Financial Markets

Executive Summary The Euro And Relative Growth The Euro And Relative Growth The Euro And Relative Growth The euro is likely to appreciate over the course of 2022. But the path will be volatile, with a retest of recent EUR/USD lows within the central band of possible outcomes. Our 2022 target for the euro is 1.20. This partly hinges on cheap valuations. Beyond 2022, a bold estimate could see the euro gravitate towards 1.40. The pricing of interest rate hikes by the ECB this year are too aggressive. But this is also the case for the Federal Reserve, especially if inflation proves transitory. Our bias is that appreciation in the euro will be more driven by improving relative economic fundamentals as the 2022 cycle unfolds. A bottom in Chinese growth could be the ultimate arbiter of which mega economy outperforms. Sentiment on the euro is only neutral. This suggests that an escalation in Russo-Ukrainian tensions, as well as a more dovish ECB, are key risks in the short term. A short EUR/JPY position is a good hedge for this risk. In our FX portfolio, we are long EUR/CHF and long EUR/GBP as equally playable themes. We would buy the EUR/USD at current levels but suspect a better entry point awaits us. Recommendations Inception Level Inception Date Return Long EUR/CHF 1.05 2021-11-19 0.62% Long EUR/GBP 0.846 2021-10-15 -.71%   Bottom Line: A positive surprise in Chinese growth, which will boost the euro area trade balance, will be a catalyst for eurozone growth. So will a decline in Russo-Ukrainian tensions and lower energy inflation. Feature The most persistent question we have received in recent weeks is the outlook for the euro. As the premier anti-dollar asset, most clients have been surprised by recent strength in the European currency, betting that a hawkish Fed and US exceptionalism will push the greenback to new highs. A domestic energy crisis interlinked with a brewing war in their backyard has created perfect conditions for selling the euro. With US inflation surprising to the upside, the case for maintaining a dollar-bullish stance remains in place. Yet, the dollar is well below its previous highs. Our suspicion is that the market faces a conundrum. Transitory inflation will nudge the Fed to underwhelm market expectations of aggressive rate hikes. Meanwhile, sticky inflation means that other central banks will eventually catch up to the Federal Reserve in tightening monetary policy. This tug of war has been a defining theme of our strategy for currencies in 2022.1 Specific to the euro area, there is a lot of bad economic news that is now well priced in, while good news is underappreciated by markets. This is becoming evident in the interest rate market, where real Bund yields are creeping noticeably higher. The spread of Omicron in the euro area is receding in lockstep with the deceleration in the US (Chart 1). As a result, the potential growth profile of the euro area is improving tremendously (Chart 2). Should this prove durable, it will put a solid floor under the euro. Chart 1The Pandemic Is Receding The Pandemic Is Receding The Pandemic Is Receding Chart 2The Euro And Relative Growth The Euro And Relative Growth The Euro And Relative Growth The Case For European Growth Growth is moderating around the world. That said, the German manufacturing PMI has been sharply outpacing that of the US. What is also true is that most measures of euro area growth that we monitor are rising fast relative to the US. The results are preliminary, but the possibility of a growth rotation from the US to other economies, including the eurozone, is very much underappreciated by markets. The economic surprise index in the euro area is strong relative to the US, pointing to a stronger euro (Chart 3). Bloomberg economic forecasts suggest that euro area growth will outpace growth in the US this year. According to the consensus, the euro area will grow by 4.2% in 2022, compared to the US at 3.9%. Remarkably, eurozone growth has typically lagged growth in the US by a significant margin. If past is prologue, it suggests the euro is not priced for this paradigm change (Chart 4). Chart 3Economic Surprises And ##br##The Euro Economic Surprises And The Euro Economic Surprises And The Euro Chart 4Bloomberg Forecasters Expect A Pickup In Eurozone Growth Bloomberg Forecasters Expect A Pickup In Eurozone Growth Bloomberg Forecasters Expect A Pickup In Eurozone Growth Other economic forecasts corroborate this view. The IMF expects eurozone growth to moderate from 5.2%, to 3.9% in 2022. This is an advantage over the US, where growth is expected to moderate from 5.6% in 2021, to 4% in 2022. The Atlanta Fed GDP growth tracker suggests US growth will slow to a crawl in Q1. The ZEW survey points to a meaningful rebound in the German (and euro area) PMI in the coming months (Chart 5). This will further widen the gap between European and US growth. The key denominator for all these forecasts is a bottoming in Chinese growth. The euro area needs the manufacturing and external sector to keep humming, with China as a critical import partner. Industrial production in the euro area, relative to the US, tends to track the Chinese credit impulse closely (Chart 6). Our bias is that the Chinese credit impulse has bottomed. This will be a catalyst for more Chinese demand for European goods. Chart 5The ZEW Survey Points To An Improving German PMI The ZEW Survey Points To An Improving German PMI The ZEW Survey Points To An Improving German PMI Chart 6Europe Is Partly Dependent On China Europe Is Partly Dependent On China Europe Is Partly Dependent On China The ECB And Interest Rates Chart 7The Gap Between Expected US-EUR Interest Rates Is Wide The Gap Between Expected US-EUR Interest Rates Is Wide The Gap Between Expected US-EUR Interest Rates Is Wide The markets have begun to reprice higher interest rates in the eurozone. Admittedly, this has been partly due to higher expected inflation. In our view, the repricing by markets is warranted due to the gaping wedge between US versus European interest rate expectations. According to December 2022 contracts, markets expect the Fed to hike interest rates by significantly more than the ECB (Chart 7). It is true that structurally, inflation in the eurozone has been lower than in the US. In fact, our European Investment Strategy colleagues highlight that by stripping out energy, and the impact of VAT tax increases, European inflation is even lower. When CPI baskets are adjusted item for item, eurozone inflation today is indeed lower compared to the US, but not by much (Chart 8). For example, energy and transportation are only 14% of the eurozone CPI basket versus 26% in the US (Table 1). Meanwhile, the ECB targets HICP inflation (not core) that sits at 5.1%, versus a target of 2%.  Chart 8Item-For-Item Inflation: US Versus Eurozone Item-For-Item Inflation: US Versus Eurozone Item-For-Item Inflation: US Versus Eurozone Table 1Differences In The US And Eurozone CPI Basket The Unsung Case For The Euro The Unsung Case For The Euro In the coming months, inflation is likely to subside in the eurozone, but probably by less than markets expect. The key driver of inflation expectations in the eurozone (and in the US) are long-dated commodity prices (Chart 9). This has become even more evident, given the surge in electricity prices across many European countries. Robert Ryan, our Chief Commodity Strategist, expects long-dated crude prices to be revised upward, as the oil curve remains persistently backwardated. This puts a floor on how low inflation expectations can relapse in the euro area and will keep the ECB on edge. Meanwhile, the employment picture in the eurozone is also improving. Adjusting for the higher rate of structural unemployment, euro area joblessness compares favorably with the US (Chart 10). It is true that wage growth remains anemic, but it is also the case that the behavior of wages can exhibit a structural shift at very low levels of employment.  Chart 9What Drives Eurozone Inflation Expectations? What Drives Eurozone Inflation Expectations? What Drives Eurozone Inflation Expectations? Chart 10US Versus Eurozone Labor Markets US Versus Eurozone Labor Markets US Versus Eurozone Labor Markets Finally, the euro zone has a lot of pent-up demand. This could help bolster growth in the coming quarters and even beyond. While not a subject of this report, we suspect that the cascading crises in the eurozone could have sown the seeds for a productivity boom in the coming years. For a 12-18-month outlook, high savings and easy fiscal policy will allow European growth to recover in the coming quarters. EUR/USD Valuation And Future Returns Making a structural case for the euro is easy when it comes to valuation. According to our in-house PPP models, an investor who buys the euro today can expect to make 4%-5% a year over the next decade, should the euro stay at current levels of undervaluation versus the US. This will occur if Eurozone inflation keeps lagging that in the US.  (Chart 11). That said, this is the Goldilocks case. A simple return to PPP fair value will suggest the euro will rise by a robust 20%. For 2022, our forecast for the euro is more in the 1.20-1.23 range, 8% above current levels. Our stance is measured because investors are only neutral the euro (Chart 12). Usually, this means that the macroeconomic environment becomes the dominant driver, rather than sentiment. With a Russo-Ukrainian crisis still in the backyard and the potential for more market volatility, an undershoot in the euro cannot be ruled out.  Chart 11The Goldilocks Case For The Euro The Goldilocks Case For The Euro The Goldilocks Case For The Euro Chart 12Sentiment On The Euro Is Only Neutral Sentiment On The Euro Is Only Neutral Sentiment On The Euro Is Only Neutral That said, interest rate differentials are now moving in favor of the euro. Italian BTPs now yield 1.9%, like US Treasurys. The US Treasury-Bund spread has also narrowed. This removes a lot of the incentive for Europeans to flood the US Treasury or TIPs market, should market volatility subside. Given this confluence of factors, we have chosen to play euro strength via two channels: Long EUR/CHF: This trade will benefit from positive interest rate differentials. Also, the Swiss franc has been bid up relative to the euro on safe-haven demand. This has outpaced the traditional demand for safety, using the DXY index as a proxy (Chart 13). Long EUR/GBP: This is a bet on improving economic fundamentals between the eurozone and the UK (Chart 14), as well as a bet on policy convergence between the two economies. Chart 13Stay Long EUR/CHF Stay Long EUR/CHF Stay Long EUR/CHF Chart 14Stay Long EUR/GBP Stay Long EUR/GBP Stay Long EUR/GBP   Footnotes 1 Please see Foreign Exchange Strategy Report, “The Biggest Macro Question By FX Investors Could Potentially Be The Least Relevant”, dated January 14, 2022.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Brazil: Are Political & Macro Risks Priced-In? Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Presidential elections are due in Brazil on October 2, 2022. While the left-of-center former President Lula da Silva will likely win, the road to his victory will not be as smooth as markets expect. Incumbent President Jair Bolsonaro will make every effort to cling to power, including fiscal populism and attacks on Brazil’s institutions. These moves may roil Brazil’s equity markets as they may provide a fillip to Bolsonaro’s popularity. Bolsonaro’s institutional attacks have triggered down moves in the market before and any fiscal expansion may worry investors as it could prove to be sticky. We urge investors to take-on only selective tactical exposure in Brazil. Equities appear cheap but political and macro risks abound. To play the rally yet stave-off political risk in Brazil, we suggest a tactical pair trade: Long Brazil Financials / Short India. Tactical Recommendation Inception Date Long Brazil Financials / Short India 2022-02-10   Bottom Line: On a tactical timeframe we suggest only selective exposure to Brazil given the latent political and macro risks. On a strategic timeframe, we are neutral on Brazil given that its growth potential coexists with high debt and low proclivity to structural reform. Feature Chart 1Brazil Underperformed Through 2020-21, Is Cheap Today Brazil Underperformed Through 2020-21, Is Cheap Today Brazil Underperformed Through 2020-21, Is Cheap Today Brazil’s equity markets underperformed relative to emerging markets (EMs) for a second consecutive year in 2021 (Chart 1). But thanks to this correction, Brazilian equities now appear cheap (Chart 1). With Brazil looking cheap, China easing policy, and Lula’s return likely, is now a good time to buy into Brazil? We recommend taking on only selective exposure to Brazil on a tactical horizon for now. Brazil in our view may present a near-term value trap as markets are under-pricing political and economic risks. Lula Set For Phoenix-Like Return Luiz Inácio Lula da Silva (or popularly Lula) of the Worker’s Party (PT) appears all set to reclaim the country’s presidency in the fall of 2022. The main risk that Lula’s presidency may bring is a degree of fiscal expansion. Despite this markets may ultimately welcome his victory at the presidential elections as Lula is in alignment with the median voter, is expected to be better for Brazil’s institutions, will institute a superior pandemic-control strategy, and may also undertake badly needed structural reforms in the early part of his tenure. Despite these points we urge investors to limit exposure to Brazil for now and turn bullish only once the market corrects further. Whilst far-right President Jair Bolsonaro managed to join a political party (i.e., the center-right Liberal Party) late last year, he is yet to secure something more central to winning elections i.e., a high degree of popularity. To boost his low popularity ratings (Chart 2), we expect Bolsonaro to leverage two planks: populism and authoritarianism. These measures will bump up Bolsonaro’s popularity enough to shake up Brazil’s markets with renewed uncertainty, but not enough to win him the presidency. Chart 2Lula Is Ahead But His Lead Has Narrowed Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Lula is a clear favorite to win. After spending more than a year in jail on corruption charges, Lula is back in the fray and has maintained a lead on Bolsonaro for the first round of polling (Chart 2). Even if a second-round run-off election were to take place, Lula would prevail over Bolsonaro or other key candidates (Chart 3). By contrast, Bolsonaro’s lower popularity means that in a run-off situation he stands a chance only if pitted against center-right candidates like Sergio Moro (his former justice minister) or João Doria (i.e., the center-right Governor of São Paulo) (Chart 4). Chart 3Lula Leads Run-Off Vote Against All Potential Candidates Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 4In A Run-Off, Bolso Stands Best Chance Of Winning If Pitted Against Moro Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ What has driven the swing to the left in Brazil? After the pandemic and some stagflation, Brazil’s median voter’s priorities have changed. In specific: Brazil’s median voter’s top concerns in 2018 were centered around improving law and order (Chart 5). A right-of-center candidate with concrete law-and-order credentials like Bolsonaro was well placed to tap into this public demand. Chart 5In 2018-19, Law And Order Issues Dominated Voters’ Concerns Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Now, however, Brazil’s voters’ top concerns are focused around improving the economy and controlling the pandemic, where Bolsonaro’s record is dismal (Chart 6). Given this change of priorities, a left-of-center candidate with a solid economic record like Lula is best placed to address voters’ concerns. Lula had the fortune to preside over a global commodity bull market and Brazilian economic boom in the early 2000s (Chart 7). Regarding pandemic control, almost any challenger would be better positioned than Bolsonaro, who initially dismissed Covid-19 as “a little flu” and lacked the will or ability to set up a stable public health policy. Chart 6In 2022, Median Voter Cares Most About Economic Issues, Pandemic-Control Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 7Lula’s Presidency Overlapped With An Economic Boom Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ A left-of-center candidate like Lula, or even Ciro Gomes (Chart 8), is more in step with the median voter today for two key reasons: Inflation Surge, Few Jobs: Inflation has surged, and the increase is higher than that seen under the previous President Michael Temer (Chart 7). Transportation, food, and housing costs have all taken a toll on voter’s pocketbooks (Chart 9). The cost of electricity has also shot up. For 46% of Brazilian families, expenditure on power and natural gas is eating into more than half of their monthly income, according to Ipec. Chart 8Left-Of-Center Candidates Stand A Better Chance In Brazil In 2022 Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 9Under Bolso Inflation Has Surged Across Key Categories Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​ Distinct from inflation, unemployment too has been high under Bolsonaro (Chart 10). Chart 10Unemployment Too Has Surged Under Bolsonaro Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 11Brazil’s Per Capita Income Growth Has Lagged That Of Peers Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 12Since 2018, Brazil's Economic Miseries Have Grown More Than Those Of Peers Since 2018, Brazil's Economic Miseries Have Grown More Than Those Of Peers Since 2018, Brazil's Economic Miseries Have Grown More Than Those Of Peers Stagnant Incomes: Despite a strong post-pandemic fiscal stimulus, GDP growth in Brazil has been low (Chart 7). In a country that is structurally plagued with high inequalities, the slow growth in Brazil’s per capita income (Chart 11) under a right-wing administration is bound to trigger a leftward shift. It is against this backdrop of rising economic miseries (Chart 12) that Latin America’s largest economy is seeing its ideological pendulum swing leftwards. This phenomenon has played out before too - most notably when Lula first assumed power as the president of Brazil in 2002. Brazil’s GDP growth was low, inflation was high and per capita incomes had almost halved under the presidency of Fernando Henrique Cardoso (or popularly FHC) over 1995-2002. This economic backdrop played a key role in Lula’s landslide win in 2002. Brazil’s political differences are rooted in regional as well as socioeconomic disparities. In the 2018 presidential elections, left-of-center candidates like Fernando Haddad generated greatest traction in the economically backward northeastern region of Brazil. On the other hand, Bolsonaro enjoyed higher traction in the relatively well-off regions in southern and northern Brazil (Maps 1 & 2). Now Bolsonaro has faltered under the pandemic and Lula can reunite the dissatisfied parts of the electorate with his northeastern base. Map 1Brazil’s South, Mid-West And North Supported Bolso In 2018 Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Map 2Left-Of-Center 2018 Presidential Candidate Haddad Had Greatest Traction In Regions With Low Incomes Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Bottom Line: The stage appears set for Lula’s return to Brazil’s presidency. But will the road be smooth? We think not. Investors should gird for downside risks that Brazilian markets must contend with as President Bolsonaro fights back. Brace For Bolso’s Fightback The road to Bolsonaro’s likely loss will be paved with market volatility and potentially a correction. Interest rates have surged in Brazil as its central bank combats inflation (Chart 13). Even as BCB’s actions will lend some stability to the Brazilian Real (Chart 13), political events over the course of 2022 will spook foreign investors. Bolsonaro will leverage two planks in a desperate attempt to retain control: Plank #1: Populism Brazil’s financial markets experienced a major correction in the second half of 2021. This was partially driven by the fact that Brazilian legislators approved a rule that allows the government to breach its federal spending cap. Given Bolsonaro’s low popularity ratings today and given that his fiscal stance has been restrained off late, Bolsonaro could well drive another bout of fiscal expansion in the run up to October 2022. Such a move will bump up his popularity but at the same time worry markets given Brazil’s elevated debt levels (Chart 14). Bolsonaro can technically pass these changes in the Brazilian national assembly given that in both houses the government along with the confidence and supply parties has more than 50% of seats. Chart 13Brazil’s Central Bank Has Hiked Rates Aggressively Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 14Brazil Is One Of The Most Indebted Emerging Markets Today Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Plank #2: Institutional Attacks To rally his supporters, the former army captain could also sow seeds of doubt in Brazil’s judiciary and electoral process. Given the strong support that Bolsonaro enjoys amongst conservatives, he may even mobilize supporters to stage acts of political violence in the run up to the elections. Bolsonaro could make more dramatic attempts to stay in power than former US President Trump, whose rebellion on Capitol Hill did not go as far as it could have gone to attempt to seize power for the outgoing president. Last but not the least, there is a possibility that the Brazilian judiciary presents an unexpected roadblock to Lula’s candidacy. Given the unpredictable path of Brazil’s judicial decisions, investors should be prepared for at least some kind of official impediments to Lula’s rise. Even if Lula is ultimately allowed to run, any ruling that casts doubt on his candidacy or corruption-related track record will upset financial markets. Global financial markets rallied through the Trump rebellion on January 6 last year. But US institutions, however flawed, are more stable than Brazil’s. Brazil only emerged from military dictatorship in 1985. Bolsonaro has fired up elements of the populace that are nostalgic for that period, as we discuss below. Bottom Line: Brazil’s equities look cheap today, but political risks have not fully run their course. President Bolsonaro may launch his fightback soon, which could drive another down-leg in Brazil’s markets. His institutional attacks have triggered down moves before and any potential fiscal expansion that Bolsonaro pursues may worry investors, as this expansion could stick under the subsequent administration. In addition, there is a chance that civil-military relations undergo high strain in the run-up to or immediately after Brazil’s elections. Is A Self-Coup By Bolso Possible? “One uncomfortable fact of the dictatorship is that its most brutal period of repression overlapped with what Milton Friedman called an economic miracle.… Brazil’s economy, nineteenth largest in the world before the coup, grew into the eighth largest. Jobs abounded and the regime then was actually popular.” – Alex Cuadros, Brazillionaires: Wealth, Power, Decadence, and Hope in an American Country (Spiegel & Grau, 2016) It is extremely difficult for President Bolsonaro to win the support of a majority of the electorate. But given his open admiration for Brazil’s dictatorship, is a self-coup possible in 2022? The next nine months will be tumultuous. A coup attempt could occur. However, we allocate a low probability to a successful self-coup because: Bolsonaro’s Popularity Is Too Low: Even dictators need to have some popular appeal. Bolsonaro has lost too much support (Chart 15), he never had full control of any major institutions (including the military), and few institutional players will risk their credibility for his sake. If he somehow clung to power, his subsequent administration would face overwhelming popular resistance. Chart 15Bolsonaro’s Low Approval Ratings - A Liability Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Bolsonaro’s Economy Is Too Weak: The dictatorship in Brazil managed to hold power for more than two decades partially because this period of authoritarianism was accompanied by a degree of economic well-being. Currently the public is shifting to the left because low growth and high inflation have dented the median voter’s purchasing power. The weak economy would make an authoritarian government unsustainable from the start. Lack Of American Support: Some military personnel may be supportive of a coup and several retired military officers are occupying civilian positions in the Brazilian federal government, thanks to Bolsonaro. So why can’t Brazil slip right back into a military dictatorship led by Bolsonaro, say if the election results are narrow and hotly contested? The coup d'état in Brazil in 1964 was a success to a large extent because this regime-change was supported by America. Back then communism was a threat to the US and Washington was keen to displace left-leaning heads of states in Latin America, such as Brazilian President João Goulart. But America’s strategic concerns have now changed. America today is attempting to coalesce an axis of democracies and the Biden administration has no incentive whatsoever to muddy its credentials by supporting dictatorship in Latin America’s largest country. Even aside from ideology, any such action would encourage fearful governments in the region to seek support from America’s foreign rivals, thus inviting the kind of foreign intervention that the US most wants to prevent in Latin America. The Brazilian Military Has Not Been Suppressed Or Sidelined: History suggests that coups are often triggered by a drop in the military’s importance in a country. However, the military’s power in Brazil has remained meaningful through the twenty-first century. Brazil has maintained steady military spends at around 1.5% of GDP over the last two decades. Thus, top leaders of Brazil’s military have no reason to feel aggrieved or disempowered. Having said that, it is not impossible that an extreme faction of junior officers might try to pull off a fantastical plot, even if they have little hope of succeeding, which is why we highlight that markets can be rudely awakened by the road to Brazil’s election this year. In Turkey in July 2016, an unsuccessful coup attempt caused Turkish equities to decline by 9% over a four-day period. Bottom Line: Investors must gird for the very real possibility of civil-military relations undergoing high degrees of strain in Brazil, particularly if a contested election occurs. While Bolsonaro’s supporters and disaffected elements of the Brazilian military could resist a smooth transition of power away from Bolsonaro, the transition will eventually take place because two powerful constituencies – Brazil’s median voter and America – will not support a coup in Brazil. Will Lula Be Good For Brazil’s Markets? Looking over Bolsonaro’s presidency, from a market-perspective, some policy measures were good, some were bad, and some were downright ugly. In specific: The Good: Pension Reforms And Independent Monetary Policy In Bolsonaro’s first year in power, he delivered pension sector reforms. The law increased the minimum retirement age and also increased workers’ pension contributions thereby resulting in meaningful fiscal savings. Bolsonaro passed a law to formalise the BCB’s autonomy and the BCB has been able to pursue a relatively independent monetary policy. BCB has now lifted the benchmark Selic rate by 725bps over 2021 thereby making it one of the most hawkish central banks amongst EMs (Chart 13). This is in sharp contrast to the situation in EMs like Turkey where the central bank cut rates owing to the influence of a populist head of state. The Bad: Poor Free Market Credentials And Fiscal Expansion In early 2021, President Bolsonaro fired the head of Petrobras (the state-owned energy champion) reportedly for raising fuel prices. Bolsonaro then picked a former army general (with no relevant work experience) to head the company. Although Bolsonaro positioned himself as a supporter of privatization in the run up to his presidency, he failed to follow through. Another area where the far-right leader has disappointed markets is with respect to Brazil’s debt levels. Under his presidency, a constitutional amendment to raise a key government spending cap was passed. Shortly afterwards came the creation of the massive welfare program Auxílio Brasil. Bolsonaro embraced fiscal populism to try to save his presidency after the pandemic. Consequently Brazil’s public debt to GDP ratio ballooned from 86% in 2018 to a peak of 99% in 2020. The Ugly: Poor Pandemic Response And Institutional Attacks The darkest hour of Bolsonaro’s presidency came on September 7, 2021, i.e., Brazil’s Independence Day. During rallies with his supporters, Bolsonaro levelled attacks on the Brazilian judiciary and sowed seeds of doubt in Brazil’s electoral process. More concretely, the greatest failing of the Bolsonaro administration has been its lax response to the pandemic. Bolsonaro delayed preventive measures, and this has meant that Brazil was one of the worst hit major economies of the world. The pandemic has claimed more than 630,000 lives in Brazil i.e., the second highest in the world. In relative terms too, Brazil has experienced a high death rate of about 2,960 per million which is even higher than the US rate of 2,720 per million. President Bolsonaro’s poor handling of the pandemic will cost the President in terms of votes in 2022 as the highest Covid-19-related death rates were seen in Southern Brazil (Map 3) i.e., a region that had voted in large numbers for Bolsonaro in 2018 (see Map 1 above). Map 3The Pandemic Has Had A Devastating Impact In Brazil’s South, Mid-West And North Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Given this backdrop, a Lula presidency will be welcomed by global financial markets, potentially for three reasons: Superior Pandemic-Control: An administration headed by Lula will bring in a more scientific and cohesive pandemic-control strategy thereby saving lives and benefiting the economy. Alignment With Institutions: Lula will act in alignment with Brazil’s institutions. He stands to benefit from the existing electoral system, the civil bureaucracy, academia, and the media. He may have rougher relations with the judiciary and parts of the military, but he is a known quantity and not likely to attempt to be a Hugo Chavez. Possibility Of Some Structural Reform: Given Brazil’s unstable debt dynamics, and the “lost decade” of economic malaise in the 2010s, there is a chance that Lula could pursue some structural reforms. Lula is more popular than his Worker’s Party, which is still tainted by corruption, so his strength in Congress will not be known until after the election. But Brazilian parties tend to coalesce around the president and Lula has experience in managing the legislative process. The probability of Lula pushing through some bit of structural reform will be the greatest in 2021. Back in 2019, it is worth recounting that only 4% of the Brazilian public supported pension reforms. Despite this Bolsonaro managed the passage of painful pension reforms in 2019 because market pressure forced the parties to cooperate. Faced with inflation and low growth, Lula may be forced to push through some piecemeal structural financial sector and economic reforms. However, if commodity prices and financial markets are cheering his election, he may spend his initial political capital on policies closer to his base of support, which means that a market riot may be necessary to force action on structural reforms. This dynamic will have to be monitored in the aftermath of the election. Assuming Lula does pursue some structural reforms while he has the political capital, and therefore that his first year is positive for financial markets, there is a reason to be positive on Brazil selectively on a tactical basis. However, electoral compulsions could cause Lula to pursue left-wing populism, fiscal expansion, and to resist privatization over the remaining three years of his presidency. Given Brazil’s already elevated debt levels (Chart 14), such a policy tilt would be market negative. It is against this backdrop that we expect a pro-Lula market rally to falter after the initial excitement. Bottom Line: Once the power transition is complete, a relief rally may follow as markets factor in the prospects of institutional stability and possibly a dash of structural reform in the first year of Lula’s presidency. But given Brazil’s elevated inequalities, even a pro-Lula rally will eventually fade as the administration will be constrained to switch back to the old ways and pursue an expansionary fiscal policy when elections loom. Investment Conclusions Brazil Presents A Value Trap, Fraught with Politico-Economic Risks From a strategic perspective, we are neutral on Brazil. A decade of bad news has been priced in but there is not yet a clear and sustainable trajectory to improve the country’s productivity. History suggests that both left-wing and right-wing presidents are often forced to backtrack on structural reforms and resort to cash-handouts in the run up to elections. This tends to add to Brazil’s high debt levels, prevents the domestic growth engine from revving up, and adds to inflation. Low growth and high inflation then set the wheels rolling for another bout of fiscal expansion (Chart 16). Chart 16The Vicious Politico-Economic Cycle That Brazil Is Trapped In Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Exceptions to this politico-economic cycle occur when a commodity boom is underway or if China, which is Brazil’s key client state, is booming. China today buys a third of Brazil’s exports (Chart 17) and is Brazil’s largest export market. The other reason we remain circumspect about Brazil’s strategic prospects is because of the secular slowdown underway in China. China is not in a position today to recreate the commodity and trade boom that buoyed Lula during his first presidency. China’s policy easing is a tactical boon at best, which can coincide with a Lula relief rally, but afterwards investors will be left with Chinese deleveraging and Brazilian populism. Political Risks Are High, Selective Tactical Exposure Brazil Will Be Optimal We urge investors to buy into Brazilian assets only selectively, even as Brazilian equities appear cheap (Chart 18). Political risks and economic risks such as low growth in GDP and earnings (Chart 19) could contribute to another correction and/or volatility in Brazilian equities. Chart 17China Buys A Third Of Brazil’s Exports Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​ ​​​​​Chart 18Brazil: Are Political & Macro Risks Priced-In? Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Chart 19Brazil's EPS Growth Tracks China's Total Social Financing Growth With A Lag Brazil's EPS Growth Tracks China's Total Social Financing Growth With A Lag Brazil's EPS Growth Tracks China's Total Social Financing Growth With A Lag China’s policy easing is an important macro factor playing to Brazil’s benefit. As we highlighted in our “China Geopolitical Outlook 2022,” Beijing is focused on ensuring stability over the next 12 months. But history suggests that Brazil’s corporate earnings respond to a pick-up in China’s total social financing with a lag of more than six months (Chart 19). Thus, even from a purely macro perspective it may make sense to turn bullish on Brazil after the election turmoil concludes. Given that politically sensitive sectors account for an unusually high proportion of Brazil’s market capitalization (Chart 18), and given the political risks in the offing for Brazil, we suggest taking-on selective exposure in Brazil. To play the rally yet mitigate political risks (that can be higher for capital-heavy sectors), we suggest a pair trade: Long Brazil Financials / Short India. We remain positive on India on a strategic horizon. However, in view of India approaching the business-end of its five-year election cycle, when policy risks tend to become elevated, we reiterate our tactical sell on India. India currently trades at a 81% premium to MSCI EM on a forward P-E ratio basis versus its two year average of 56%. A Quick Note On The Nascent EM Rally Investors should gradually look more favorably on emerging markets, but tactical caution is warranted. MSCI EM and MSCI World are down YTD 1.1% and 4.6% respectively. Despite the dip, we are not yet turning bullish on EM as a whole, owing to both geopolitical and macroeconomic factors. Global geopolitical risks in the new year are high. We recently upgraded the odds of Russia re-invading Ukraine from 50% to 75%. Besides EM Europe, we also see high and underrated geopolitical risks in the Middle East in the short run. Both the Russia and Iran conflicts raise a non-negligible risk of energy shocks that undermine global growth. Once these hurdles are cleared, we will turn more positive toward risky assets. Macroeconomically, the current EM rally can be sustained only if China delivers a substantial stimulus, and the US dollar continues to weaken. The former is likely, as we have argued, but the dollar looks to be resilient and it will take several months before China’s credit impulse rebounds. Hence conditions for a sustainable EM rally do not yet exist. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Executive Summary Rising TIPS Yields = Equity Multiples Compression Rising TIPS Yields = Equity Multiples Compression Rising TIPS Yields = Equity Multiples Compression Equity sector and style rotations could prevent the broad equity indexes from plunging, but these rotations will not be sufficient to propel the overall stock indexes to new highs. Rising US bond yields remain the key risk to US growth stocks in both absolute and relative terms. As US growth stocks drift lower in absolute terms, the S&P 500 will stay in a trading range but is unlikely to make new highs. Equity leadership rotations typically occur during or after bear markets and/or major corrections in global share prices. Hence, a major selloff in global stocks is likely before EM, commodities, global cyclicals and value stocks move toward a period of secular outperformance (i.e., a multi-year bull market in absolute and relative terms). Recommendation   Inception Date Return Underweight EM Relative To DM Stocks (In Common Currency) 2021-03-25 15.8% Bottom Line: Continue underweighting EM in a global equity portfolio. Cyclically, continue favoring value versus growth stocks. Feature We expect US bond yields to continue to rise, and global growth stocks to continue to underperform global value stocks in the months ahead. This prompts the question: What does this scenario mean for overall global share prices, EM markets, and EM relative equity performance? Equity Rotation And Overall Market Performance Can the S&P 500 or global equity index advance in absolute terms when US and global growth stocks sell off in absolute terms? Our hunch is as follows: As US growth stocks drift lower, the S&P 500 will stay in a trading range, but is unlikely to make new highs. A review of past episodes of sector and style rotation is in order. We recall two episodes of major rotation: 1. The closest historical comparison is in the year 2000. The top panel of Chart 1 illustrates US value stocks were resilient even after the Nasdaq bubble started bursting in March 2000. Besides, the S&P 500 index held up well in the first half of that year even though Nasdaq stocks were plummeting (Chart 1, bottom panel). Nevertheless, despite the rotation, value/old economy stocks failed to break out of their previous highs (Chart 1, top panel). We would expect a similar pattern to emerge in the current cycle as the Nasdaq index wobbles. Despite the Nasdaq selloff, oil prices continued to rise until October 2000, and the US median stock had a bumpy ride but made a new high in early 2002 (Chart 2). Chart 1US Equity Rotation In 2000 US Equity Rotation In 2000 US Equity Rotation In 2000 Chart 2Rotation In 2000: The Nasdaq, Oil And The Median Stock Rotation In 2000: The Nasdaq, Oil And The Median Stock Rotation In 2000: The Nasdaq, Oil And The Median Stock   Overall, as rising US interest rates weigh on growth stocks, the rest of the market can stay in a trading range. Segments with very good fundamentals and cheap valuations could even make new marginal highs. Nevertheless, given the sheer weight of growth stocks in the broad US equity index, it will be hard for the S&P 500 to make new highs when growth stocks wobble. However, a key difference between now and the 2000-2002 market is that back then, US bond yields were falling. Thus, the bear market in the US equity market in general and Nasdaq stocks in particular, occurred alongside falling US bond yields (Chart 3). Currently, the Fed is in a tightening mode and US bond yields are climbing. A rising discount factor is negative for all stocks (Chart 4): It is more negative for high-multiples stocks and less negative for low multiples companies. Chart 3The Nasdaq Bubble Burst Despite Falling Interest Rates The Nasdaq Bubble Burst Despite Falling Interest Rates The Nasdaq Bubble Burst Despite Falling Interest Rates Chart 4Rising TIPS Yields = Equity Multiples Compression Rising TIPS Yields = Equity Multiples Compression Rising TIPS Yields = Equity Multiples Compression   Another interesting observation about the 2000-2002 bear market is that it occurred despite resilient US consumer spending, and a very robust housing market and credit growth (Chart 5, top two panels). Remarkably, corporate profits collapsed by about 60% even though real GDP barely contracted at all (Chart 5, bottom two panel). We do not predict a similar equity bust this time around. Instead, we are highlighting that US equity valuations and corporate profits can shrink even if US consumer spending does not contract. What happens to costs, profit margins, inflation and interest rates are as important as the consumer spending outlook. To sum up, when the Nasdaq’s bubble began bursting in March of 2000, investors rotated into old economy stocks and the S&P 500 held up well until July of that year. From July onward, the selloff broadened, and the overall US equity indexes entered a bear market. The latter lasted until March 2003. 2. Another episode of extended market rotation occurred in the lead up to and during the 2008 bear market. The US financial/credit crisis in 2007-08 commenced with the selloff in sub-prime securities in March 2007. Corporate spreads began widening, and bank share prices rolled over in June 2007. Next, the S&P 500 and EM stocks peaked in October 2007 (Chart 6). Despite these developments, commodity prices and EM currencies continued to rally until the summer of 2008 when they finally collapsed in the second half of that year (Chart 6, bottom panel). Chart 5US Profits Recession In 2001 Occurred Despite No Economic Recession US Profits Recession In 2001 Occurred Despite No Economic Recession US Profits Recession In 2001 Occurred Despite No Economic Recession Chart 6Domino Effect In 2007-08 Domino Effect in 2007-08 Domino Effect in 2007-08 Clearly, what was initially a rotation out of US cyclicals and financials into commodities and EM eventually proved to be nothing more than part of a domino effect. Again, we are not making the case that the US economy and financial markets are headed into a financial crisis. Our point here is that rotations do occur and can last for a while. Yet, a sustainable bull market in aggregate equity indexes does not emerge until there is a broad-based selloff during which the majority of sectors and bourses drop in absolute terms. Bottom Line: Rotation episodes can last several months. Equity sector and style rotations could prevent the broad equity indexes from plunging but these rotations will not be sufficient to propel the overall stock indexes to new highs. Equity Leadership Changes Occur Around Major Selloffs Having examined these rotation episodes, we can now take a step back and see the big picture: equity leadership rotations typically occur during or after bear markets and/or major corrections in global share prices. Chart 7 illustrates EM relative stock prices versus DM along with the global equity index. Over the past 25 years, there have been several major leadership changes between EM and DM, and all of them coincided with, or were preceded by, either a bear market or a substantial drawdown in global share prices. Chart 7EM Versus DM: Equity Rotations EM Versus DM: Equity Rotations EM Versus DM: Equity Rotations EM Versus DM: Equity Rotations EM Versus DM: Equity Rotations Similarly, the relative performance of global growth versus value stocks often experiences trend reversals during or after selloffs (Chart 8). Chart 8Global Growth Versus Value: Leadership Rotations Global Growth Versus Value: Leadership Rotations Global Growth Versus Value: Leadership Rotations Global Growth Versus Value: Leadership Rotations Global Growth Versus Value: Leadership Rotations Finally, secular trend changes in the relative performance of the global tech sector, energy stocks and materials have also occurred during or after drawdowns in global share prices (Chart 9). Chart 9Global Technology, Energy And Materials: Leadership Rotations Global Technology, Energy And Materials: Leadership Rotations Global Technology, Energy And Materials: Leadership Rotations Global Technology, Energy And Materials: Leadership Rotations Global Technology, Energy And Materials: Leadership Rotations A word on commodity prices is warranted. We are surprised that industrial metal prices have so far held up well and oil prices have been surging despite China’s slowdown. The culprits behind the rally in resource prices are strong DM demand for commodities and investor purchases of commodities as an inflation hedge. Therefore, it might take investor concerns about US demand and/or a slowdown in global manufacturing to trigger a relapse in commodity prices. Rising US interest rates and a continued US dollar rally will eventually lead to a meaningful drawdown in commodity prices. Yet, the precise timing of this shift is uncertain. Critically, among financial markets, oil prices are often the last to fall and/or rally. Hence, investors should not use oil as a leading indicator for other markets. As to share prices of commodity producers, global materials have rolled over at their previous high (Chart 10, top panel), while energy stocks have surged through multiple technical resistances. However, they now face another technical hurdle (Chart 10, bottom panel). If oil share prices decisively break above this long-term moving average, it would likely signal that they have entered a multi-year bull market. Chart 10Global Energy Stocks And Materials: A Long-Term Profile Global Energy Stocks And Materials: A Long-Term Profile Global Energy Stocks And Materials: A Long-Term Profile Bottom Line: Major equity leadership rotations normally occur around bear markets or major corrections. Hence, a major selloff in global stocks is likely before EM, commodities, global cyclicals and value stocks move toward a period of secular outperformance (i.e., a multi-year bull market in absolute and relative terms). Investment Considerations Chart 11EM And US Stocks Relative To The Global Benchmark: No Change In Trend EM And US Stocks Relative To The Global Benchmark: No Change In Trend EM And US Stocks Relative To The Global Benchmark: No Change In Trend We will contemplate upgrading EM if a broad selloff transpires. In such an equity drawdown, there is a 50% chance that EM may outperform the S&P 500 if the selloff is led by growth stocks, as occurred during the carnage in global stocks in January this year or in the fourth quarter of 2018 (Chart 11, top panel). Yet, the EM overall equity index will underperform Europe and Japan in such a broad-based drawdown. A weaker dollar is essential for EM outperformance. For now, we remain positive on the dollar for the next several months and are hence underweight EM stocks and credit markets versus their DM peers. As to US stocks, the jury is still out on whether their secular outperformance is over. Notably, US share prices relative to the global equity index have rebounded from their 200-day moving average (Chart 11, bottom panel). When such a technical pattern occurs, odds are high that US stocks will make new highs in relative terms. US equities outperforming the rest of the world is not consistent with growth stocks underperforming value ones. Hence, a potential US outperformance represents a risk to our core view that growth stocks will continue underperforming value stocks. How do we reconcile these inconsistencies? It might be that US growth stocks’ recent rebound persists for the next several weeks and they outperform value stocks during this window. In such a case, our equity leadership rotation theme will be delayed. Yet, in this scenario EM stocks will continue underperforming DM ones. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Executive Summary A Floor In Biden’s Approval? Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks Biden’s approval rating is forming a bottom. Democrats will pivot away from Covid-19 to boost the economy and consumer sentiment. While Democrats face a dismal midterm election, Republican infighting could conceivably cost the GOP control of the Senate. Policy uncertainty will rise as the election approaches. Republican infighting is unlikely to affect the outcome in the House of Representatives, although Republicans could lose three-to-nine seats that they might otherwise hold if the party establishment fails to coordinate effectively with former President Trump as we expect. Our tactical trades hinge on Biden’s near-term external risks: the risk of an energy shock that weighs on Treasury yields and pushes up the dollar. Defensives like health care should benefit. Our cyclical recommendations continue to favor cyclical equities such as small cap energy stocks.     Bottom Line: Investors should be tactically prepared for geopolitical risks to push up the dollar and push down Treasury yields in the short run, contrary to the cyclical BCA House View. Feature Has Biden’s Approval Hit The Floor? Probably. President Biden’s net approval rating is still under water at -9%, only slightly better than President Trump’s at this stage in the approach to the 2018 midterm elections. Biden’s handling of the economy receives a lower approval rating, which is dangerous for his party because the economy is likely to be the most important issue in the midterm election, given that the Covid-19 pandemic is waning. If Biden follows the path of his predecessors then his approval rating will trend upward as the midterm approaches. That will not prevent a Republican victory in the House but it could affect the Senate and the size of the Republican majority (Chart of the Week). The latest jobs report saw 467, 000 new jobs created. The labor participation rate grew from 81.9% to 82%, while women’s participation rose from 56.5% to 56.8%. The unemployment rate ticked up from 3.9% to 4%, with the broader U6 measure rising from 7.2% to 7.9%, but the reason was that more workers joined the workforce, which is a good thing for the economy (Chart 1). The Omicron variant of the Covid-19 virus is having little impact so the labor market is continuing to heal, a positive for the Biden administration, which is otherwise struggling. Chart 1A Solid Jobs Report A Solid Jobs Report A Solid Jobs Report American sentiment about the economy will hinge on inflation. If inflation abates along with the virus then the Democratic Party will be able to pare some losses in the midterms. At the moment the polarization of economic sentiment – divergence based on partisan affiliation – is declining, but for reasons that will give the administration a headache. Democratic sentiment is falling while Republican sentiment is improving (Chart 2). If inflation stays high, Republican sentiment will tick back down and  the public will be increasingly united in a negative view of the president’s economic management. If inflation peaks and rolls over, Democratic sentiment will recover as the election approaches and Republican sentiment will at least not get much worse. Chart 2Economic Sentiment Polarization In Decline Economic Sentiment Polarization In Decline Economic Sentiment Polarization In Decline For this reason Biden and the Democrats are rapidly pivoting away from Covid-19 and social restrictions and trying to create the “return to normalcy” that failed last year. While they were in the opposition they had an interest in hyping the virus but now they are the incumbents and it is important to show that the pandemic is in the rear-view mirror. With 64% of Americans now vaccinated, and 40% having received booster shots, government social restrictions are likely to become less stringent (Chart 3). The latest data from the service sector will motivate this policy pivot away from the virus. The manufacturing sector improved again last month but the non-manufacturing sector was less upbeat in January. Services activity declined by a whopping 12% in January. It is still above its November 2020 level, when Biden got elected, but only by around 2.2%. The non-manufacturing employment index declined by 4.3% and only stands 0.8% above its November 2020 level. The ratio of new orders to inventories declined by 0.6% in January (Chart 4). Chart 3Democrats To Pivot Away From Covid-19 Democrats To Pivot Away From Covid-19 Democrats To Pivot Away From Covid-19 These statistics suggest that the non-manufacturing sector slowed down sharply in January, probably due to omicron and post-Christmas belt tightening. But employers did not let go of a lot of workers, as seen by the discrepancies between business activity and employment. The mostly positive jobs report reinforces this point. The weakness is seen as temporary and employers expect higher demand in coming months. Now that consumer durable spending is running out of steam (at least, excluding cars), consumers are likely to switch to consuming services, as long as services are open for them to consume. There is little reason to think restrictions will stay tight, given the political points cited above. Even in Europe the Covid “hawks” are loosening controls. Chart 4Democrats Want To Boost Service Sector Democrats Want To Boost Service Sector Democrats Want To Boost Service Sector All that being said, the Biden administration has limited ability to control inflation that emanates from foreign supply shocks (e.g. Asia, Russia, Iran). Also voter perceptions of inflation will lag, even if inflation starts to abate. Crime and immigration will also weigh on the administration this fall. And the political clockwork favoring the opposition in midterm elections is remorseless. Bottom Line: Biden and the Democrats are likely to shift policy focus away from emphasis on the pandemic, which weighs on the service sector and employment, and instead pursue other policy options in preparation for the midterm election. The outlook is not positive but if Biden’s approval rating bottoms then Democrats’ chances of performing better in the midterm elections will rise and policy uncertainty will also rise. Will GOP Infighting Affect The Midterms? Maybe In The Senate Former President Trump clashed with former Vice President Mike Pence and others in the Republican Party over whether Pence had the right “to change the Presidential Election results” in 2020 by refusing to validate electoral college votes from states in which electoral fraud was alleged. Pence called the idea “un-American” and reiterated his position that the vice president has no “unilateral authority” to discard a state’s electoral votes while certifying the electoral count.1 Trump lashed out because moderate Republicans are flirting with Democrats over how to pass a bipartisan revision to the Electoral Count Act of 1887, which left a number of ambiguities in the US electoral process, including about the vice president’s role in election certification. It is conceivable that the law will be revised in time for the 2024 election but odds are against a quick solution: the original law took 10 years to pass. Throughout the 2022-24 election cycle, Trump will continue to clash with his party, which raises the single greatest risk to Republicans: that they will be too divided to capitalize fully on the Democrats’ weaknesses. We do not expect Trump to coordinate effectively with Republicans. His interest in revolutionizing the political establishment and winning a second term in 2024 diverges from the interest of the traditional Republicans, who want to preserve the political establishment with themselves on top, and want a fresh face to contend for eight years in the White House in 2024. However, Trump controls a plurality of the party’s grassroots voters (about 54%2 according to opinion polls) so that the Republican Party cannot afford to spurn him. If Trump were willing to cooperate with party leaders, then he would have cooperated when it mattered most: ahead of the Georgia special elections on January 5, 2020. If he had recognized the constitutional supremacy of the electoral college vote, he might have saved Republican control of the Senate. He did not, so the burden of proof falls on those who say that Trump can coordinate effectively with the Republican Party at critical junctures. Most likely the party will continue to play both sides, keeping Trump in the party but seeking a post-Trump future. Trump will continue to pursue the Republican nomination in 2024 and the party will have to acquiesce to him as long as he retains the support of a majority of the party’s grassroots. Trump’s conflict with the party will flare up in the primary elections this spring because Trump will endorse his own favorite candidates regardless of whether the Republican establishment agrees and views them as the most likely to win. Any success of Trump-backed populists in the primaries may become a liability for Republicans in the general election if the seat is competitive and the Democrats put up a moderate candidate. This point is primarily relevant in the Senate: Five Senate Republicans are stepping down, leaving an open competition in Alabama, Missouri, North Carolina, Ohio, and Pennsylvania (Table 1). The last three of these (NC, OH, PA) are competitive seats, especially if the Republican candidate is weak and Biden’s approval revives by the time of the vote. Trump has only made an endorsement in North Carolina, where his candidate is far from assured to win. Given that control of the Senate could hang on a single seat, it is at least possible that Trump’s split with the GOP could affect the Senate balance of power in 2023-24. Table 1Senate Incumbents Not Seeking Re-Election, 2022 Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks Trump will also have an impact on the House of Representatives but he is less likely to affect the outcome of the midterm there, given that Republicans are likely to win 40 seats when they only need five to take control. There are a lot more Democrats retiring from the House than Republicans in this cycle, a positive indication for Republicans (Chart 5). In total there are 48 competitive seats (13 Republican-leaning, 22 Democrat-leaning, and 13 toss-up).3 Of these 48 competitive seats, 12 seats are “open” (no incumbent), divided evenly among Republicans and Democrats. In most of these competitive seats, but especially in Democrat-leaning seats and toss-up seats, a Trump-backed Republican will have a harder time winning than a traditional Republican.  All ten Republicans who voted to impeach President Trump after the January 6 rebellion are vulnerable to Trump challengers (Table 2). Three are already retiring. Given that Wyoming Representative Liz Cheney won her seat by a 44% margin, and yet is polling poorly relative to her Trump-backed challenger, it is fair to say that all seven of the remaining Republican impeachers are vulnerable to a Trumpist challenge. Of these, the general election could be competitive in five seats, i.e. those held by John Katko (R, NY-24), David Valadao (R, CA-21), Peter Meijer (R, MI-3), Fred Upton (R, MI-6), and Jaime Herrera Beutler (R, WA-3). However, given that the national tide does not favor the Democrats, five seats is the maximum that Democrats could poach from this group of lawmakers due to Republican infighting (three is a more likely number).   Chart 5House Members Not Seeking Re-Election, 2022 Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks Table 2House Republicans Who Voted To Impeach President Trump Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks More broadly there are 21 moderate Republicans in the House whose seats could be vulnerable to intra-party struggle (Table 3): So far President Trump has only endorsed candidates in seats which Republicans are highly likely to win anyway: namely Beth Van Duyne (R, TX-24), Mario Diaz-Balart (R, FL-25), and Carlos Gimenez (R, FL-26). But as the primary heats up, Trump’s endorsements could cause more tension with the Republican Party machinery.  The following six moderate Republicans’ seats could be at risk: Maria Elvira Salazar (R, FL-27), Rodney Davis (R, IL-13), Jeff Van Drew (R, NJ-2), Andrew Garbarino (R, NY-2), Mike Turner (R, OH-10), and Brian Fitzpatrick (R, PA-1). Of these, Fitzpatrick and Garbarino do not face any challengers yet, and only Davis faces a Trump-backed challenger. So six is the maximum Democrats could steal while one-to-three vulnerable seats is more likely. Table 3Republican Moderates Vulnerable To Populist Challengers Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks Summing up, the Republican Party could fail to retain three-to-nine Republican seats that they might otherwise win in this cycle. Previously we put the number at five-to-nine seats.   These numbers do not include any Democratic-leaning seats that Republicans could fail to poach if they choose a populist candidate who is not competitive in a “purple” state or district. In conclusion, Republican infighting will not prevent Republicans from retaking the House of Representatives this fall. Cyclical factors in favor of Republicans will overwhelm their internal differences. But infighting could leave them with a smaller majority than consensus expects. In 2024 Republican internal divisions will become much more important than in 2022. A competitive Republican primary election for president will reduce Republican odds in the general election. If President Trump fails to win the nomination, he could defect and form his party. If he wins the nomination, Liz Cheney or another traditional Republican could defect and run as a third party, acting as a spoiler. Given the tight margins of victory in presidential elections, even a splinter group could steal enough votes to determine the outcome. The midterms will shed light on the depth of GOP divisions but in general these divisions reinforce our view that while Democrats will perform poorly in the midterms, they are still favored to retain the White House in 2024. Bottom Line: While the odds are stacked against Democrats in the midterms, Republican infighting could affect several Senate seats and will subtract anywhere from three-to-nine seats from expected seat gains in the House. While control of the House will not be affected, it is conceivable that control of the Senate could hang in the balance. Policy uncertainty will rise if Republican infighting makes Senate races more competitive later this year. Housekeeping To conclude we offer a few remarks on our outstanding investment recommendations: Cyclically Long Energy Small Caps: US energy production is rising in keeping with global oil and commodity prices. West Texas Intermediate crude sells for $89 per barrel on the spot market, inventories are drawing, OPEC 2.0 is intact, and there are plenty of supply risks on the horizon. American natural gas exports are picking up but not enough to meet demand if conflict in Ukraine causes a European shortage, while US oil exports are falling (Chart 6). Chart 6US Energy Production Picking Up US Energy Production Picking Up US Energy Production Picking Up Evidence from initial unemployment claims in O&G-dependent states like North Dakota and Wyoming suggests that shale producers need more time to ramp up production (Chart 7), as highlighted by our Commodity Strategist Bob Ryan.  Small cap energy stocks have not benefited much from the sharp spike in energy prices this year. We see this as an opportunity, given that US small caps are insulated from geopolitical troubles and will become key players if shortages occur (Chart 8). The risk comes if the supply response overwhelms the supply disruptions, as occurred in 2014 – but oil companies were in a much better position to surge production at that time. The 2015 nuclear deal with Iran also appeared more durable at that time than it will this year if it is rejoined, and there is no guarantee it will be rejoined. Cyclically Long Infrastructure Stocks: Infrastructure stocks peaked along with the equity market and in the wake of the Biden administration’s $550 billion Infrastructure Investment and Jobs Act, which is now being implemented. Indicators of infrastructure construction peaked in late 2020 and early 2021 and are slipping of late. But as long as the economy does not relapse into recession they should stabilize, especially as the virus wanes and global demand recovers (Chart 9). Cyclically Long Cyber-Security Stocks: Global threats, proxied by the Canadian dollar’s exchange rate with the Russian ruble, suggest that cyber security stocks will rebound after getting caught up in the current tech selloff (Chart 10). Tech stocks are also likely to bounce if inflation expectations peak as the Federal Reserve kicks into action.     Chart 7It Takes Time To Boost Shale Output It Takes Time To Boost Shale Output It Takes Time To Boost Shale Output Chart 8US Small Caps Yet To Benefit From Oil Price US Small Caps Yet To Benefit From Oil Price US Small Caps Yet To Benefit From Oil Price Chart 9Buy The Dip In Infrastructure Stocks Buy The Dip In Infrastructure Stocks Buy The Dip In Infrastructure Stocks Chart 10Cyber Stocks A 'Buy' In Tech Selloff Cyber Stocks A 'Buy' In Tech Selloff Cyber Stocks A 'Buy' In Tech Selloff Investment Takeaways Chart 11A Floor In Biden’s Approval? Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks US financial markets do not care about the midterm elections in the near term but that will change as policy uncertainty will rise over the course of the year. A bottom in Biden’s approval rating (Chart 11) and Republican primary election infighting both suggest that the Democratic Party’s odds in the midterms will improve going forward, raising policy uncertainty, especially over the Senate. Midterm uncertainty typically works in favor of the US dollar, Treasuries, defensive equity sectors, and growth stocks. As such it poses a risk to current market trends. The recent selloff in Big Tech confirms what we have argued since we launched the US Political Strategy: the tech sector faces a slow boil from inflation and rising interest, which are more immediate threats than government regulation. Having said that, we favor growth versus value on a tactical basis as we expect the dollar to rise and Treasury yields to fall on the back of geopolitical risks in the near term (Chart 12).  Chart 12A Tactical Bounce For Tech Stocks? A Tactical Bounce For Tech Stocks? A Tactical Bounce For Tech Stocks?   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com   Footnotes 1     See Vice President Michael R. Pence’s letter, dated January 6, 2021, available at “Read Pence’s full letter saying he can’t claim ‘unilateral authority’ to reject electoral votes,” PBS, pbs.org. See also Mychael Schnell, “Trump says he wanted Pence to overturn election, eyes effort to reform law,” January 31, 2022, and Brett Samuels, “Pence breaks with Trump: ‘I had no right to overturn the election,’” February 4, 2022, thehill.com. 2     Please see “Over half of Americans believe the country's economy is headed in the wrong direction,” Ipsos, December 29, 2021, Ipsos.com 3    See Cook Political Report, “2022 House Race Ratings,” February 8, 2022, cookpolitical.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks Table A3US Political Capital Index Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks Chart A1Presidential Election Model Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks Chart A2Senate Election Model Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks Table A4APolitical Capital: White House And Congress Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks Table A4BPolitical Capital: Household And Business Sentiment Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks Table A4CPolitical Capital: The Economy And Markets Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks

Executive Summary Macroeconomic Backdrop Favors Defensive Consumer Staples Macroeconomic Backdrop Favors Defensive Consumer Staples Macroeconomic Backdrop Favors Defensive Consumer Staples Markets now expect five-to-six rate hikes in 2022  The rate of change in rates as opposed to their level has triggered the fast and furious repricing of long-duration assets.  However, rising rates are a temporary headwind to equities The repricing of the equity market came through the P/E as opposed to the “E” Demand is clearly shifting from goods to services. Supply disruptions are clearing Earnings were strong, but investors expected more We are upgrading Consumer Staples, which is a “deep” defensive sector that offers downside protection in an environment of heightened volatility and slowing economic growth   Bottom Line: While it is impossible to time the market, we believe that the worst is behind us. US equities are outright oversold, and valuations are much more reasonable. However, we recommend investors be cautious in sector selection: For now, stay away from Tech, and add to Consumer Staples to reduce portfolio volatility. Feature Performance Hit Undo 2021 January had a nasty shock in store for equity investors: At the lowest point, the S&P 500 was down 12% from its peak, and NASDAQ was down 20%, officially entering correction territory. January market moves were a partial reversal of the 2021 gains (Chart 1A), with some of the hottest investment themes, such as clean energy, fintech, and Cathie Wood's innovation ETFs hit the hardest (Chart 1B). Investors were rushing to monetize their super-charged gains before the Fed starts draining liquidity off the market. Chart 1APerformance: Sectors And Styles Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Chart 1BPerformance: Investment Themes Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Post-Mortem A post-mortem of the sell-off shows that the stocks that have pulled back most, were trading at extended valuations and had long duration, i.e., companies that are not very profitable now but expect to grow earnings at a robust pace far into the future. These companies are akin to lottery tickets – a small payment now may result in a low-probability event of a high gain in the future. Small-cap growth stocks are down 30% from their peak. Over time, the sell-off of small-cap growth has spread to other areas of the market and has hit all sectors but Energy, almost indiscriminately. Overall, the S&P 500's multiple has contracted by over 10% (Chart 1C). Chart 1CJanuary Correction Was Down To Multiple Contraction Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Valuations And Technicals Pullbacks are responsible for equity market hygiene, cleansing the market of overextended valuations, taking the froth off the names that got ahead of themselves, and offering a reset for a new leg of upward moves, fueled by inflows into oversold names and cash deployed by new market entrants. Forward multiples of the S&P 500 have come down from 21.7x to a more reasonable 19.5x (Chart 2A). Now, 8 out of the 11 sectors have a forward PE below 20x (Chart 2B). Chart 2AMultiples Have Come Down A lot From The Peak Multiples Have Come Down A lot From The Peak Multiples Have Come Down A lot From The Peak Chart 2BValuations Moderated Across All Sectors But Energy Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack By many technical metrics, such as the bull/bear ratio (Chart 2C), market breadth, and RSI, the market appears oversold. Many investors may consider this a good entry point. Chart 2CRetail Investors Have Capitulated Retail Investors Have Capitulated Retail Investors Have Capitulated Macroeconomic Backdrop Six Is The New Four This correction was triggered by a market surprised by the grave tone of Fed officials, acknowledging their concern about the intransigent, as opposed to transient, inflation. While monetary tightening has been on the cards for a while now, what a difference a month makes! In December, the market was pricing in three rate hikes in 2022, while currently, the probability of five rate hikes stands at over 90%, and of six rate hikes at over 80% (Chart 3A). The 10-year Treasury yield moved from 1.5% at the end of December to 1.87% at its January peak. It is important to note that monetary policy is still easy and it was the rate of change in rates as opposed to their level that triggered the fast and furious repricing of long-duration assets. Chart 3AInvestors Expect Five-To-Six Hikes In 2022 Investors Expect Five-To-Six Hikes In 2022 Investors Expect Five-To-Six Hikes In 2022 Is Monetary Tightening A Death Knell For US Equities? Historically, equities wobbled two-to-three months prior to the first rate hike, and then took a breather for another couple of months for the dust to settle (Chart 3B). January and now February volatility and pullbacks are textbook behavior of equities at the cusp of a new monetary regime. However, in three of the four tightening cycles since 1990, the stock market was higher a year later. The same is true for long-term rates: In all but one of the episodes of a sharp rise in the 10-year Treasury yield since 1990, the stock market rose (Table 1). Chart 3BEquities Wobble Around The First Rate Hike Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Table 1Equity Performance Around Periods Of Rising Treasury Yields Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Economic Growth: Supply (Finally) Meets Demand Of course, the best antidote to higher rates is strong economic growth. So far, everything is in order on that front, with economists projecting solid 2022 nominal GDP growth of around 7.6%. Economic growth is slowing but off high levels. At last, global supply chains are gradually unclogging, and shipping bottlenecks are starting to clear. Even automakers are now saying that auto chips are becoming more readily available. However, part of the reason that supply and demand are getting closer to each other is that demand for goods is waning, dampened by both saturation and higher costs. The latest ISM PMI reading shows that both new orders and the backlog of orders are falling (Chart 4, top panel). Prices paid have also turned, heralding that the worst of price increases may be behind us (Chart 4, bottom panel). Will this contain inflation enough to appease the Fed? Possible, but not highly likely. Chart 4Demand Is Weakening Demand Is Weakening Demand Is Weakening Earnings: Good But Not Good Enough With economic growth slowing, earnings and sales growth are also rolling over (Chart 5A). As investors are trying to decipher the state of the American economy, they are increasingly focused on corporate guidance. So far 12 companies offered positive guidance vs 28 with negative guidance. The Negative/Positive ratio for Q4-2021 currently stands at 2.3, compared to 0.8 in the prior four quarters. Price action in response to projected lower growth has been brutal. And while 78% of companies have beaten earnings expectations, this is a smaller share than during the other pandemic recovery quarters. The magnitude of the earnings surprise has also fallen (Chart 5B). Chart 5AEarnings And Sales Growth Are Slowing Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Chart 5BThe Magnitude Of Earnings Surprises Has Fallen Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack This earnings season has also seen some of the largest moves on the back of companies’ reports. Positive surprises by Google, Microsoft, and Amazon have soothed investors' fears and led to broad-based next-day rallies, while skimpy results from PayPal and Meta, not only have sent these companies down more than 20%, erasing billions in market capitalization, but also have dragged down their nearest competitors (Square, Snap, etc.). Also, many companies are complaining about rising input and labor costs cutting into their profitability. This is hardly a surprise. According to our analysis of the NIPA accounts, in the US labor costs constitute 55% of sales. With wages rising at the fastest pace in years, their effect on corporate profitability can be meaningful (Chart 6A). To make things worse, input costs are also soaring – the latest PPI reading is 9.7%. Chart 6AMargins Are Contracting As... Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack However, companies are more and more constrained in their ability to pass on their cost increases to customers, although the elasticity of demand varies across industries. Many companies can no longer afford to raise prices without suppressing demand for their products. Corporate pricing power has turned decisively lower (Chart 6B). As a result, profit margins have contracted across all sectors, except Energy. Bottom-line – earnings are good so far, but they have failed to allay investor fears of waning profitability. Chart 6B...Corporate Pricing Power Is Declining ...Corporate Pricing Power Is Declining ...Corporate Pricing Power Is Declining Sector Positioning Revenge Of The Nerds – Be Granular While we believe that equities are poised for another leg up, as economic growth remains strong and corporate earnings are decent, we recommend that investors be granular in their sector selection: Avoid areas most adversely affected by a tighter monetary regime and slowing growth. Per our previous analysis, we recommend underweighting the Technology sector on a tactical basis, but within Tech, stay overweight more defensive Software and IT Services. We also like Banks and Insurers that benefit from rising rates and prefer Value and Small over Growth. We are also constructive on Industrials, which are the primary beneficiaries of the new Capex cycle and the US industrial renaissance. Consumer Services Are Finally Rebounding In the meantime, with Omicron finally receding, consumer spending is shifting from consumer goods to services (Chart 7A). Consumers are flush with cash, and still have $2.2 trillion in their coffers. We have been overweight the Travel complex (Hotels, Restaurants, Cruises) since October. However, performance was derailed in the late fall as many consumers chose to stay at home and wait for the variant to pass. Also, many of the industries in the Travel complex have been challenged by the sheer number of staff quarantining or on sick leave. We upgraded Airlines at the beginning of January and remain optimistic about the outperformance of the Consumer Services sector. Upgrading Consumer Staples We are also upgrading Consumer Staples, which is a “deep” defensive that offers downside protection in an environment of heightened volatility and slowing economic growth (Chart 7B). Moreover, consumer confidence is down as Americans are disheartened by prices in the supermarket and at the gas station. However, demand for consumer staples is inelastic and should be inflation-proof. The sector is trading at 21x forward multiples and is expected to grow earnings at 6% over the next 12 months, bettering the S&P 500. Chart 7AWaning Demand For Goods Is Replaced By Demand For Services Waning Demand For Goods Is Replaced By Demand For Services Waning Demand For Goods Is Replaced By Demand For Services Chart 7BMacroeconomic Backdrop Favors Defensive Consumer Staples Macroeconomic Backdrop Favors Defensive Consumer Staples Macroeconomic Backdrop Favors Defensive Consumer Staples Investment Implications The market correction is still running its course, and while it is impossible to time the market, we believe that the worst is behind us. US equities are outright oversold, and valuations are much more reasonable. Rising rates are a temporary headwind. However, we recommend investors be cautious in sector selection: For now, stay away from Tech, and add to Consumer Staples to reduce portfolio volatility.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     S&P 500  Chart 8Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 9Profitability Profitability Profitability Chart 10Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 11Uses Of Cash Uses Of Cash Uses Of Cash Communication Services Chart 12Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 13Profitability Profitability Profitability Chart 14Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 15Uses Of Cash Uses Of Cash Uses Of Cash Consumer Discretionary Chart 16Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 17Profitability Profitability Profitability Chart 18Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 19Uses Of Cash Uses Of Cash Uses Of Cash Consumer Staples Chart 20Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 21Profitability Profitability Profitability Chart 22Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 23Uses Of Cash Uses Of Cash Uses Of Cash Energy Chart 24Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 25Profitability Profitability Profitability Chart 26Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 27Uses Of Cash Uses Of Cash Uses Of Cash Financials Chart 28Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 29Profitability Profitability Profitability Chart 30Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 31Uses Of Cash Uses Of Cash Uses Of Cash Health Care Chart 32Sector vs Industry Groups Sector vs Industry Groups Sector vs Industry Groups Chart 33Profitability Profitability Profitability Chart 34Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 35Uses Of Cash Uses Of Cash Uses Of Cash Industrials Chart 36Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 37Profitability Profitability Profitability Chart 38Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 39Uses Of Cash Uses Of Cash Uses Of Cash Information Technology Chart 40Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 41Profitability Profitability Profitability Chart 42Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 43Uses Of Cash Uses Of Cash Uses Of Cash Materials Chart 44Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 45Profitability Profitability Profitability Chart 46Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 47Uses Of Cash Uses Of Cash Uses Of Cash Real Estate Chart 48Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 49Profitability Profitability Profitability Chart 50Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 51Uses Of Cash Uses Of Cash Uses Of Cash Utilities Chart 52Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 53Profitability Profitability Profitability Chart 54Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 55Uses Of Cash Uses Of Cash Uses Of Cash Recommended Allocation Footnotes

Executive Summary Inflation has broken out to 40-plus-year highs in the US and is rapidly becoming a pressing issue for major central banks around the world. Financial markets are vulnerable to upside inflation surprises, which could induce the Fed and its peers to pursue markedly less friendly monetary policy. Despite the ongoing surge in consumer and producer prices, longer-term inflation expectations remain firmly anchored at low levels. Surveys and market prices betray no concern about a lasting inflection. We have ticked a majority of the boxes on our inflation checklist, but we will remain constructive on risk assets as long as inflation expectations remain well-behaved. Long-Run Inflation Expectations Are Well Anchored The Last Line Of Inflation Defense (Is Holding Fast) The Last Line Of Inflation Defense (Is Holding Fast) Bottom Line: The Fed will only slam on the brakes if long-run inflation expectations break out, opening the door to a vicious circle in which inflation begets inflation. Risk assets will outperform this year unless expectations become unmoored. Feature We will be holding our quarterly webcasts next Monday, February 14, for clients in EMEA and the Americas and Tuesday, February 15, for Asia-Pacific clients in lieu of publishing a Weekly Report. Please join us with your questions to make it a fully interactive event. We will resume our regular publication schedule on the 21. Chart 1Inflation And The Fed Have Markets On Edge Inflation And The Fed Have Markets On Edge Inflation And The Fed Have Markets On Edge When we assembled our inflation checklist last May, the future path of consumer prices was still quite uncertain. At the time, the drivers of elevated inflation readings were concentrated in categories that had suffered the worst pandemic disruptions, like air fares, hotels, new cars, used cars, rental cars and auto insurance, and it was unclear how much upward price pressures would spread more broadly across the economy. Delta and Omicron had yet to worsen existing supply chain tangles. While inflation was sure to exceed its post-crisis levels for an extended period, it was not at all clear that it would do so by a significant margin. Now that inflation has broken out to Volcker-era highs, investors’ focus is squarely on the Fed’s response. Fears that inflation would prompt the Fed to tighten policy more and faster than previously expected underpinned the selling spasm that stretched across the last two full weeks of January (Chart 1). The equity market had moved on from the Fed outlook before Friday’s employment report pushed the 10-year yield to a new pandemic high, but it promises to be a recurring theme until the impending rate hike cycle is complete. Turning to our checklist, we contend that inflation expectations hold the key to the Fed’s reaction and that they continue to hold fast as a bulwark against the Fed adopting a war footing that would torpedo financial markets and the economy. Making A List (And Checking It Seven Times) It doesn’t take a certified market technician to confirm that inflation has broken out (Chart 2). It doesn’t take our checklist, either, though we’ve now checked seven of its twelve boxes (Table 1). Its purpose wasn’t to replace what investors could see with their own eyes but rather to augment it with a framework for assessing future inflation moves and their impact on monetary policy settings. We do not expect that the FOMC will bring the party to an abrupt end while investors, businesses and consumers remain untroubled about long-run inflation. Chart 2Breakout Breakout Breakout Table 1Inflation Checklist The Last Line Of Inflation Defense (Is Holding Fast) The Last Line Of Inflation Defense (Is Holding Fast) Though we think the Inflation Expectations boxes are the key, we make a full tour through the checklist to spotlight the data behind each line. We have ticked the Labor Supply/Utilization box, despite the still-low labor force participation rate (Chart 3, top panel) because the evidence suggests it is not going to return to its pre-pandemic level any time soon. The prime age employment-to-population ratio has made much more steady progress and is back within the range of the last three expansions, suggesting that the economy has returned to full employment with the exception of industries hit hardest by the pandemic1 (Chart 3, bottom panel). Chart 3The Economy Is Closing In On Full Employment ... The Economy Is Closing In On Full Employment ... The Economy Is Closing In On Full Employment ... Labor demand continues to soar, with nearly half of all respondents to the NFIB survey indicating that they have unfilled job openings and the Department of Labor’s job openings rate routinely setting new records (Chart 4). The combination of roaring demand and limited supply would seem to be a recipe for salary and wage growth, but it still hasn't come to pass. Though the main wage series have all picked up in nominal terms (Chart 5), the supply/demand imbalance has yet to produce compensation increases that can outpace inflation (Chart 6). Rampant concerns that wage gains will drag on corporate profit margins have yet to materialize and we leave the wage box unchecked. Chart 4... And Demand For Workers Is Still Exploding ... And Demand For Workers Is Still Exploding ... And Demand For Workers Is Still Exploding Chart 5Nominal Wage Gains Look Large, ... Nominal Wage Gains Look Large, ... Nominal Wage Gains Look Large, ... ​​​​​​ Chart 6... But They're Lagging Inflation ... But They're Lagging Inflation ... But They're Lagging Inflation ​​​​​​ The breakouts in the marquee core CPI (Chart 7, top panel) and PCE (Chart 7, bottom panel) indexes have captured a lot of attention, but their trimmed-mean measures have quietly overtopped their longstanding ranges as well. The trimmed-mean series, which throw out the outliers at both ends of the distribution, supported the transitory view last summer but are now confirming that the underlying pace of consumer price increases has materially quickened. Chart 7It's Not Just About The Outliers Anymore It's Not Just About The Outliers Anymore It's Not Just About The Outliers Anymore As for future inflation, our pipeline inflation indicator has eased over the last few months (Chart 8, top panel), but remains elevated and the preponderance of other cost pressure evidence keeps us from unchecking its box. Dollar strength has helped to guard against imported inflation pressures (Chart 8, bottom panel). They have been tame so far, but with inflation breaking out in Europe (Chart 9, top panel) and just about every major economy except China (Chart 9, bottom panel), rising import costs are likely to add some inflation momentum at the margin. Chart 8The Dollar's Tailwind Has Been An Inflation Headwind, ... The Dollar's Tailwind Has Been An Inflation Headwind, ... The Dollar's Tailwind Has Been An Inflation Headwind, ... Chart 9... But Inflation's Become A Problem Everywhere But China ... But Inflation's Become A Problem Everywhere But China ... But Inflation's Become A Problem Everywhere But China The Levees Are Holding Firm Although we checked six of the first eight boxes, we maintain a sanguine view about inflation’s impact on monetary policy and financial markets. Some of the boxes are more equal than others, and if we had to pick just one indicator to determine whether inflation will compel the Fed to take stern action, it would be the shape of the inflation expectations curve. Inflation begins to beget inflation when economic actors – workers, businesses, consumers and lenders – begin to expect it will linger into the future and change their behavior to align with their expectations. When inflation is expected to remain persistently high over the long term, individual workers or their unions insist on higher wages to maintain purchasing power, businesses at all points of the supply chain demand higher prices to protect their margins, consumers accelerate their big-ticket purchase decisions to get the most bang for their buck and lenders require higher nominal pro forma returns. The resulting feedback loops help inflation become entrenched in the same way that expectations of falling prices have paved the way for a deflationary mindset to grip Japan. Despite all the attention that rising prices have drawn, investors (Table 2) and households (Chart 10) continue to expect inflation to decelerate from the short term to the intermediate term, and again from the intermediate term to the long term. As long as economic actors are unconcerned about the longer-term picture, the Fed will be able to remove accommodation at a deliberate pace that will not pull the rug out from under financial markets. Table 2These Inverted Curves ... The Last Line Of Inflation Defense (Is Holding Fast) The Last Line Of Inflation Defense (Is Holding Fast) Chart 10... Are Good Omens ... Are Good Omens ... Are Good Omens To that end, the FOMC has heretofore limited itself to open mouth operations. Chair Powell may have talked tough at last month’s post-meeting press conference, but the committee passed on the chance to terminate the asset purchase program early. A rate hike is all but assured at the next meeting in mid-March and Powell indicated that investors should expect the Fed to move faster than the 25-basis-points(bps)-every-other-meeting pace of the last tightening cycle, but our US Bond Strategy team is inclined to bet the under on the money market’s 125-bps full-year expectation. We have checked the commentary box but are not going to check the dots box ahead of the March meeting’s update. It is further possible that the Fed’s expressed concerns about inflation will reduce the need for it to take action to combat it. We have previously cited our Global Fixed Income Strategy colleagues’ view that investors need only worry about inflation when central banks don't. One-year inflation expectations have come down considerably and intermediate- and long-term expectations have eased since late November (Chart 11), when Omicron’s emergence and the Fed’s hawkish pivot stirred concern. Omicron caused less supply-side disruption than initially feared and markets have relaxed a little now that the inflation cop is once again walking the beat. Chart 11Long-Term Expectations Stay Put, No Matter What Happens At The Short End The Last Line Of Inflation Defense (Is Holding Fast) The Last Line Of Inflation Defense (Is Holding Fast) Investment Implications Ever since the year began, we have stressed the point that tighter policy is not necessarily tight policy. Economic and market inflection points are conditioned upon the level of the fed funds rate, not its direction. Restrictive monetary policy settings are not yet in sight and we doubt that they will emerge in time to shadow risk assets’ 2022 prospects. We like the tighter-does-not-equal-tight formulation, but it obscures an important nuance. Strictly speaking, the Fed is not tightening monetary policy when it tapers its monthly asset purchases – it’s merely dialing down the level of monetary accommodation. Similarly, raising the target fed funds rate from an emergency range of 0 to ¼% two years after COVID reached the US and several months after it ceased to be an acute threat merely reduces the level of monetary stimulus. Even if the FOMC does deliver 125 bps of hikes by year end, lifting the funds rate to 1⅜%, it will still be egging on the economy because no one believes the neutral rate is 1⅜% or lower. Removing accommodation is more like easing up on the gas than squeezing the brakes. As long as inflation doesn’t scare economic participants, causing their longer-run inflation expectations to become unmoored, the Fed will be able to reduce monetary stimulus in an incremental fashion akin to applying less pressure to the gas pedal. That does not mean investors can forget about the Fed; we expect policy scares will roil financial markets off and on throughout the rest of the year. Ultimately, though, we think the elevated volatility will prove unfounded as our base case is that the Fed will not have to slam on the brakes. The steeply downward sloping inflation expectations curve suggests that it will take a lot for expectations to reset but we will be keeping an eye on it nonetheless, because uncomfortably high inflation, and the Fed’s eagerness to counter it, remains the biggest risk to our view.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      Per the January Employment Situation Report, Leisure and Hospitality now accounts for nearly 60% of nonfarm payroll and 97% of private sector service employment losses since February 2020.

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The golden rule for investing in the stock market simply states: “Stay bullish on stocks unless you have good reason to think that a recession is imminent.” The catch, of course, is that it is difficult to know whether a recession is lurking around the corner. Still, we can learn a lot from past recessions. As we document in this week’s report, every major downturn was caused by the buildup of imbalances within the economy, which were then laid bare by some sort of catalyst, usually monetary tightening. Today, the US is neither suffering from an overhang of capital spending, as it did in the lead-up to the 2001 recession, nor an overhang of housing, as it did in the lead-up to the Great Recession. US inflation has risen, but unlike in the early 1980s, long-term inflation expectations remain well anchored. This gives the Fed scope to tighten monetary policy in a gradual manner. Outside the US, vulnerabilities are more pronounced, especially in China where the property market is weakening, and debt levels stand at exceptionally high levels. Fortunately, the Chinese government has enough tools to keep the economy afloat, at least for the time being. Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand Bottom Line: Equity bear markets rarely occur outside of recessions. With global growth set to remain above trend at least for the next 12 months, investors should continue to overweight equities. However, they should underweight the tech sector since tech stocks remain disproportionately vulnerable to rising rates, increased regulation, and a retrenchment in pandemic-induced spending on electronics and online services. Macro Matters Investors tend to underestimate the importance of macroeconomics for stock market outcomes. That is a pity. Charts 1, 2, and 3 show that the business cycle drives the evolution of corporate earnings; corporate earnings, in turn, drive the stock market; and as a result, the business cycle determines the path for stock prices. Chart 1The Business Cycle Drives Earnings… The Business Cycle Drives Earnings... The Business Cycle Drives Earnings... Chart 2…Earnings In Turn Drive Stock Prices… ...Earnings In Turn Drive Stock Prices... ...Earnings In Turn Drive Stock Prices... An appreciation of macro forces leads to our golden rule for investing in the stock market. It simply states: Stay bullish on stocks unless you have good reason to think that a recession is imminent. Chart 3…Hence, The Business Cycle Is The Main Driver Of Equity Returns ...Hence, The Business Cycle Is The Main Driver Of Equity Returns ...Hence, The Business Cycle Is The Main Driver Of Equity Returns Historically, stocks have peaked about six months before the onset of a recession. Thus, it usually does not pay to turn bearish on stocks if you expect the economy to grow for at least another 12 months. In fact, aside from the brief but violent 1987 stock market crash, during the past 50 years, the S&P 500 has never fallen by more than 20% outside of a recessionary environment (Chart 4). Peering Around The Corner The catch, of course, is that it is difficult to know whether a recession is lurking around the corner. Leo Tolstoy began his novel Anna Karenina with the words “Happy families are all alike; every unhappy family is unhappy in its own way.” By the same token, every economic boom seems the same, whereas every recession has its own unique features. This makes forecasting recessions difficult. Difficult, but not impossible. Even though recessions differ substantially in their magnitude and causes, they all share the following three characteristics: 1) The buildup of imbalances that make the economy vulnerable to a downturn; 2) A catalyst that exposes these imbalances; and 3) Amplifiers or dampeners that either exacerbate or mitigate the slump. Let us review six past recessions to better understand what these three characteristics reveal about the current state of the global economy. Chart 4Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand The 1980 And 1982 Recessions The double-dip recessions of 1980 and 1982 were the last in which inflation played a starring role. Throughout the 1970s, the Fed consistently overstated the degree of slack in the economy (Chart 5). This led to a prolonged period in which interest rates stayed below their equilibrium level. The resulting upward pressure on inflation from an overheated economy was compounded by a series of oil shocks, the last of which occurred in 1979 following the Iranian revolution. Chart 6The Volcker Era: It Took Massive Monetary Tightening To Bring Down Inflation The Volcker Era: It Took Massive Monetary Tightening To Bring Down Inflation The Volcker Era: It Took Massive Monetary Tightening To Bring Down Inflation Chart 5The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s In an effort to break the back of inflation, newly appointed Fed chair Paul Volcker raised rates, first to 17% in April 1980, and then following a brief interlude in which the effective fed funds rate dropped back to 9%, to a peak of 19% in July 1981 (Chart 6).   The 1990-91 Recession Overheating also contributed to the early 1990s recession. After reaching a high of 10.8% in 1982, the unemployment rate fell to 5% in 1989, about one percentage point below its equilibrium level at that time. Core inflation began to accelerate, reaching 5.5% by August 1990. The Fed initially responded to the overheating economy by hiking interest rates. The fed funds rate rose from 6.6% in March 1988 to a high of 9.8% by May 1989. By the summer of 1990, the economy had already slowed significantly. Commercial real estate, still reeling from the effects of the Savings and Loan crisis, weakened sharply. Defense outlays continued to contract following the collapse of the Soviet Union. The final straw was Saddam Hussein’s invasion of Kuwait, which caused oil prices to surge and consumer confidence to plunge (Chart 7).   The 2001 Recession An overhang of IT equipment sowed the seeds of the 2001 recession. Spending on telecommunications equipment rose almost three-fold over the course of the 1990s, which helped lift overall nonresidential capital spending from 11.2% of GDP in 1992 to 14.7% in 2000 (Chart 8). Chart 7Overheating In The Leadup To The 1990-91 Recession Overheating In The Leadup To The 1990-91 Recession Overheating In The Leadup To The 1990-91 Recession The recession itself was fairly mild. After subsequent revisions to the data, growth turned negative for just one quarter, in Q3 of 2001. However, due to the lopsided influence of the tech sector in aggregate profits – and even more so, in market capitalization – the dotcom bust had a major impact on equity prices (Chart 9). Chart 9The Dotcom Bust Dragged Down Tech Earnings The Dotcom Bust Dragged Down Tech Earnings The Dotcom Bust Dragged Down Tech Earnings Chart 8A Glut Of I.T. Equipment Sowed The Seeds Of The 2001 Recession A Glut Of I.T. Equipment Sowed The Seeds Of The 2001 Recession A Glut Of I.T. Equipment Sowed The Seeds Of The 2001 Recession Having raised rates to 6.5% in May 2000, the Fed responded to the downturn by easing monetary policy. Falling rates were effective in reviving the economy – indeed, perhaps too effective. The resulting housing boom paved the way for the Great Recession.   The Great Recession (2007-2009) The housing sector was the source of imbalances in the lead-up to the Great Recession. In the US, and in other countries such as Spain and Ireland, house prices soared as lenders doled out credit on increasingly lenient terms. Chart 10A Long House Party A Long House Party A Long House Party Rising house prices stoked a consumption boom and incentivized developers to build more homes. In the US, the personal savings rate fell to historic lows. Residential investment reached a high of 6.7% of GDP, up from an average of 4.3% of GDP in the 1990s (Chart 10). While the housing bubble would have burst at some point anyway, tighter monetary policy helped expedite the downturn. Starting in June 2004, the Fed raised rates 17 times, pushing the fed funds rate to 5.25% by June 2006. The ECB also hiked rates; it raised the refi rate from 2% in December 2005 to 4.25% in July 2008, continuing to tighten policy even after the Fed had begun to cut rates. Once global growth started to weaken, a number of accelerants kicked in. As is the case in every recession, rising unemployment led to less spending, which in turn led to even higher unemployment. To make matters worse, a vicious circle engulfed the housing market. Falling home prices eroded the collateral underlying mortgage loans, producing more defaults, tighter lending standards, and even lower home prices. The Fed responded to the crisis by cutting rates and introducing an alphabet soup of programs to support the financial system. However, the zero lower-bound constraint limited the degree to which the Fed could cut rates, forcing it to resort to unorthodox measures such as quantitative easing. While these measures arguably helped, they fell short of what was needed to resuscitate the economy. Fiscal policy could have picked up the slack, but political considerations limited the scale and scope of the 2009 Recovery Act. The result was a needlessly long and drawn-out recovery.   The Euro Crisis (2012) Chart 11The State Is Here To Mop Up The Mess The State Is Here To Mop Up The Mess The State Is Here To Mop Up The Mess A reoccurring theme in economic history is that financial crises often force governments to assume private-sector liabilities in order to avoid a full-scale economic collapse. Unlike Greece, where government debt stood at very high levels even before the GFC, debt levels in Spain and Ireland were quite modest before the crisis. However, all that changed when Spain and Ireland were forced to bail out their banks (Chart 11). Unlike the US, UK, and Japan, euro area member governments did not have access to central banks that could serve as buyers of last resort for their debts. This limitation created a feedback loop where rising bond yields made it more onerous for governments to service their debts, which led to a higher perceived likelihood of default and even higher yields (Chart 12). Chart 12Multiple Equilibria In The Debt Market Are Possible Without A Lender Of Last Resort The Golden Rule For Investing In The Stock Market The Golden Rule For Investing In The Stock Market The ECB could have short-circuited this vicious cycle. Unfortunately, under the hapless leadership of Jean-Claude Trichet, instead of providing assistance, the central bank raised rates twice in 2011. This helped spread the crisis to Italy and other parts of core Europe. It ultimately took Mario Draghi’s “whatever it takes pledge” to restore some semblance of normality to European sovereign debt markets. Lessons For Today The current environment bears some resemblance to the one preceding the recessions of the early 1980s. As was the case back then, inflation today has surged well above the Federal Reserve’s target, forcing the Fed to turn more hawkish. Oil prices have also risen, despite slowing global growth. Even Russia has returned to its status as the world’s leading geopolitical boogeyman. Yet, digging below the surface, there is a big difference between today and the early ‘80s. For one thing, long-term inflation expectations remain well anchored. While expected inflation 5-to-10 years out has risen to 3.1% in the latest University of Michigan survey, this just takes the reading back to where it was not long after the Great Recession. It is still nowhere near the double-digit levels reached in the early ‘80s (Chart 13). Market-based inflation expectations are even more subdued. In fact, the widely watched 5-year/5-year forward TIPS breakeven inflation rate is currently well below the Fed’s comfort zone (Chart 14). Chart 13Long-Term Inflation Expectations Are Inching Up But Are Still Low Long-Term Inflation Expectations Are Inching Up But Are Still Low Long-Term Inflation Expectations Are Inching Up But Are Still Low Chart 14Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Higher oil prices are unlikely to have the sting that they once did. The energy intensity of the global economy has fallen steadily over time, especially in advanced economies (Chart 15). Today, the US generates three-times as much output for every joule of energy consumed than it did in 1970. Household spending on energy has declined from a peak of 8.3% of disposable income in 1980 to 3.8% in December 2021. The US also produces over 11 million barrels of oil per day, more than Saudi Arabia (Chart 16). Chart 15The Global Economy Has Become Less Energy Intensive Over Time The Global Economy Has Become Less Energy Intensive Over Time The Global Economy Has Become Less Energy Intensive Over Time Chart 16When It Comes To Energy Production, The USA Is Now #1 When It Comes To Energy Production, The USA Is Now #1 When It Comes To Energy Production, The USA Is Now #1 Unlike in the late 1990s, advanced economies do not face a significant capex overhang. Quite the contrary. Capital spending has been fairly weak across much of the OECD. In the US, the average age of the nonresidential capital stock has risen to the highest level since the 1960s (Chart 17). Looking out, far from cratering, capital spending is set to rise, as foreshadowed by the jump in core capital goods orders (Chart 18). Chart 17The Aging Capital Stock The Aging Capital Stock The Aging Capital Stock Chart 18The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright Chart 19Need More Houses Need More Houses Need More Houses In contrast to the glut of housing that helped precipitate the Global Financial Crisis, housing remains in short supply in many developed economies. In the US, the homeowner vacancy rate has fallen to a record low. There are currently half as many new homes available for sale as there were in early 2020 (Chart 19). Even in Canada, where homebuilding has held up well, government officials have been hitting the panic button over a brewing home shortage.   The Biggest Risk Is Debt The biggest macroeconomic risk the global economy faces stems from high debt levels. While household debt has fallen by 20% of GDP in the US, it has risen in a number of other economies. Corporate debt has generally increased everywhere, in many cases to finance share buybacks and M&A activity (Chart 20). Public debt has also soared to the highest levels since during World War II. Chart 20Mo' Debt Mo' Debt Mo' Debt Among emerging markets, China’s debt burden is especially pronounced. Total private and public debt reached 285% of GDP in 2021, nearly double what it was in early 2008. The property market is also slowing, which will weigh on growth. Like many countries, China finds itself in a paradoxical situation: Any effort to pare back debt is likely to crush nominal GDP by so much that the debt-to-GDP ratio rises rather than falls. Ironically, the only solution is to adopt reflationary policies that allow the economy to run hot. In the near term, this could prove to be a favorable outcome for investors since it will mean that monetary policy stays highly accommodative. Over the long haul, however, it may lead to a stagflationary environment, which would be detrimental to equities and other risk assets. In summary, investors should remain overweight stocks for now. However, they should underweight the tech sector since tech stocks remain disproportionately vulnerable to rising rates, increased regulation, and a retrenchment in pandemic-induced spending on electronics and online services.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix The Golden Rule For Investing In The Stock Market The Golden Rule For Investing In The Stock Market Special Trade Recommendations Current MacroQuant Model Scores The Golden Rule For Investing In The Stock Market The Golden Rule For Investing In The Stock Market

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The US midterm elections will bring another round of intense polarization and policy uncertainty this year, though the overall stock market today appears well prepared for the most likely result: a GOP victory in House and Senate. Yet our quantitative Senate election model is “too close to call.” It expects Democrats to retain 50 seats in the Senate and hence the thinnest possible majority. We doubt it, subjectively, but the important point is that the Senate will be stymied either way. Indeed, the only way investors could truly be surprised would be if Democrats made a comeback and retained control of both chambers, but this outcome is very unlikely.  Voters make up their minds early in the year during midterm elections, so Democrats may not benefit from any softening of inflation later this year. Still, gridlock ensures that domestic policy uncertainty will rise as well as foreign policy uncertainty. The  dollar will be resilient, favoring a tactically defensive positioning. Quant Model For US Senate Election US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Bottom Line: While we expect Republicans to win both the House and the Senate in 2022, our quant model says the Senate is too close to call. Value has bottomed on a structural time frame but the coming months will be challenging and we recommend growth stocks tactically. Feature This report updates our quantitative models for the 2022 Senate and 2024 presidential elections (Chart of the Week). As always, we use the quantitative modeling as a complement to our qualitative analysis. Formal modeling helps to question our assumptions and views. It is not a substitute for empirical analysis and good judgment, whether in economics or politics. Our qualitative analysis utilizes the geopolitical method, a method based on realist political theory, in which we analyze the concrete checks and balances (constraints) that prevent policymakers from achieving their objectives. We then assign scenario probabilities and compare with BCA Research macro and market views to identify investment risks and opportunities. Advantage Republicans In Midterm Elections Our base case for the midterm election is a Republican victory in both the House of Representatives and the Senate. This outlook is consensus in online betting odds (Chart 1). However, the consensus may be underestimating the Democrats in the Senate election. The Senate is still in play and that is where investors should focus this year. However, the only true risk to expectations would be Democrats keeping the House and Senate. Every other scenario involves different shades of gridlock. Democrats can only hold onto both chambers if a shock event occurs that massively upsets expectations. Such a shock would have to be devastating for the Republicans, as it would go against long-established political cycles and current trends. The implication would be a rare chance to pass major legislation on partisan lines: corporate tax hikes and social programs cut out of the current “Build Back Better” planning. Online betters currently give this Democratic scenario a 10% probability: it is essentially a “black swan” and would be inflationary on the margin. Chart 1Midterm Election Odds Favor Republicans US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Other scenarios are more or less disinflationary as Republicans in the opposition will attempt to rein in government spending: If Republicans win both chambers, then they will have an impetus to pass legislation and it is more likely that they will do so, as President Biden could find common ground (a la Bill Clinton after 1994). But if Republicans win only the House, then they will only be capable of obstruction and brinksmanship, a la the “Tea Party” Republicans of 2010-16. This scenario would be disinflationary and would heighten political risks such as the risk of a national debt default over a refusal to raise the debt ceiling in 2023. Bottom Line: The only midterm election outcome that could surprise US markets in a major way in 2022 would be a Democratic victory in both houses of Congress. But the consensus is right to put the odds of that at 10%. Otherwise the midterm scenarios are just different shades of gridlock, albeit with higher policy uncertainty under a split Congress. Republicans Highly Likely To Take The House We have not yet unveiled our House Election model but here we can make some preliminary predictions. The opposition party has gained seats in the House in 90% of the midterm elections since 1862 (incumbent party gained seats four out of 40 times). Exceptions are rare (e.g. 1902, 1934, 1998, and 2002) and not applicable to the 2022 context so far.1 About 47 seats in the House are thought to be competitive this year, compared to around 75 in 2018, 81 in 2010, and 38 in 2002. Of the 47 competitive seats, 30 are especially competitive, with 18 Democratic and 12 Republican. Four Democratic seats are wide open to competition, i.e. lacking an incumbent, the same as four Republican seats. However, more Democrats (29) are stepping down than Republicans (13), a sign that Democratic incumbents recognize cyclical patterns turning against them.2 President Biden has a net negative approval rating (53% disapprove while 42% approve), similar to President Trump in 2018, when Republicans lost 42 seats in the House. Presidential approval has a significant correlation with House losses for the president’s party since the end of World War II. This is especially true when taking the average of presidential approval and his party’s support in the generic congressional ballot. By this measure Democrats are lined up to lose 40 House seats, whereas they only need to lose a net of five to lose control. The nation’s woes are unlikely to improve significantly in time for the election: Inflation is surging and real wages are collapsing (Chart 2). Even if economists observe inflation rolling over before the election, voter inflation expectations will lag, and will be brought into the ballot box. Americans are the unhappiest they have been since the 1970s, as a consequence of the pandemic, the economy, toxic society and politics, and other factors (Chart 3). Chart 2Consumers Facing Rising Prices Amid Declining Incomes Consumers Facing Rising Prices Amid Declining Incomes Consumers Facing Rising Prices Amid Declining Incomes Chart 3Unhappiness Reaches New High US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock A rebound in consumer confidence is not enough to save Biden’s party from losses at the ballot box, as President Obama learned in 2010 and 2014 (Chart 4). Similarly a big drop in confidence can hurt the president in the midterms even if confidence recovers in time for the vote, as happened to Republicans in 2018. Biden has another foreign policy crisis on his hands (Russia), after losing trust on his handling of Afghanistan, and may have more crises to deal with by November (Iran, Latin America). If a crisis hits the oil price, as with Russia or Iran, then prices at the pump will go higher, as we discussed in “Biden’s External Risks.” As for the immigration surge, while it will not concern the business community during a time of labor shortage and inflation, it will concern voters, especially in border states like Arizona (Chart 5). The current surge is historic and may come back to haunt the Democrats. Chart 4Lackluster Consumer Confidence Won't Help Democrats Lackluster Consumer Confidence Won't Help Democrats Lackluster Consumer Confidence Won't Help Democrats Chart 5Immigration Crisis Looms On Southern Border Immigration Crisis Looms On Southern Border Immigration Crisis Looms On Southern Border Republicans will benefit slightly from the post-2020 congressional redistricting. Democrats will probably not make substantial gains as a result of Republican infighting in the primaries, though it could make a big difference in the Senate. We will revisit the latter two issues in future reports (redistricting and Republican primaries) but they only matter if Democrats make a significant comeback in opinion. Otherwise the general swing of public opinion will swamp these marginal effects in the House elections. Worst of all for Democrats, evidence shows that voters tend to make up their minds early in the year. That is when the correlation is strongest between the generic congressional opinion poll and the vote share of elections, though for Democrats in particular late-year polling is equally significant (Chart 6). Chart 6AMidterm Voters Mostly Decided At The Start Of The Year US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Chart 6BMidterm Voters Mostly Decided At The Start Of The Year US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock What could lift the Democrats’ odds? The following factors: The relevance of the Covid-19 pandemic will wane. The economy, while slowing, will continue expanding and unemployment will be very low (Chart 7). Democrats are still somewhat likely to pass a reconciliation bill with the most popular parts of their “Build Back Better” agenda. Democrats will use social “wedge issues” to mobilize their political base. A racialized battle over the Supreme Court nomination and any conservative Supreme Court ruling on abortion may mobilize African Americans and women. It is possible, not likely, that a foreign policy crisis could generate a lasting patriotic backlash against foreign insults, as we discussed last week. This dynamic is relevant given our Geopolitical Strategy’s 75% odds of new Russian military action in Ukraine. A lot can change in nine months during rapidly changing and highly polarized contests in which every marginal vote matters. Bottom Line: While Republicans are highly likely to retake control of the House, the Senate is still in competition. Chart 7Economy Will Slow, Unemployment To Remain Low Economy Will Slow, Unemployment To Remain Low Economy Will Slow, Unemployment To Remain Low The Senate Leans GOP But Still In Play The Senate is more competitive than the House in this year’s election, as 20 Republican seats are up for grabs versus only 14 Democratic seats. About nine of these seats are truly competitive, compared to 13 in 2018, 11 in 2010, and 15 in 2002.3 Only one Democrat is stepping down, in the very blue state of Vermont, whereas five Republicans are stepping down, three of which from competitive states. Hence Democrats have a better chance of picking up Republican seats in North Carolina and Pennsylvania than otherwise. However, even here, Democrats only have a one-seat margin of safety. A net loss of a single seat will yield control of the chamber. Our quantitative model relies on the following six variables: State-level economic health Incumbent party margin of victory in state’s previous Senate race (i.e. 2020) The incumbent president’s net average approval rating Average net support rate of incumbent party in generic congressional ballot A dummy variable for the generic ballot, for statistical purposes A “time for change” penalty for any party that has controlled the Senate for six or more years The model’s results are shown in Chart 8. Currently the model says the status quo will hold, with a 50/50 split in the Senate. Democrats lose Georgia but gain Pennsylvania and hence the balance of power stays the same, as Vice President Kamala Harris casts any tie-breaking vote. Chart 8Senate Quant Election Model Points To Even Split US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Specifically the model says: Arizona is a toss-up but leans Democratic, with 55% odds. Pennsylvania is a toss-up but switches to the Democrats with 54% odds. North Carolina is a toss-up but leans Republican with 47% odds. Georgia switches to the Republican side and is no longer viewed as a toss-up at 43% odds. Looking at the change in these election probabilities since November 2020, North Carolina has seen the biggest drop for the Democrats, followed by Arizona (Chart 9). Democratic odds are worsening in four states, while Republican odds are worsening in three states. Since North Carolina and Pennsylvania are losing their Republican incumbents, this change in odds is a problem for the GOP. By contrast, Democrats are running incumbents in the four states where they are vulnerable. The problem for Democrats, again, is that voters make up their minds early. The closest correlation between the generic party polling and the incumbent party’s performance in the Senate in a midterm election occurs in February at 94% (Chart 10). Chart 9Senate Model: Change In Predicted Probability US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Senate elections, like all American elections, are increasingly nationalized.4 This is evident in the 75% correlation we find between the generic polls and the performance of the incumbent party in the Senate (Chart 10 again). So, for example, while one might view Senator Mark Kelly of Arizona as likely to win given the incumbent advantage and the fact that he is a former astronaut and US Navy captain, and he may indeed win, nevertheless a national wave of anti-incumbent feeling could overwhelm his re-election bid. Still, state effects could matter. To examine these from a macro perspective we look at each state’s Misery Index (inflation plus unemployment) compared to the national average in Chart 11. Here are the notable takeaways: Chart 10Midterm Voters Mostly Decided At The Start Of The Year US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Chart 11AState Level Miseries Point To Risks For Democrats In GA And AZ… US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Chart 11B… And To Republicans In PA And WI US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Misery in Arizona, Georgia, and Pennsylvania is higher than average and rising – negative news for Democrat Kelly, Democrat Raphael Warnock, and the yet-to-be-decided Republican candidate in Pennsylvania. Misery in Florida is also slightly above the national average and rising, though Senator Marco Rubio is likely secure. Wisconsin misery is lower than national average and rising (possibly hurting Republican incumbent Senator Ron Johnson). North Carolina misery is lower than national average and falling (helping the yet-to-be-decided Republican candidate). In other words, Misery Indexes support our model’s findings, yet suggest that Democrats face a headwind in Arizona – where our model is also flagging an important risk for Democrats. In sum, our model’s direction of change suggests Democrats will lose another seat and thus the Senate. Going forward, the key moving parts are the economy and the president’s and his party’s approval ratings. There is a chance that these variables will bottom early in the year and improve later, which underscores that the Senate will remain competitive. What investors can be certain about is that Democrats are extremely unlikely to make significant seat gains in the Senate. So even if they retain control, it will be with the thinnest of possible majorities, and hence the Senate will only be capable of passing bipartisan Republican-authored House bills – or vetoing Republican House bills to save the president from having to veto them. It is also certain that Republicans will fall far short of the 67 votes they would need to remove Biden from office, if House Republicans find or invent a reason to impeach him. Bottom Line: The Senate outcome is too close to call but subjectively we doubt Democrats will pull it off given the negative macro trends cited above. Our Senate election model gives 51% odds that Democrats will retain a de facto majority with 50 seats. 2024 Presidential Vote: Odds Favor Democrats For Now The US presidential election is 34 months away. Investors need to be prepared for any outcome, including another contested election. But it is important to have a base case – especially because a Republican (or Democratic) victory in both House and Senate in 2022 would open up the prospect of single-party control in 2025, which has much bigger policy implications than various shades of gridlock. As a rule of thumb, investors should think of presidential elections as a referendum on the incumbent party, not the president’s person, for the prior four years of material performance. Thus Democrats are currently favored to keep the White House. Voters will feel better than they did in 2020, which suffered a triple crisis of pandemic, recession, and unrest. Significant changes must occur to alter this trajectory – such as a recession, Biden’s stepping down, or a humiliating foreign policy defeat.5 Our quantitative model supports this view: it currently gives a 55.2% chance of Democratic victory in the Electoral College (Chart 12). Chart 12US Election 2024: Quant Model Tips Dems US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Our model relies on the following four variables: State economic health Incumbent party margin of victory in the previous election A penalty for parties that have held the White House for two terms (not applicable in 2024) The president’s approval rating (level) Interestingly our model produces 308 electoral votes for Biden, compared to his actual 306 in 2020, except that some states trade places: Democrats win Florida while Republicans take back Arizona and Georgia. Specifically the model says: North Carolina is a toss-up state but leans Republican. Wisconsin is a toss-up state but just slightly leans Democratic. Florida and Pennsylvania have moved above toss-up range into the Democratic camp. Arizona and Georgia have slipped beneath the toss-up range into the Republican camp. Looking at the change in each state’s odds of voting for the incumbent, Democrats’ chances are falling in eight states while Republicans chances are falling in three states (Chart 13). Wisconsin and Arizona are seeing the most substantial drops, followed by Pennsylvania. Thus the current direction of change is negative for Democrats as one would expect. Biden’s thin margin of victory in 2020 and weak approval ratings make him vulnerable, so the economic performance will largely determine the model’s results going forward. If Biden avoids a recession, that may be enough to retain the White House according to the model. Florida is an interesting case. The model gives a 59% chance it will go to the Democrats. We are suspicious of this outcome but it suggests investors should not take a Republican victory there for granted. Consider: Chart 13Presidential Model: Change In Predicted Probability US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock While we gave President Trump 45% odds of winning in 2020, we predicted he would win Florida due to the state’s partisan leaning.6 That leaning has probably not changed much, although Governor Ron DeSantis’s latest approval rating is only at 45%. However, the six-month change in Florida’s coincident economic indicator has fallen 0.6% since November 2020 and the Misery Index is rising above the national average, as noted above. If Biden loses Florida but the rest of our model is correct, Democrats will retain the White House with 279 electoral college votes. That would leave Wisconsin as the decisive battleground. Yet Wisconsin is very tenuously in their camp today, so any change in the model that gives Florida back to the Republicans would likely give them Wisconsin as well … The result of Biden losing Arizona, Georgia, and Wisconsin (among other combinations) would be a 269-269 tie in the electoral college, in which each state’s delegation to the House of Representatives would have a single vote. A Republican win in the House in 2022 would thus result in a Republican White House in another explosive contested election. But let’s not get ahead of ourselves, 2024 is more than two years away. Bottom Line: Our presidential model gives a 55% chance that Democrats will retain the White House in 2024. Subjectively we agree. A Democratic defeat in 2022 will not rule out a Democratic victory in 2024, especially if Biden is alive and kicking, given the incumbent advantage. But economic factors will largely determine how the model evolves over the next 34 months. Our model also suggests the Electoral College math will be close and that another contested election is possible. Investment Takeaways Based on the current stock market correction, financial markets have priced a fair amount of policy uncertainty already. And this report suggests the midterms merely offer different shades of gridlock. However, Biden’s external risks – namely conflict with Russia – could cause further risk-off moves. And uncertainty will increase as midterms get closer. US policy uncertainty is falling relative to the rest of the world (Chart 14). This is positive for King Dollar, at least over a tactical time frame. The Fed’s interest rate liftoff is also positive for the dollar. Chart 14Lower US Uncertainty In The Near Future Supports The DXY Lower US Uncertainty In The Near Future Supports The DXY Lower US Uncertainty In The Near Future Supports The DXY Hence on a short-term basis, the stock-to-bond ratio can fall further and cyclicals can fall further relative to defensives. Tactically we recommend going long growth versus value stocks (Chart 15). Value has surged in the New Year and the dollar and rate hikes will counteract that, as well as any global energy shock that kills demand. Chart 15Tactically Go Long Growth Versus Value Tactically Go Long Growth Versus Value Tactically Go Long Growth Versus Value However, this is a tactical call. Otherwise, we remain in line with the BCA House View, which favors stocks over bonds and a weaker dollar over the next 12 months.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Guy Russell Research Analyst guyr@bcaresearch.com   Footnotes 1     Brookings Institution, “Losses by the President’s Party in Midterm Elections, 1862-2014,” Vital Statistics on Congress, February 8, 2021, www.brookings.edu. 2     For the number of competitive seats, see Cook Political Report, cookpolitical.com, and Fair Vote, fairvote.org.  3    See footnotes 1 and 2 above. In addition see the Green Papers, “General Election 2002 – Contests to Watch,” October 25, 2002, thegreenpapers.com, and Ken Rudin, “2010 Senate Ratings: 11 Seats Seen As Tossups; GOP With At Least 3 Pickups,” NPR, July 9, 2010, npr.org. 4    See Joel Sievert and Seth C. McKee, “Nationalization in U.S. Senate and Gubernatorial Elections,” American Politics Research 47:5 (2019), pp. 1036-1054. 5    Our qualitative presidential election framework relies heavily on the work of Professor Allan Lichtman, American University. See our updated Lichtman-style checklist in BCA US Political Strategy, “Biden Is Underwater But His Legislation Will Float,” September 8, 2021, bcaresearch.com. 6    See BCA Research Geopolitical Strategy, “Upgrading Trump’s Odds of Re-Election,” October 26, 2020, bcaresearch.com. See also my interview on Bloomberg’s The Tape Podcast, “Full Blue Sweep Will Push Biden To Left,” July 13, 2020, Bloomberg.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Table A3US Political Capital Index US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Chart A1Presidential Election Model US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Chart A2Senate Election Model US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Table A4APolitical Capital: White House And Congress US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Table A4BPolitical Capital: Household And Business Sentiment US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock Table A4CPolitical Capital: The Economy And Markets US Midterm 2022: Different Shades Of Gridlock US Midterm 2022: Different Shades Of Gridlock

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary Asian Inflation Has Diverged From US Emerging Asia: Domestic Bond Strategy Emerging Asia: Domestic Bond Strategy Inflation has been largely subdued in emerging Asia and will remain so for now. This argues for the outperformance of emerging Asian local bonds versus their EM peers, as well as DM/US bonds.   The most important macro driver of Asian domestic bond yields is inflation. Rising inflation usually also hurts local currencies – creating a toxic cocktail for bonds’ total returns in US dollar terms. Diverging currency dynamics in emerging Asia is what will determine the relative performances of individual bond markets. Chinese, Indian, and Malaysian currencies have a better outlook than currencies in Indonesia, Thailand and the Philippines. Book profits on the short Korean won position: this trade has generated a 5.2% gain since its initiation on March 25, 2021. Recommendation   Initiation Date Return to Date Short KRW / Long USD 2021-03-25 5.2% Bottom Line: Regional fixed income managers should overweight China, Korea, India and Malaysia, and underweight Indonesia, Thailand and the Philippines within an emerging Asian bond portfolio. In an overall EM domestic bond portfolio however, Thailand and the Philippines should be accorded a neutral allocation, given their better inflation outlook compared to their peers in EMEA and Latin America. Feature US Treasury yields will likely go up further. If history is any guide, EM Asian bond yields should also rise in tandem (Chart 1). The basis is that business cycles in Asia and the US usually move together. Yet, in this cycle, inflation in emerging Asia has diverged considerably from that of the US. US core consumer price inflation has surged while in Asia, core inflation remains largely contained (Chart 2). How should bond investors position themselves in Asian domestic bond markets? Chart 1Asian Bond Yields Usually Move In Line With US Treasury Yields... Asian Bond Yields Usually Move In Line With US Treasury Yields... Asian Bond Yields Usually Move In Line With US Treasury Yields... Chart 2...But Diverging Inflation Means Asian Bonds Will Outperform US Bonds ...But Diverging Inflation Means Asian Bonds Will Outperform US Bonds ...But Diverging Inflation Means Asian Bonds Will Outperform US Bonds Chart 3Relative Domestic Bond Performances In Asian Markets Relative Domestic Bond Performances In Asian Markets Relative Domestic Bond Performances In Asian Markets In this report, we will discuss some of the common factors that drive Emerging Asian bond markets. We will also highlight each individual market’s idiosyncrasies to explain our recommended allocation across local currency bond markets in emerging Asia for the coming year.     Our recommended allocation is as follows: China, Korea, India and Malaysia merit an overweight stance in an emerging Asia domestic bond portfolio, while Indonesia, Thailand, and the Philippines warrant an underweight allocation (Chart 3). That said, given a much more benign inflation outlook in Asia than elsewhere in EM, we recommend that Thailand and the Philippines be accorded a neutral allocation in an overall EM domestic bond portfolio. The Two Drivers For international investors in local bonds, total returns are predicated on two main drivers: (1) the direction and magnitude of change in bond yields; and (2) currency performance. In all Asian countries, the most potent macro factor that drives local bond yields is the country’s inflation. Rising inflation is usually a harbinger of higher bond yields (and hence, worsening bond performance); and falling inflation is an indicator of lower yields (Charts 4 and 5). Chart 4Inflation Is The Most Important Macro Driver … Inflation Is The Most Important Macro Driver... Inflation Is The Most Important Macro Driver... Chart 5… Of Bond Yields In Emerging Asia ... Of Bond Yields In Emerging Asia ... Of Bond Yields In Emerging Asia What’s more, rising inflation in a country is also often associated with a depreciating currency. Currencies in countries with higher/rising inflation in general do worse than in countries with lower/falling inflation. This aspect is especially important when doing a cross-country comparison. The fact that higher inflation negatively impacts both the drivers of bond performance – it pushes up yields and weakens the currency – can indeed be seen happening in Asian financial markets. Rising inflation leads to poor performance of domestic bonds’ total return in dollar terms; and falling inflation leads to a better performance. The upshot is that the potential inflation trajectory is key to any country’s domestic bond performance in both absolute and relative terms. Inflation In Asia Is Benign Most of the Asian countries have their core and trimmed mean consumer price inflation running at or well below their central banks’ targets (Charts 6 and 7). Their inflation outlook also remains largely benign.1 As such, bond yields in these countries are unlikely to rise materially in the near future. Chart 6Inflation Is Running At Or Below … Inflation Is Running At Or Below... Inflation Is Running At Or Below... Chart 7… Central Banks’ Target in Asia ... Central Banks' Target in Asia ... Central Banks' Target in Asia Notably, even the recent surge in US yields did not spook Asian bond yields. The yield differentials between individual Asian domestic and US yields have remained flattish in the past few months. All this implies that Asian domestic bonds, in general, would likely fare better relative to the rest of the EM and the US – where inflation is high and well above their central banks’ targets. Currency Is A Key Differentiator Given inflation, and therefore the bond yield trajectories among Asian economies are unlikely to deviate significantly from one another, the key differentiator of their bond market performance (on a total return basis) will be their exchange rates. In fact, Asian currencies do vary considerably in their outlooks as their fundamentals differ.  For instance, in China and Korea, higher bond yields are usually associated with an appreciating currency (Chart 8, top and middle panels). The key driver of bond yields in these economies is the business cycle. Accelerating growth often pushes up both the currency as well as interest rates. The opposite is also true: decelerating growth usually leads to a weaker currency and falling bond yields.  The consequence is that in these countries, bond performance is tempered by two opposing forces. For example, the effect of falling yields (which is a positive for total return) is often mitigated by the effect of a falling currency (which is a negative for total return), or the other way around. In contrast to China and Korea, ASEAN countries usually experience rising bond yields accompanied by a depreciating currency (Chart 9). A crucial reason for this is significantly higher foreign ownership of their domestic bonds. In periods of stress, when foreigners exit their bond holdings, this leads to both higher yields and a falling currency. During risk-on periods, foreigners’ purchases do the opposite. Chart 8Higher Bond Yields Coincide With A Stronger Currency In China And Korea Higher Bond Yields Coincide With A Stronger Currency In China And Korea Higher Bond Yields Coincide With A Stronger Currency In China And Korea Chart 9Higher Bond Yields Coincide With A Weaker Currency In ASEAN Higher Bond Yields Coincide With A Weaker Currency In ASEAN Higher Bond Yields Coincide With A Weaker Currency In ASEAN In this context, foreign ownership of domestic bonds in ASEAN countries has fallen in the past few years, but remains non-trivial: 19% in Indonesia, 24.2% in Malaysia, 19.9% in the Philippines, and 11.3% in Thailand. Hence, the currency view on ASEAN countries is crucial to get the outlook right for their domestic bond performance. Incidentally, Thailand, the Philippines and Indonesia have a weak currency outlook, while Malaysia’s is neutral. We discuss the individual currency outlooks in more detail in the respective country sections below. But in summary, this warrants a more positive stance on Malaysian domestic bonds compared to Indonesian, Thai and Filipino bonds. Finally, in case of India, bond yields and the rupee have little correlation (Chart 8, bottom panel). The main reasons for that are near absence of foreign investors in Indian government bond markets, and large captive domestic bond investors (its commercial banks). Yet, unlike China and Korea, India also has higher inflation and a persistent current account deficit. All these make the correlation of bond yields with the exchange rate different in India from both ASEAN as well as China and Korea. In the sections below, we discuss each country’s currency and overall bond outlook in more detail. We also explain the reasons behind our relative bond strategy. China: Overweight Chart 10Chinese Bond Yields Will Likely Fall More Chinese Bond Yields Will Likely Fall More Chinese Bond Yields Will Likely Fall More China’s economy will remain weak in the coming months. The hit to the economy from slowing property construction is material. Besides, COVID-induced rotational lockdowns are hurting consumption, income and investment in the service sector. The latest round of stimulus has so far not been sufficient to produce an immediate recovery. We expect growth to revive only in H2 2022. For now, the PBOC will reduce its policy rate further. This and the fact that the yield curve is positively slopped heralds more downside in Chinese government bond yields (Chart 10). Concerning the exchange rate, the ongoing US dollar rally could eventually cause a short period of yuan weakness. However, the latter will be small and short lived. In brief, Chinese domestic bonds will outperform both their Asian and EM peers in the coming months. Korea: Overweight The following factors argue for overweighting Korean bonds within both emerging Asian and EM domestic bond portfolios: Chart 11Korea Has No Genuine Inflation Korea Has No Genuine Inflation Korea Has No Genuine Inflation The Korean won has already depreciated quite a bit against the US dollar. While further downside is possible in the very near term, the medium-term outlook is positive. Even though headline and core inflation have exceeded the central bank’s target of 2%, trimmed mean consumer price inflation has not yet exceeded 2% (Chart 4, middle panel) and services CPI, excluding housing, seems to have rolled over. Importantly, no wage inflation spiral is evident. Unit labor costs have been falling in both the manufacturing and service sectors (Chart 11). Hence, there is little pressure for companies to hike prices. India: Overweight Indian bonds should continue to outperform other EM domestic bonds (Chart 3, middle panel). The combination of prudent fiscal policy, a benign inflation outlook and a cheap currency makes Indian bonds attractive to foreign investors. Even though yields will go up somewhat given a recovering economy, the rise will be capped as the inflation outlook remains benign. The reason for a soft inflation outlook is wages and expectations thereof are quite low (Chart 12). Global commodity prices will also likely soften in the months ahead. That will ease price pressures in India. The Indian rupee is cheap – it is now trading 12% below its fair value versus the US dollar (Chart 13). The rupee will likely be one of the best performers among EM currencies in the year ahead. Chart 12Low Urban And Rural Wages Will Keep A Lid on Indian Inflation Low Urban And Rural Wages Will Keep A Lid on Indian Inflation Low Urban And Rural Wages Will Keep A Lid on Indian Inflation Chart 13Indian Rupee Is Cheap Indian Rupee Is Quite Cheap And Will Likely Outperform Many EM Currencies Indian Rupee Is Quite Cheap And Will Likely Outperform Many EM Currencies   The spread of India’s 10-year bonds over that of GBI-EM Broad index is 190 basis points. The currency performance will likely offset any possible capital loss owing to rising yields, while a positive carry will boost total returns. Stay overweight. Indonesia: Underweight Indonesian relative bond yields versus both EM and the US have already fallen massively and at multi-year lows (Chart 14). The currently low yield differential between Indonesia and the aggregate EM local bonds as well as US Treasury yields is a negative for Indonesia’s relative performance going forward. Chart 15 shows that the rupiah is also vulnerable over the next several months as the Chinese credit and fiscal impulse has fallen to its previous lows while the rupiah has not yet depreciated. We believe raw material prices will correct in the coming months, weighing on the rupiah. Hence, the country’s local bonds’ relative performance is facing a currency headwind too. Chart 14Indonesian Relative Bond Yields Are Quite Low Indonesian Bond Yields Are Quite Low Relative To Their EM And US Counterparts Indonesian Bond Yields Are Quite Low Relative To Their EM And US Counterparts Chart 15Indonesian Rupiah Is Vulnerable Indonesian Rupiah Is Vulnerable Indonesian Rupiah Is Vulnerable   Notably, a weaker currency by itself could cause bond yields to rise – because that may prompt foreign bond holders to exit this market. For now, investors would do well to underweight this domestic bond market in an emerging Asian or global EM portfolio. Malaysia: Overweight Chart 16Malaysian Yield Curve Is Too Steep Given The Deflationary Macro Backdrop Malaysian Yield Curve Is Too Steep Given The Deflationary Macro Backdrop Malaysian Yield Curve Is Too Steep Given The Deflationary Macro Backdrop Malaysian domestic bonds will likely fare well as the nation’s economy is still working through credit excesses of the previous decade. Domestic demand weakness has been exacerbated by a constrained fiscal policy. All of this has paved the way for a strong disinflationary backdrop.   The job market has not recovered either: the unemployment rate is hovering at a high level. That in turn has put downward pressures on wages. Average manufacturing wages are weak. Dwindling wages have contributed to depressed household incomes, leading to weak consumption and falling house prices (Chart 16). Considering the economic backdrop, Malaysia’s yield curve is far too steep (Chart 16, bottom panel). Odds are that the curve will flatten going forward – yields at the long end of the curve are likely heading lower. At a minimum, they will rise less than most other EM countries. Notably, the ringgit is quite cheap, and is unlikely to depreciate much versus the US dollar. Hence, it will outperform many other Asian/EM currencies. That calls for an overweight position in Malaysian local bonds within an Asian/EM universe.  Thailand: Underweight To Neutral Given the high correlation between Thai bond yields and the baht (rising yields coincide with a weakening currency), the total return of Thai bonds in USD terms is highly dependent on the baht’s performance. (Chart 17). The baht outlook remains weak, as the two main drivers of the currency, exports and tourism revenues, remain sluggish and absent, respectively. As such, absolute return investors in Thai domestic bonds should continue to avoid this market. Asset allocators should underweight Thai domestic bonds in an emerging Asia basket. In an overall EM domestic bond portfolio, however, Thai bonds warrant a neutral allocation. That’s because Thailand has been a defensive bond market due to its traditionally strong current account, very low inflation, and lower holding of bonds by foreigners (now at 11.3% of total). In periods of stress, the baht usually falls less than most other EM currencies; and often Thai bond yields fall more (or rise less) than overall GBI-EM yields (Chart 18, top panel). Chart 18Thai Bonds' Relative Performance Can Get Better During Periods Of Risk-Off Thai Bonds' Relative Performance Can Get Better During Periods Of Risk-Off Thai Bonds' Relative Performance Can Get Better During Periods Of Risk-Off Chart 17Thai Domestic Bonds' Absolute Performance Is Highly Contingent On The Baht Thai Domestic Bonds' Absolute Performance Is Highly Contingent On the Baht Thai Domestic Bonds' Absolute Performance Is Highly Contingent On the Baht   The net result is that Thai bonds outperform their overall EM brethren in common currency terms during risk-off periods. This is what happened during the EM slowdown of 2014-15, and again during the pandemic scare in early 2020 (Chart 18, bottom panel). Given we are entering a period of volatility in risk assets, it makes sense to have a neutral positioning on Thai bonds in an EM domestic bond portfolio. The Philippines: Underweight To Neutral The Philippines also merits an underweight allocation in an emerging Asian domestic bond portfolio, but a neutral stance within EM. This is because of this market’s dependence on the appetite of foreign debt investors for Philippine debt securities. This appetite depends on how much extra yield the country offers over US Treasuries. Chart 19 shows that whenever the yield differential between the Philippines’ local bonds and US Treasuries widens to 400 basis points or more, the Philippines typically witnesses net debt portfolio inflows over the following year. On the other end, when the yield differential narrows to around 300 basis points or less, foreign fixed income inflows typically stop, and often turn into outflows during the following year. This is what is happening now. Chart 19Narrow Yield Differential With US Treasuries Is Hurting Philippines' Portfolio Inflows Narrow Yield Differential With US Treasuries Is Hurting Philippines' Portfolio Inflows Narrow Yield Differential With US Treasuries Is Hurting Philippines' Portfolio Inflows Chart 20Philippines Peso Is At Risk As The Current Account Has Slid Back Into Deficit Philippines Peso Is At Risk As The Current Account Has Slid Back Into Deficit Philippines Peso Is At Risk As The Current Account Has Slid Back Into Deficit Going forward, rising US yields would mean that the Philippines’ bond spreads over US Treasuries will continue to stay less than 300 basis points. Consequently, reduced foreign debt inflows will weigh on the peso. Notably, the Philippines’ current account balance has also slid back to deficit, which makes the peso more vulnerable (Chart 20). On a positive note, contained inflation means little upward pressure on bond yields. Further, there might be a lower need of new bond issuances this year as a substantial amount of proceeds from past bond issuances are lying unspent with the central bank. This would help put a cap on bond yields.  Investment Conclusions Emerging Asian local bonds will outperform their counterparts in Latin America and EMEA in common currency terms for now. In the medium and long run, emerging Asian bonds will outperform US/DM bonds on a total return basis in common currency terms. We will discuss rationale for the latter in our future reports. Considering both the overarching macro backdrop as well as their individual situations, it makes sense to overweight China, Korea, India and Malaysia in an emerging Asian domestic bonds portfolio. Whereas Indonesia, Thailand and the Philippines warrant an underweight allocation. Yet, in an overall EM domestic bond portfolio, we recommend a neutral allocation for Thailand and the Philippines. The reason is they have a much better inflation outlook compared to economies in EMEA and Latin America. Chart 21Book Profit On Our Recommended Short Korean Won Trade Book Profit On Our Recommended Short Korean Won Trade Book Profit On Our Recommended Short Korean Won Trade Notably, among the Asian currencies, we have a positive bias on the Chinese yuan and the Indian rupee. On the contrary, we have been shorting the Korean won, the Thai baht, the Philippine peso and the Indonesian rupiah vis-à-vis the US dollar. That said, this week we recommend taking profits on the short Korean won position: this trade has generated a 5.2% gain since its initiation on March 25, 2021 (Chart 21). Our view on the won has played out well. While the exchange rate might continue depreciating in the near run, the risk/reward of staying short is not very attractive now. Finally, we recommend continuing to receive 10-year swap rates in China and Malaysia. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     For a detailed discussion on each country’s inflation dynamics, please click on our reports on China, India, Indonesia, Malaysia, Thailand, Philippines.

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary Cyclical UST Curve Flattening, But With Unusually Low Rate Expectations Deciphering The Messages From The US Treasury Curve Deciphering The Messages From The US Treasury Curve The US Treasury curve is unusually flat given high US inflation and with the Fed not having begun to raise interest rates. The dichotomy between deeply negative real interest rates and a flattening yield curve is not only evident in the US, but in other major developed countries like Germany and the UK. A low term premium on longer-term US Treasury yields is one factor keeping the curve so flat, but the term premium will likely rise as the Fed begins to hike rates. An overly flat US Treasury curve more likely reflects a belief that the neutral real fed funds rate (r-star) is actually negative. This is consistent with markets pricing in a very low peak in the funds rate for the upcoming tightening cycle, despite the current high inflation and tight labor market. Bottom Line: The Fed will hike by less than the market expects in 2022 and longer-term Treasury yields remain too low versus even a moderate 2-2.5% peak in the fed funds rate. Stay in US curve steepeners, as the Treasury curve is already too flat and will not flatten as much as discounted in forward rates this year. Feature Last week’s FOMC meeting essentially confirmed that the Fed will begin lifting rates in March and deliver multiple rate hikes this year. This was considered a hawkish surprise as the Fed signaled imminently tighter monetary policy even with the elevated financial market volatility seen so far in 2022. Fed Chair Jerome Powell noted that the US economy was in a stronger position compared to the 2016-18 tightening cycle, justifying a faster pace of hikes – and an accelerated pace of QE tapering – this time around. Markets have responded to the increasingly hawkish guidance of the Fed by pushing up rate expectations for 2022, continuing a path dating back to last September’s FOMC meeting when the Fed first signaled that QE tapering was imminent (Chart 1). There are now 163bps of Fed rate hikes by year-end discounted in the US overnight index swap (OIS) curve. Some Wall Street investment banks are calling for the Fed to hike as much as 6 or 7 times in 2022. We see this as much too aggressive. Chart 1Fed Hawkishness Pushing Up Rate Expectations For 2022/23 - But Not Beyond That Fed Hawkishness Pushing Up Rate Expectations For 2022/23 - But Not Beyond That Fed Hawkishness Pushing Up Rate Expectations For 2022/23 - But Not Beyond That Our base case scenario calls for the Fed to lift rates “only” 3-4 times this year. The persistently high inflation that is troubling the Fed is likely to peak in the first half of 2022, taking some heat off the FOMC to move as aggressively as discounted in markets this year. Although inflation will remain high enough, and the labor market tight enough, to keep the Fed on a tightening path into 2023. The US Treasury Curve Looks Too Flat What is unique about the upcoming Fed tightening cycle is that it is starting with such a flat US Treasury curve. The spread between the 2-year and 10-year yield now sits at 61bps, the lowest level since October 2020. This dynamic is not unique to the US, as yield curves are quite flat in other major countries where policy rates are near 0% and inflation remains relatively high, like the UK and Germany (Chart 2). In the US, the modest slope of the Treasury curve is notably unusual given a growth and inflation backdrop that would be more consistent with much higher bond yields: The US unemployment rate fell to 3.9% in December, well within the range of full employment estimates from FOMC members (Chart 3, top panel) Chart 2Bond Bearish Yield Curve Flattening In The US & UK Bond Bearish Yield Curve Flattening In The US & UK Bond Bearish Yield Curve Flattening In The US & UK US labor costs are accelerating; the wages and salaries component of the Employment Cost Index for Private Industry Workers rose to a 38-year high of 5.0% on a year-over-year basis in Q4/2021 (middle panel) Chart 3Challenges To The Fed's Inflation Fighting Credibility Challenges To The Fed's Inflation Fighting Credibility Challenges To The Fed's Inflation Fighting Credibility ​​​​​​ Higher inflation is becoming more embedded in medium term consumer inflation expectations measures like the University of Michigan 5-10 year ahead series that climbed to 3.1% last month (bottom panel). Importantly, market-based measures of inflation expectations have pulled back, even with little sign of inflation pressures easing. The 5-year TIPS breakeven, 5-years forward has fallen 35bps from the October 2021 peak of 2.41%. The bulk of that decline occurred in January of this year, alongside a rising trend in real TIPS yields as markets began pricing in a faster pace of Fed rate hikes. TIPS breakevens can often be something of a “vote of confidence” by the markets in the appropriateness of the Fed’s policy stance; rising when policy appears overly stimulative and vice versa. Thus, the decline in the TIPS 5-year/5-year forward breakeven, which climbed steadily higher since the Fed introduced massive monetary easing in March 2020 in response to the pandemic, can be interpreted as a sign that markets agree with the Fed’s recent hawkish turn. However, while the move in TIPS breakevens is sensible, the flatness of the Treasury curve appears unusual. In Chart 4, where we look at the previous times since 1975 that the 2-year/10-year US Treasury spread flattened to 70bps (just above the current level). In past cycles, the Treasury curve would be flattening into such a level after the Fed had already hiked rates a few times, which is obviously not the case today. Also, US unemployment was typically approaching, or falling through, the full employment NAIRU when the 2/10 Treasury curve fell to 70bps, suggesting diminished spare economic capacity and rising inflation pressures – similar to the current backdrop. Chart 4The UST Curve Is Unusually Flat Right Now The UST Curve Is Unusually Flat Right Now The UST Curve Is Unusually Flat Right Now Chart 5UST Curve Too Flat Relative To Inflation Pressures UST Curve Too Flat Relative To Inflation Pressures UST Curve Too Flat Relative To Inflation Pressures In those past cycles, the funds rate was rising at a faster pace than that of core inflation, suggesting that the Fed was pushing up real interest rates. The backdrop looks very different today, with US realized inflation soaring and the real funds rate now deeply negative. In the top panel of Chart 5, we show a “cycle-on-cycle” chart of the 2/10 Treasury curve versus an average of the previous five instances where the curve flattened to 70bps. The green line is the median outcome of all the cycles, while the shaded region represents the range of all the outcomes. In the other panels of the chart, we show US economic variables (the Conference Board leading economic index and the ISM Manufacturing index) and US inflation variables (the wages and salaries component of the Employment Cost Index and the US Congressional Budget Office estimate of the US output gap). The panels are all lined up so that the vertical line in the middle of the chart represents the date that the 2/10 curve falls to 70bps. The conclusion from Chart 5 is that the US economic variables shown are currently at the high end of the range of past curve flattening episodes, but the inflation variables are well above the high end of the historical range. In other words, the current modest slope of the 2/10 Treasury curve is in line with US growth momentum but is too flat relative to US inflation trends. So Why Isn’t The US Treasury Curve Steeper? There are a few possible reasons why the US curve is as flat as it is before the Fed has even begun tightening amid above-trend US growth and very high US inflation: Fears of a deeper financial market selloff The Fed believes strongly in the role of financial conditions in transmitting its monetary policy into the US economy. That often means that, during tightening cycles, the Fed hikes rates “until something breaks” in the financial markets, like a major equity market downturn or a big widening in corporate credit spreads. Such moves act as a brake on US growth through negative wealth effects for investors and by raising the cost of capital for businesses – reducing the need for additional Fed tightening. If bond investors thought that a major market selloff was likely before the Fed could successfully lift rates back to neutral (or even restrictive) levels during a tightening cycle, then they would discount a lower peak level of the funds rate. This would also lower the expected peak level of longer-term Treasury yields, resulting in a flatter Treasury yield curve. Given the current elevated valuations on so many asset classes – like equities, corporate credit and housing – it is likely that the relatively flat Treasury curve incorporates some believe that the Fed will have difficulty delivering a lot of rate hikes in this cycle. However, it should be noted that the US financial conditions remain quite accommodative, even after the recent equity market turbulence (Chart 6), and represent no impediment to US growth that reduces how much tightening the Fed will need to do. Longer-term bond term premia are too low A relatively flat yield curve could reflect a lack of a term premium on longer-maturity bonds. That is certainly the case when looking at the slope of the 2/10 government yield curve in the US, as well as in the UK and Germany (Chart 7).1 Chart 6US Financial Conditions Are No Impediment To US Growth US Financial Conditions Are No Impediment To US Growth US Financial Conditions Are No Impediment To US Growth ​​​​​​ Chart 7Flatter Yield Curves? Or Just Lower Bond Term Premia? Flatter Yield Curves? Or Just Lower Bond Term Premia? Flatter Yield Curves? Or Just Lower Bond Term Premia? ​​​​​ The term premium is the defined as the extra yield that investors require to commit to own a longer-maturity bond instead of the compounded yield from a series of shorter-maturity bonds. The latter can also be expressed as the “expected path of short-term interest rates”, which is often proxied by an average expected path of the monetary policy rate over the life of the longer-maturity bond. So the term premium on a 10-year US Treasury yield is the difference between the actual 10-year Treasury yield and the expected (or average) path of the fed funds rate over the next ten years. The term premium can also be thought of as a risk premium to holding longer-term bonds. On that basis, the term premium should correlate to measures of bond risk, like bond price volatility or inflation volatility. That is definitely true in the US, where the 10-year Treasury term premium shows a strong correlation to the MOVE index of Treasury market option-implied volatility or a longer-term standard deviation of headline CPI inflation (Chart 8). Estimated term premia can also rise during periods of slowing economic growth momentum, but that is typically due to a rapid decline in the expected path of interest rates rather than a rise in bond risk premia (in this case, this is probably more accurately described as a rise in bond uncertainty). Currently, a low term premium on US Treasury yields is justified by the relatively low level of bond volatility and solid US growth momentum. However, the term premium looks far too low compared to the more volatile US inflation seen since the start of the COVID-19 pandemic. With the Fed set to respond to that higher inflation with rate hikes, rising real interest rate expectations could also give a lift to the Treasury term premium. Our favorite proxy for the market expectation of the peak/terminal real short-term interest rate for the major developed market economies is the 5-year/5-year forward OIS rate minus the 5-year/5-year forward CPI swap rate. That “real” 5-year/5-year forward rate measure is typically well correlated to our estimates of the 10-year term premium in the US, Germany and the UK (Chart 9). This correlation likely reflects the level of certainty bond investors have over the likely future path of real interest rates. When there is more uncertainty about how high rates will eventually go to in a tightening cycle, a higher term premium is required. The opposite is true during periods of very low and stable interest rates. Chart 8Drivers Of US Term Premia Pointing Upward Drivers Of US Term Premia Pointing Upward Drivers Of US Term Premia Pointing Upward ​​​​​​ Chart 9Bond Term Premia Positively Correlated To Real Rate Expectations Bond Term Premia Positively Correlated To Real Rate Expectations Bond Term Premia Positively Correlated To Real Rate Expectations ​​​​​​ Chart 10Global Yield Curves Are Too Flat Versus Real Policy Rates Global Yield Curves Are Too Flat Versus Real Policy Rates Global Yield Curves Are Too Flat Versus Real Policy Rates Currently, the estimated 10-year US term premium is increasing alongside a rising market-implied path for the real fed funds rate. We anticipate these trends will continue as the Fed lift rates over the next couple of years, boosting longer-term Treasury yields and potentially putting some steepening pressure on the US Treasury curve (or at least limiting the degree of flattening as the Fed tightens). Markets believe that the neutral real rate (r*) is negative Historically, yield curve slopes for government bonds were well correlated to the level of real interest rates, measured as the central bank policy rate minus headline inflation. That relationship has broken down in the US, with the Treasury curve flattening in the face of soaring US inflation and an unchanged fed funds rate (Chart 10). Similar dynamics can also be seen in the German and UK yield curves. The most plausible reason for such a dramatic shift in the relationship between curve slopes and real policy rates is that bond investors now believe that the neutral real interest rate, a.k.a. “r-star”, is negative … and perhaps deeply so. The New York Fed has produced estimates of the US r-star dating back to the 1960s. The gap between the real fed funds rate and that r-star estimate has typically been fairly well correlated to the slope of the Treasury curve (Chart 11). When the real fed funds rate is below r-star, indicating that the policy is accommodative, the Treasury curve is usually steepening, and vice versa. Under this framework, the recent flattening trend of the Treasury curve would indicate that policy is actually getting tighter, despite the falling, and deeply negative, real fed funds rate of -5.4% (deflated by core inflation). Chart 11UST Curve Slope Is Positively Correlated To The 'Real Policy Gap' UST Curve Slope Is Positively Correlated To The 'Real Policy Gap' UST Curve Slope Is Positively Correlated To The 'Real Policy Gap' The last known estimate of r-star from the New York Fed was 0%, but no update has been provided for almost two years. Blame the pandemic for that. The sharp lockdown-fueled collapse in US GDP growth in 2020, and the rapid recovery in growth as the economy reopened, made it impossible to estimate the the “neutral” level of real interest rates given such massive swings in demand that were not related to monetary policy. One way to try and “back out” the implicit pricing of r-star currently embedded in US Treasury yields is to estimate a model linking the gap between the real fed funds rate and r-star to the slope of the Treasury curve. We did just that, with the results presented in Chart 12. This model estimates the “Real Policy Gap”, or r-star minus the real fed funds rate, as a function of the 2/10 Treasury curve slope. In other words, the model shows the Real Policy Gap that is consistent with the current slope of the curve. Chart 12Current UST Yield Curve Makes Slope Sense ... If The Fed Followed The Taylor Rule With 7% Inflation Current UST Yield Curve Makes Slope Sense ... If The Fed Followed The Taylor Rule With 7% Inflation Current UST Yield Curve Makes Slope Sense ... If The Fed Followed The Taylor Rule With 7% Inflation The model estimates that the current 2/10 curve slope is consistent with a Real Policy Gap of 96bps. With US core CPI inflation currently at 5%, and assuming r-star is still 0% as per the last New York Fed estimate, the fed funds rate would have to rise to 4% to justify the current slope of the 2/10 curve. While that may sound like an implausibly large increase in the funds rate, similar results are produced using straightforward Taylor Rules.2 We can also use our Real Policy Gap model to infer the level of inflation that is consistent with a Gap of 96bps, for various combinations of the funds rate and r-star. Those are shown in Table 1. Assuming the funds rate rises in line with current market expectations to 1.7% and r-star remains close to 0%, the current slope of the 2/10 Treasury curve suggests a fall in US inflation to just around 3% - still above the Fed’s inflation target - from the current 5%. Table 1The UST Curve Slope Has Already Discounted A Big Drop In US Inflation Deciphering The Messages From The US Treasury Curve Deciphering The Messages From The US Treasury Curve We see this as the most plausible reason for the relatively flat level of the 2/10 US Treasury curve. Markets expect somewhat lower US inflation and a moderate rise in the funds rate over the next couple of years, making the real funds rate less negative but not pushing it above a negative r-star expectation. This would suggest upside risk for US Treasury yields, and potential bearish steepening pressure, as markets come to realize that the neutral real fed funds rate is actually positive, not negative. Fight The Forwards, Stay In US Treasury Curve Steepeners While it may sound counter-intuitive with the Fed set to begin a rate hiking cycle, we continue to see better value in tactically positioning in US Treasury curve steepening trades. Specifically, we are keeping our recommended trade in our Tactical Overlay on page 19, where we are long a 2-year Treasury bullet versus a duration-neutral barbell of cash (a 3-month US Treasury bill) and a 10-year Treasury bond. The trade is currently underwater, but we see good reasons to expect the performance to rebound over the next few months. The front end of the curve now discounts more hikes than we expect will unfold in 2022, which should limit further increases in the 2-year Treasury yield. At the same time, the 10-year yield looks too low relative to the expected cyclical peak for the fed funds rate (Chart 13). One way we can assess this is by comparing 5-year/5-year forward Treasury rates to survey estimates of the longer run, or terminal, fed funds rate. The median FOMC forecast (or “dot”) for the terminal funds rate is 2.5%, the median terminal rate forecast from the New York Fed’s Survey of Primary Dealers is 2.25% and the median terminal rate forecast from the New York Fed’s Survey of Market Participants is 2%. This sets a range of estimates of the longer-run terminal rate of 2-2.5%, in line with the current expectations of the BCA Research bond services. The current 5-year/5-year forward Treasury rate is 2.0%, at the low end of that range. We see those forwards rising to the upper part of that 2-2.5% range by the end of 2022, which will push the 10-year Treasury yield toward our year-end target of 2.25%. Chart 13The 5-Year/5-Year UST Forward Rate Is Too Low The 5-Year/5-Year UST Forward Rate Is Too Low The 5-Year/5-Year UST Forward Rate Is Too Low ​​​​​​ Chart 14Stay In UST Curve Steepeners, Even With Fed Liftoff Imminent Stay In UST Curve Steepeners, Even With Fed Liftoff Imminent Stay In UST Curve Steepeners, Even With Fed Liftoff Imminent ​​​​​​ Some of our colleagues within the BCA family see the longer-term neutral funds rate as considerably higher than survey estimates, perhaps as high as 3-4%. We are sympathetic to that view, but it will take signs of US economic resiliency in the face of rate hikes before bond investors – and more importantly, the Fed – arrive at that conclusion. This would make steepening trades more attractive on a strategic, or medium-term, basis as the market realizes that the Fed is further behind the policy curve (i.e. the funds rate even further below a higher terminal rate) than previously envisioned. For now, we do not see the US Treasury curve flattening at the pace discounted in the Treasury forward curve over the next 3-6 months (Chart 14, top panel). However, this will be more of a carry trade by betting against the forwards over time. A bearish steepening of the Treasury curve with a swift upward move in the 10-year Treasury yield is less likely with bond investor/trader positioning already quite short (bottom two panels).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com       Footnotes 1      The term premium estimates shown here are derived from our own in-house framework. For those familiar with the various term premium estimates on the 10-year US Treasury yield produced by the Fed, our estimates are currently in line with those produced by the ACM model and the Kim & Wright model. 2     A fun US Taylor Rule calculator, which can be used to generate Taylor Rules under a variety of assumptions, is available on the Atlanta Fed’s website here. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Deciphering The Messages From The US Treasury Curve Deciphering The Messages From The US Treasury Curve The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades