Inflation/Deflation

Next week, on September 7-8, is the BCA New York Conference, the first in-person version since 2019. I look forward to seeing many of you there, and if you haven’t already booked your place, you still can! (a virtual version is also available). As such, the next Counterpoint report will come out on September 15. Executive Summary The 2022-23 = 1981-82 template for markets is working well. If it continues to hold, these are the major investment implications: Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential correction that lifts the yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023. Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals. Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023. Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85, though our central case is $55 in 2023.  If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Bottom Line: The 2022-23 = 1981-82 template for markets is working well, and should continue to do so. Feature History doesn’t repeat, but it does rhyme. And the period that rhymes closest with the current episode in the global economy and markets is 1981-82, a rhyming which we first highlighted four months ago in Markets Echo 1981, When Stagflation Morphed Into Recession, and then developed in More On 2022-23 = 1981-82, And The Danger Ahead. In those reports, we presented three compelling reasons why 2022-23 rhymes with 1981-82: 1981-82 is the period that rhymes closest with the current episode in the global economy and markets. First, the simultaneous sell-off in stocks, bonds, inflation protected bonds, industrial commodities, and gold in the second quarter of 2022 is uniquely linked with an identical ‘everything sell-off’ in the second quarter of 1981. It is extremely rare for stocks, bonds, inflation protected bonds, industrial commodities, and gold to sell off together. Such a simultaneous sell-off has happened in just these 2 calendar quarters out of the last 200. Meaning a ‘1-in-a-100’ event conjoins 2022 with 1981 (Chart I-1 and Chart I-2). Chart I-1A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... Chart I-2...And The 'Everything Sell-Off' In 1981 ...And The 'Everything Sell-Off' In 1981 ...And The 'Everything Sell-Off' In 1981 Second, the Jay Powell Fed equals the Paul Volcker Fed. Now just as then, the world’s central banks are obsessed with ‘breaking the back’ of inflation. And now, just as then, the central banks are desperate to repair their badly battered credibility in managing inflation. Third, the Russia/Ukraine war that started in February 2022 equals the Iraq/Iran war that started in September 1980. Now, just as then, a war between two commodity producing neighbours has unleashed a supply shock which is adding to the inflation paranoia. To repeat, it is a 1-in-a-100 event for all financial assets to sell off together. This is because it requires an extremely rare star alignment. Inflation fears first morph to stagflation fears and then to recession fears. Leaving investors with nowhere to hide, as no mainstream asset performs well in inflation, stagflation, and recession. So, the once-in-a-generation star alignment conjoining 2022 with 1981 is as follows: Inflation paranoia is worsened by a major war between commodity producing neighbours, forcing reputationally damaged central banks to become trigger-happy in their battle against inflation, dragging the world economy into a coordinated recession. September 2022 Equals August 1981 If 2022-23 = 1981-82, then where exactly are we in the analogous episode? There are two potential synchronization points. One potential synchronization is that the Russia/Ukraine war which started on February 24, 2022 equals the Iraq/Iran war which started on September 22, 1980. In which case, September 2022 equals April 1981. But given that inflation is public enemy number one, a better synchronization is the Fed’s preferred measure of underlying inflation, the US core PCE deflator. Aligning the respective peaks in core PCE inflation, we can say that February 2022 equals January 1981. Meaning that our original report in May 2022 aligned with April 1981, and September 2022 equals August 1981 (Chart I-3 and Chart I-4). Chart I-3The Peak In Core PCE Inflation In ##br##February 2022 The Peak In Core PCE Inflation In February 2022 The Peak In Core PCE Inflation In February 2022 Chart I-4...Aligns With The Peak In Core PCE Inflation In ##br##January 1981 ...Aligns With The Peak In Core PCE Inflation In January 1981 ...Aligns With The Peak In Core PCE Inflation In January 1981 In which case, how has the template worked since we introduced it on May 19th? The answer is, very well. The template predicted that the long bond price would track sideways, which it has. The template predicted that the S&P 500 would decline from 4200 to 4000, which it has. The template predicted that the copper price would decline from $9250/MT to $8500/MT. In fact, it has fallen even further to $8200/MT. In the case of oil, the better synchronization is the starts of the respective wars. This template predicted that the Brent crude price would decline sharply from a knee-jerk peak in the $120s, which it has. Not a bad set of predictions! If 2022-23 = 1981-82, Here’s What Happens Next Assuming the template continues to hold, here are the major implications for investors: Bond prices will enter a sustained rally in 2023. Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential tactical correction that takes its yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023 in which the 30-year T-bond yield will fall to sub-2.5 percent (Chart I-5). Chart I-5If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500 in the coming months. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023 (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023 (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85 (Chart I-9) though our central case is $55 in 2023.  Chart I-9If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price But What If 2022-23 Doesn’t = 1981-82? And yet, and yet…what if the Jay Powell Fed doesn’t equal the Paul Volcker Fed? What if central banks lose their nerve before inflation is slayed? Long bond yields could gap much higher, or at least not come down, causing a completely different set of investment outcomes. In this case, the correct template would not be 1981-82, but the 1970s. If central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. However, there is one huge difference between now and the 1970s, which makes that template highly unlikely. In the 1970s, the global real estate market was worth just one times world GDP, whereas today it has become a monster worth four times world GDP, and whose value is highly sensitive to the long bond yield. In the US, the mortgage rate has surged to well above the rental yield for the first time in 15 years. Simply put, it is now more expensive to buy than to rent a home, causing a disappearance of would be homebuyers, a flood of home-sellers, and an incipient reversal in home prices (Chart I-10). Chart I-10If Bond Yields Don't Come Down, Then House Prices Will Crash If Bond Yields Don't Come Down, Then House Prices Will Crash If Bond Yields Don't Come Down, Then House Prices Will Crash Hence, if long bond yields were to gap much higher, or even stay where they are, it would trigger a housing market crash whose massive deflationary impulse would swamp any inflationary impulse. The upshot is that the 2022-23 = 1981-82 template would suffer a hiatus. Ultimately though, it would come good, because a crash in the $400 trillion global housing market would obliterate inflation. In other words, if central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. Fractal Trading Watchlist As just discussed, copper’s tactical rebound is approaching exhaustion. This is confirmed by the 130-day fractal structure of copper versus tin reaching the point of extreme fragility that has consistently marked turning-points in this pair trade (Chart I-11). Chart I-11Copper's Tactical Rebound Is Exhausted Copper's Tactical Rebound Is Exhausted Copper's Tactical Rebound Is Exhausted Hence, this week’s recommendation is to short copper versus tin, setting the profit target and symmetrical stop-loss at 12 percent.   Chart 1Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Chart 2Copper Is Experiencing A Tactical Rebound Copper Is Experiencing A Tactical Rebound Copper Is Experiencing A Tactical Rebound Chart 3US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 11The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 12A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 13Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary The US dollar has become expensive, but it is not unusual for currencies to overshoot or undershoot their fair value. Valuation is not an effective market timing tool. In the US, high interest rates and a strong exchange rate are needed to bring down inflation. The US dollar will remain firm as long as the Fed maintains its credibility in the fight against inflation. China needs lower interest rates and a weaker currency to battle deflationary pressures. The PBoC will continue cutting interest rates. Persistent divergence between Chinese and US monetary policies heralds further yuan depreciation against the dollar. For a number of EM countries, exchange rate fluctuations have historically determined trends in their interest rates rather than the other way around (i.e., interest rates dictating EM currency trends). Shrinking global trade will boost the US dollar while EM currencies will depreciate further. The US Dollar Is Expensive But Could Still Overshoot The US Dollar Is Expensive But Could Still Overshoot The US Dollar Is Expensive But Could Still Overshoot Bottom Line: We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN and IDR. In addition, we recommend shorting HUF vs. CZK, KRW vs. JPY, and BRL vs. MXN. Macro forces that are bullish for the US dollar are bearish for global equities and other risk assets. A defensive investment stance is still warranted. Feature The US dollar is now in expensive territory (Chart of the week above) but we maintain our view that the US dollar is poised to overshoot. Chart 1EM Currencies Are Breaking Down EM Currencies Are Breaking Down EM Currencies Are Breaking Down BCA’s Emerging Markets Strategy team has been structurally bullish on the US dollar since 2011, with a brief period during which we sidestepped our positive view from July 9, 2020 until late March 2021 (Chart 1). We then re-instated short positions in select EM currencies versus the US dollar on March 25, 2021. This strategy has paid off. In this report, we discuss reasons why we expect the greenback to continue overshooting in the near run. Currency Valuations In Appendix 1 we present our valuation models for various currencies using the real effective exchange rate (REER) based on unit labor costs. In our opinion, the REER based on unit labor costs is the most accurate measure of exchange rate valuation. The basis is that it takes into account both wages and productivity. Labor costs are the largest cost component for many companies, and unit labor costs are critical to competitiveness. Hence, this measure is superior to the ones based on CPI and PPI. Table 1Currency Valuation Ranking Using Real Effective Exchange Rate Based on Unit Labor Costs* The US Dollar Will Overshoot, EM Currencies Will Undershoot The US Dollar Will Overshoot, EM Currencies Will Undershoot The underlying data for the REER based on unit labor costs are from the IMF and OECD. Unfortunately, the IMF and OECD do not provide REER based on unit labor costs for many emerging economies. Appendix 1 contains valuation indicators for those EM exchange rates (MXN, CLP, COP, KRW, SING, PLN, HUF and CZK) for which IMF or OECD data is available. Charts 15-17 in the appendix show that the US dollar is currently more than one standard deviation above its fair value. Meanwhile, the euro and yen are extremely cheap – each standing at more than one standard deviation below their respective fair value.   Table 1 shows the valuation ranking of various currencies using REER based on unit labor costs. For mainstream EM currencies, excluding China, Russia, Korea and Taiwan, we have built valuation aggregates using an average REER based on CPI and PPI measures. Chart 2 presents an equal-weighted aggregate REER based on CPI and PPI for 15 EM currencies. This indicator does not suggest that mainstream EM currencies are cheap. Finally, the same indicator − REER based on CPI and PPI – for the Chinese yuan reveals that the currency is modestly cheap (0.8 standard deviation below its mean) (Chart 3). Chart 2Mainstream EM Currencies Are Not Cheap Mainstream EM Currencies Are Not Cheap Mainstream EM Currencies Are Not Cheap Chart 3The RMB Is Modestly Cheap But Might Undershoot The RMB Is Modestly Cheap But Might Undershoot The RMB Is Modestly Cheap But Might Undershoot   While we acknowledge that the US dollar is expensive, we continue to expect the greenback to overshoot over the coming months. First, valuations matter only at extremes. Most currencies (other than the yen and the euro) are not cheap. For example, Charts 21-24 (in the Appendix) demonstrate that commodity currencies including AUD, NZD, and NOK are on the expensive side, while the Canadian dollar is fairly valued. Second, our macro themes – a hawkish Fed and contracting global trade (discussed below) − call for a stronger greenback. Finally, our Foreign Exchange Strategy team has shown that momentum indicators work well for currency trading in the short term. Bottom Line: The US dollar has become expensive, but it is not unusual for currencies to overshoot or undershoot their fair value. Valuation is not an effective market timing tool. Presently, the US dollar's momentum is strong and it will likely continue supporting the currency's upward trajectory. Monetary Policy Divergence Chart 4US Core Inflation Is Well Above 2% US Core Inflation Is Well Above 2% US Core Inflation Is Well Above 2% The US economy is relatively less exposed to headwinds from rising interest rates than the rest of the world. This dynamic favors the US dollar against other currencies. US: We view US inflation as genuine and entrenched. The average of seven measures of underlying inflation remains very elevated at 5.5% (Chart 4). In the US, high interest rates and a strong exchange rate are needed to bring down inflation. As long as the Fed remains committed to bringing down inflation, the US dollar will be firm. The US dollar will plummet if the Fed turns dovish prematurely. The basis is that US inflation expectations will spike and real interest rates will tumble, which will weigh on the dollar. Although the Fed might eventually pivot earlier than needed, this policy shift is not imminent. China: In contrast with the US, China’s inflation is too low: core and services CPI inflation have rolled over and are below 1% (Chart 5). The mainland economy is extremely weak, and the property market is struggling. China needs lower interest rates and a weaker currency to battle deflationary pressures. The PBoC will continue cutting interest rates. Persistent divergence between Chinese and US monetary policies heralds further yuan weakness against the dollar (Chart 6). Chart 5China's Inflation Is Too Low And Falling China's Inflation Is Too Low And Falling China's Inflation Is Too Low And Falling Chart 6The CNY Will Depreciate Versus The USD The CNY Will Depreciate Versus The USD The CNY Will Depreciate Versus The USD     A weakening RMB versus the US dollar is typically associated with declining commodity prices (Chart 7). Falling commodity prices will weigh on commodity currencies. The yuan depreciation will also continue reinforcing the downtrend in emerging Asian currencies. Mainstream EM: For many emerging markets, interest rates do not explain fluctuations in their currencies. In developing countries that run current account deficits and/or rely on foreign capital, interest rates rise when their exchange rates plummet (Chart 8). Chart 7CNY Depreciation = Lower Commodity Prices CNY Depreciation = Lower Commodity Prices CNY Depreciation = Lower Commodity Prices Chart 8Interest Rates Do Not Drive EM FX Interest Rates Do Not Drive EM FX Interest Rates Do Not Drive EM FX   On the flip side, appreciating EM currencies unleash disinflationary pressures in their domestic economies, giving room for central banks to cut rates. Therefore, for EM economies that are dependent on global capital, it is exchange rates that have historically dictated interest rate dynamics, rather than the other way around. Continental Europe: The European economy is hamstrung by extremely high energy prices and rising interest rates. Importantly, wages in Europe are not rising as fast as they are in the US. Household real disposable income is falling faster in Europe than it is in the US. Plus, the continental European economy is more exposed than the US to global trade − which is about to contract (more on this below). Thus, the European economy has a reduced capacity to absorb higher borrowing costs vis-a-vis the US. Consequently, the real interest rate differential will continue moving in favor of the US, supporting the greenback versus the euro. The Anglo-Saxon block: The US economy will prove to be more resilient to higher borrowing costs than many other DM economies such as the UK, Australia, New Zealand and Canada. As a result, the interest rate differential will move in favor of the US dollar. Chart 9US Households Have Deleveraged US Households Have Deleveraged US Households Have Deleveraged In many of these countries, the household debt burden is higher than it is in the US. In fact, US consumer debt and debt servicing have fallen significantly over the past 15 years (Chart 9). Importantly, a considerable portion of outstanding mortgages in the UK, Australia, New Zealand and Canada have either a floating rate or a fixed rate for only a few years. As borrowing costs rise, consumer finances in these countries will experience material distress. By comparison, the majority of outstanding US mortgages are fixed for 30 years or so. Hence, rising borrowing costs hurt new American homebuyers but do not impact existing mortgage holders. Bottom Line: On a relative basis, the US is in a better position to absorb higher interest rates than many other economies. As a result, the interest rate differential will move in favor of the US over the rest of the world, hence, supporting the greenback in the near run. Shrinking Global Trade Is Bullish For The US Dollar The US dollar is a counter-cyclical currency, and it will continue to appreciate as the global manufacturing cycle slows (Chart 10).  The rationale is that manufacturing and exports constitute a smaller share of GDP in the US than in many other major economies. What if Fed over-tightening, causes a recession and pushes down US interest rates considerably? Would the US dollar plunge in this case? We do not believe so. Instead, a recession could be positive for the broad trade-weighted dollar. As US domestic demand and consumption shrink, its imports will also drop. The US dollar often rallies when the nation’s imports are contracting (Chart 11). Chart 10The US Dollar Is A Counter-Cyclical Currency The US Dollar Is A Counter-Cyclical Currency The US Dollar Is A Counter-Cyclical Currency Chart 11Shrinking US Imports = Rising US Dollar Shrinking US Imports = Rising US Dollar Shrinking US Imports = Rising US Dollar   Dwindling imports mean that the US will be emitting fewer dollars to the rest of the world. Global US dollar liquidity will continue to shrink, and the greenback will rally further, including against EM currencies (Chart 12). Bottom Line: As global trade shrinks, the US dollar will extend its rally. Mainstream EM Currencies In the long run, return on capital – not interest rate differentials – drive mainstream EM currencies. Chart 12 illustrates that EM currencies depreciate when their return on equity differential versus the US is negative and vice versa. In turn, the key driver of return on capital is productivity. Productivity growth has been downshifting across mainstream EMs since 2007 (Chart 13). Chart 12Tightening Global USD Liquidity = A Strong US Dollar Tightening Global USD Liquidity = A Strong US Dollar Tightening Global USD Liquidity = A Strong US Dollar Chart 13EM vs. US: Relative Return On Capital And Exchange Rates EM vs. US: Relative Return On Capital And Exchange Rates EM vs. US: Relative Return On Capital And Exchange Rates       Weak productivity growth and lower return on capital (versus the US) explain EM currency and equity underperformance since 2010. We have not yet detected a major change in EM fundamentals. Investment Strategy Chart 14Weak EM Productivity = EM Currency Depreciation Weak EM Productivity = EM Currency Depreciation Weak EM Productivity = EM Currency Depreciation The US dollar will overshoot in the near term. We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN and IDR. In addition, we recommend shorting HUF vs. CZK, KRW vs. JPY, and BRL vs. MXN. When the dollar appreciates it is neither the time to be long EM risk assets in absolute terms nor to be overweight EM in global equity and fixed-income portfolios. We continue underweighting EM in global equity and credit portfolios. EM local currency bonds offer value, but further currency depreciation and more rate hikes by their central banks are near-term risks to EM domestic bonds. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Appendix   Chart 15The US Dollar The US Dollar The US Dollar Chart 16The Japanese Yen The Japanese Yen The Japanese Yen Chart 17The Euro The Euro The Euro Chart 18The British Pound The British Pound The British Pound Chart 19The Swiss Franc The Swiss Franc The Swiss Franc Chart 20The Swedish Krona The Swedish Krona The Swedish Krona Chart 21The Norwegian Krone The Norwagain Krone The Norwagain Krone Chart 22The Canadian Dollar The Canadian Dollar The Canadian Dollar Chart 23The Australian Dollar The Australian Dollar The Australian Dollar Chart 24The New Zealand Dollar The New Zealand Dollar The New Zealand Dollar Chart 25The Korean Won The Korean Won The Korean Won Chart 26The Singapore Dollar The Singapore Dollar The Singapore Dollar Chart 27The Mexican Peso The Mexican Peso The Mexican Peso Chart 28The Chilean Peso The Chilean Peso The Chilean Peso Chart 29The Colombian Peso The Colombian Peso The Colombian Peso Chart 30The Polish Zloty The Polish Zloty The Polish Zloty Chart 31The Hungarian Forint The Hungarian Forint The Hungarian Forint Chart 32The Czech Koruna The Czech Koruna The Czech Koruna Footnotes   Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Executive Summary Low-Yielding Countries Facing High USD Hedging Costs Low-Yielding Countries Facing High USD Hedging Costs Low-Yielding Countries Facing High USD Hedging Costs The US dollar will remain strong alongside continued Fed rate hikes. Interest rate differentials will remain positive for the greenback, alongside other USD-positive factors like slowing global growth and rising investor risk aversion. Relatively high US interest rates have made hedging away US currency risk very expensive for some of the largest holders of US Treasuries like Japan. US Treasury yields, on an FX-hedged basis, look unattractive relative to local currency denominated bonds across the developed world. Increased foreign demand for US Treasuries evident in the US TIC data appears to reflect a re-establishment of positions unwound by global hedge funds and mutual funds dating back to the 2020 “dash for cash” in global financial markets. UST yields must rise even further versus non-US yields to attract more fundamental buyers like Japanese and European institutional investors, given elevated volatility in both US Treasury prices and the dollar. Bottom Line: Global investors should continue to underweight US Treasuries in global bond portfolios, on both a currency-unhedged and USD-hedged basis. Feature Dear Client, The schedule for the next two Global Fixed Income Strategy reports will be impacted by the upcoming Labor Day holiday and next week’s BCA’s annual conference in New York (I hope to see you there!). This Friday, September 2, we will be publishing a joint report with our colleagues at Foreign Exchange Strategy discussing Japan. On Monday, September 12, we will be publishing another joint report with our colleagues at European Investment Strategy, covering estimates of global neutral interest rates. -Rob Robis The title of our report from four weeks ago was “Dovish Central Bank Pivots Will Come Later Than You Think.” This could have also been the title for Fed Chair Jerome Powell's Jackson Hole speech. He reiterated the Fed’s commitment to tighten policy further and “keep at it” until the US economy slows enough to bring down inflation. Other central bankers who spoke at the conference had a similar tone to Powell, talking up an ongoing inflation fight that will require much slower growth and higher unemployment. Related Report  Global Fixed Income StrategyRecent USD Strength Is Not Bond Bullish By quickly and bluntly dispensing any notion that the Fed could soon pause its rate hiking cycle, Powell poured ice cold water on the risk asset rally that boosted the S&P 500 by nearly 17% between mid-June and mid-August. The S&P 500 plunged 3.4% after Powell’s speech, a tightening of US financial conditions that was likely welcomed by the Fed, as it helps their goal of slowing the US economy. Minneapolis Fed President Neil Kashkari even said he was “happy” to see the negative market reaction to Powell’s speech. Powell, Kashkari and the rest of the FOMC are probably happy over the strength of the US dollar, which is also helping tighten US financial conditions – while also having a major impact on global bond returns and currency hedging decisions for investors. A Collision Of A USD Bull Market & Global Bond Bear Market Chart 1A Big Move In The USD A Big Move In The USD A Big Move In The USD The current strength of the US dollar is becoming increasingly broad-based. The EUR/USD exchange rate has fallen below parity, while USD/JPY continues to flirt with the 140 level (Chart 1). The British pound is trading at a 2-year low versus the US dollar, many important emerging market (EM) currencies are struggling, and the Chinese renminbi is set to retest the 7.0 level. The strength of the US dollar is no recent phenomenon. The current uptrend dates back to the start of 2021, with the DXY dollar index up 21% since then. The dollar bull market has been supported by several factors, most critically rising US interest rates. The 2-year US Treasury yield started 2021 just above 0% and now sits at 3.4%. Higher US interest rates have raised the benefit of hedging currency risk into US dollars for global bond investors. The Bloomberg Global Aggregate Bond Index in USD-hedged terms has outperformed the unhedged version of the index by 6.3% over the past year, one of the largest such increases dating back to 2000 (Chart 2). This means that global bond investors have been paid handsomely to simply swap non-US bond exposures into US dollars – in some cases, making low-yielding assets like Japanese government bonds (JGBs), hedged from yen into dollars, comparable to US Treasury yields. Chart 2Big Gains From Hedging Global Bond Exposure Into USD Big Gains From Hedging Global Bond Exposure Into USD Big Gains From Hedging Global Bond Exposure Into USD This wedge between USD-hedged and unhedged bond returns is unlikely to reverse soon, as the fundamental drivers of the dollar remain biased to more dollar strength. The US dollar is not only supported by more favorable interest rate differentials versus other currencies (both in nominal and inflation-adjusted terms), but is also benefitting from its safe haven status at a time of considerable uncertainty on the future of the global economy (Chart 3). Global growth expectations are depressed and showing no signs of turning around anytime soon, particularly in Europe and the UK where electricity and gas prices are climbing at a record pace. The dollar not only typically appreciates during periods of slowing growth, but also during episodes of investor risk aversion. Investors remain cautious, according to indicators like the US equity put/call ratio which shows greater demand for downside protection via puts – an outcome that also typically coincides with a stronger US dollar. In this current environment of broad-based US dollar strength, the gap between hedged and unhedged bond returns has varied widely depending on the base currency of the investor. For a euro-based investor, the performance gap between the unhedged Global Aggregate index and the EUR-hedged index has been 6% over the past year (Chart 4). Chart 3USD Strength Supported By Key Fundamental Drivers USD Strength Supported By Key Fundamental Drivers USD Strength Supported By Key Fundamental Drivers ​​​​​​ Chart 4FX Hedging Decisions Mean Everything In A Global Bond Bear Market FX Hedging Decisions Mean Everything In A Global Bond Bear Market FX Hedging Decisions Mean Everything In A Global Bond Bear Market ​​​​​ Chart 5Low-Yielding Countries Facing High USD Hedging Costs Low-Yielding Countries Facing High USD Hedging Costs Low-Yielding Countries Facing High USD Hedging Costs The gap has been even larger for yen-based investors, with the unhedged index beating the JPY-hedged index by a whopping 13% over the past twelve months. Although Japanese fixed income investors are not typically known for taking unhedged currency risk on foreign bond holdings, doing so would have turned an awful year of global bond returns into a great year, simply due to yen weakness. When looking at current levels of interest rate differentials versus the US, which are the main determinant of currency hedging costs, the low yielding currencies like the euro, yen and Swiss franc see the greatest gain on returns versus the high-yielding US dollar (Chart 5). Hedging euros into dollars results in an annualized pickup of 252bps, while hedging yen into dollars produces an even bigger gain of 327bps. At the same time, the USD-hedging gains for relatively higher yielders are much lower. Hedging Australian dollars into US dollars only produces an annualized gain of 48bps, while hedging Canadian dollars into US dollars produces an annualized loss of -18bps. These varying hedging costs matter for global bond investors, as they impact the attractiveness of an individual country’s bond yields, depending on the investor’s base currency. We show the unhedged yield levels, and currency-hedged yield levels for six main developed market base currencies (USD, EUR, JPY, GBP, CAD, AUD) in the tables on the next two pages. Table 1 shows 2-year government bond yields, Table 2 shows 5-year government bond yields, Table 3 shows 10-year government bond yields and Table 4 shows 30-year government bond yields. Unsurprisingly, hedging into euros and yen, where short-term interest rates are the lowest, produces the smallest yields. Meanwhile, hedging into higher-rate currencies like US dollars and Canadian dollars generates the highest yields. Table 1Currency-Hedged 2-Year Government Bond Yields Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors Table 2Currency-Hedged 5-Year Government Bond Yields Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors Table 3Currency-Hedged 10-Year Government Bond Yields Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors Table 4Currency-Hedged 30-Year Government Bond Yields Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors We take the analysis a step further in the next set of tables on pages 9-11. Here, we take the hedged yields for each currency and compare them to the yields of the base currency. For example, in Table 5, it can be seen that a 2-year US Treasury yield of 3.4%, hedged into euros, produces a yield of 0.82% that is -17bps below the 2-year German yield (which is obviously denominated in euros). In other words, from the point of view of a euro-based investor who wants to hedge away the currency risk in a global bond portfolio, he gets paid a bit more to own a German bond over a US Treasury. Table 5Currency-Hedged 2-Year Govt. Bond Yield Spreads Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors Similar results are shown in the subsequent tables for 5-year yields (Table 6), 10-year yields (Table 7) and 30-year yields (Table 8). From these tables, we can make the following broad conclusions: Table 6Currency-Hedged 5-Year Govt. Bond Yield Spreads Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors Table 7Currency-Hedged 10-Year Govt. Bond Yield Spreads Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors Table 8Currency-Hedged 30-Year Govt. Bond Yield Spreads Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors For USD-based bond investors, all non-US markets except Canada have a yield pickup over US Treasuries on an FX-hedged basis For EUR-based investors, all non-euro area markets except Australia produce yields lower than those of Germany on an FX-hedged basis For GBP-based investors, all non-UK bond markets except the US and Canada have yields greater than those of Gilts for maturities from 5-30 years (the results are more mixed across countries for 2-year yields) For JPY-based investors, euro area and Australian bonds are clearly more attractive than JGBs on an FX-hedged basis, while US Treasuries, UK Gilts and Canadian government bonds offer FX-hedged yields below puny JGB yields. This is true up to the 10-year maturity point, as 30-year JGB yields – which are not targeted by the Bank of Japan in its yield curve control program – are much higher than those on the rest of the JGB curve For CAD-based investors, hedging virtually all non-Canadian bonds into CAD results in yields that are higher than Canadian government bond yields, with the largest hedged yield advantage for euro area and Australian bonds For AUD-based investors, only euro area bonds offer a consistent yield pickup over Australian government bonds on an FX-hedged basis. Broadly speaking, government bonds in the euro area and Australia offer consistently attractive FX-hedged yield pickups over the unhedged bonds for all currencies shown in the tables. On the other hand, Canadian government bonds have consistently less attractive FX-hedged yields across all currencies shown. Perhaps most importantly, US Treasuries look unattractive on an FX-hedged basis to all but CAD-based investors – a result that has meaningful implications for the potential of foreign buying to help stem the rise of US bond yields. Bottom Line: The US dollar bull market is having a huge influence on global bond returns. US Treasury yields, on an FX-hedged basis, look unattractive relative to most local currency denominated bonds across the developed world. Who Are The Foreign Buyers Of US Treasuries? When simply looking at currency-unhedged yield spreads, US Treasury yields offer particularly inviting yields over low-yielding (and low “beta” to US yields) markets like Germany and Japan. The unhedged 10-year US-Germany spread is now 160bps, while the unhedged US-Japan spread is up to 286bps (Chart 6). Meanwhile, among high-beta markets, the US-Canada 10-year spread is flat on an FX-unhedged basis, while an unhedged Australian 10-year bond yields 56bps more than a 10-year US Treasury. Chart 6UST Yields Only Look Attractive In FX-Unhedged Terms UST Yields Only Look Attractive In FX-Unhedged Terms UST Yields Only Look Attractive In FX-Unhedged Terms Yet after factoring in the currency hedging costs shown earlier, US Treasuries look consistently unattractive versus the other major developed economy bond markets. Chart 7UST Yields Look Unattractive After Hedging Out USD Exposure UST Yields Look Unattractive After Hedging Out USD Exposure UST Yields Look Unattractive After Hedging Out USD Exposure ​​​​​ A 10-year US Treasury hedged into euros now yields -77bps less than a 10-year German bund, at the low end of the historical range for this spread dating back to 2000 (Chart 7). A 10-year Treasury hedged into GBP and JPY also offers lower yields versus 10-year UK Gilts (-11bps) and 10-year JGBs (-50bps), respectively. The 10-year hedged US-Australia spread (with the US yield hedged into AUD) is also at a stretched negative extreme at -114bps (Chart 8). Despite these broadly unattractive hedged US yield spreads, the US Treasury market has seen significant foreign inflows this year, according to the US Treasury Department’s capital flow (TIC) data. Total net purchases of US Treasuries by foreign buyers accelerated to $470bn (on a 12-month rolling total basis) as of the latest data for June (Chart 9). When broken down by type of buyer, private buyers bought a net $619bn, while official buyers were net sellers to the tune of -$149bn. Chart 8No Compelling Yield Advantage To Owning FX-Hedged USTs No Compelling Yield Advantage To Owning FX-Hedged USTs No Compelling Yield Advantage To Owning FX-Hedged USTs When looking at the TIC data by country, China was an important net seller of -$18bn of Treasuries. This is consistent with the reduced demand for US dollar assets from China, where policymakers are actively targeting a weaker renminbi. Chart 9TIC Data Shows USTs Seeing Foreign Buying (Ex-China) TIC Data Shows USTs Seeing Foreign Buying (Ex-China) TIC Data Shows USTs Seeing Foreign Buying (Ex-China) ​​​​​ There was also net selling from many EM countries that have seen reduced trade surpluses and, hence, fewer US dollars to recycle into Treasuries. Chart 10Even Higher UST Yields Needed To Entice Japanese & European Buyers Even Higher UST Yields Needed To Entice Japanese & European Buyers Even Higher UST Yields Needed To Entice Japanese & European Buyers The largest net buying (Chart 10) was seen from the UK (+$306bn) and Cayman Islands (+$154bn) – the latter being a large source of Treasury buying through hedge funds and offshore investment funds located there. Those two countries accounted for almost all of the net foreign inflows into Treasuries, despite the fact they only hold a combined 12% of all foreign US Treasury holdings. There was modest net buying from the euro area (+$37bn) and small net selling by the country with the largest stock of US Treasury holdings, Japan. The relatively subdued inflows from Europe, and lack of inflows from Japan, are consistent with the unattractive hedged US-Europe and US-Japan yield spreads shown earlier, particularly at a time of elevated US bond yield volatility. The huge inflows from the UK and Cayman Islands are harder to explain on a fundamental basis, but are likely due to a continued normalization of Treasury market liquidity after the spring 2020 “dash for cash”. In a report published back in January, Fed researchers analyzed foreign demand for US Treasuries around the worst of the COVID pandemic shock in 2020. The report concluded that the huge collapse in private inflows into Treasuries – from a peak of +$238bn at the start of 2020 to a trough of -$373bn at the end of 2020 – was the result of aggressive net selling by hedge funds and global mutual funds. These are exactly the types of investors that would be domiciled in the Cayman Islands and UK (London). Specifically, the Fed report noted that: “In short, two prominent reasons for the large sales are the unwind of the Treasury basis trade by hedge funds (including foreign-domiciled funds) and the sudden, massive investor outflows from mutual funds that caused these funds to sell their most liquid assets, U.S. Treasury securities, to meet these redemptions.” The “basis trade” mentioned likely involved buying cash Treasuries versus selling Treasury futures, attempting to exploit unsustainable price differences between the two. As market liquidity conditions dried up in the spring of 2020 during the first wave of global lockdowns, leveraged bond investors needed to frantically unwind positions. For Treasury basis trades, that would have involved selling cash Treasuries, which was likely what is being picked up in the TIC data from the Cayman Islands which showed a huge plunge in net buying in 2020. The mutual fund outflows were likely a global phenomenon, but given the large fund management presence in London, the huge net selling of Treasuries from the UK in 2020 were almost certainly related to global fund managers, not purely UK investors. As Treasury market liquidity conditions normalized in 2021 and 2022, those large sellers in the UK and Cayman Islands (and other offshore investment locations) have likely turned into big net buyers, as evidenced from the TIC data. However, the modest inflows from Europe, and outflows from Japan, tell a more important story about the fundamental demand for US Treasuries. Treasury yields must rise further, widening both currency-hedged and unhedged spreads versus non-US government bonds to more historically attractive levels, to entice more foreign buying. Bottom Line: UST yields must rise even further versus non-US yields to attract more fundamental buyers like Japanese and European institutional investors, given elevated volatility in both US Treasury prices and the dollar. Global investors should underweight US Treasuries in global bond portfolios, on both a currency-unhedged and USD-hedged basis.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Currency Hedging Matters More Than Ever For Bond Investors Currency Hedging Matters More Than Ever For Bond Investors Tactical Overlay Trades

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

Executive Summary   Surging Electricity, Gas Prices Will Fuel Higher Inflation Energy-Price Surge Will Drive Inflation Higher Energy-Price Surge Will Drive Inflation Higher Heat waves in the Northern Hemisphere are sending electricity and natgas prices through the roof, which will feed into higher inflation prints in the months ahead. Heat waves and droughts this summer also will damage crops, and, on the back of higher natgas prices, will raise the cost of fertilizer, and push food prices up. Central banks attempting to control inflation cannot address exogenous supply shocks related to weather and commodity shortages via monetary policy, which will complicate their attempts to rein in inflation. Higher prices for necessary commodities – heat, cooling and food – will, perforce, account for increasing shares of firms’ operating expenses and household budgets. This will reduce spending on other goods and services. And it will provide central banks with some policy space to keep rate hikes from becoming so draconian they add unmanageable strains to firms’ and households’ budgets. Bottom Line: A remarkable confluence of exogenous weather shocks and supply constraints in commodity markets will push food and energy prices higher, and raise inflation expectations. Further down the line, supplies of base metals will come under pressure, as refinery and smelting operations are curtailed. We remain long direct commodity exposure via the COMT ETF. We also remain long equity exposure to oil and gas producers and miners via XOP and XME ETFs, respectively, (please see tables at the back of this report for details). Feature Electricity and natural gas prices continue to surge in Europe – this week on the back of reduced wind-power availability and higher air-conditioning demand (Chart 1). Meanwhile, Brent crude oil prices again were trading above $100/bbl earlier this week.1 Related Report  Commodity & Energy StrategyTight Commodity Markets: Persistently High Inflation             Elsewhere in the Northern Hemisphere, energy prices in the US also are trading higher, as are agricultural commodities. In the US, drought and heat are stressing grains. The US Climate Prediction Center is expecting hotter- and dryer-than-average weather conditions until November.2 In China, drought and heat waves are straining the electricity network. Energy rationing is forcing curtailments of power and closures of factories and metals refineries, and limiting exports of fertilizers; natural gas comprises ~ 70% of fertilizer inputs. Chart 1Surging Electricity, Gas Prices Will Fuel Higher Inflation Energy-Price Surge Will Drive Inflation Higher Energy-Price Surge Will Drive Inflation Higher Higher Energy, Grain Prices; Higher Inflation Chart 2AFood, Energy Drive US, EU Inflation Energy-Price Surge Will Drive Inflation Higher Energy-Price Surge Will Drive Inflation Higher Chart 2BFood, Energy Drive US, EU Inflation Energy-Price Surge Will Drive Inflation Higher Energy-Price Surge Will Drive Inflation Higher Higher energy and food prices will continue to drive inflation gauges in the US (Chart 2A) and Europe (Chart 2B). Our modeling shows the Bloomberg energy, agricultural and base metals spot subindexes – aggregations of the futures in the complete index – are cointegrated with the 5-year/5-year CPI swaps (5y5y CPI), meaning these series share a common long-term trend (Chart 3). The complete Bloomberg Commodity index based on prompt-delivery contracts also is cointegrated with CPI 5y5y inflation expectations, as is the 3-year forward WTI futures, which is one of the strongest relationships (Chart 4). Chart 35Y5Y CPI Inflation Expectations Move With Commodity Groups 5Y5Y CPI Inflation Expectations Move With Commodity Groups 5Y5Y CPI Inflation Expectations Move With Commodity Groups Chart 4Spot Commodities Impact 5y5y Expectations Spot Commodities Impact 5y5y Expectations Spot Commodities Impact 5y5y Expectations We continue to expect higher Brent and WTI crude oil prices going forward, particularly following the announcement from Saudi Arabia’s oil minister earlier this week that cutting oil production – say, in the event the US and Iran agree to revive the nuclear deal proffered by the EU – remains among its options to manage its production.3 For 4Q22, we expect Brent to trade at $119/bbl, while next year we expect prices to average $117/bbl. Any shock that moves Brent and WTI higher will push inflation higher. Fed Policy Rates And Commodities In earlier research, we noted oil prices are more than an input cost for manufacturing, mining, agriculture, etc. We share the ECB’s view that the oil price is a barometer of global economic activity, as well as being an input cost and the price of an asset.4 In this report, we delve into the relationship between Fed policy and commodity markets, specifically oil prices. We believe we have identified a feedback loop between market-cleared crude oil prices and Fed monetary policy vis-à-vis setting the Fed funds rate. We use the following theoretical framework to study this. High crude-oil prices feed into general price levels, which drive up inflation and inflation expectations as revealed in the CPI 5y5y swaps. Seeing this, the Fed begins to signal it will tighten monetary policy, trying to cool aggregate demand. On the other side of the coin, low crude oil prices drive inflation and inflation expectations lower – assuming markets are not in the midst of a market-share war – giving the Fed space to run a looser monetary policy. Granger Causality tests provide evidence of a short-term relationship between crude oil futures prices, inflation expectations evident in the 5y5y CPI swaps market, and Fed funds rate expectations revealed in the 1-year/1-year (1y1y) US Overnight Indexed Swap rates. We find past and present values of the front-month WTI contract help predict market expectations of 1-year Fed funds rates one year from now.5 What is interesting about this result is that we find Granger Causality between the expected Fed funds rates revealed in the 1y1y US OIS rate and 3-year forward WTI futures, which is a strong explanatory variable for 5y5y CPI swaps. This is to say, the 1y1y OIS rate Granger Causes the 3-year WTI futures, but not vice versa. Consistent with the feedback loop we posit between crude oil futures and Fed funds rates, we find that past and present values of the 1y1y Fed funds rate derived from the OIS curve help predict expected WTI prices 3 years forward. This means the 3-year WTI futures are reacting to short-term inflation expectations revealed in the OIS rates – and, most likely, the Fed’s assumed policy-response function contained in forward guidance – which, in turn, is used to calibrate 5y5y CPI swaps expectations (Chart 5). Chart 5Forward Oil Prices Drive 5y5y CPI Swaps Forward Oil Prices Drive 5y5y CPI Swaps Forward Oil Prices Drive 5y5y CPI Swaps Investment Implications Weather shocks – drought and heat waves across the Northern Hemisphere – and supply constraints (energy demand in excess of energy supply) will push food and energy prices higher, and lift inflation and inflation expectations. Tight natural gas markets will increase the cost of fertilizer, which will keep grain prices elevated. Further down the line, supplies of base metals will come under pressure, as refinery and smelting operations are curtailed. We remain long direct commodity exposure via the COMT ETF. We also remain long equity exposure to oil and gas producers and miners via XOP and XME ETFs, respectively.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodities Round-Up Energy: Bullish US commercial crude oil inventories ex-SPR barrels fell 3.3mm barrels week-on-week for the week ended 19 August 2022, according to the EIA. Including SPR barrels, total US crude oil inventories were down 11.4mm barrels. Total US oil stocks – crude and products – including the SPR barrels were down 6.7mm barrels; without the SPR draws, inventories built 1.4mm barrels. The US SPR now stands at 453.1 million barrels, the lowest since January 1985, according to reuters.com. The US has made 1mm b/d available to the market from its SPR over since May; this program will terminate at the end of October. We expect the SPR release will be extended, if the US and Iran cannot agree to extend the Iran nuclear deal in the near future. Low-sulfur distillates fell 1.7mm barrels, reflecting tight inventories of diesel, heating oil and jet fuel (Chart 6). Total products supplied (the EIA’s nomenclature for demand) fell 2.5mm b/d y/y, and now stands at 19.34mm b/d. Base Metals: Bullish Iron ore prices rose on Chinese growth prospects following the People’s Bank of China (PBoC) decision to cut lending rates on Monday, one week after its initial rate cut. More aggressive policy will be needed to stimulate credit activity and growth in an economy which has to contend with a zero COVID tolerance policy and a faltering property market. With no dearth of money in the economy, credit demand maybe the issue, not supply. M2 money supply – which includes cash and deposits - rose 12% y/y in July, while new bank lending dropped nearly 40% y/y (Chart 7). Precious Metals: Neutral Gold prices on Tuesday were supported by weak US manufacturing and household sales data. Significant support for the yellow metal will occur after the US Federal Reserve begins reducing interest rates, which we do not believe will occur this year. The Fed will continue tightening monetary policy, at the risk of increasing unemployment. Chart 6 Energy-Price Surge Will Drive Inflation Higher Energy-Price Surge Will Drive Inflation Higher Chart 7 M2 Money Supply Increasing While New Bank Loans Decreasing M2 Money Supply Increasing While New Bank Loans Decreasing       Footnotes 1     Please see European Power Prices Smash Records in Another Inflation Blow published by bloomberg.com on August 23, 2022. The surge in prices has lifted European power prices above the equivalent of $1,000/bbl, more than 10x the Brent price on Wednesday. See also Drought Negatively Impacting China, the U.S. and Europe, as Ukrainian Black Sea Exports Continue published on August 22, 2022 by farmpolicynews.illinois.edu. 2     Please see Prognostic Discussion for Long-Lead Seasonal Outlooks published by the National Weather Service’s Climate Prediction Center on August 18, 2022. See also Farm Futures Daily AM - U.S., China heat concerns lift grains - 08/24 (penton.com) for a summary of ag market trading and crop conditions. 3    Please see Oil pares losses after Saudi oilmin says OPEC+ has options including cuts published by reuters.com on August 22, 2022. 4    At a high level of abstraction, we model crude oil demand as a function of real GDP, while supply is assumed to react to realized demand – i.e., oil producers are data-dependent vis-à-vis the volume of crude they produce to meet demand. Our crude-oil price estimate is calculated using supply, demand and inventories – along with US financial variables. In other words, our model uses real and financial variables to estimate a crude-oil price, which, we contend, qualifies it as a summary statistic for the variables on the right-hand side of our model. Please see Tight Commodity Markets: Persistently High Inflation, a Special Report we published on March 24, 2022 for further discussion. We note this is aligned with the way the ECB thinks about oil prices. It is available at ces.bcaresearch.com. 5    Market expectations for the US federal funds rate are derived using US Overnight Indexed Swap rates. The US Secured Overnight Financing Rate (SOFR) is used as the floating rate for the swap deal and tracks the federal funds rate.   Investment Views and Themes Strategic Recommendations Trades Closed in 2022

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

Executive Summary Upgrade Euro Area ILBs To Overweight Upgrade Euro Area ILBs To Overweight Upgrade Euro Area ILBs To Overweight Inflation breakevens have stabilized in the US, where gasoline prices have fallen, but have reaccelerated in the UK and euro area, where natural gas prices have exploded. Inflation breakevens have declined in Canada, potentially due to markets starting to discount a rapid decline in Canadian house price inflation. Our suite of global breakeven models shows that US and Canadian 10-year breakevens are too low, while euro area and UK breakevens are too high. When adjusted for market expectations for the future stance of monetary policies, expressed as the slope of nominal bond yield curves, only the UK stands out with a “conflicted” combination of too-high breakevens and an inverted nominal Gilt curve. Bottom Line: Upgrade inflation-linked bonds to overweight in the euro area (Germany, France, Italy), while downgrading Canadian linkers to underweight. Stay underweight UK linkers, with the Bank of England on course to tip the UK into a deep recession. Maintain a neutral stance on US TIPS, but look to upgrade if the Fed signals a less hawkish path for US monetary policy. Feature Chart 1Intensifying Inflation Worries In Europe Intensifying Inflation Worries In Europe Intensifying Inflation Worries In Europe Inflation-linked bonds (ILBs) have played a useful role for fixed income investors looking to protect their portfolios from the pernicious effects of the current era of high inflation. The rising inflation tide had been lifting all global ILB boats. Given the global nature of the brief deflationary shock from the global COVID lockdowns in 2020, and the persistent inflationary shock of the policy-induced recovery from the pandemic, ILB yields – and breakeven spreads versus nominal bonds – have tended to be positively correlated between countries. Now, some interesting divergences have started to appear between market-based inflation expectations (ILB breakevens or CPI swaps) at the country level. Most notably, inflation expectations have been climbing in the euro area and UK, while staying more stable – below the 2022 peak - in the US (Chart 1). In smaller ILB markets like Canada and Australia, breakevens have rolled over and remain at levels consistent with central bank inflation targets even in the fact of high realized inflation. Amid signs of easing inflation pressures from the commodity and traded goods spaces, and with global central banks now in full-blown tightening cycles to try and rein in overshooting inflation, ILB markets are likely to continue being less correlated. Being selective with ILB allocations at the country level, both on the long and short side of the market, will provide better relative return opportunities for bond investors over the next 6-12 months. To assess where those ILB opportunities lie within the developed market universe, we must first go over what is happening with various measures of inflation expectations in each country. A Country-By-Country Tour Of The Recent Dynamics Of Inflation Expectations US Chart 2Lower Gas Prices, Lower US Inflation Expectations Lower Gas Prices, Lower US Inflation Expectations Lower Gas Prices, Lower US Inflation Expectations In the US, the correlation with inflation expectations and gasoline prices remains quite strong (Chart 2). That has been the case when gas prices were soaring, but the correlation works in both directions. The US national gasoline price has fallen by 22% since the peak on June 13, according to the American Automobile Association. Lower gas prices have helped ease consumer inflation expectations. The July reading of the New York Fed’s Survey of Consumer Expectations showed a dip in the 1-year-ahead inflation expectation to 6.2% from 6.8% in June. The 5-year-ahead inflation expectation, which was introduced to the New York Fed survey back in January, fell sharply in July to 2.3% from 2.8% in June (and from a peak of 3% back in March). The fall in US survey-based inflation is also mirrored in lower TIPS breakevens. The 10-year TIPS breakeven fell from 2.76% at the peak of the national gasoline price in mid-June to a low of 2.29% on July 7. The 10-year breakeven has since recovered to 2.58%, but is still below the levels at the time of the peak in gas prices – and considerably lower than the cyclical peak of 3.02% reached in April. The 2-year TIPS breakeven has fallen even more, down from 4.93% to 2.87% since the April peak. UK Chart 3A Historic Energy Price Shock In The UK A Historic Energy Price Shock In The UK A Historic Energy Price Shock In The UK The UK inflation story has been heavily focused on the historic surge in energy prices. UK headline CPI inflation reached double-digit territory in July, climbing to 10.1% on a year-over-year basis, with the energy component of the CPI rising by a staggering 58%. Within that energy component, natural gas prices have been a huge driver, with the gas component of the CPI index up 96% year-over-year in July (Chart 3). Yet despite the relentless climb in energy prices, and the well-publicized “cost of living crisis” with high inflation rates in many non-energy sectors of the UK economy, survey-based measures of UK inflation expectations have stopped rising. The medium-term (5-10 years ahead) inflation expectation from the Citigroup/YouGov survey of UK consumers fell to 3.8% in July, down from the 4.4% peak reached back in March. Even shorter-term inflation expectations have stabilized in the face of rising energy costs (bottom panel). The dip in survey-based inflation expectations as of the July surveys may only be that – a dip – with the 10-year breakeven rate on index-linked Gilts having climbed from 3.8% to 4.2% so far in August. It’s also possible that the household inflation surveys are picking up the impact from the recent slowing of global goods price inflation (and easing global supply chain disruptions). More likely, in our view, UK households are starting to factor in the impact of BoE monetary tightening and an imminent UK recession – one that the BoE is now forecasting – on future inflation. Euro Area Chart 4European Inflation Expectations On The Rise European Inflation Expectations On The Rise European Inflation Expectations On The Rise In the euro area, inflation expectations are finally responding to the steady climb in realized inflation evident across the region. Headline CPI inflation in the region climbed to 8.9% in July, the highest reading since the inception of the euro in 1999. The inflation has been concentrated in a few sectors, with four percentage points of that 8.9% coming from energy prices and another two percentage points coming from food, tobacco and alcohol. Core inflation (excluding food and energy) was 4.0% in July, less alarming than the headline number but still double the ECB’s inflation target of 2%. The ECB now produces its own survey of consumer inflation expectations, which it has been conducting without publishing the results since April 2020. The ECB started publishing the survey this month, as part of a broader Consumer Expectations Survey that also asks questions on topics like future economic growth and the health of labor markets. The most recent survey in June showed that 1-year-ahead inflation expectations were 5%, and 3-year-ahead were 2.8% (Chart 4). Both measures have risen sharply since February – the month before the Russian invasion of Ukraine that triggered the spike in oil and European natural gas prices – when the 1-year-ahead and 3-year-ahead measures were 3.2% and 2.1%, respectively. Euro area market-based inflation expectations are a little more subdued than those from the ECB’s consumer survey. The 5-year breakeven inflation rate on German ILBs is now at 3.4%, while the 10-year breakeven is at 2.5%. A similar message comes from European inflation swaps, with the 5-year measure at 3.4% and the 10-year measure at 2.8%. Canada Chart 5A Housing-Driven Peak In Canadian Inflation Expectations? A Housing-Driven Peak In Canadian Inflation Expectations? A Housing-Driven Peak In Canadian Inflation Expectations? In Canada, realized inflation is still elevated, but may be peaking. Headline CPI inflation was 7.6% in July, down from 8.1% in June, although this came almost entirely from lower energy inflation. Measures of underlying inflation produced by the Bank of Canada (BoC) also stabilized in July, with the trimmed CPI inflation measure ticking down from 5.4% from 5.5% in June (Chart 5). The latest read on survey-based inflation expectations from the BoC’s quarterly Consumer Expectations Survey for Q2/2022 showed a pickup in the 1-year-ahead measure (from 5.1% in Q1 to 6.8%), 2-year-ahead measure (from 4.6% in Q1 to 5%) and 5-year-ahead measure (from 3.2% to 4%). All of those measures are well above the latest readings on market-based inflation expectations from Canadian ILBs, a.k.a. Real Return Bonds, with the 5-year breakeven at 2.2% and 10-year breakeven at 2.1%. Market liquidity is always a factor in the relatively small Canadian Real Return Bond market, yet it is somewhat surprising that breakevens are so low compared with realized and survey-based inflation. The aggressive tightening so far by the BoC, including a whopping 100bp rate hike last month and more expected over the next year, may be playing a role in dampening inflation breakevens – especially with the BoC’s tightening already having an impact on the Canadian housing market. National house price inflation, which tends to lead overall headline CPI inflation by around one year, was 14.2% in July, down from the 2022 peak of 18.8% (top panel). Australia Chart 6Inflation Expectations Remain Moderate In Australia & Japan Inflation Expectations Remain Moderate In Australia & Japan Inflation Expectations Remain Moderate In Australia & Japan In Australia, headline CPI inflation reached 6.1% in Q2/2022, up from 5.1% in Q1/2022, while the median inflation rate was 4.2%. While energy costs were a big contributor to the rise in overall inflation, the pickup was fairly broad-based with notable increases in the inflation rates related to housing (both house prices and furniture prices). Survey-based measures of inflation expectations in Australia focus on more shorter time horizons, thus they are highly correlated to current realized inflation. On that note, the Melbourne University measure of 1-year-ahead consumer inflation expectations soared from 4.9% in Q1/2022 to 6.2% in Q2/2022, while the early read on Q3/2022 2-year-ahead inflation expectations from the Union Officials survey rose to 4.1% from 3.5% in the previous quarter (Chart 6). Market-based inflation expectations are relatively subdued given the high readings of realized inflation and shorter-term survey-based inflation expectations. The 10-year Australian ILB breakeven is now at 1.9%, while the 5-year/5-year forward CPI swap rate is at 2.4%. The aggressive RBA tightening in 2022, with the Cash Rate having increased 175bps over the last four policy meetings, may be playing a role in holding down ILB breakevens. The relatively moderate pace of wage gains in Australia, with the Wage Price Index climbing 2.6% year-over-year in Q2, may also be weighing on ILB breakevens (middle panel). Japan There is not much exciting to say on the inflation front in Japan. The core (excluding fresh food) CPI inflation rate targeted by the Bank of Japan (BoJ) did hit a 7-year of 2.4% in July, but the core CPI measure more in line with international standards (excluding fresh food and energy) was only 1.2% in July (bottom panel). That was the strongest reading since 2015 but still well below the BoJ’s 2% inflation target. Survey-based consumer inflation expectations from the BoJ’s Opinion Survey showed a noticeable increase in Q2/2022, with the 5-year-ahead measure rising to 5% from 3% in Q1. This is obviously well above realized Japanese inflation, although the same survey showed that Japanese consumers believed that the current inflation rate was also 5%. Market-based Japanese inflation expectations are well below the BoJ survey-based measure, but in line with realized core inflation with the 2-year and 10-year CPI swap rates at 1.22% and 0.9%, respectively. The Message From Our Inflation Breakeven Valuation Models Chart 7A Diminished Case For Overweighting Inflation-Linked Bonds A Diminished Case For Overweighting Inflation-Linked Bonds A Diminished Case For Overweighting Inflation-Linked Bonds From an overall global perspective, the case for favoring ILBs versus nominal government bonds across all countries is less intriguing today than was the case in 2021 and early 2022 (Chart 7). Commodity price inflation is slowing rapidly alongside decelerating global growth. This is true both for oil and especially for non-oil commodities, with the CRB Raw Industrials index now falling on a year-over-year basis (middle panel). Supply chain disruptions on goods prices are easing, which is evident in lower rates of goods inflation in the US and other countries. Given the divergences evident between realized inflation, expected inflation and monetary policy outlook outlined in our tour of global inflation expectations, there may be better opportunities to selectively allocate to ILBs on a country-by-country basis. One tool to help us identify such opportunities is our suite of inflation breakeven fair value models. The models are all constructed in a similar fashion, determining the fair value of 10-year ILB breakevens as a function of the same two factors for each country: The underlying trend in realized inflation, defined as the five-year moving average of headline CPI inflation. This forms the medium-term “anchor” for breakevens. The year-over-year percentage change in the Brent oil price, denominated in local currency terms for each country. This attempts to capture cyclical trends around that medium-term anchor based on movements in oil and currencies. We have breakeven fair value models for eight developed market countries, which are shown in the next four pages of this report. The list of countries includes the US (Chart 8), the UK (Chart 9), France (Chart 10), Germany (Chart 11), Italy (Chart 12), Canada (Chart 13), Australia (Chart 14) and Japan (Chart 15). Chart 8Our US 10-Year Inflation Breakeven Model Our US 10-Year Inflation Breakeven Model Our US 10-Year Inflation Breakeven Model ​​​​​​ Chart 9Our UK 10-Year Inflation Breakeven Model Our UK 10-Year Inflation Breakeven Model Our UK 10-Year Inflation Breakeven Model ​​​​​​ Chart 10Our France 10-Year Inflation Breakeven Model Our France 10-Year Inflation Breakeven Model Our France 10-Year Inflation Breakeven Model ​​​​​​ Chart 11Our Germany 10-Year Inflation Breakeven Model Our Germany 10-Year Inflation Breakeven Model Our Germany 10-Year Inflation Breakeven Model ​​​​​​ Chart 12Our Italy 10-Year Inflation Breakeven Model Our Italy 10-Year Inflation Breakeven Model Our Italy 10-Year Inflation Breakeven Model ​​​​​​ Chart 13Our Canada 10-Year Inflation Breakeven Model Our Canada 10-Year Inflation Breakeven Model Our Canada 10-Year Inflation Breakeven Model ​​​​​ Chart 14Our Australia 10-Year Inflation Breakeven Model Our Australia 10-Year Inflation Breakeven Model Our Australia 10-Year Inflation Breakeven Model ​​​​​ Chart 15Our Japan 10-Year Inflation Breakeven Model Our Japan 10-Year Inflation Breakeven Model Our Japan 10-Year Inflation Breakeven Model ​​​​​ Full disclosure: we decided last year to de-emphasize our breakeven fair value models after the 2020 COVID recession and, more importantly, the sharp global economic recovery in 2021 from the pandemic shock. The rapid acceleration of oil prices – up 2-3 times in all countries - triggered by that recovery created some wild swings in the estimated breakeven fair value. Today, with oil inflation at more “normal” levels below 100%, we have greater confidence in using the models once again in our strategic thinking on ILBs. The broad conclusions from the models are the following: 10-year inflation breakevens are too low in the US, Canada and Germany 10-year inflation breakevens are too high in the UK and Italy 10-year inflation breakevens are fairly valued in France, Japan and Australia. Taken at face value, our models would suggest overweighting ILBs in the US, Canada and Germany and underweighting ILBs in the UK (and staying neutral on France, Japan and Australia) as part of a new regional ILB diversification strategy. However, there is an additional element to consider when assessing the attractiveness of inflation breakevens at the macro level – the expected stance of monetary policy. ILB inflation breakevens often represent a market-based “report card” on the appropriateness of a central bank’s monetary policy. If monetary settings are deemed to be overly stimulative, the markets will price in higher expected inflation and wider breakevens. The opposite holds true if policy is deemed to be too restrictive, leading to reduced expected inflation and narrower breakevens. Thus, any regional ILB allocation strategy should not only use fair value assessments, but also a monetary policy “filter”. In Chart 16, we show a scatter graph plotting the latest deviations from fair value of 10-year breakevens from our eight country fair value models on the x-axis, and the cumulative amount of expected interest rate increases discounted in overnight index swap (OIS) curves for each country on the y-axis. For the latter, we define this as the peak in rates discounted in 2023 (which is the case for all the countries) minus the trough in policy rates at the start of the current monetary tightening cycle (which is near 0% for all the countries). Chart 16No Clear Link Between Rate Hikes & Breakeven Valuations A Regional Diversification Strategy For Inflation-Linked Bonds A Regional Diversification Strategy For Inflation-Linked Bonds The idea behind the chart is that inflation breakeven valuations should be inversely correlated to the amount of monetary tightening expected by markets. Too many rate hikes would result in markets discounting lower breakevens, and vice versa. However, there is no reliable relationship evident in the chart. For example, the OIS curves are discounting roughly similar levels of cumulative tightening in the US, UK, Canada and Australia, yet ILB breakeven valuations are very different between those countries. In Chart 17, we show a slightly different version of that scatter graph, this time plotting the ILB breakeven fair values versus the slope of the 2-year/10-year nominal government bond yield curve for all eight countries. The logic here is that the slope of the yield curve represents the bond market’s assessment of the appropriateness of future monetary policy. When policy is deemed to be too tight – with an expected peak in rates above what the market believes to be the neutral rate – the yield curve will be flat or even inverted, as markets discount slowing growth in the future and, eventually, lower inflation. Chart 17A Stronger Link Between Yield Curves & Breakeven Valuations A Regional Diversification Strategy For Inflation-Linked Bonds A Regional Diversification Strategy For Inflation-Linked Bonds There is a clear positive relationship between yield curve slope and inflation expectations evident in the new chart. This provides some evidence justifying adding a monetary policy filter to a regional ILB allocation strategy. Related Report  Global Fixed Income StrategyDovish Central Bank Pivots Will Come Later Than You Think Under this framework, US and Canadian breakevens trading below fair value is consistent with the inverted yield curves in both countries, with markets now discounting a restrictive level of future interest rates that would dampen inflation expectations. The fair value of Australian and Japanese breakevens also appears in line with the slope of the yield curves in those countries. In terms of divergences, the overvaluation of UK breakevens is inconsistent with the inverted nominal Gilt curve, while the three euro area countries should have somewhat higher breakevens (trading more richly to fair value) given the relatively steeper slope of their yield curves. Investment Conclusions Chart 18Upgrade Euro Area ILBs To Overweight Upgrade Euro Area ILBs To Overweight Upgrade Euro Area ILBs To Overweight After surveying our ILB breakeven fair value models, and cross-checking them versus trends in survey-based inflation expectations and our own assessment of future monetary policies, we arrive at the following country allocations within our new regional ILB strategy: Neutral on US TIPS, despite the attractive valuations. However, look to upgrade if the Fed signals a less hawkish path for US monetary policy (not our base case) or if breakevens fall even further below fair value without more deeper US Treasury curve inversion. Underweight UK ILBs. Breakevens are overshooting due to the near-term inflation risk from soaring energy prices – an outcome that will force the BoE to deliver an even tighter monetary policy, with a more deeply inverted yield curve, that will drive the UK into a disinflationary recession. Underweight Canadian ILBs, despite the attractive valuations. Canadian inflation has likely peaked, and the BoC is engineering a disinflationary downturn in the Canadian housing market with aggressive rate hikes that will maintain an inverted yield curve. Overweight German, French and Italian ILBs. The ECB is likely to deliver fewer rate hikes than markets are discounting, keeping the euro area yield curves relatively steep versus the curves of other developed countries. This also provides a better way to play the near-term inflationary upside from overshooting natural gas prices in Europe than overweighting UK ILBs, with the BoE expected to be much more hawkish than the ECB (Chart 18). Neutral Australia and Japan. Underlying inflation momentum is slower than in the other regions, while breakeven valuations are neutral and not out of line with the expected stance of monetary policy. We are incorporating this new regional ILB strategy into our Model Bond Portfolio, which can be seen on pages 18-20. The changes from current allocations involve upgrades to Germany, France and Italy to overweight, and a downgrade of Canada to underweight.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark A Regional Diversification Strategy For Inflation-Linked Bonds A Regional Diversification Strategy For Inflation-Linked Bonds The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) A Regional Diversification Strategy For Inflation-Linked Bonds A Regional Diversification Strategy For Inflation-Linked Bonds

Please note that there will no US Bond Strategy publication next week. Our regular publishing schedule will resume on September 6th with our Portfolio Allocation Summary for September. Executive Summary This report describes a framework for implementing long/short positions in the TIPS market relative to duration-matched nominal Treasuries. The framework is modeled after the Golden Rule of Bond Investing that we use to implement portfolio duration trades. The TIPS Golden Rule states that investors should buy TIPS versus nominal Treasuries when their 12-month headline inflation expectations are above those priced into the market, and vice-versa. We demonstrate a method for forecasting headline CPI inflation and conclude that it will fall into a range of 2.4% to 4.8% during the next 12 months, with risks to the upside. This suggests a high likelihood that headline inflation will exceed current market expectations. The TIPS Golden Rule’s Track Record The TIPS Golden Rule's Track Record The TIPS Golden Rule's Track Record Bottom Line: We see value in TIPS on a 12-month investment horizon but anticipate that an even better entry point to get long TIPS versus nominal Treasuries will emerge during the next couple of months as headline CPI weakens. We recommend a neutral allocation to TIPS for now, though we are looking for a good opportunity to increase exposure. Feature Regular readers will no doubt be familiar with our Golden Rule Of Bond Investing, the framework we use to think about our portfolio duration recommendations. In brief, the Golden Rule states that investors should set their overall bond portfolio duration based on how their own 12-month fed funds rate expectations differ from the expectations that are priced into the market. Our research shows that this investment strategy has a strong historical track record.1 The thing we like most about the Golden Rule framework is that it provides us with a good method for filtering incoming information. Does this new piece of news or economic data change our 12-month rate expectations? If not, then we probably don’t want to assign much weight to it when setting our portfolio duration. In this Special Report we demonstrate that the same Golden Rule logic that we apply to duration trading can also be applied to the TIPS market. Specifically, it can be applied to long/short positions in TIPS versus duration-matched nominal Treasuries. Developing The TIPS Golden Rule Before diving into the TIPS Golden Rule, it’s worth running through the logic that underpins this investment strategy. The logic starts with the Fisher Equation – the well-known formula that relates nominal bond yields to real bond yields. Simply, the Fisher Equation can be stated as follows:     Nominal Yield = Real Yield + The Cost Of Inflation Protection In financial market terms, we can re-write the equation as:     Nominal Treasury Yield = TIPS Yield + TIPS Breakeven Inflation Rate Two of the three variables in this equation have what we call valuation anchors. The nominal Treasury yield’s valuation is anchored by expectations about the future path for the federal funds rate. Put differently, if you buy a 5-year Treasury note and hold it until maturity, your excess returns versus a position in cash are purely determined by the path of the federal funds rate over that 5-year investment horizon. Similarly, the TIPS breakeven inflation rate’s valuation is anchored by expectations about CPI inflation. If held to maturity, the profits from an inflation protection position (long TIPS/short nominals or short TIPS/long nominals) are purely determined by the path of CPI inflation during the investment horizon. It’s worth noting that, unlike the nominal Treasury yield and the TIPS breakeven inflation rate, the TIPS yield has no independent valuation anchor. Within our framework, the best way to forecast the TIPS yield is to follow a 3-step process: Forecast the nominal yield based on a view about the fed funds rate. Forecast the TIPS breakeven inflation rate based on a view about inflation. Use the Fisher Equation to combine the results from steps 1 and 2 into a forecast for the TIPS yield. As an aside, while our framework relies on viewing the nominal Treasury yield and the TIPS breakeven inflation rate as reflective of expectations for the fed funds rate and CPI inflation respectively, we do not argue that those bond yields can be used to accurately forecast the fed funds rate or CPI inflation. In fact, history tells us that bond markets are usually poor predictors of future outcomes for the fed funds rate and for CPI inflation. Chart 1 shows that there is only a loose correlation (R2 = 22%) between 12-month bond-market implied expectations for the change in the fed funds rate and the actual change in the fed funds rate. Similarly, Chart 2 shows that there is hardly any correlation (R2 = 3%) between market-implied inflation expectations and the 12-month rate of change in headline CPI. Chart 1Market Prices Are A Poor Predictor Of The Fed Funds Rate The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart 2Market Prices Are A Poor Predictor Of Inflation The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing In other words, it’s more advisable to view the expectations priced into bond markets as a breakeven threshold for trading, not as a tool for forecasting. Stating The TIPS Golden Rule To apply the TIPS Golden Rule, investors should follow these three steps: Calculate market-implied expectations for what headline CPI inflation will be over the next 12 months. This can be done by looking at the 1-year CPI swap rate or the 1-year TIPS breakeven inflation rate.2 Develop an independent forecast for 12-month headline CPI inflation. We demonstrate one method for doing this later in the report.3 Compare your own headline CPI forecast with the forecast that is priced in the market. If your own forecast is higher, then you should go long TIPS/short nominal Treasuries. If your own forecast is lower, then you should go short TIPS/long nominal Treasuries. Testing The TIPS Golden Rule Chart 3 shows the historical track record of the TIPS Golden Rule going back to 2005.4 The top panel shows 12-month excess returns from the Bloomberg Barclays TIPS index relative to a duration-matched position in nominal Treasuries. The bottom panel shows whether inflation surprised market expectations to the upside or to the downside during the investment horizon. We can see that, visually, it looks as though TIPS tend to outperform nominal Treasuries when there is an inflationary surprise and underperform when there is a deflationary surprise. Chart 3The TIPS Golden Rule's Track Record The TIPS Golden Rule's Track Record The TIPS Golden Rule's Track Record Chart 4 shows the same relationship in a little more detail. The 12-month inflation surprise is placed on the x-axis and 12-month TIPS excess returns are on the y-axis. For the TIPS Golden Rule to be useful, we would need to see most of the datapoints in the top-right and bottom-left quadrants of the chart, and indeed this is the case. Chart 412-Month TIPS Excess Returns Vs. Inflation Surprises The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Finally, Table 1 shows the relationship in even more detail. It shows that inflationary surprises coincide with positive TIPS excess returns 73% of the time for an average excess return of 2.6%. It also shows that deflationary surprises coincide with negative TIPS excess returns 80% of the time, for an average excess return of -3.2%. Table 112-Month TIPS Excess Returns* And Inflation Surprises (2005 – Present) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Please note that all the above return calculations are performed on the overall Bloomberg Barclays TIPS Index relative to a duration-matched position in nominal Treasuries. However, the TIPS Golden Rule also performs well when applied to TIPS of any maturity. The Appendix of this report replicates the above analysis for every point along the TIPS curve and shows that the results are consistently excellent. Applying The TIPS Golden Rule Now that we have stated the TIPS Golden Rule and demonstrated its effectiveness as an investment strategy, it is time to apply it to the current market. To do that, we first determine 1-year market-implied inflation expectations by looking at the 1-year CPI swap rate. As of last Friday’s close, the 1-year CPI swap rate is 3.16%. This means that if we think headline CPI inflation will be above 3.16% during the next 12 months, then we should go long TIPS versus duration-matched nominal Treasuries. If we think headline CPI inflation will come in below 3.16% during the next 12 months, then we should go short TIPS versus duration-matched nominal Treasuries. Next, we must build up our own forecast of headline CPI inflation for the next 12 months. To do this, we follow a bottom-up approach where we split the CPI basket into five components (energy, food, shelter, core goods, and core services ex. shelter) and model each one individually. Energy Inflation (9% Of Headline CPI) Chart 5Modeling Energy Inflation Modeling Energy Inflation Modeling Energy Inflation Energy accounts for roughly 9% of headline CPI, though its often violent price swings mean that this component usually accounts for a much larger percentage of the volatility in headline CPI. In practice, we can accurately model Energy CPI using the prices of retail gasoline, natural gas, and heating oil (Chart 5). To get a 12-month forecast for Energy CPI we therefore need forecasts for the prices of retail gasoline, natural gas, and heating oil. In this analysis, we will consider two possible scenarios for energy prices. First, a benign ‘low oil price’ scenario where we assume that the prices of retail gasoline, natural gas and heating oil follow the paths discounted in their respective futures curves. Second, we consider a ‘high oil price’ scenario that incorporates the view of our Commodity & Energy Strategy service that a drop in Russian oil supply, among other factors, will cause the Brent crude oil price to reach $119 per barrel by the end of this year and average $117 per barrel in 2023.5 To incorporate this outlook into our model, we regress the prices of retail gasoline, natural gas and heating oil on the Brent crude oil price and extrapolate forward using our commodity strategists’ forecasts. The ‘low oil price’ scenario has Energy CPI inflation falling from its current 32.9% level all the way down to -9.9% during the next 12 months. In contrast, our ‘high oil price’ scenario has it falling to just 15.8%. Food Inflation (13% Of Headline CPI) Chart 6Modeling Food Inflation Modeling Food Inflation Modeling Food Inflation Our Food CPI model is based on the cost of fertilizer, agricultural commodity prices and diesel prices. This model has done a reasonably good job explaining trends in Food CPI inflation over time, but the last few months have seen food inflation jump well above the levels suggested by our model (Chart 6). Given that the inputs to our Food CPI model are highly correlated with the oil price, we also apply the ‘low oil price’ and ‘high oil price’ scenarios discussed above to our Food CPI forecast. Using this method, the ‘low oil price’ scenario has Food CPI inflation falling to 3.8% during the next 12 months and the ‘high oil price’ scenario has it coming down to 4.2%. One key risk to these forecasts is that they both assume that the current gap between food inflation and our model’s fair value will close. It’s possible that other factors not included in our model could prevent the gap from closing. We therefore consider our Food CPI forecast to be quite optimistic. Core Goods Inflation (21% Of Headline CPI) Chart 7Modeling Goods Inflation Modeling Goods Inflation Modeling Goods Inflation Core goods inflation, currently running at 6.9%, appears to have already peaked following its post-pandemic surge. We model Core Goods CPI using the New York Fed’s Global Supply Chain Pressure Index, as it is the supply chain constraints that arose during the pandemic that explain the bulk of the movement in core goods prices since that time (Chart 7).6 To forecast Core Goods CPI, we assume that global supply chain constraints continue to ease and that the New York Fed’s index reverts to its pre-pandemic level during the next 12 months. This gives us a forecast for 12-month Core Goods CPI inflation of 0%. Shelter Inflation (32% Of Headline CPI) Chart 8Modeling Shelter Inflation Modeling Shelter Inflation Modeling Shelter Inflation We model shelter inflation, currently running at 5.6%, using the unemployment rate, rental vacancy rate and home prices (Chart 8). Except for the unemployment rate, all our model’s independent variables enter with a lag of at least 12 months. In other words, we wouldn’t expect any near-term change in home prices to impact Shelter CPI for at least a year. To forecast Shelter CPI, we assume that the unemployment rate rises to 4% during the next 12 months. This results in a shelter inflation forecast of 4.7% for the next 12 months. Much like with food inflation, we tend to view this forecast as relatively optimistic as it assumes a large reversion from the current rate of shelter inflation back to our model’s fair value. It’s conceivable that other factors not included in our model, such as rapid wage growth, could prevent this reversion from occurring. Services ex. Shelter Inflation (24% Of Headline CPI) Chart 9Modeling Services Inflation Modeling Services Inflation Modeling Services Inflation This final component of CPI is a bit of a hodgepodge of different service industries that may not have much in common. However, we find that wage growth does a good job of tracking its trends (Chart 9). We therefore model Services ex. Shelter CPI using the Employment Cost Index, which enters our model with a 10 month lag. To forecast Services ex. Shelter CPI, we assume that the Employment Cost Index holds steady at its current growth rate. This gives us a Services ex. Shelter CPI inflation forecast of 5.5% for the next 12 months. Combining Our Bottom-Up Inflation Forecasts & Investment Conclusions Combining our bottom-up forecasts, we calculate a 12-month headline CPI inflation rate of 2.4% for the ‘low oil price’ scenario and a rate of 4.8% for the ‘high oil price’ scenario. For core CPI inflation, we calculate a 12-month forecast of 3.6%. Given the optimistic assumptions that we incorporated into our forecasts, particularly the large reversions of food and shelter inflation back to our estimated fair value levels, we view the risks to our forecasts as heavily tilted to the upside. We also acknowledge that the re-normalization of global supply chains may not proceed as smoothly as the scenario that is baked into our forecasts. Any hiccup in that process would cause our goods inflation forecast to be too low. Chart 10Inflation Forecasts Inflation Forecasts Inflation Forecasts Chart 10 shows our 12-month headline and core CPI forecasts alongside the market-implied forecast from the CPI swap curve, currently 3.16%. Notice that the market-implied inflation forecast is much closer to the bottom-end of our range of headline CPI estimates, and we have already acknowledged that a lot of things will have to go right for our estimates to pan out. In other words, we see a high likelihood that 12-month headline CPI will be above 3.16% for the next 12 months which, according to our TIPS Golden Rule, tells us that we should go long TIPS versus duration-matched nominal Treasuries. While we acknowledge that there is likely some value in going long TIPS versus nominal Treasuries today, we are inclined to maintain our recommended neutral allocation to TIPS versus nominals for now. Given the recent drop in oil prices, we anticipate further weakness in headline inflation during the next couple of months. This could push TIPS breakeven inflation rates even lower in the near term, creating even more value. The bottom line is that we see attractive value in TIPS versus nominal Treasuries on a 12-month investment horizon. While we maintain a neutral allocation to TIPS for now, we anticipate turning more bullish in the near future, hopefully from a better entry point after one or two more weak CPI prints. Appendix Chart A112-Month TIPS Excess Returns Vs. Inflation Surprises (1-3 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A112-Month TIPS Excess Returns* And Inflation Surprises (1-3 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A212-Month TIPS Excess Returns Vs. Inflation Surprises (3-5 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A212-Month TIPS Excess Returns* And Inflation Surprises (3-5 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A312-Month TIPS Excess Returns Vs. Inflation Surprises (5-7 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A312-Month TIPS Excess Returns* And Inflation Surprises (5-7 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A412-Month TIPS Excess Returns Vs. Inflation Surprises (7-10 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A412-Month TIPS Excess Returns* And Inflation Surprises (7-10 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A512-Month TIPS Excess Returns Vs. Inflation Surprises (10-15 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A512-Month TIPS Excess Returns* And Inflation Surprises (10-15 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A612-Month TIPS Excess Returns Vs. Inflation Surprises (15+ Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A612-Month TIPS Excess Returns* And Inflation Surprises (15+ Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Timper Research Analyst robert.timper@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. 2 In this report we use the 1-year CPI swap rate because it is easier to access. 3 To make the TIPS Golden Rule easy to implement, we use seasonally adjusted headline CPI for all our calculations even though TIPS are technically linked to the non-seasonally adjusted index. We also ignore the fact that TIPS coupons adjust to CPI releases with a lag. Our analysis shows that the rule works very well even without incorporating these complications. 4 CPI swap rates are only available from 2004 onwards, so this is the largest historical sample we can use. 5 Please see Commodity & Energy Strategy Weekly Report, “EU Russian Oil Embargoes, Higher Prices”, dated August 18, 2022. 6 For more details on the Global Supply Chain Pressure Index: https://www.newyorkfed.org/research/policy/gscpi#/overview Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary The Fed Versus The Market The Fed Versus The Market The Fed Versus The Market In today’s report, we summarize the arguments of bulls and bears to examine the possible longevity of the rally. The Bulls’ view is centered around several key themes:  Inflation has turned.  The Fed is less hawkish than initially assumed, and Jay Powell is not Paul Volcker.  The economy is resilient, and consumers are spending.  Corporate earnings will surprise on the upside thanks to consumer strength. Meanwhile, the bears argue that:  Growth is slowing and a soft landing is elusive, which will lead to earnings disappointment.  Valuations and Technicals are no longer attractive – the best part of the rally is likely over, and risk-reward is skewed to the downside.  Inflation is embedded and broad-based and it will take many months to reach the level that is palatable to the Fed. Bottom Line: The rally was expected, but its force and durability took us by surprise. Now, after a strong rebound, risks are skewed to the downside and the markets are fragile, but the rally may continue.  We offer our take on what can bring this rally to a halt, and the “danger” signs investors need to be on the lookout for. Feature The fast and furious rally off the June 16 lows has taken many investors by surprise. Over the past two months, the S&P 500 has rebounded by 17%, the NASDAQ is up 22%, while Growth has outperformed Value by 9%. Thematic small-cap growth ETFs have fared even better (Chart 1) with Cathie Wood’s ARKG and ARKK up nearly 50%. The Technology and Consumer Discretionary sectors are up 23% and 28% respectively, while Energy and Materials are relatively flat, showcasing a rotation away from the inflation winners to losers. In this week’s report, we will “dissect” the rally and its key drivers to better understand what can bring this rally to a halt. We will also summarize the arguments of the bulls and present our “bearish” rebuttal to some of the assumptions. Sneak Preview: After the powerful rebound, the market is fragile, and risks are skewed to the downside. By summarizing the arguments of bulls and bears, we are offering our take on what can bring this rally to a halt, i.e., hawkish Fed speeches, disappointing inflation readings, rising rates, and bad earnings. However, a positive surprise along each of these dimensions may also result in the next leg up. Chart 1ETF Universe Overview What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? Anatomy Of The Rally To understand what fuels the rally, we need to understand what its key catalysts are. Oversold: First and foremost, in mid-June, US equities were severely oversold – the BCA Capitulation Indicator hit levels last seen in the spring of 2020 (Chart 2). The BoA institutional survey has also reported an extreme level of bearishness. Pull back in the price of energy: This created fertile ground for a rebound, but the catalyst came from the turn in commodities and energy prices. Extreme pessimism about global growth after the Fed’s aggressive response to a disappointing inflation print has triggered a sell-off in oil and metals. Since mid-June, the GSCI Commodities and the GSCI Energy index are in a bear market downtrend, 21% and 25% off their peaks. Inflation moderating: This disinflationary development has unleashed a positive reinforcement loop: Lower energy prices led to a turn in the CPI print. And many still believe that, after all, inflation is transitory: With supply disruptions clearing and prices of energy and commodities turning, inflation will dissipate just as fast as it arrived. We know this because inflation breakevens are currently at levels last seen a year ago (Chart 3). Chart 2Capitulated Capitulated Capitulated Chart 3Cooling Off : Back To 2021 Cooling Off : Back to 2021 Cooling Off : Back to 2021 Gentler Fed: That is when the market decided that easing price pressures in concert with slowing growth would compel the Fed to pursue a shallower and shorter path of interest rate increases than initially expected – rate increases derived from OIS started to undershoot the “dot plot” (Chart 4). Effectively, the bond market started to forecast that the Fed will end the year at 3.5% and ease as soon as early 2023. In other words, the Fed is nearing the end of the hiking cycle. Naturally, the long end of the Treasury curve has pulled back to April levels, despite a much higher Fed rate. One way or another, yields have stabilized. Lower rates are a boon for equities: As a long-duration asset, equity valuations are inversely correlated with long yields (Chart 5). A better-than-expected Q2 earnings season was the icing on the cake. Chart 4The Market Expects Cuts As Soon As Early 2023 The Market Expects Cuts As Soon As Early 2023 The Market Expects Cuts As Soon As Early 2023 Chart 5Falling Yields Propelled Equities Higher Falling Yields Propelled Equities Higher Falling Yields Propelled Equities Higher Was The Rally Surprising? The rally itself did not surprise us – after all, we did expect the market to turn on a dime at the earliest whiff of falling inflation (Chart 6). Admittedly, we were taken aback by its strength and longevity. With inflation turning, we also expected a change in leadership from the Energy and Materials sectors to Technology and Consumer Discretionary (Chart 7). We also predicted back in January in our “Are We There Yet?!” report that, based on the previous hiking cycles, Tech would rebound roughly three months after the first rate hike (Chart 8), which was taking us to June. Chart 6When Inflation Turns, Equities Rebound What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? Chart 7Turn in Inflation Triggers A Change In Sector Leadership What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? Chart 8A Closer Look At Technology What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? In early July, we upgraded Growth to overweight as an asset that would benefit from an anticipated turn in CPI, rate stabilization, and slowing growth (Chart 9). We have also reaffirmed our overweight in Software and Services as a way to play Growth on a sector level. We have downgraded Energy to underweight to reduce exposure to Value. Chart 9Growth And Quality Lead Markets Higher When Inflation Abates What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? What The Bulls Think Let’s summarize what the bulls think are the catalysts for the next leg up: Inflation has turned. Looking for further signs that inflation is easing. The Fed is less hawkish than initially assumed, and Jay Powell is not Paul Volcker. Looking for signs that the Fed is getting closer to the end of the hiking cycle. So far, the economy is resilient, and consumers are spending – excess savings and excess demand for labor will soften the blow. Looking for signs that the recession can be avoided. Corporate earnings will surprise on the upside thanks to consumer strength. In the next section, I will juxtapose these optimistic expectations with those of a bear, i.e., of yours truly. A full disclosure – I am not a perma-bear but even eight weeks into the best recovery rally ever, I can’t shake off my pessimism. After all, I am used to the markets going up on injections of liquidity and expect them to shudder when liquidity is mopped out of the system. What The Bears Think, Or A Litany Of Worries Inflation is embedded and broad-based Broad-based: While headline inflation is turning, mostly thanks to prices of energy and materials, it will take a long time for core inflation to revert to the desired 2% as it is broad-based. This is evident from trimmed and median CPI metrics, which continue their ascent. Inflation has also spilled into sticky service items, such as rent (Chart 10). Wage-price spiral: Then there is that pesky wage-price spiral that is manifesting itself in soaring labor costs (Chart 11), which companies pass on to their customers. In the meantime, productivity is falling, and unit labor costs are increasing at 9.5% per year, a rate of growth last seen in 1980s (Chart 12). Demand for labor still exceeds supply with 1.8 job openings for every job seeker, and much more tightening is required to bring supply and demand into balance. Chart 10Entrenched? Entrenched? Entrenched? Chart 11Wage-price Spiral Wage-price Spiral Wage-price Spiral Chart 12ULC Soaring ULC Soaring ULC Soaring Wages and service inflation are more important to structural inflation than energy. Rent and its equivalents constitute 30% of the CPI basket, while wages are roughly 50% of corporate sales and by far the largest component of the cost structure. Inflation is embedded and broad-based and it will take many months to reach the level that is palatable to the Fed. What Does The Fed Think? Fed minutes: Fortunately, we don’t need to guess. The Fed minutes state that "participants agreed that there was little evidence to date that inflation pressures were subsiding" and that inflation “would likely stay uncomfortably high for some time.” Further, “though some inflation reduction might come through improving global supply chains or drops in the prices of fuel and other commodities … Participants emphasized that a slowing in aggregate demand would play an important role in reducing inflation pressures," the minutes said. The Fed minutes state that in moving expeditiously to neutral and then into restrictive territory, “the Committee was acting with resolve to lower inflation to 2% and anchor inflation expectations at levels consistent with that longer-run goal.” In its previous communications, the Fed emphasized that its commitment to a 2% target is unconditional. Is powell more like burns or volcker? In addition, there is an ongoing debate between bulls and bears on the character of the Fed – is Jay Powell a strong-willed hawk like Paul Volker, or more of a waverer like Arthur Burns, who presided over the relentless march of inflation in the seventies? We think that the Chairman can channel Paul Volcker. After all, the Fed has surprised investors by acting swiftly and decisively. Back in March, the Fed dot plot indicated that by the end of the year, the target rate will reach a mere 1.75%. However, we hit a 2.25%-2.50% rate range as soon as July. Jay Powell is concerned about his legacy: He would not want to be remembered as a Chair who mishandled inflation by keeping rates too low despite historically low unemployment and resilient consumers whose accounts are padded with excess post-pandemic savings. The Fed is more hawkish than what the majority of market participants, unscathed by the inflation of the seventies and eighties, believe. The Fed dot plot, to which the Chairman referred on multiple occasions, projects a Fed funds rate of 4% at year-end and of 4.5-5.0% next year (Chart 13). Meanwhile, Fed funds futures are only pricing a rate of about 3.4% for December 2022, even after the hawkish talk from both ex-dove Kashkari and a hawk Bullard (3.75%-4.0% by year-end and 4.4% by the end of 2023). Further, the Fed itself states in its minutes that rates would have to reach a "sufficiently restrictive level" and remain there for "some time" to control inflation that was proving far more persistent than anticipated. The Chicago Fed President Charles Evans has also affirmed that the Fed is definitely not cutting rates in March 2023. Chart 13The Fed Versus The Market The Fed Versus The Market The Fed Versus The Market Doves latch on to comments from the meeting that the Fed will be data-driven, and that it is concerned about overtightening. To us, these are just the musings of the “responsible grown-ups.” Quantitative Tightening: Now let’s not forget another leg of the stool – Quantitative Tightening. QT has been very tame so far and, since the program commenced, the size of the Fed’s balance sheet, $8.9 trillion, has barely budged. In September, the Fed is scheduled to step up QT to a maximum pace of $95 billion from $47.5 billion— running off up to $60 billion in Treasuries, and $35 billion of mortgage securities. Shortages of securities available for run-off due to a dearth of refinancing may trigger a shift to outright selling, further tightening financial conditions. Equities are at odds with the Fed: Last, but not least, equity markets are on a collision course with the Fed. Since June, financial conditions have eased as opposed to tightened, making the Fed’s job so much harder (Chart 14). Chart 14The Rally Eased Financial Conditions The Rally Eased Financial Conditions The Rally Eased Financial Conditions The Fed may prove to be more hawkish than in the past as it is on a quest to combat inflation and takes its mission very seriously. “Don’t fight the Fed” the adage holds. Economic Growth Is Slowing The BCA Business Cycle Indicator signals that economic growth is slowing (Chart 15), which is also evident from a host of economic data releases, ranging from GDP growth to business surveys to housing data. One of the few data series that has defied gravity so far is the jobs report, but the job creation rate is a coincidental indicator at best, and a lagging one at worst. Jobs are usually lost after the start of a recession (Chart 16). Chart 15Economy Is Slowing Economy Is Slowing Economy Is Slowing Chart 16Unemployment Never "Just Ticks Up" Unemployment Never "Just Ticks Up" Unemployment Never "Just Ticks Up" Can consumers save the day? After all, $2.2 trillion in excess savings should help to handle the pressures of negative real wage growth and income growth that is below trend. Yes and no. Gasoline savings can certainly support increases in discretionary spending, all else equal. As for excess savings – adding this money back into the economy may ignite another bout of inflation, working against the Fed, and triggering more rate increases. Many clients ask us if we anticipate a recession. Broadly speaking we do, as the Fed has an arduous task ahead of it in balancing the supply and demand of labor. However, we do not expect a recession in 2022 or even early 2023. Can the Fed succeed by only reducing excess job openings from 1.8 to 1, thus avoiding a rise in unemployment? This is possible, but the probability of such an outcome is low as unemployment never “just ticks up” (Chart 16). However, what the market is pricing is also important. At the moment, the rally shows that it considers the current growth slowdown just a growth scare to be shrugged off. Will there be more disappointments? We think so, as the US economy is facing multiple headwinds from slowing demand for exports due to geopolitical turbulence and payback of overstimulated consumer demand at home. And it is not a recession per se, but a growth disappointment, that may take equities on the next leg down. Growth is slowing and a soft landing is illusive. Earnings Growth Will Continue Its March Towards Zero We believe that earnings growth will continue to slow into year-end – flagging consumer demand at home and abroad, a strong dollar, and soaring unit labor costs that can no longer be fully passed on to stretched consumers, as corporate pricing power is decelerating. Even in Q2-2022, ex-Energy EPS growth is already negative at -1.5%, with Consumer Discretionary, Financials, Communications, and Utilities reporting an earnings contraction. As we predicted back in October, the S&P 500 margins are also compressing, currently at 50bps off their peak, with consensus expecting them to lose another two points within the next 12 months as companies are grappling with rising costs (Chart 17). Analysts are finally in a downgrading mode (Chart 18), with growth over the next 12 months now expected to be 7.7% compared to 10% earlier this summer. Analyst downgrades will continue, and an earnings recession is highly probable as early as Q4-2022. Chart 17Profitability Is Under Pressure Profitability Is Under Pressure Profitability Is Under Pressure Chart 18Earnings Are Finally Being Downgraded Earnings Are Finally Being Downgraded Earnings Are Finally Being Downgraded In terms of the durability of the rally – earnings growth disappointment will be enough to cause equities to pull back. Earnings growth is slowing and more disappointments may be in store. Valuations And Technicals The S&P 500 is currently trading at 18x forward earnings, which is nearly a two-point rebound off the market trough of 15.8x. This is roughly where PE NTM was in April when the 10-year yield stood at 2.80%. Therefore, the multiple reverted on the back of falling rates, and the market is fairly valued considering where rates are now. And another factor to consider: Analysts are slashing earnings expectations, and with E in a P/E likely to be downgraded further – the “true” forward multiple is likely higher than it appears. The BCA Valuation Indicator is also flashing “overvalued” (Chart 19). From the equity risk premium standpoint, 3% is low by historical standards (Chart 20). And if we consider Shiller PE, it has come down from an eye-watering 38x to a still elevated 29x. Chart 19Pricey Again? Pricey Again? Pricey Again? Chart 20Equities Are No Longer Cheap By ERP Or Shiller PE Metrics Equities Are No Longer Cheap By ERP Or Shiller PE Metrics Equities Are No Longer Cheap By ERP Or Shiller PE Metrics Therefore, it is hard to call equities cheap at this point. But being generous, we will call them “fairly priced.” Regardless – at these levels of valuations, the best part of the rally is likely over, and risk-reward is no longer favorable. From a technical standpoint, this rally is broad-based with nearly 90% of the S&P 500 industries trading above their 50-day moving average (Chart 21). But according to the BCA Technical Indicator, equities are no longer oversold and have just crossed into neutral territory (Chart 22). Interestingly, once the Technical indicator starts to rise, it usually ascends for a while, making us wary to boldly call an immediate end to this rally. Chart 21Thrusting Thrusting Thrusting Chart 22No Longer Oversold? No Longer Oversold? No Longer Oversold? Valuations and Technicals are no longer attractive – the best part of the rally is likely over and risk-reward is skewed to the downside. Investment Implications Or Can This Rally Continue? Timing the market is hard at best, impossible at worst. After a 17% rise from the bottom, the S&P 500 is no longer cheap or oversold. Buying equities for valuations or technical reasons is too late – risks are skewed to the downside. Our working assumption is that the rally will pause waiting for the new data that will trigger a new leg up or down. Further, as we pointed out in the Fat and Flat report, the current period is reminiscent of the 1980-1982 Volcker era. So far, the market is following this pattern to a T (Chart 23). The problem is that each leg of the up-and-down market may take months. As such, being (eventually) right and principled does not pay off. After all, the economy is not a market. Therefore, until one of the following happens, the music will continue and the markets can keep dancing, which may be for a while. Chart 23Volcker Era Redux Volcker Era Redux Volcker Era Redux The rally will continue until: There is a communication from the Fed re-emphasizing its hawkish stance and determination to get inflation back to 2%. It may be as one of the FOMC member’s speeches broadcast at Jackson Hole. Long-term Treasury yields pick up either because of the Fed’s actions or speeches or because the economy is overheating. Negative inflation surprise – it may come as either a higher-than-expected inflation reading or evidence that inflation is entrenched, such as rising service or rent inflation, soaring wages, a pick-up in the price of oil or commodities, or a growth surprise out of China, to name but a few. Negative earnings surprise – guidance from a number of companies indicating that economic growth is slowing, and earnings will disappoint. A negative economic surprise may be perceived by the market as “bad news is good news.” We recommend the following: Maintain a well-diversified portfolio, with sufficient allocation to both cyclicals and defensives. Increase exposure to Growth sectors, such as Technology. We particularly favor Software and Services as it leverages the pervasive theme of digitization and migration to the cloud. Reduce allocation to Energy and Materials – these sectors tend to underperform when inflation turns. They are also quintessential value sectors. Maintain some allocation to cyclicals – we are overweight the Industrial sector as it leverages a long-term theme of onshoring and automation. We may be upgrading the Consumer Discretionary sector in the near future. We are also overweight Banks and Insurance for portfolio diversification – these sectors benefit from rising rates and positive growth surprise. Markets turn on a dime and it is good to be prepared. Allocate capital to long-term investment themes: Green and Clean and EV, benefiting from the funds allocated by the IRA bill, Cyber Security, and Defense. Bottom Line: The rally was expected, but its force and durability took us by surprise. Now, after a strong rebound, risks are skewed to the downside and the markets are fragile, but the rally may still continue. We offer our take on what can bring this rally to a halt, and the “danger” signs investors need to be on the lookout for. In the meantime, overweight Growth and maintain a well-diversified portfolio.     Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation   Recommended Allocation: Addendum What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up  

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