’s anti-inflation campaign a boost but it is too soon to declare that oil prices will substantially abate. The US-Iran deal will likely fail, increasing Middle Eastern instability and supply risks. Investment Takeaways Given that we expect continued volatility in the oil space, we are booking a 14% gain on our long small cap energy versus large cap energy trade. We are also booking a 16.5% gain on our overweight position in the oil and gas transportation and storage sub-sector. We will revisit these trades in future reports. Overall we maintain a defensive portfolio strategy. Biden’s anti-inflation campaign is meeting with some success in the Middle East but the US confrontation with Russia and the likely failure of US-Iran talks suggests that price spikes can still kill more demand and lead to further growth upsets.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com   Footnotes 1     See Joseph R. Biden, Jr, “Joe Biden: My Plan for Fighting Inflation,” Wall Street Journal, May 30, 2022, wsj.com.  2     See Lawrence H. Summers and Alex Domash, “History Suggests a High Chance of Recession over the Next 24 Months,” Harvard Kennedy School, March 15, 2022, www.hks.harvard.edu.  3    See Antony J. Blinken, “The Administration’s Approach to the People’s Republic of China,” US Department of State, May 26, 2022, state.gov.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Table A3US Political Capital Index Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Chart A1Presidential Election Model Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Chart A2Senate Election Model Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign  Table A4House Election Model Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Table A5APolitical Capital: White House And Congress Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Table A5BPolitical Capital: Household And Business Sentiment Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Table A5CPolitical Capital: The Economy And Markets Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign

Executive Summary What Will Be The Implications Of China’s Common Prosperity Policies? What Will Be The Implications Of China's Common Prosperity Policies? What Will Be The Implications Of China's Common Prosperity Policies? On the one hand, Chinese stocks are oversold, equity valuations are attractive and investor sentiment is downbeat. This means that a lot of bad news has already been priced into Chinese share prices, which is positive from a contrarian perspective. On the other hand, the government remains committed to its dynamic zero-COVID policy and will resort to lockdowns whenever there is an outbreak. The Omicron variants have extremely high transmission rates, which means that the probability of new lockdowns is non trivial. Hence, the biggest risk to Chinese share prices is renewed outbreaks and lockdowns – developments which are impossible to forecast. That is why, in our opinion, Chinese stocks are facing fat tails risks. Infrastructure spending will recover modestly in H2 2022. The property sector rebound will be very muted. Chinese exports will contract. The structural outlook is unfriendly for shareholders of platform companies. The known unknowns are: Will the dynamic zero-COVID policy be successful in containing the virus? Will “animal spirits” among consumers and businesses be revived? Will western investors come back to Chinese stocks? The RMB is facing near-term risks as its interest rate differential versus the US dollar dips deeper into negative territory. Bottom Line: For absolute return investors, one way to play such a bifurcated market outlook is to buy out-of-money call options and out-of-money put options simultaneously while maintaining a core / benchmark allocation in Chinese stocks. We maintain our long A-shares / short investable Chinese stocks strategy. Feature As strict lockdowns in key cities are lifted, the Chinese economy is bound for a snap back. Consumer spending will improve, and the government’s infrastructure push will revive capital spending modestly. What does this mean for Chinese stocks? Numerous crosscurrents make the current outlook for Chinese stocks hard to navigate. This report elaborates on variables that we can forecast and those we cannot. Odds of a material rally are not insignificant, but the probability of another relapse is not trivial either. That is why Chinese stocks presently have fat tails. For absolute return investors, one way to play such a bifurcated market outlook is to buy out-of-money call options and out-of-money put options simultaneously while maintaining a core/ benchmark allocation in Chinese stocks. The rationale for maintaining a neutral position is that Chinese share prices could also be range-bound in the coming months. In other words, positives could offset negatives, and the fat tails outcomes might not transpire. In regard to relative performance and regional allocation, we continue to recommend that emerging market portfolios overweight Chinese A-shares and maintain a neutral stance on investable stocks. Meanwhile, global equity portfolios should remain neutral on A-shares while underweighting investable ones. This positioning is consistent with our overall EM allocation – we continue to recommend underweighting EM within a global equity portfolio. What We Know Equity Valuations And Investor Sentiment Are Depressed To begin with, there are a number of indicators that point to low equity valuations and depressed investor sentiment towards Chinese stocks: Analysts’ net EPS revisions for both Chinese A-shares and investable stocks have plunged deep into negative territory (Chart 1). Chinese net EPS revisions are also low relative to EM and global stocks (Chart 2). Chart 1Sentiment On Chinese Stocks Is Downbeat Sentiment On Chinese Stocks Is Downbeat Sentiment On Chinese Stocks Is Downbeat Chart 2Net EPS Revisions: China vs. EM And China vs. Global Stocks Net EPS Revisions: China vs. EM And China vs. Global Stocks Net EPS Revisions: China vs. EM And China vs. Global Stocks   The average of the NBS manufacturing PMI new orders and backlog of orders suggests that A-shares EPS will shrink considerably (Chart 3). A-share valuations have become attractive. Our composite valuation indicator points to below average valuations (Chart 4, top panel). This indicator is based on three variables: (1) median multiples; (2) 20% trimmed-mean multiples; and (3) equal-weighted multiples. The latter uses equal weights rather than market cap weights for sub-sectors in the calculation. Chart 3China: Corporate Profits Are Contracting China: Corporate Profits Are Contracting China: Corporate Profits Are Contracting Chart 4Chinese A-Shares Are Attractive Chinese A-Shares Are Attractive Chinese A-Shares Are Attractive   In turn, each component is constructed using the averages of the trailing P/E, forward P/E, price-to-cash earnings, price-to-book value (PBV) and price-to-dividend ratios. The 20%-trimmed mean excludes the top 10% and the bottom 10% of sub-sectors, i.e., it removes outliers. Our cyclically adjusted P/E ratio for A-shares currently stands at close to one standard deviation below its mean (Chart 4, bottom panel). The trailing and forward P/E ratios for the equal-weighted A-share index are 18 and 12, respectively. As to the investable universe, any valuation measure for the index is not useful because banks and SOEs continue to be “cheap” for a reason. In turn, internet stocks are fallen angels and their past valuations are not a good roadmap for the future. We discuss the structural outlook for their profitability below. Chart 5Chinese Investable Stocks Have Reached Technical Support Lines Chinese Investable Stocks Have Reached Technical Support Lines Chinese Investable Stocks Have Reached Technical Support Lines Finally, Chinese equities have become oversold. Investable non-TMT share prices are back to their lows of the past 12 years while TMT/growth stocks are at their long-term moving average (Chart 5). In sum, a lot of bad news has already been priced into Chinese share prices, which is positive from a contrarian perspective. Dynamic Zero-COVID Policy We have a very high conviction level that the government will remain committed to its dynamic zero-COVID policy for now. COVID cases in Shanghai and Beijing have declined following the lockdowns. This will only embolden authorities to pursue their dynamic zero-COVID policy and resort to lockdowns whenever outbreaks occur. Consistent with the dynamic zero-COVID policy, the government will inject more stimulus into the economy to offset the negative impact of past and potential future lockdowns. With inflation very subdued, the central government will not shy away from stimulating demand. In fact, the PBoC is allegedly resorting to “window guidance”, i.e., instructing banks to increase their loan origination. However, we do not have a high conviction view on: (1) whether lockdowns could prevent the virus from spreading and (2) whether stimulus will lift household and business confidence and their willingness to consume and invest. See more on this below. Infrastructure Investment Will Recover Modestly So far, the data does not suggest that a recovery in infrastructure investment is underway. Chart 6 illustrates that the number of investment projects approved by National Development and Reform Commission and the length of newly installed electricity transmission lines are not yet rising (Chart 6). Also, steel bar and cement prices are falling despite low output of these materials (Chart 7). This signifies very weak demand. Chart 6Few Signs of Recovery In Infrastructure Investment Few Signs of Recovery In Infrastructure Investment Few Signs of Recovery In Infrastructure Investment Chart 7Falling Prices of Raw Materials = Weak Demand Falling Prices of Raw Materials = Weak Demand Falling Prices of Raw Materials = Weak Demand   Furthermore, land sales make up 40% of local government revenue and the value of land sales is down substantially from a year ago. Lower land sales weighing on local government finances and their ability to spend. Nevertheless, odds are that the central government will force local governments to boost infrastructure investment modestly by providing more funding and increasing their special bond issuance quota. For example, Beijing ordered state-owned policy banks to set up an 800 billion yuan ($120 billion) line of credit for infrastructure projects. Chart 8A Snapback in Home Sales Is Possible A Snapback in Home Sales Is Possible A Snapback in Home Sales Is Possible That said, a revival in traditional infrastructure investment will be more muted than it has been in past cycles. Beijing has been very clear in recent years that local governments should not pursue inefficient debt-fueled infrastructure spending, to the point that local officials have been warned that they will be held responsible for debt-financed spending during their lifetime, i.e., even after they retire from their positions. This risk – and the lack of funding due to the shortfall in land sales – will structurally limit local governments’ capacity and drive to invest in traditional infrastructure.  The Property Sector Rebound Will Be Muted Residential property sales will likely tick up after having crashed by 30% in the past 12 months (Chart 8). Yet, this will be a mean-reversion rebound rather a full-fledged cyclical recovery. Even though authorities have been easing restrictions for property buyers, any rebound in home sales and construction activity will be modest for the following reasons: The economic slump of the past 12 months and recent lockdowns have weighed on household incomes, which will hinder demand. Housing remains unaffordable for many households who live in poor conditions. Meanwhile, many affluent households already own multiple properties. A lack of confidence in the outlook for house prices will reduce high-income household’s willingness to invest in new properties. Even though restrictions have eased, property developers – which have experienced a major crackdown, are still overleveraged, and face uncertain housing demand – will be reluctant to increase their debt and start new projects. Rather, the lack of funding for property developers points to a major drop in completions in the near term (Chart 9). As we argued in the report titled China: Is The Property Carry Trade Over?, the real estate market is experiencing a structural breakdown, rather than a cyclical one. The performance of property developers stocks supports this hypothesis (Chart 10, top panel). As such, any recovery will be tame and fragile. Chart 9Shrinking Property Developer Funding = Less Housing Completion Shrinking Property Developer Funding = Less Housing Completion Shrinking Property Developer Funding = Less Housing Completion Chart 10Structural Breakdowns in Stocks And Bonds Of Property Developers Structural Breakdowns in Stocks And Bonds Of Property Developers Structural Breakdowns in Stocks And Bonds Of Property Developers   In addition, the prices of property developers offshore bonds remain in a clear downtrend (Chart 10, bottom panel). Exports Are Set To Contract Chinese exports will contract in H2 2022 due to reduced spending on goods in the US and Europe as well as in the developing world. Specifically, in the US and euro area, consumption of goods ex-autos boomed during the pandemic and will revert to their means as households spend more on services and less on goods (Chart 11). Declining real household disposable income will also reinforce this trend (Chart 12). Chart 11US and Euro Area ex-Auto Goods Consumption Will Shrink US and Euro Area ex-Auto Goods Consumption Will Shrink US and Euro Area ex-Auto Goods Consumption Will Shrink Chart 12US And Euro Area Household Real Disposable Income Is Contracting US and Euro Area Household Real Disposable Income Is Contracting US and Euro Area Household Real Disposable Income Is Contracting     In fact, US retail inventory of goods ex-autos has already surged (Chart 13). As retailers cut back on their new orders, Chinese exports will contract materially. Chart 13US Retail Goods ex-Auto Inventories Have Swelled US Retail Goods ex-Auto Inventories Have Swelled US Retail Goods ex-Auto Inventories Have Swelled In addition, domestic demand in developing economies will also disappoint. EM household spending on consumer goods will underwhelm as more of their income is spent on food and energy. Also, high and rising local interest rates will curb credit origination in mainstream emerging economies. Consequently, their capital spending, employment and income growth will remain subdued. In China, exports as a share of GDP has increased to 19% from 17.5% in 2019. Hence, a contraction in exports will be painful for the overall economy. The Structural Outlook Is Unfriendly For Shareholders Of Platform Companies The government has toned down its rhetoric and its actions related to platform/internet companies. However, we view this development as a tactical rather than a structural change. The key economic policymaker Liu He made market friendly statements towards platform companies on March 16 and May 17 when their share prices were plunging. We believe that the aim of his comments was solely to calm the market and restore investor confidence. We maintain that the structural outlook for shareholders of platform companies remains negative for the following reasons: Higher uncertainty about their business model = higher equity risk premium = lower equity multiples. The government will be regulating their profitability like those of monopolies and oligopolies, which justifies lower multiples. These companies will be performing social duties – i.e. redistributing profits from shareholders to the Chinese people. Beijing’s involvement in their management and the prioritization of national and geopolitical objectives over shareholder interests. Risks of delisting from US stock exchanges are significant. Common prosperity policies pose a risk to the broader corporate sector. These policies will redistribute national income from corporates to households. Chart 14 illustrates that the share of employee compensation has been rising and the share of corporate profits in national income has been falling since 2011-12. These trends will be reinforced by common prosperity policies in the coming years. This is an negative development for shareholders of Chinese companies. Chart 14What Will Be The Implications Of China's Common Prosperity Policies? What Will Be The Implications Of China's Common Prosperity Policies? What Will Be The Implications Of China's Common Prosperity Policies? The Known Unknowns Will The Dynamic Zero-COVID Policy Be Successful? The biggest risk to Chinese share prices is renewed virus outbreaks and lockdowns. It is impossible to forecast these risks. That is why, in our opinion, Chinese stocks are facing fat tail risks. On the one hand, Omicron variants have extremely high transmission rates, making the virus very hard to contain. On the other hand, the government has shown that its dynamic zero-COVID policy has for now succeeded in containing the virus in both Shanghai and Beijing. It is certain, however, that the Chinese economy will incur considerable costs to prevent Omicron from spreading. In addition to the financial costs of ongoing widespread testing, there are also logistical impediments and inefficiencies that these testing and verification policies introduce, even in the absence of lockdowns.  Will “Animal Spirits” Among Consumers And Businesses Revive? Another major unknown is whether confidence among consumers and businesses will recover so that they resume spending. If private sector sentiment remains weak, then stimulus measures will have a low multiplier. In other words, the ongoing stimulus will likely fail to boost economic activity. Our proxies for marginal propensity to spend by households and enterprises have been very depressed (Chart 15). Other sentiment/confidence surveys convey the same message. Further, credit demand is non-existent. Banks have lately been buying corporate acceptance bills to fulfill their loan quota (Chart 16). Chart 15Chinese Households And Enterprises Are Reluctant To Spend More Chinese Households And Enterprises Are Reluctant To Spend More Chinese Households And Enterprises Are Reluctant To Spend More Chart 16China: Banks Bought Refinancing Bills in April To Make Their Loan Quota China: Banks Bought Refinancing Bills in April To Make Their Loan Quota China: Banks Bought Refinancing Bills in April To Make Their Loan Quota   Critically, the property market has always been a key determinant of overall consumer and business sentiment. Since 2008, there has been no recovery in the Chinese economy without a recovery of property sales, prices and construction (Chart 17). We are doubtful that property sales and construction will stage a strong recovery in the next six to nine months. Thus, our bias is that the multiplier effect of Chinese stimulus will underwhelm in the coming months. Will Western Investors Come Back To Chinese Stocks? Geopolitical tensions between the US and China and the events around the US-Russia clash reduce the likelihood that western investors will come back to Chinese markets, even as growth prospects improve. Chart 18 demonstrates that foreign investors have only marginally reduced their holdings of Chinese onshore stocks (A-shares) and bonds. These data encompass not only western investors, but also investors from other emerging Asian countries. Chart 17China: Housing Cycle = Business Cycle China: Housing Cycle = Business Cycle China: Housing Cycle = Business Cycle Chart 18Foreigners Sold A Small Portion Of Their Onshore Equity and Bond Holdings Foreigners Sold A Small Portion Of Their Onshore Equity and Bond Holdings Foreigners Sold A Small Portion Of Their Onshore Equity and Bond Holdings   The risk is that western investors will use any rebound in Chinese shares to reduce their exposure. This will weigh on investable stocks and preclude any significant and durable rally. A Word On The Exchange Rate The RMB will remain volatile in the coming months and will likely depreciate further against the US dollar: Shrinking exports will weigh on foreign exchange availability from exporters. With Asian currencies depreciating against the US, Beijing will be willing to tolerate moderate and gradual yuan depreciation against the greenback to maintain its export competitiveness. The one-year interest rate differential between China and the US has recently turned negative which has probably triggered a shift of deposits from RMB into the USD (Chart 19). In Hong Kong, deposits have recently begun shifting from yuan to HKD, i.e., USD (Chart 20). This development has coincided with the China-US, and hence, China-HK, interest rate differential turning negative. Chart 19China-US: The Interest Rate Differential Has Turned Negative China-US: The Interest Rate Differential Has Turned Negative China-US: The Interest Rate Differential Has Turned Negative Chart 20A Shift From RMB To HKD or USD Deposits A Shift From RMB To HKD or USD Deposits A Shift From RMB To HKD or USD Deposits   Finally, there will be more foreign capital outflows if either (1) COVID outbreaks and, hence, lockdowns persist, or (2) US-China tensions escalate. As Chart 18 above illustrates, foreign portfolio capital outflows have so far been modest. Bottom Line: The near-term outlook for the US dollar remains positive as the Fed maintains its hawkish stance. Consistently, the RMB will struggle in the near term but its multi-year outlook is positive. Investment Recommendations The outlook for Chinese stocks is characterized by fat tails. Odds of a material rally are not insignificant but also the probability of another relapse is not trivial either. For absolute return investors, one way to play such a bifurcated market outlook is to buy out-of-money call options and out-of-money put options simultaneously while maintaining a core / benchmark allocation in Chinese stocks. In regard to relative performance /regional allocation, we continue to recommend that emerging market portfolios overweight Chinese A-shares and maintain a neutral stance towards investable stocks. Meanwhile, global equity portfolios should remain neutral on A-shares while underweighting investable ones. This positioning is in-line with our overall EM allocation – we continue to recommend underweighting EM within a global equity portfolio. Consistently, we maintain our long A-shares / short investable Chinese stocks strategy. Onshore government bond yields will continue sliding as the main problem in China is deflation and weak growth, not inflation. The RMB is facing near term risks as its interest rate differential versus the US dollar dips deeper into negative territory. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com

Executive Summary Investors face a dilemma. The faster that inflation comes down, the better it will be for valuations via a stronger rally in the bond price. But if a collapse in inflation requires a sharp deceleration in growth, the worse it will be for profits. Bond yields are likely in a peaking process, but the sharpest declines may come a few months down the road, after an unambiguous roll-over in food and energy inflation. The stock market’s valuation-driven sell-off is likely over, but the danger is that it morphs into a profits-driven sell-off. As such, the stock market will remain under pressure through 2022, though it is likely to be higher 12 months from now in June 2023. High conviction recommendation: Overweight healthcare versus basic resources. In other words, tilt towards sectors that benefit the most from rising bond prices and that suffer the least from contracting profits. New high conviction recommendation: Go long the Japanese yen. As bond yield differentials re-tighten, the yen will rally. Additionally, the yen will benefit from its haven status in a period of recessionary risk. Fractal trading watchlist: JPY/USD, GBP/USD, and Australian basic resources. If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market Bottom Line: The risk is that the valuation-driven sell-off morphs into a profits-driven sell-off. Feature In May, many stock markets reached the drawdown of 20 percent that defines a technical bear market. Yet what has caught many people off guard is that the bear market in stocks has happened during a bull market in profits. Since the start of 2022, US profits are up by 5 percent.1 The bear market in stocks has happened during a bull market in profits… so far. This shatters the shibboleth that bear markets only happen when there is a profits recession. The 2022 bear market has been a valuation-driven bear market. US profits rose 5 percent, but the multiple paid for those profits collapsed by 25 percent, taking the market into bear territory. None of this should come as any surprise to our regular readers. As we have pointed out many times, a stock market can be likened to a bond with a variable rather than a fixed income. So, just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like. It turns out that that long-duration US stock market has the same duration as a 30-year bond. This means that: The US stock market = (The 30-year T-bond price) multiplied by (US profits) It follows that if the 30-year bond price falls by more than profits rise, then the stock market will sell off. And if the 30-year bond price falls by much more than profits rise, then the stock market will enter a valuation-driven bear market. Therein lies the story of 2022 so far (Chart I-1). Chart I-1The Bear Market Is Valuation-Driven. Profits Are Up... For Now The Bear Market Is Valuation-Driven. Profits Are Up... For Now The Bear Market Is Valuation-Driven. Profits Are Up... For Now Just As In 1981-82, Will The Sell-Off Morph From Valuation-Driven To Profits-Driven? In Markets Echo 1981, When Stagflation Morphed Into Recession, we argued that a good template for what happens to the economy and the markets in 2022-23 is the experience of 1981-82. Does 2022-23 = 1981-82? Then, just as now, the world’s central banks were obsessed with ‘breaking the back’ of inflation, and piloting the economy to a ‘soft landing’. Then, just as now, the central banks were desperate to repair their badly damaged credibility in managing the economy. And then, just as now, an invasion-led war between two major commodity producers – Iran and Iraq – was disrupting commodity supplies and adding to inflationary pressures. In 1981, just as now, the equity market sell-off started as a valuation sell-off, driven by a declining 30-year T-bond price. Profits held up through most of 1981, just as they have so far in 2022. In September 1981, US core inflation finally peaked, with bond yields following soon after. In the current experience, March 2022 appears to have marked the equivalent peak in US core inflation (Chart I-2 and Chart I-3). Chart I-2Does September 1981... Does September 1981... Does September 1981... Chart I-3...Equal March 2022? ...Equal March 2022? ...Equal March 2022? In late 1981, when the 30-year T-bond price rebounded, the good news was that beaten-down equity valuations also reached their low point. The bad news was that just as the valuation-driven sell-off ended, profits keeled over, and the valuation-driven sell-off morphed into a profits-driven sell-off (Chart I-4). In 2022-23, could history repeat? Chart I-4In September 1981, The Sell-Off Morphed From Valuation-Driven To Profits-Driven In September 1981, The Sell-Off Morphed From Valuation-Driven To Profits-Driven In September 1981, The Sell-Off Morphed From Valuation-Driven To Profits-Driven Recession Or No Recession? That Is Not The Question History rhymes, it rarely repeats exactly. What if the 2022-23 experience can avoid the outright economic recession of the 1981-82 experience? This brings us to another shibboleth that needs to be shattered. You don’t need the economy to go into recession for profits to go into recession. To understand why, we need to visit the concept of operational leverage. Profits is a small number that comes from the difference of two large numbers: sales and the costs of generating those sales. As any company will tell you, sales can be volatile, but costs – which are dominated by wages – are sticky and much slower to change. The upshot is that if sales growth exceeds costs growth, there is a massively leveraged impact on profits growth. This is the magic of operational leverage. But if sales growth falls below sticky cost growth, the magic turns into a curse. The operational leverage goes into reverse, and profits collapse. Using US stock market profits as an example, the magic turns into a curse at real GDP growth of 1.25 percent, above which profits grow at six times the difference, and below which profits shrink at six times the difference (Chart I-5). Chart I-5A Model For US Profits Growth: (Real GDP Growth - 1.25) Times 6 A Model For US Profits Growth: (Real GDP Growth - 1.25) Times 6 A Model For US Profits Growth: (Real GDP Growth - 1.25) Times 6 Strictly speaking, we should compare US profits growth with world GDP growth because multinationals generate their sales globally rather than domestically. But to the extent that the US has both the world’s largest stock market and the world’s largest economy, it is a reasonable comparison. We should also compare both profits and sales in either nominal or real terms, rather than a mixture. But even with these tweaks, we would still find that the dominant driver of profit growth is operational leverage. ‘Recession or no recession?’ is a somewhat moot question, because even non-recessionary low growth is enough to tip profits into contraction. Therefore, the conclusion still stands – ‘recession or no recession?’ is a somewhat moot question, because even non-recessionary low growth is enough to tip profits into contraction. Such a period of low growth is now likely. If 2022-23 = 1981-82, What Happens Next? To repeat: The US stock market = (The 30-year T-bond price) multiplied by (US profits) This means that investors face a dilemma. The faster that inflation comes down, the better it will be for valuations via a stronger rally in the bond price. But if a collapse in inflation requires a sharp deceleration in growth, the worse it will be for profits. This was the precise set-up in December 1981, the equivalent of June 2022 in our historical template. In which case, what can we expect next? 1. Bond yields are likely in a peaking process, but the sharpest declines may come a few months down the road, after an unambiguous roll-over in food and energy inflation (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To The Bond Yield If 2022-23 = 1981-82, Then This Is What Happens To The Bond Yield If 2022-23 = 1981-82, Then This Is What Happens To The Bond Yield 2. The stock market’s valuation-driven sell-off is likely over, but the danger is that it morphs into a profits-driven sell-off. As such, the stock market will remain under pressure through 2022, though it is likely to be higher 12 months from now in June 2023 (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market 3. Long-duration defensive sectors will outperform short-duration cyclical sectors. In other words, tilt towards sectors that benefit the most from rising bond prices and suffer the least from contracting profits. As such, a high conviction recommendation is to overweight healthcare versus basic resources (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To Healthcare Versus Resources If 2022-23 = 1981-82, Then This Is What Happens To Healthcare Versus Resources If 2022-23 = 1981-82, Then This Is What Happens To Healthcare Versus Resources 4. In foreign exchange, the setup is very bullish for the Japanese yen through the next 12 months. The yen’s recent sell-off is explained by bond yields rising outside Japan. As these bond yield differentials re-tighten, the yen will rally. Additionally, the yen will benefit from its haven status in a period of recessionary risk. A new high conviction recommendation is to go long the Japanese yen (Chart I-9). Chart I-9The Yen's Sell-Off Is Due To Bond Yields Rising Outside Japan The Yen's Sell-Off Is Due To Bond Yields Rising Outside Japan The Yen's Sell-Off Is Due To Bond Yields Rising Outside Japan Fractal Trading Watchlist Supporting our bullish fundamental case for the Japanese yen, the sell-off in JPY/USD has reached the point of fragility on its 260-day fractal structure that marked previous major turning points in 2013 and 2015 (Chart 10). Hence, a first new trade is long JPY/USD, setting the trade length at 6 months, and the profit target and symmetrical stop-loss at 5 percent. Chart I-10The Sell-Off In JPY/USD Has Reached A Potential Turning Point The Sell-Off In JPY/USD Has Reached A Potential Turning Point The Sell-Off In JPY/USD Has Reached A Potential Turning Point Supporting our bearish fundamental case for resources stocks, the outperformance of Australian basic resources has reached the point of fragility on its 130-day fractal structure that marked previous turning points in 2013, 2015, and 2021 (Chart I-11). Hence, a second new trade is short Australian basic resources versus the world market, setting the trade length at 6 months, and the profit target and symmetrical stop-loss at 10 percent. Chart I-11The Australian Basic Resources Sector Is Vulnerable To Reversal The Australian Basic Resources Sector Is Vulnerable To Reversal The Australian Basic Resources Sector Is Vulnerable To Reversal Finally, we are adding GBP/USD to our watchlist, given that its 260-day fractal structure is close to the point of fragility that marked major turns in 2014, 2015, and 2016. Our full watchlist of 29 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions GBP/USD At A Turning Point GBP/USD At A Turning Point GBP/USD At A Turning Point Chart 1AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal   Chart 2Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Chart 3Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 4US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 5BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 6Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Chart 7CNY/USD Has Reversed CNY/USD Has Reversed CNY/USD Has Reversed Chart 8CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 9Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 10The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 11The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 12FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 13Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 14The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 15The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 16Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 18The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 19A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 21Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 22Cotton Versus Platinum Is Reversing Cotton Versus Platinum Is Reversing Cotton Versus Platinum Is Reversing Chart 23Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Chart 24The Rally In USD/EUR Has Ended The Rally In USD/EUR Has Ended The Rally In USD/EUR Has Ended Chart 25The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 26A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 27Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Chart 28US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 29GBP/USD At A Turning Point GBP/USD At A Turning Point GBP/USD At A Turning Point   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Defined as 12-month forward earnings per share. Fractal Trading System More On 2022-23 = 1981-82, And The Danger Ahead More On 2022-23 = 1981-82, And The Danger Ahead More On 2022-23 = 1981-82, And The Danger Ahead More On 2022-23 = 1981-82, And The Danger Ahead 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Listen to a short summary of this report.       Executive Summary Recession Checklist Monthly Portfolio Update: Recession Or No Recession? Monthly Portfolio Update: Recession Or No Recession? US stocks were down almost 20% at their lowest point in May. Any lower and they would be pricing in recession. Central banks will raise rates to or above neutral to ensure that inflation comes back down to their targets. This will cause growth to slow. Markets will now start to worry more about faltering growth than about high inflation. In our recession checklist (see Table), no indicator is yet pointing to recession, but some may do so soon. The jury is likely to be out for some time on whether there will be a recession in the next 12-18 months. In the meantime, equities are likely to move sideways, amid high volatility. Monthly Portfolio Update: Recession Or No Recession? Monthly Portfolio Update: Recession Or No Recession? Bottom Line: Investors should stay cautiously positioned for now, with only a neutral weighting in equities, and tilts towards more defensive markets and sectors. We recommend a large holding in cash to allow for funds to be redeployed quickly when there is a better entry-point.   The narrative driving global markets has shifted from worries about inflation, to fretting about the risk of recession. Although headline inflation remains high (8.3% year-on-year in the US and 8.1% in the eurozone), inflation pressures have clearly peaked (for now, at least): Broad measures, such as the US trimmed-mean PCE, have started to ease significantly (Chart 1).  Recommended Allocation Monthly Portfolio Update: Recession Or No Recession? Monthly Portfolio Update: Recession Or No Recession? Chart 1Inflationary Pressures Are Starting To Ease Monthly Portfolio Update: Recession Or No Recession? Monthly Portfolio Update: Recession Or No Recession? But now signs are emerging of a slowdown in economic growth. The Citigroup Economic Surprise Indexes in all the major regions have turned down (Chart 2), and global industrial production is falling year-on-year (albeit partly because of lingering supply-side bottlenecks) (Chart 3).   Chart 2Global Growth Is Turning Down Global Growth Is Turning Down Global Growth Is Turning Down Chart 3IP Growth Has Turned Negative IP Growth Has Turned Negative IP Growth Has Turned Negative Equity markets – with US stocks down 19% from their peak to the May low, and global stocks 17% – are pricing in a slowdown, but not yet a recession. As we have often argued, it is almost unheard of to have a bear market (defined as a greater than 20% decline in US stocks) without a recession – the last time that happened was in 1987 (and all on one day, Black Monday) (Chart 4). Note from the chart how often stocks correct by 19-20%, on concerns about recession, without tipping into a bear market. That is where we stand today. Chart 4US Stocks Don't Fall More Than 20% Without A Recession US Stocks Don't Fall More Than 20% Without A Recession US Stocks Don't Fall More Than 20% Without A Recession Table 1Recession Checklist Monthly Portfolio Update: Recession Or No Recession? Monthly Portfolio Update: Recession Or No Recession? So the key question is: Will we have a recession over the next 12-18 months? We have dug out the recession checklist we last used in 2019 (Table 1). While none of the indicators are yet clearly pointing to recession, several may do so by year-end (Chart 5). And there are a number of warning signs starting to flash. The US housing market – the most interest-rate sensitive part of the economy – could soon see home prices falling, after the 200 BPs rise in the 30-year mortgage rate since the start of the year (Chart 6). Wages have failed to rise in line with inflation, which has led to retail sales falling year-on-year in real terms (Chart 7). And there are even some signs that companies are slowing their hiring, presumably on worries about the durability of the recovery: In the latest ISM surveys, the employment component fell to close to 50 (Chart 8). Chart 5Some Recession Indicators Look Worrying Some Recession Indicators Look Worrying Some Recession Indicators Look Worrying Chart 6Housing Is The Most Vulnerable Sector Housing Is The Most Vulnerable Sector Housing Is The Most Vulnerable Sector Chart 7Real Retail Sales Are Falling Real Retail Sales Are Falling Real Retail Sales Are Falling Chart 8Signs That Companies Are Growing Wary Of Hiring? Signs That Companies Are Growing Wary Of Hiring? Signs That Companies Are Growing Wary Of Hiring? The strongest argument against there being a recession is the $2.2 trillion of excess savings held by US households (and $5 trillion among households in all major developed economies). The argument is that, even if interest rates rise and real wage growth is negative, consumers can continue to spend by dipping into these accumulated savings. But there are some problems here. The savings are highly concentrated among the rich, who have a lower propensity to spend (Chart 9). Because of “mental accounting” biases, people may think only of current income, not savings, when considering how much to spend. And, as spending shifts back from goods to services, now that pandemic rules are largely over (Chart 10), spending on manufactured products is likely to fall below trend (since many purchases were brought forward). But it is hard to catch up on previously missed services spending (you can’t take three vacations this year to make up for those you missed in 2020 and 2021), and so services spending will, at best, only return to trend. Chart 9The Rich Have All The Money The Rich Have All The Money The Rich Have All The Money Chart 10Can Services Take Over From Goods Spending? Can Services Take Over From Goods Spending? Can Services Take Over From Goods Spending?     Meanwhile, central banks will be focused on fighting inflation. All of them are expected to take rates to or above neutral over the next 12 months (Chart 11) – implying a squeeze on aggregate demand. Although inflation may be peaking, it is still well above most central banks’ comfort zones. In the US, for example, the FOMC expects core PCE to ease to 4.1% by year-end and 2.6% by end-2023, but that is still higher than its 2% target. The Fed is likely to remain focused on the upside risks to inflation: From rising services prices (Chart 12), and the risk of a price-wage spiral (Chart 13). BCA Research’s bond strategists expect the Fed to hike by 50 BPs at each of the next two meetings (in June and July), and then to revert to 25 BPs a meeting, as long as it is clear by then that inflation is trending down.1 Chart 11Rates Are Going To Or Above Neutral Everywhere Rates Are Going To Or Above Neutral Everywhere Rates Are Going To Or Above Neutral Everywhere Chart 12Inflation Risks: Rising Services Prices... Inflation Risks: Rising Services Prices... Inflation Risks: Rising Services Prices... Our conclusion is that the jury is out on the probability of recession – and is likely to stay out for a while. So far this year, equities and bonds have both performed poorly – with a 60:40 equity/bond portfolio producing the worst start to a year in three decades (Chart 14). Equities have wobbled because of tight monetary policy and worries about slowing growth; bonds because of inflation concerns. This is likely to remain the case until there is more clarity about the risk of recession. In this environment, we expect global equities to move sideways, with significant volatility – falling on signs of weakening growth, but rallying on hopes that the Fed may change its course.2  Chart 13...And A Price-Wage Spiral ...And A Price-Wage Spiral ...And A Price-Wage Spiral Chart 14Nowhere To Hide This Year Nowhere To Hide This Year Nowhere To Hide This Year We continue, therefore, to recommend fairly cautious portfolio positioning, with a neutral weight in global equities (and a preference for defensive country and sector allocations). Investors should keep a healthy holding in cash, giving them dry powder to use when a better entry-point into risk assets presents itself. Fixed Income: Bond yields have fallen over the past month, with the US 10-year Treasury yield slipping to 2.8% from 3.1% in early May. As per BCA Research’s Golden Rule of Bond Investing, the level of yields will be determined by whether the Fed (and other central banks) surprise dovishly or hawkishly relative to market expectations (Chart 15).3 The Fed is likely to hike slightly less this year than the market is pricing in, but may continue to raise rates beyond mid-2023, compared to a market expectation of rate cuts then (see Chart 11, panel 1 above). This points to the 10-year yield remaining broadly flat for the rest of this year, but possibly rising after that. Historically, rates tend to peak in line with trend nominal GDP growth (Chart 16). This means that, if the expansion continues for another couple of years, the 10-year yield could reach 4%. We, therefore, recommend an underweight on bonds. However, government bonds do now represent a good hedge again, with strong capital gain in the event of recession (Table 2). We recommend a neutral weight on government bonds within the fixed-income category. Chart 15The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 16Rates Tend To Peak In Line With Trend Nominal GDP Growth Rates Tend To Peak In Line With Trend Nominal GDP Growth Rates Tend To Peak In Line With Trend Nominal GDP Growth Table 2Government Bonds Now Offer Good Returns In A Recession Monthly Portfolio Update: Recession Or No Recession? Monthly Portfolio Update: Recession Or No Recession? Chart 17Credit Now Offers Attractive Valuations Monthly Portfolio Update: Recession Or No Recession? Monthly Portfolio Update: Recession Or No Recession? The recent rise in credit spreads has opened some opportunities. Valuations for both investment-grade (IG) and high-yield (HY) bonds are now attractive again, with all but the highest-quality bonds trading at a breakeven spread higher than the long-run median (Chart 17). The likelihood of defaults is rising, however, so we lower our weighting in HY (whilst remaining slightly overweight) and raise the weight in IG, also to a small overweight. We fund this by cutting our recommendation in Emerging Market debt to underweight. Credit, especially in the US, now offers tempting returns as long as the economy avoids recession, and is a relatively low-risk way to gain exposure to upside surprises.   Chart 18US Performance Has Lagged This Year US Performance Has Lagged This Year US Performance Has Lagged This Year Equities: US relative equity performance has been a little disappointing year-to-date, dragged down by the performance of the IT sector (Chart 18).  Nonetheless, we stick to our overweight, given the market’s lower beta and the likely greater resilience of the US economy. Among sectors, we raise our weighting in Energy to overweight from neutral. Our energy strategists recently lifted their forecast for end-2022 Brent crude to $120 from $90, and raise the possibility of even $140 (see below for more on why). Despite the sharp outperformance of Energy stocks over the past six months, the sector has barely registered net inflows – presumably because of ESG (Chart 19). As we argued in a recent report, oil producers could be the new “sin stocks”, making the sector attractive over the next few years to investors who do not have ethical restraints on investing in it. We fund the overweight in Energy by lowering our weighting in Industrials to neutral. Capex is a late-cycle play and capital-goods makers benefited as manufacturers rushed to increase production during the recent consumer boom. But signs are now emerging that companies are becoming more cautious on capex (Chart 20). Chart 19Weak Flows Into The Energy Sector Despite Strong Performance Monthly Portfolio Update: Recession Or No Recession? Monthly Portfolio Update: Recession Or No Recession? Chart 20Companies Are Becoming More Cautious On Capex Companies Are Becoming More Cautious On Capex Companies Are Becoming More Cautious On Capex Commodities: China’s growth remains very weak and, although commodity prices have started to fall (with copper down 9% and iron ore 11% in Q2), they have not yet caught up with the slowdown in Chinese imports (Chart 21). The key question is whether China will now roll out a big stimulus. Given the government’s determination to persevere with the zero-Covid policy, and its need to achieve the 5.5% GDP growth target this year, it will eventually have no choice. But it is reluctant to trigger another housing boom, and there are doubts about how effective stimulus would be given the property market’s dysfunction. For now, we remain cautious on the Materials sector, and on commodities as an alternative asset – though the long-term structural story (because of the build-out of alternative energy) remains strong. Oil and natural-gas prices are likely to remain high due to disruptions in supply from Russia. Russia will probably have to shut 1.6 m b/d of production following the EU embargo on Russian oil imports. The EU is rushing to build up natural-gas inventories before the winter, in case Russia bans gas exports to Europe in retaliation (Chart 22). Higher oil prices are positive for the Energy sector, and for countries such as Canada (whose equity market we raise to neutral, funding this by trimming the overweight in the US). Chart 21Commodity Prices Dragged Down By Weak Chinese Growth Commodity Prices Dragged Down By Weak Chinese Growth Commodity Prices Dragged Down By Weak Chinese Growth Chart 22The EU Will Need To Buy Lots Of Natural Gas Monthly Portfolio Update: Recession Or No Recession? Monthly Portfolio Update: Recession Or No Recession? Currencies: Momentum, cyclical factors, and interest-rate differentials still favor the US dollar. Although the Fed will not raise rates quite as much as futures are pricing in, other central banks – especially the ECB and the Reserve Bank of Australia – will miss by more (Table 3). Nevertheless, the USD looks very overvalued (Chart 23) and speculators are long the currency. This means that, once global growth bottoms, there could be a sharp depreciation in the dollar. We remain neutral on the USD. Our preferred defensive currency is the CHF, since the other usual safe haven, the JPY, will remain depressed if, as we expect, the Bank of Japan persists with its yield curve control, limiting the 10-year JGB yield to 0.25%. Table 3Most Central Banks Will Not Hike As Much As Futures Predict Monthly Portfolio Update: Recession Or No Recession? Monthly Portfolio Update: Recession Or No Recession? Chart 23US Dollar Is Very Overvalued US Dollar Is Very Overvalued US Dollar Is Very Overvalued Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1     Please see US Bond Strategy Report, “Echoes Of 2018” dated May 24, 2022. 2     BCA Research’s US equity strategists call this a “Fat and Flat” market. Please see “What Is Next For US Equities? They Will Be Fat And Flat”. 3     Please see “Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks” for an explanation of how the Golden Rule works in different countries.   Recommended Asset Allocation Model Portfolio (USD Terms)

Executive Summary European Spreads Have Cheapened Up More Than US Spreads European Spreads Have Cheapened Up More Than US Spreads European Spreads Have Cheapened Up More Than US Spreads Corporate bond spreads in the US and Europe have widened since early April, with European credit taking a bigger hit because of worsening growth and inflation momentum. European corporate bond valuations look fairly cheap, both for investment grade and high-yield.  This is true in absolute terms but also relative to the US, where spread valuations are more mixed.  An easing of stagflation fears in Europe is a necessary condition for a valuation convergence with the US. The US investment grade credit curve is steep relative to the overall level of credit spreads, making longer-maturity corporates more attractive. Energy bonds offer the most compelling combination of valuation and fundamental support (from high oil prices) within US investment grade. Within US high-yield, Energy valuations look much less compelling after the recent outperformance. The best medium-term industry values in European credit are in investment grade Financials and high-yield Consumer Cyclicals & Non-Cyclicals. Bottom Line: Continue to favor both US high-yield and European investment grade corporates versus US investment grade.  Stay neutral high-yield exposure on both sides of the Atlantic.  Within Europe, stay up in quality within both investment grade and high-yield until near-term macro risks on growth & inflation subside. Feature Corporate bonds in the US and Europe have gone through a rough patch in recent weeks, underperforming government bonds in response to the “triple threat” of high inflation, tightening monetary policy and slowing growth momentum.  European credit has taken the more severe hit compared to the US, with markets pricing in greater risk premia because of additional regional threats to growth (and inflation) from the Ukraine war. In this Special Report, jointly presented by BCA Research US Bond Strategy and Global Fixed Income Strategy, we assess credit spread valuations in US and European corporates after the latest selloff, across credit tiers, maturities and industry groups.  Stay Cautious On US Corporate Bonds Chart 1US Credit Spreads US Credit Spreads US Credit Spreads In a recent Special Report, we argued in favor of a relatively defensive allocation to US corporate bonds. Specifically, we advised investors to adopt an underweight (2 out of 5) allocation to US investment grade corporates and a neutral (3 out of 5) allocation to US high-yield. Our rationale was that a flat US Treasury curve signaled that we were in the middle-to-late stages of the economic recovery. Additionally, at the time, corporate bond spreads weren’t all that attractive compared to the average levels seen during the last Fed tightening cycle (Chart 1). Spreads have widened somewhat since we downgraded our allocation and, as such, we see some scope for spread tightening during the next few months as inflation rolls over and the Fed lifts rates by no more than what is already priced in the curve. That said, with the Fed in the midst of a tightening cycle, we think it’s unlikely that spreads can stay below average 2017-19 levels for any meaningful length of time. As a result, we maintain our current cautious allocation to US corporate bonds. US High-Yield Versus US Investment Grade The recent period of US corporate bond underperformance can be split into two stages based on the relative performance of investment grade and high-yield. US investment grade underperformed junk in the early stages of the selloff (between September and mid-March), as spread widening was driven by the Fed’s shift toward a more restrictive policy stance and not a meaningful uptick in the perceived risk of a recession and/or default wave (Chart 2A). Chart 2ACorporate Bond Excess Returns* Versus Duration-Times-Spread: September 27, 2021 To March 14, 2022 Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff But recession and default fears started to ramp up in mid-March, and this caused high-yield to join the selloff (Chart 2B). In fact, US investment grade corporates managed to recoup some of their earlier losses while lower-rated junk bonds struggled to keep pace. Chart 2BCorporate Bond Excess Returns* Versus Duration-Times-Spread: March 14, 2022 To Present Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff We contend that the risk of a meaningful uptick in corporate defaults during the next 12 months is low. In fact, we estimate that the US high-yield default rate will fall to between 2.7% and 3.7% during the next year, well below the 5.2% currently priced into junk spreads. Going forward, we expect the US corporate bond landscape to be defined by increasingly restrictive monetary policy and a benign default outlook. As we noted in the aforementioned Special Report, this environment is reminiscent of the 2004-06 Fed tightening cycle when high-yield bonds performed much better than investment grade. Investors should maintain a preference for high-yield over investment grade within an otherwise defensive allocation to US corporate bonds. US Industry Groups Chart 3A shows the performance of US corporate bonds in the early stages of the recent selloff, but this time split by industry group. High-yield Energy sticks out as a strong outperformer, though we also notice that every high-yield sector performed better than its investment grade counterpart. Chart 3ACorporate Bond Excess Returns* Versus Duration-Times-Spread: September 27, 2021 To March 14, 2022 Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Chart 3B once again shows how the relative performance between investment grade and high-yield has flipped since mid-March, though we see that high-yield Energy, Transportation and Utilities have performed better than the rest of the index.  Chart 3BCorporate Bond Excess Returns* Versus Duration-Times-Spread: March 14, 2022 To Present Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Interestingly, despite the strong outperformance of high-yield Energy bonds, investment grade Energy credits performed mostly in line with other investment grade sectors. We believe this presents an excellent opportunity.  The vertical axis of Chart 4A shows our measure of the risk-adjusted spread available in each investment grade industry group. Our risk-adjusted spread is the residual after adjusting for each sector’s credit rating and duration. The horizontal axis shows each sector’s Duration-Times-Spread as a simple measure of risk. Our model shows that Financials, Technology, Energy, Utilities, Communications and Basic Industry all stand out as attractive within the investment grade corporate bond universe. We identify the investment grade Energy sector as a particularly compelling buy. Chart 4AUS Investment Grade Corporate Sector Valuation Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff In a prior report, we demonstrated, unsurprisingly, that the oil price is an important determinant of whether Energy bonds perform better or worse than the rest of the corporate index. With our commodity strategists calling for the Brent crude oil price to average $122/bbl next year, this will provide strong support to Energy bond returns. Cheap starting valuations for investment grade Energy bonds make them look even more compelling. Chart 4B repeats our valuation exercise but for high-yield industry groups. Within high-yield, we find that Financials, Transportation, Communications and Consumer sectors stand out as attractive. Interestingly, high-yield Energy bonds now look slightly expensive compared to the rest of the junk bond universe, a result of the sector’s recent incredibly strong performance. Chart 4BUS High-Yield Corporate Sector Valuation Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff US Credit Curve We define the credit curve as the difference in option-adjusted spread between the “Long Maturity” and “Intermediate Maturity” sub-indexes for each investment grade credit tier, as defined by Bloomberg. We exclude high-yield from this analysis because very few high-yield bonds are classified as “Long Maturity”. To analyze the credit curve, we observe that credit curves tend to be steeper when credit spreads are tight, and vice-versa. This is because tight spreads indicate that the perceived near-term risk of default is low. As a result, short-maturity spreads tend to be lower than spreads at the long-end of the curve. Conversely, a wide spread environment indicates that the perceived near-term risk of default is high, and this risk will be more reflected in shorter maturity credits. Charts 5A, 5B and 5C show the slopes of the credit curves for Aa, A and Baa-rated securities. Immediately we notice that credit curves are positively sloped in each case, and also that each credit curve is somewhat steeper than would be predicted based on the average spread for the overall credit tier. Chart 5AAa-Rated Credit Curve Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Chart 5BA-Rated Credit Curve Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Chart 5CBaa-Rated Credit Curve Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff This strongly suggests that investors should favor long-maturity over short-maturity US investment grade corporate bonds. European Corporates Look Cheap Vs. US Equivalents – For Patient Investors Chart 6European Credit Spreads At Past 'Non-Crisis' Peaks European Credit Spreads At Past 'Non-Crisis' Peaks European Credit Spreads At Past 'Non-Crisis' Peaks Turning to the euro area, the Bloomberg investment grade OAS and high-yield OAS currently sit at 167bps and 490bps, respectively (Chart 6). These levels are well below the peaks seen during the 2020 COVID recession and the 2011/12 European debt crisis, but are in line with the spread widening episodes in 2014/15 and 2018. Our preferred measure of credit spread valuation, 12-month breakeven spreads, show that European investment grade and high-yield spreads are in the 75th and 67th percentile of outcomes, respectively, dating back to the inception of the euro in 1998 (Chart 7).1 These are both higher compared to the breakeven percentile rankings for US investment grade (48%) and US high-yield (52%). The gap between the breakeven percentile rankings for investment grade bonds in the euro area versus the US is the widest seen over the past two decades.  That gap reflects the fact that European economic growth has softened versus the US according to the S&P Global manufacturing PMIs, while European inflation has accelerated towards very elevated US levels (Chart 8).  Chart 7European Spreads Have Cheapened Up More Than US Spreads European Spreads Have Cheapened Up More Than US Spreads European Spreads Have Cheapened Up More Than US Spreads Chart 8European Corporate Underperformance Reflects Relative Growth & Inflation European Corporate Underperformance Reflects Relative Growth & Inflation European Corporate Underperformance Reflects Relative Growth & Inflation Both of those trends are a product of the Ukraine war, which has led to a massive spike in European energy costs given the region's huge reliance on Russian energy supplies, particularly for natural gas. While the US has also suffered a massive increase in its own energy bills, the inflation spike has been higher in Europe, leading to a bigger drag on economic confidence and growth. Thus, the widening spread differential between corporate bonds in Europe relative to the US likely reflects a growth-related risk premium. Chart 9A Turning Point For European Corporate Bond Performance? A Turning Point For European Corporate Bond Performance? A Turning Point For European Corporate Bond Performance? As euro area inflation has ratcheted higher, so have expectations of ECB monetary tightening. The euro area overnight index swap (OIS) curve now discounts 172bps over the next 12 months, a huge swing from the start of 2022 when markets were expecting the European Central Bank (ECB) to stand pat on the interest rate front. In comparison, markets are pricing in another 224bps of Fed tightening over the next 12 months, even after the Fed has already delivered 75bps of tightening since March. Importantly, the gap between our 12-month discounters, which measure one-year-ahead interest rate changes discounted into OIS curves, for the US and Europe has proven to be a reliable leading indicator – by around nine months - of the relative year-over-year excess returns (on a USD-hedged basis) of European and US corporate bonds, especially for investment grade (Chart 9). The fact that this is a leading relationship suggests that the upward repricing of ECB rate expectations seen so far in 2022 is not yet a reason to turn more cyclically negative on European corporate bonds versus the US. The earlier upward repricing of expected Fed tightening is the more relevant factor, and is signaling that both US investment grade and high-yield corporates should underperform European equivalents over at least the rest of 2022.  BCA Research Global Fixed Income Strategy already has a recommended allocation along those lines, with an overweight to euro area investment grade and an underweight to US investment grade. While the trade has underperformed of late, the combined messages from the relative 12-month breakeven spread rankings (cheaper European valuations) and 12-month discounters (the Fed is further ahead in the tightening cycle) leads us to stick with that relative cross-Atlantic tilt. The main risk to that stance is any deterioration of the flow of energy supplies from Russia to Europe that results in a stagflationary outcome of a bigger growth slowdown with even faster inflation. That is a scenario that would make it difficult for the ECB to back down from its recent hawkish forward guidance, resulting in European corporate spreads incorporating an even wider risk premium.  Given that near-term uncertainty, we are advocating that investors maintain no relative tilt on more growth-sensitive, and riskier, European high-yield relative to the US – stay neutral on both. Stay Up In Quality On European Corporates Looking at euro area corporate debt across credit ratings and maturity buckets, there are few compelling immediate valuation stories in absolute terms, although there are potential opportunities unfolding on a relative basis.  Within investment grade, credit quality curves have steepened during the recent selloff, with lower-rated credit seeing larger spread widening (Chart 10). The gap between Baa-rated and A-rated European corporate spreads now sits at 52bps, right in the middle of the 25-75bps range since 2014. In high-yield, the gap between Ba-rated and B-rated credit spreads is 222bps, and the gap between B-rated and Caa-rated spreads is 370bps (Chart 11) – both are still below the previous peaks in those relationships seen in 2012, 2015 and 2020. Chart 10European IG Credit Quality Curve Can Steepen ##br##More European IG Credit Quality Curve Can Steepen More European IG Credit Quality Curve Can Steepen More Chart 11European HY Credit Quality Curve Still Below Previous Peaks European HY Credit Quality Curve Still Below Previous Peaks European HY Credit Quality Curve Still Below Previous Peaks For both investment grade and high-yield, there is still room for credit curves to steepen if European growth expectations continue to deteriorate. However, when looking at spread valuations across the credit quality spectrum, and across maturity buckets, euro area corporate spreads look much cheaper than US equivalents. In Chart 12, we show a snapshot of the current 12-month breakeven percentile rankings for individual credit quality tiers and maturity groups, for investment grade and high-yield in the euro area and US.  The relative attractiveness of European credit relative to the US is evident, with European spreads now at higher percentile rankings across all quality tiers and maturity buckets. The largest gaps between 12-month breakeven percentile rankings are in the +10 year maturity bucket, the AAA-rated and AA-rated investment grade credit tiers, and the Ba-rated high-yield credit tier. This suggests any trades favoring European corporates versus the US should stay up in credit quality. Chart 12Corporate Spread Valuations By Maturity & Credit Rating Favor Europe Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Comparing European & US Industry Spread Valuations When looking at the industry composition of the euro area and US corporate bond indices, there are a few major notable differences. Within investment grade, there is a greater concentration of Energy and Technology names in the US, while Financials are more represented in the European index (Chart 13).  Those same three industries also have the largest relative weightings in the high-yield indices (Chart 14), although there is also a slightly larger weighting of high-yield Transportation companies in Europe compared to the US.  This means that a bet on European credit versus the US is essentially a bet on European Financials versus US Energy and Technology. Chart 13Investment Grade Corporate Bond Market Cap Weights Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Chart 14High-Yield Corporate Bond Market Cap Weights Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff When looking at the same sector metrics that were shown earlier in this report for the US – comparing risk-adjusted spreads to Duration-Times-Spread – we find some interesting cross-Atlantic valuation differentials. For investment grade in Europe (Chart 15), only Energy and Financials have positive risk-adjusted spread valuations (after controlling for duration and credit quality), while having the highest level of risk expressed via Duration-Times-Spread. This contrasts to the US where more sectors have positive risk-adjusted spreads - Energy, Financials, Utilities, Basic Industry and Communications. Investors should favor the latter three industries in the US relative to Europe. Chart 15Euro Area Investment Grade Corporate Sector Valuation Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Within high-yield in Europe, Energy and Financials also offer positive risk-adjusted valuations, but so do Consumer Cyclicals and Consumer Non-Cyclicals (Chart 16). This lines up similarly to US high-yield valuations. The notable valuation gaps exist in Transportation and Communications, which look cheap in the US and expensive in Europe, creating potential cross-Atlantic relative value trade opportunities between those sectors (and within an overall neutral allocation to junk in both regions). Chart 16Euro Area High-Yield Corporate Sector Valuation Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 12-month breakeven spreads measure the amount of spread widening that would be necessary to make the return on corporate bonds equal to that of duration-matched government bonds over a one-year horizon.  The spread is calculated as a ratio of the index OAS and index duration for the relevant credit market. We look at the historical percentile ranking of that ratio to make a more “apples for apples” comparison of spreads that factors in index duration changes over time. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary Selloffs across financial markets and evidence of decelerating growth have reminded us to play it close to the vest, but they haven't made us bearish. The stability of intermediate- and long-run inflation expectations suggests that the inflation genie has not yet gotten out of the bottle and that the Fed will be able to hold off on squashing the expansion until late 2023 or early 2024. Households' willingness to dip into their excess savings to maintain their spending in the face of inflationary pressures bodes well for the economy for the remaining year and a half that the excess savings cushion can be expected to last. The definitive causes of reduced labor force participation continue to elude researchers but we expect participation will improve over the rest of the year as the low-paid workers responsible for the exodus return to the grind. The Fed Fever Has Broken The Fed Fever Has Broken The Fed Fever Has Broken Bottom Line: Investors have no end of things to worry about, but we remain disposed to see the glass as half-full. We expect the expansion to continue at least into the second half of 2023 and that risk assets will generate positive excess returns over Treasuries and cash for the next twelve months. Feature We have begun meeting clients face-to-face again, in addition to continuing with conference calls. Our discussions with investors and colleagues highlight how uncertain the market and economic landscapes remain. Conditions remain especially uncertain and our views depend on the flow of data; as more pieces of the puzzle emerge, the way we assemble it is subject to change. Conviction Levels In Uncertain Times You are among the optimists at BCA and have been for a while. Are the equity selloff and the current slowdown making you nervous? Do you still see the glass as half-full? It’s our job to be nervous. The way we see the money management ecosystem, managers are responsible for worrying for their clients and we’re responsible for worrying for the managers. We continually ask how we could be getting it wrong and actively seek out information that challenges our view. We are neither foolish nor inexperienced enough to be overconfident; we’re always looking over our shoulder and our head has been on a swivel ever since the pandemic arrived. Related Report  US Investment StrategyIt All Depends On Whom You Ask The recent equity decline and growth deceleration have not materially changed our already low conviction level. All investment researchers look backward to look forward. That is to say that we review past interactions between macro variables and financial assets for guidance about future interactions. We even build regression models to formalize our empirical studies, though we keep them in their proper place. We know that models have blind spots and do not rely solely on them any more than we would change lanes on the highway based only on a glance at our rear-view mirrors. A central challenge of the last two-plus years has been that real-time conditions are so unusual that there is little historical framework for evaluating them. Much of what has occurred over that stretch has lacked a close precedent: vast swaths of the economy had not previously been idled in the interest of public safety; Congress did not appropriate 25% of a year’s GDP for distribution to households, businesses and state and local governments in any prior 13-month stretch; job losses had not been so starkly concentrated among unskilled workers while leaving knowledge workers largely unscathed; aggregate household savings and net worth have never risen so much, so fast; and central banks have launched campaigns that would make William McChesney Martin’s head spin, much less Walter Bagehot’s. The scope of the economic challenges and the novelty of the policy responses limit the usefulness of analytical methods that depend on the notion that the future will largely resemble the past. It is therefore too soon to tell if we should be more nervous. As we write, the S&P 500 has blasted 8% off its intraday lows five sessions ago and incoming economic data continue to resist a blanket bullish or bearish interpretation. We empathize with investors’ impatience; one would think that the key macro questions should be settled by now, given how long we’ve been discussing them. They are not settled, though, and we will revisit open debates as new data arrive. The Term Structure Of Inflation Expectations Real-time inflation prints are terrible and much more concerning than tame inflation expectations. Why are you focusing almost exclusively on inflation expectations? We have been keeping a close eye on the course of inflation expectations over time, or their term structure, ever since inflation began to emerge from its extended hibernation. As unsettling as it has been to witness 40-year highs in inflation, we have taken solace from the fact that market prices have uniformly indicated that businesses and investors expect that inflation will recede to familiar levels over the longer run. As indicated by the arrows in the right-hand column, long-term inflation expectations are considerably lower than near-term expectations as implied by the TIPS and nominal Treasury markets (Table 1, top panel) and directly indicated by CPI swaps (Table 1, bottom panel). Expressed as a continuous time series, neither the Treasury (Chart 1, top panel) nor the CPI swaps (Chart 1, bottom panel) market has wavered in its view that high inflation will not persist beyond the near term. Table 1The Inflations Expectations Curve Is Sharply Inverted Another Round Of Questions Another Round Of Questions   That is important because it suggests that neither businesses nor investors will need to adjust their strategies to accommodate a lasting upward inflection in price pressures. For businesses, that means that they don’t foresee a need to fight tooth and nail to pass along increased costs. Investors continue to be content with nominal long-term Treasury yields vastly below current year-over year inflation, investment-grade corporate yields that are about half of it and high-yield corporate yields that are a percentage point below it. Chart 1Investors And Businesses Don't Foresee A Lasting Change ... Another Round Of Questions Another Round Of Questions ​​​​​​ Chart 2... And Neither Do Households ... And Neither Do Households ... And Neither Do Households Although high inflation seems to have spooked the households responding to University of Michigan consumer sentiment survey takers, they remain unperturbed about its long-run direction. The difference between University of Michigan respondents’ long-run and near-term inflation expectations remains around multi-year lows (Chart 2), as 5-year expectations have held steady at 3% for three straight months. The inference that University of Michigan survey respondents expect high inflation to be fleeting is supported by their views on the advisability of big-ticket purchases. The share of respondents who deem it a bad time to buy a car because prices are (temporarily) high remains near all-time high levels (Chart 3, middle panel), while those who think buying now is auspicious because prices won’t come down is near all-time lows (Chart 3, top panel). The difference between the two continues to set record lows (Chart 3, bottom panel). The consensus view on consumer durables purchases is the same – now is a bad time to buy because high prices won’t last (Chart 4). The economic takeaway is that consumers are willing to bide their time until prices come back to earth and will not exacerbate upward price pressures by clamoring to buy before prices go even higher. Chart 3Consumers Are Willing To Wait Out Supply-And-Demand Imbalances, ... Consumers Are Willing To Wait Out Supply-And-Demand Imbalances, ... Consumers Are Willing To Wait Out Supply-And-Demand Imbalances, ... Chart 4... Instead Of Exacerbating Them By Rushing To Buy Now ... Instead Of Exacerbating Them By Rushing To Buy Now ... Instead Of Exacerbating Them By Rushing To Buy Now Bottom Line: Economic participants adjust their behavior based on their long-run inflation expectations. If they think the current fever will break, businesses, investors and consumers will not act in ways that fuel a self-reinforcing cycle in which high prices beget still higher prices. The longer that economic actors expect inflation pressures will abate, the greater the chance that they will. Interest Rates And The Fed You’ve been calling for interest rates to stop backing up, but it still feels like they only want to rise. It has been quite a ride from 1.72% on 10-year Treasuries from the beginning of March to 3.12% at the beginning of May, but we have gotten 40 basis points of retracement over the last three weeks (Chart 5). The nearly unanimous view that rates would keep rising was a contrarian sign that the move may have been played out. Reduced expectations for Fed rate hikes have also played a part in bringing yields down. After peaking at 3.45% on May 3rd, the day before the FOMC wrapped up its May meeting, the expected fed funds rate in twelve months is down to 3.09% (Chart 6). Chart 5The Benchmark Treasury Yield ... The Benchmark Treasury Yield ... The Benchmark Treasury Yield ... ​​​​​ Chart 6... Has Moved With Rate-Hike Expectations ... Has Moved With Rate-Hike Expectations ... Has Moved With Rate-Hike Expectations ​​​​​​ Chart 7Everything, All At Once Everything, All At Once Everything, All At Once While the prevailing view among commentators is that the Fed waited too long to begin removing monetary accommodation, financial markets have moved swiftly to price in a policy shift. Chair Powell and his colleagues have been taking every opportunity to communicate their seriousness about combating inflation and financial conditions have responded to their public relations campaign without delay (Chart 7, top panel) – yields have backed up (Chart 7, second panel), spreads have widened (Chart 7, third panel), stocks have fallen (Chart 7, fourth panel) and the dollar has surged (Chart 7, bottom panel). Our Global Investment Strategy colleagues argue that the Fed may soon perceive that tighter financial conditions threaten its soft landing goals and dial back the hawkish rhetoric if inflation eases in line with our house view. The Fed’s hawkish surprises might be behind us for the time being. Lightning Round You have argued that households will be more inclined to spend their excess pandemic savings than hoard them and that those savings will provide a buffer against inflation’s bite. The latest Personal Income Report showed that April’s savings rate was nearly half of its pre-pandemic level; are you now worried that the savings are going too fast to cushion the economy? We stand by our view that households will spend their excess savings and continue to think our guesstimate that they will spend half of them will prove to be conservative. We consider the declining savings rate – 6% in January, 5.9% in February, 5% in March and 4.4% in April, versus February 2020’s 8.3% – to be good news, indicating that socked-away stimulus payments are having the beneficial time-release effect of keeping the consumer afloat despite high inflation. We calculate that April’s accelerated consumption as a share of disposable income amounted to $60 billion of dis-savings relative to our no-pandemic baseline estimate, knocking excess savings down to $2,150 billion. At that rate, one-half of the excess balance will last for another 17 months. Will labor force participation ever get back to its pre-pandemic levels? If it doesn’t, upward wage pressures could be greater than you expect, and a wage-price spiral could be brewing. No one has satisfactorily determined why participation remains muted. It seems most likely to us that COVID fears, as indicated by the Census Bureau’s Household Pulse Survey, are the principal driver. Lavish stimulus measures may have played a role as well, though their tailwind has surely faded for households at the bottom rungs of the wealth and income distribution. We expect that participation will recover across the rest of the year as COVID morphs from acute threat to manageable nuisance and as the low-income workers who account for the shrinkage in the labor force (Chart 8) are pressed by financial exigency to return to the grind (Chart 9). Chart 8Those Who Have Left The Work Force ... Those Who Have Left The Work Force ... Those Who Have Left The Work Force ... ​​​​​ Chart 9... May Have To Come Back Soon ... May Have To Come Back Soon ... May Have To Come Back Soon ​​​​​​ What is your view on inflation? If you think recession fears are overblown, you must not think inflation will be bad enough over the rest of the year to induce the Fed to kill the expansion. The difference between our view and the recession-is-imminent crowd’s is merely one of timing. We expect inflation will abate enough over the rest of the year that the Fed won’t have to break up the party until late 2023/early 2024. We do think, however, that Congress and the Fed overstimulated demand in the wake of the pandemic and sowed the seeds for the eventual end of the expansion and the bull markets in equities and credit. We don’t think the overstimulation will manifest itself until late 2023 or early 2024, however, so we expect that the expansion and the bull markets in risk assets will trundle along for another year. Housekeeping We planned to dial up the risk exposures in our ETF portfolio this week, in line with BCA’s recent tactical equity upgrade to overweight from neutral. It isn’t always easy to make tactical recommendations on a weekly publication schedule and while waiting out a five-and-a-half-hour flight delay at O'Hare last Friday, we wished that we could have pushed a button to increase our equity allocation. Now that the S&P 500 has rallied over 6.5% week-to-date as we go to press, we are going to hold off on making any adjustments until next week at the earliest. With apparent short-term resistance just 1% away at 4,200 (the previous triple-bottom support level), we expect that we may find a better entry point and are willing to wait patiently for it.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

Executive Summary Equities Are Closer To Capitulation What Is Next For US Equities? They Will Be Fat And Flat What Is Next For US Equities? They Will Be Fat And Flat The market appears to be moving away from concerns about inflation toward worries about slowing growth. The initial stage of the sell-off in risky assets, pricing in tighter monetary policy, may now be complete. The next and final stage of the bear market will be pricing in a global growth slump. Slowing growth is not yet built into consensus expectations, neither for earnings nor GDP – downgrades and negative surprises are in store. The US consumers are under duress and are unlikely to lend a “spending hand” to support economic growth. Inflation is easing. Positive inflation surprises will ignite powerful rallies but are unlikely to alter the trajectory of monetary policy. The Fed “put” is no longer at play – falling equities will help the Fed tame inflation via the “wealth effect”. The next chapter for the market is down but in a “fat and flat” manner, with “growth disappointment” equity sell-off being punctuated by short-lived rallies on hopes that the Fed may change its course. Our updated Equities Capitulation Scorecard is marginally more positive on equities but is still signaling that not all conditions for a sustainable rebound are yet met.​​​​​​ Bottom Line: Repricing of tighter monetary policy is likely complete. The next leg down for equities will be pricing in slower economic growth and a potential earnings recession. We expect the market to be “fat and flat” over the next few months, i.e., alternating between pullbacks and short-lived rallies. Monetary Tightening Is Probably Priced In Until now, the sell-off in equity markets was a repricing of tighter monetary conditions. One may argue that most of the damage has been done: Since the beginning of the year, the NASDAQ is down 30% while the S&P is down 20%. Nearly 34% of stocks in the S&P 500, and 14% of stocks in the NASDAQ are trading below their 200-day moving average. Does this mean that the sell-off is over and that hawkish Fed fears are overdone? After all, over the past few days, Fed rate expectations appear to have topped out (Chart 1), and Treasury yields have come down 37 bps from their recent peak to 2.75% (Chart 2). Monetary conditions have tightened substantially year to date, although more tightening is still on the way (Chart 3). The Citi Inflation Surprise Index has turned decisively down (Chart 4) and some of the series most affected by supply chain bottlenecks, such as shipping costs, have been deflating. Chart 1Fed Rate Expectations Have Stabilized Fed Rate Expectations Have Stabilized Fed Rate Expectations Have Stabilized Chart 2Treasury Yield Has Come Down Treasury Yield Has Come Down Treasury Yield Has Come Down Chart 3Financial Conditions Are Getting Tighter Financial Conditions Are Getting Tighter Financial Conditions Are Getting Tighter Chart 4Inflation Is Starting To Surprise To The Downside Inflation Is Starting To Surprise To The Downside Inflation Is Starting To Surprise To The Downside Is it clear sailing for longer-duration assets like growth equities? Not so fast: While much adversity has been priced in, a sustainable rebound in equities is probably still elusive. Worries About Economic Growth Are Starting To Dominate The Market Narrative We posit that long-term rates have come down because the markets have moved on from worries about raging inflation and the hawkish Fed to concerns about a downshift in growth both in the US and globally. As such, both earnings and economic growth disappointments are on the cards, potentially leading the markets down further. Overall, the next phase of the sell-off in global risk assets will likely be characterized by heightened growth worries. This phase will also mark the final chapter of this bear market. Thunder Clouds On The Horizon During the J.P. Morgan Investor Day, Jamie Dimon, in his otherwise upbeat speech, said that there are “thunder clouds on the horizon.” Indeed, the list of investor concerns is long: A global growth slowdown, build-up of inventories, inflation damaging consumer purchasing power, the soaring costs of raw materials, declining corporate profitability, tightening monetary conditions and, to top it all, a stronger dollar. However, from Dimon’s standpoint, these are just that: Clouds that could dissipate at any time. Of course, there is always a chance that things will turn out better than expected, and a “softish landing” is on the cards. We hope Dimon is right… Economic Growth Surprises To The Downside For now, our working assumption is that the economy is still strong, but growth is decelerating. To us, this is a story about the second derivative. The troubling part is that slowing growth is not yet built into consensus expectations: It is confounding that GDP growth forecasts have still barely budged from the beginning of the year and do not yet reflect all the headwinds listed above (Chart 5). Moreover, the Q1-2022 GDP revision has shown that growth was weaker than initially reported, with the latest reading of -1.5%, growth reduced by investments weaker than initially anticipated.  The Atlanta Fed Nowcast GDP tracker points to only 1.8% annualized growth in Q2-2022. Elevated expectations are setting investors up for disappointment, which will lead to the next leg of the sell-off. The Citigroup Economic Surprise Index has recently shifted into negative territory (Chart 6). Chart 5GDP Forecasts Need To Be Revised Down Further GDP Forecasts Need To Be Revised Down Further GDP Forecasts Need To Be Revised Down Further Chart 6Economic Data Disappoints Economic Data Disappoints Economic Data Disappoints What is the evidence of slowing growth? Walking down the main street of any major city and seeing restaurants overflowing with customers and people buzzing in and out of shops, one may think that the economy is booming. Yet, there is plenty of evidence to the contrary. The ISM PMI is on a downward trajectory, hitting 55 in May, which was also 2.4 points below consensus. The S&P Global (former Markit) May flash PMI readings have also declined from 59.2 in April to 57.5 in May. This is hardly surprising: As night follows day, monetary tightening leads to slowing growth (Chart 7). Inventory overhang: It is noteworthy that the ISM PMI new orders-to-inventories ratio (NOI) is in a free-fall: It is foreshadowing further weakness in manufacturing activity as demand for durable goods is fading (Chart 8). May durable goods orders were also soft. Chart 7Monetary Tightening Leads To Slower Growth Monetary Tightening Leads To Slower Growth Monetary Tightening Leads To Slower Growth Chart 8Inventories Are Building Up Inventories Are Building Up Inventories Are Building Up   Freight volumes are also contracting, pointing to weakening growth, and are consistent with the NOI ratio (Chart 9). Global growth is also slowing as evidenced by the contraction in global trade volumes (Chart 10): US and European demand for goods ex-autos is shrinking following the pandemic binge, while China’s recovery has been delayed. Chart 9Freight Volumes Also Point To Weaker Growth Freight Volumes Also Point To Weaker Growth Freight Volumes Also Point To Weaker Growth Chart 10Global Export Volumes Are Set To Shrink Global Export Volumes Are Set To Shrink Global Export Volumes Are Set To Shrink Economic growth is slowing, and more negative surprises are in store. Earnings Growth Expectation Have Gotta Come Down While the stock market is not the economy, they are closely intertwined. One of the key differences between the two, however, is that the US economy is dominated by services, while the S&P 500 has higher exposure to goods. With the current demand for services outstripping demand for goods, the economy should fare better than the market (Chart 11). Therefore, it does not bode well for S&P 500 earnings expectations that the Q1-2022 GDP revision flagged earnings contracting 2.3% on a quarter-on-quarter basis, under the weight of slowing sales and rising costs. And while the S&P 500 Q1-22 results were just fine, the ratio of negative/positive guidance for Q2-22 was roughly two to one. Slowing growth at home and abroad, rising costs of raw materials and wages, as well as fading demand for goods will weigh on earnings over the balance of the year (Chart 12). Chart 11Slowing Growth Will Weigh On Earnings Slowing Growth Will Weigh On Earnings Slowing Growth Will Weigh On Earnings Chart 12US EPS Expectations Have Not Yet Been Downgraded US EPS Expectations Have Not Yet Been Downgraded US EPS Expectations Have Not Yet Been Downgraded Also, there is the not-so-small issue of a strong dollar, which has gained nearly 13% since January 2021. This makes US goods more expensive and also reduces companies’ bottom lines via the currency translation effect. According to our rough estimates, every percentage change in the USD reduces earnings growth by roughly 33 bps, i.e., 4.3% off earnings caused by the entire dollar move. We expect slower top-line growth and shrinking profit margins to translate into flat to negative real earnings growth over the next 12 months. Importantly, US economic growth does not need to contract for a profit recession to take hold. However, S&P 500 EPS expectations have not yet been downgraded and 12-month forward EPS growth expectations are at about 10%; despite the recent market rout, US stocks have not yet priced in negative profit growth. However, either downgrades or earnings disappointments are coming, neither of which bodes well for US equity performance. Earnings growth expectations need to come down to reflect reality on the ground.   Valuations Are Only Optically Cheap And one more salient point: If earnings expectations are set to unrealistically high levels, then the recent forward multiple of the S&P 500 is not 17x, but 2 to 3 points higher, and, voilà, US equities no longer look cheap. Will US Consumers Save The Day? Perhaps things are not as dire as we describe. After all, US consumers are healthy, their balance sheets are pristine, and retail sales look good. There is also the not-so-small issue of $2.2 trillion in excess savings. This argument rings true. Chart 13Negative Real Wage Growth Is Sapping Consumer Confidence Negative Real Wage Growth Is Sapping Consumer Confidence Negative Real Wage Growth Is Sapping Consumer Confidence However, inflation continues to put pressure on US consumers. Negative real wage growth is sapping their confidence (Chart 13) and is cutting into their purchasing power. Soaring inflation also makes people concerned about the future as they watch their life savings melt away. Underwhelming reports from Walmart and Target are cases in point: Lower-income consumers are shifting spending away from discretionary items and towards necessities. Strong reports from Dollar General and Family Dollar indicate that many Americans are price sensitive and are shopping around. Home Depot commented that fewer customers walked through its doors (but the ones that did, tended to spend more in nominal terms). And retail sales are reported in nominal terms: Rising prices inflate growth rates. Indeed, excess savings may help achieve the “soft landing.” However, there are early signs that either many lower-income Americans have spent the money, or their savings accounts are earmarked for a rainy day, and many people aim to spend only what they earn. However, higher-income Americans are still willing to spend, but this group is shifting spending away from goods and towards services, which is consistent with strong results from the US airline carriers, which report a significant gain in pricing power. A similar message came from both Nordstrom and Macy’s. Clearly, American consumers are highly heterogeneous, and there is a significant bifurcation between “haves” and “have nots.” It is, however, concerning that many of the wealthier Americans have lost a significant percentage of their nest eggs in the stock market. The theory goes that the wealth effect is one of the main mechanisms through which monetary tightening affects consumer demand (Chart 14). It stands to reason that it is only a matter of time (unless the stock market rebounds) before even the wealthier cohorts start tightening their belts, dampening demand for consumer services. Chart 14Nest Eggs Are Dwindling Nest Eggs Are Dwindling Nest Eggs Are Dwindling Another obvious implication is the effect of dwindling investments on the housing market: Americans are watching their down payments disappear, with cash buyers subject to the same negative forces. The US consumer is under duress, and the more embedded the inflation and the deeper the market rout, the greater proportion of the US population is affected, making them less and less likely to lend a “spending hand” to support economic growth.  Inflation Will Turn: Too Little, Too Late One may also argue that inflation will turn, which would help both the economy and the markets, and will reset the Fed trajectory. Inflation will come down assisted by the arithmetic of the base effect. Supply chain bottlenecks are clearing, shipping costs are coming down, and demand is weakening – all of these developments point to inflation coming down over the next few months. However, this process may be rather slow: Inflation permeates the entire economy (Chart 15), and there are also signs that a vicious wage-price spiral is taking hold (Chart 16). Therefore, inflation is unlikely to revert to levels that the Fed and the US consumer will consider acceptable any time soon. Chart 15Inflation Is Broad-based And It Will Take Time For It To Revert To Acceptable Levels Inflation Is Broad-based And It Will Take Time For It To Revert To Acceptable Levels Inflation Is Broad-based And It Will Take Time For It To Revert To Acceptable Levels Chart 16Wage-Price Spiral Is Taking Hold Wage-Price Spiral Is Taking Hold Wage-Price Spiral Is Taking Hold Just recently, Fed Chairman Jerome Powell reiterated the Fed’s commitment to hiking interest rates until core consumer price inflation gets closer to 2%. Notably, in his speech at a WSJ event on May 17, Powell noted: “This is not a time for tremendously nuanced readings of inflation… We need to see inflation coming down in a convincing way. Until we do, we’ll keep going.” Given that US core consumer price inflation is currently at around 6.2%, a mere rollover in core inflation from current levels will not be enough for the Fed to tone down its hawkishness. While we believe that the Fed will be steadfast in its objective to combat inflation, any positive news on inflation will be perceived by a hopeful market as a sign that the Fed may alter its course, which would lead to a rally, only to be punctured by the negative news from either growth or the Fed. Positive inflation surprises will ignite powerful rallies but are unlikely to alter the trajectory of monetary policy. The Fed “Put” Is No More The Fed “put” is no longer at play as the Fed has signaled that it cares far more about combating inflation than the performance of the stock market. In fact, falling equities will play into Powell’s hand as a negative wealth effect is likely to put a lid on inflationary pressures, with the wealthier Americans paying the toll.   When Bad News Is Good News We make a case that disappointing growth will be the next chapter of this market saga. One might wonder if poor growth readings would actually be perceived by the market as a positive: Not only does disappointing growth put downward pressure on Treasury yields but also creates an expectation that the Fed will pause and monetary policy will end up looser than initially projected. Our take is that stable or lower rates will offer support for equities, and that is the reason why we conclude that the first stage of the repricing is complete. Will slower growth invite a more gentle and considerate Fed? We don’t think so as the Fed has already telegraphed that it now aims for a “softish landing” and that fighting inflation will incur some “pain”. Investment Implications Chart 17In 1980-82, The Market Was "Fat And Flat" In 1980-82, The Market Was "Fat And Flat" In 1980-82, The Market Was "Fat And Flat" We expect the market to be “fat and flat” over the next few months, i.e., alternating between pullbacks and short-term rallies. Rallies are frequent during bear markets and other severe corrections and are generally significant in magnitude. Markets showed a similar pattern in 1980-1982 as Chairman Volker was battling inflation (Chart 17). The bull market took hold only in 1982. Rallies will follow pullbacks because the market is not yet ready for a sustainable rebound. This first leg of the correction was pricing in tighter monetary policy. The next leg down will be the market pricing in slowing growth both at home and abroad, corporate earnings disappointments, and weakening consumer demand. Over the next few months, the market is likely to trend down but in a “fat and flat” manner, with “growth disappointment” equity sell-off being punctuated by fast and furious rallies on hopes that inflation is abating, and that a gentler, data-driven Fed would be more supportive of the economy and the markets. Thus, with markets looking oversold, a short-lived rally is now likely. It will be accompanied by a change in leadership: Energy and Materials will give back gains, while Big Tech and other cyclicals will bounce. And US equities may still plumb new lows on the back of economic growth or earnings growth disappointments. The market will also not take it kindly if inflation turns out to be stickier than expected and is accompanied by slowing growth: Stagflation is one of the most challenging regimes for US equities (Chart 18). Sticky inflation would call for an even more aggressive rate hiking cycle. Chart 18Stagflation Would Be The Worst Possible Outcome For The Markets What Is Next For US Equities? They Will Be Fat And Flat What Is Next For US Equities? They Will Be Fat And Flat Table 1Equities Are Closer To Capitulation What Is Next For US Equities? They Will Be Fat And Flat What Is Next For US Equities? They Will Be Fat And Flat We believe that a sustainable rebound will take place once most of the negative “news” is priced in. Compared to two months ago, we conclude that the first part of the adjustment process, i.e., pricing in tighter monetary policy, has run its course. Now it is a matter of adjusting growth expectations. Our “Equities Capitulation” scorecard (“Have We Hit Rock Bottom” report), adds up to -1, a slightly less negative reading than the -2 just a few weeks ago — but a reading which still signals negative equity returns (Table 1). We conclude that staying close to the benchmark, with a small tilt towards defensive growth, remains the most sensible strategy.   Bottom Line The first stage of the market correction is probably complete and tighter monetary policy is getting priced in. The next leg down for equities will be pricing in slower economic growth and a potential earnings recession. We expect the market to be “fat and flat” over the next several months as rallies ignited by soothing inflation readings are punctured by growth disappointments and a resolute Fed.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Recommended Allocation Recommended Allocation: Addendum What Is Next For US Equities? They Will Be Fat And Flat What Is Next For US Equities? They Will Be Fat And Flat