Labor Market

Listen to a short summary of this report.         Executive Summary Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Adverse supply shocks have pushed down global growth this year, while pushing up inflation. With the war raging in Ukraine and China trying to contain a major Covid outbreak, these supply shocks are likely to persist for the next few months. Things should improve in the second half of the year. Inflation will come down rapidly, probably even more than what markets are discounting. Global growth will reaccelerate as pandemic headwinds abate. The return of Goldilocks will allow the Fed and other central banks to temper their hawkish rhetoric, helping to support equity prices while restraining bond yields. Unfortunately, this benign environment will sow the seeds of its own demise. Falling inflation during the remainder of the year will lift real incomes, leading to increased consumer spending. Inflation will pick up towards the end of 2023, forcing central banks to turn hawkish again. Trade Inception Level Initiation Date Stop Loss Long iShares Core S&P Small Cap ETF (IJR) / SPDR S&P 500 ETF (SPY) 100 Apr 21/2022 -5% Trade Recommendation: Go long US small caps vs. large caps via the iShares Core S&P Small-Cap ETF (IJR) and the SPDR S&P 500 ETF (SPY). Bottom Line: Global equities are heading towards a “last hurrah” starting in the second half of this year. Stay overweight stocks on a 12-month horizon. Push or Pull? Economists like to distinguish between “demand-pull” and “cost-push” inflation. The former occurs in response to positive demand shocks while the latter reflects negative supply shocks. In order to tell one from the other, it is useful to look at real wages. When real wages are rising briskly, households tend to spend more, leading to demand-pull inflation. In contrast, when wages fail to keep up with rising prices, it is a good bet that we have cost-push inflation on our hands. Chart 1 shows that real wages have been falling across the major economies over the past year. The decline in real wages has coincided with a steep drop in consumer confidence (Chart 2). This points to cost-push forces as the main culprits behind today’s high inflation rates. Chart 1Real Wages Are Declining Real Wages Are Declining Real Wages Are Declining Chart 2Consumer Confidence Has Soured Consumer Confidence Has Soured Consumer Confidence Has Soured A close look at the breakdown of recent inflation figures supports this conclusion. The US headline CPI rose by 8.5% year-over-year in March. The bulk of the inflation occurred in supply-constrained categories such as food, energy, and vehicles (Chart 3). Chart 3The Acceleration In Inflation Has Been Driven By Pandemic And War-Impacted Categories Here Comes Goldilocks Here Comes Goldilocks The Toilet Paper Economy When the pandemic began, shoppers rushed out to buy essential household supplies including, most famously, toilet paper. Chart 4In A Break From The Past, Goods Prices Soared During The Pandemic In A Break From The Past, Goods Prices Soared During The Pandemic In A Break From The Past, Goods Prices Soared During The Pandemic The toilet paper used in offices is somewhat different than the sort used at home. So, to some extent, work-from-home (and do other stuff-at-home) arrangements did boost the demand for consumer-grade toilet paper. However, a much more important factor was household psychology. People scrambled to buy toilet paper because others were doing the same. As often occurs in prisoner-dilemma games, society moved from one Nash equilibrium – where everyone was content with the amount of toilet paper they had – to another equilibrium where they wanted to hold much more paper than they previously did. What has gone largely unnoticed is that the toilet paper fiasco was replicated across much of the global supply chain. Worried that they would not have enough intermediate goods on hand to maintain operations, firms began to hoard inputs. Retailers, anxious at the prospect of barren shelves, put in bigger purchase orders than they normally would have. All this happened at a time when demand was shifting from services to goods, and the pandemic was disrupting normal goods production. No wonder the prices of goods – especially durable goods — jumped (Chart 4).   Peak Inflation? The war in Ukraine could continue to generate supply disruptions over the coming months. The Covid outbreak in China could also play havoc with the global supply chain. While the number of Chinese Covid cases has dipped in recent days, Chart 5 highlights that 27 out of 31 mainland Chinese provinces are still reporting new cases, up from 14 provinces in the beginning of February. The number of ships stuck outside of Shanghai has soared (Chart 6). Chart 527 Out Of 31 Chinese Provinces Are Reporting New Cases, Up From 14 Provinces In The Beginning Of February Here Comes Goldilocks Here Comes Goldilocks Chart 6The Clogged-Up Port Of Shanghai Here Comes Goldilocks Here Comes Goldilocks Chart 7Inflation Will Decelerate This Year Thanks To Base Effects Inflation Will Decelerate This Year Thanks To Base Effects Inflation Will Decelerate This Year Thanks To Base Effects Nevertheless, the peak in inflation has probably been reached in the US. For one thing, base effects will push down year-over-year inflation (Chart 7). Monthly core CPI growth rates were 0.86% in April, 0.75% in May, and 0.80% in June of 2021. These exceptionally high prints will fall out of the 12-month average during the next few months. More importantly, goods inflation will abate as spending shifts back toward services. Chart 8 shows that spending on goods remains well above the pre-pandemic trend in the US, while spending on services remains well below. Excluding autos, US retail inventories are about 5% above their pre-pandemic trend (Chart 9). Core goods prices fell in March for the first time since February 2021. Fewer pandemic-related disruptions, and hopefully a stabilization in the situation in Ukraine, could set the stage for sharply lower inflation and a revival in global growth in the second half of this year. How long will this Goldilocks environment last? Our guess is that it will endure until the second half of next year, but probably not much beyond then. As inflation comes down over the coming months, real income growth will rise. What began as cost-push inflation will morph into demand-pull inflation by the end of 2023. The Fed will need to resume hiking at that point, potentially bringing rates to over 4% in 2024. Chart 8Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Chart 9Shelves Are Well Stocked In The US Shelves Are Well Stocked In The US Shelves Are Well Stocked In The US Investment Implications Wayne Gretzky famously said that he always tries to skate to where the puck is going to be, not where it has been. Macro investors should follow the same strategy: Ask what the global economy will look like in six months and invest accordingly. The past few months have been tough for the global economy and financial markets. Last week, bullish sentiment fell to the lowest level in 30 years in the American Association of Individual Investors poll (Chart 10). Global growth optimism dropped in April to a record low in the BofA Merrill Lynch Fund Manager Survey.    Chart 10AAII Survey: Equity Bulls Are In Short Supply AAII Survey: Equity Bulls Are In Short Supply AAII Survey: Equity Bulls Are In Short Supply Chart 11The Equity Risk Premium Remains Elevated The Equity Risk Premium Remains Elevated The Equity Risk Premium Remains Elevated Yet, a Goldilocks environment of falling inflation and supply-side led growth awaits in the second half of the year. Even if this environment does not last beyond the end of 2023, it could provide a “last hurrah” for global equities. Despite the spike in bond yields, the earnings yield on stocks still exceeds the real bond yield by 5.4 percentage points in the US, and by 7.8 points outside the US (Chart 11). TINA’s siren song may have faded but it is far from silent. Global equities have about 10%-to-15% upside from current levels over a 12-month horizon. We recommend that investors increase allocations to non-US stock markets, value stocks, and small caps over the coming months (see trade recommendation below). Consistent with our view that the neutral rate of interest is higher than widely believed in the US and elsewhere, we expect the 10-year Treasury yield to eventually rise to around 4% in 2024. However, with US inflation likely to trend lower in the second half of this year, we do not expect much upside for yields over a 12-month horizon. If anything, the fact that bond sentiment in the latest BofA Merrill Lynch survey was the most bearish in 20 years suggests that the near-term risk to yields is to the downside.  Trade Idea: Go Long US Small Caps Versus Large Caps Small caps have struggled of late. Over the past 12 months, the S&P 600 small cap index has declined 3%, even as the S&P has managed to claw out a 5% gain. At this point, small caps are starting to look relatively cheap (Chart 12). The S&P 600 is trading at 14-times forward earnings compared to 19-times for the S&P 500. Notably, analysts expect small cap earnings to rise more over the next 12 months, as well as over the long term, than for large caps. Chart 12Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Chart 13Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small caps tend to perform best in settings where growth is accelerating and the US dollar is weakening (Chart 13). Economic growth should benefit from a supply-side boost later this year as pandemic headwinds fade and more low-skilled workers rejoin the labor market. With inflation set to decline, the need for the Fed to generate hawkish surprises will temporarily subside, putting downward pressure on the dollar. Investors should consider going long the S&P 600 via the iShares Core S&P Small-Cap ETF (IJR) versus the S&P 500 via the SPDR S&P 500 ETF (SPY). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn Twitter   Global Investment Strategy View Matrix Here Comes Goldilocks Here Comes Goldilocks Special Trade Recommendations Current MacroQuant Model Scores Here Comes Goldilocks Here Comes Goldilocks

Executive Summary In this first of a regular series of ‘no holds barred’ conversations with a concerned client we tackle the hot topic of inflation. Month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation too. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral. Surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. This recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. On a 6-12 month horizon, underweight inflation protected bonds and commodities… …overweight conventional bonds and stocks… …and tilt towards healthcare and biotech. The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price Bottom Line: US core inflation is about to peak, demand destruction will ultimately pull down headline inflation, and there is no imminent risk of a wage-price spiral. On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. Feature Welcome to the first of a regular series of Counterpoint reports that takes the form of a ‘no holds barred’ conversation with a concerned client. Roughly once a month, our open and counterpoint conversations will address a major question or concern for investors. This inaugural conversation tackles the hot topic of inflation. On Peak Inflation Client: Thank you for addressing my worries. Like many people right now, I am concerned about inflation. My first question is, when is inflation going to peak? CPT: The good news is that, in an important sense, inflation has already peaked. Month-on-month core inflation in the US reached a high of 0.9 percent through April-June last year. In the more recent pickup through October-January it reached a ‘lower peak’ of 0.6 percent. And in March it dropped to 0.3 percent. Client: Ok, but inflation usually refers to the 12-month inflation rate – when will that peak? CPT: The 12-month inflation rate is just the sum of the last twelve month-on-month rates. So, when the big numbers of April-June of last year drop off to be replaced by the smaller numbers of April-June of this year, the 12-month inflation rate will fall sharply (Chart I-1). Chart I-1Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Client: Even if the 12-month inflation rate does peak soon, it will still be far too high. When will it return to the 2 percent target? CPT: In the pandemic era, monthly core inflation has been non-linear. Meaning it has been either ‘high-phase’ of 0.5 percent and above, or ‘low-phase’ of 0.3 percent and below. In March it returned to low-phase. If it stays in low-phase, then as an arithmetic identity, the 12-month core inflation rate will be close to its target twelve months from now. Client: So far, you have just talked about core inflation which excludes energy and food prices. What about headline inflation? Specifically, isn’t the Ukraine crisis a massive supply shock for Russian and Ukrainian sourced energy and food? Demand destruction will ultimately pull down headline inflation too. CPT: Yes, headline inflation may take longer to come down than core inflation. But supply shocks ultimately resolve themselves through demand destruction. Client: Could you elaborate on that? CPT: Sure. With fuel and food prices surging, many people are asking: do I really need to make that journey? Do I really need to keep the heating on? Can I buy a cheaper loaf of bread? So, they will cut back, and to the extent that they can’t cut back on energy and food, demand for other more discretionary items will come down, and eventually weigh on prices. Client: At the same time, the pandemic is still raging – look at what’s happening in Shanghai right now. Won’t further disruptions to supply chains just add further fuel to inflation? CPT: Yes, but to repeat, inflation that is entirely due to a supply shock ultimately resolves itself through demand destruction. On The Source Of The Inflation Crisis Client: I am puzzled. If supply shock generated inflation resolves itself, then what has caused the post-pandemic inflation to be anything but ‘transitory’? CPT: The simple answer is the pandemic’s draconian lockdowns combined with massive handouts of government cash unleashed a massive demand shock. But it wasn’t a shock in the magnitude of demand, it was a shock in the distribution of demand (Chart I-2). Chart I-2The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand Client: Could you explain that? CPT: Well, we were all locked at home and flush with government supplied cash, and we couldn’t spend the cash on services. So, we spent it on what we could spend it on – namely, durable goods. This created a massive shock in the distribution of demand, out of services whose supply could easily adjust downwards, and into goods whose supply could not easily adjust upwards. Client: Can you give me some specific examples? CPT: Sure. Airlines could cut back their flights, but auto manufacturers couldn’t make more cars. So, airfares didn’t collapse but used car prices went vertical! The result being the surge in inflation. Client: Do you have any more evidence? Inflation is highest in those economies where the cash handouts and furlough schemes were the most generous, like the US and the UK. CPT: Yes, the three separate surges in month-on-month core inflation all occurred after surges in durable goods demand (Chart I-3). Additionally, inflation is highest in those economies where the cash handouts and furlough schemes were the most generous – like the US and the UK. Chart I-3The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand Client: If we get more waves of Covid, what’s to stop all this happening again? CPT: Nothing, so we should be vigilant. That said, we now have coping strategies for Covid that do not necessitate massive handouts of government cash. Also, we have already binged on durable goods, making it much harder to repeat that trick. On Wages And Inflation Expectations Client: I am still worried that if workers can negotiate much higher wages in response to higher prices, then it would threaten a wage-price spiral. CPT: Agreed, but it is technically incorrect to focus on wage inflation. The correct metric to focus on is unit labour cost inflation – which is wage growth in excess of productivity growth. In the US, this was 3.5 percent through 2021, slowing to just a 0.9 percent annual rate in the fourth quarter. So, it is not flashing danger, at least yet. Client: Ok, but what about the surge in inflation expectations. Isn’t that flashing danger? CPT: We should treat inflation expectations with a huge dose of salt, as they simply track the oil price, and therefore provide a nonsensical prediction of future inflation! (Chart I-4) Chart I-4The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense Client: What can explain this nonsense? CPT: Simply that when the oil price is high, investors flood into inflation hedges such as inflation protected bonds. So, the surge in inflation expectations is just capturing the frothiness in inflation protected bond prices that this massive hedging demand is creating. We can see similar frothiness in some commodity prices. The recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. Client: How so? CPT: Well to the extent that commodity prices drive headline inflation, the apples-for-apples relationship should be between commodity price inflation and headline inflation, and this is what we generally see (Chart I-5). But recently, this relationship has broken down and instead we see a tighter relationship between headline inflation and commodity price levels (Chart I-6 and Chart I-7). The likely causality here is that, just as for inflation protected bonds, massive inflation hedging demand has created frothiness in some commodity prices. Chart I-5Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Chart I-6Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Chart I-7...But A Tight Relationship Between Headline Inflation And Commodity Price Levels ...But A Tight Relationship Between Headline Inflation And Commodity Price Levels ...But A Tight Relationship Between Headline Inflation And Commodity Price Levels On The Investment Implications Client: To sum up your view then, month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral, and surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. What does this view mean for investment strategy? On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. CPT: Well given that inflation is peaking, one obvious implication is that the massive demand for inflation hedges will recede and take the frothiness out of their prices. On a 6-12 month horizon this means underweighting inflation protected bonds and commodities (Chart I-8). Chart I-8The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price Client: What about the surge in bond yields – when will that reverse? CPT: Empirically, we have seen that bond yields turn just ahead of the turn in the 12-month core inflation rate. Hence, on a 6-12 month horizon this means overweighting bonds. Client: Finally, what does all this mean for stock markets? CPT: The weakness of stock markets this year has been entirely due to falling valuations, rather than falling profits. If the headwind to valuations from rising bond yields turns into a tailwind from falling bond yields, it will boost stocks – especially long-duration stocks with relatively defensive profits. On a 6-12 month horizon this means overweighting stocks, and our favourite sectors are healthcare and biotech. Client: Thank you very much for this open and counterpoint conversation. Fractal Trading Watchlist Due to the Easter holidays, there are no new trades this week. However, the full updated watchlist of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Greece's Brief Outperformance To End Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 20Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Conversation With A Concerned Client: On Inflation Conversation With A Concerned Client: On Inflation Conversation With A Concerned Client: On Inflation Conversation With A Concerned Client: On Inflation 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary We have been constructive-to-bullish on financial markets and the economy since policymakers marshaled the full force of their resources to protect the economy from the pandemic in the spring of 2020. The policymakers-versus-the-virus framework, and the view that policymakers would triumph, stood us in good stead across 2020 and 2021. Now, however, the Fed is shifting from countering COVID’s adverse economic effects to reinforcing them. The near-term silver lining is that monetary policy works with a lag, just like fiscal transfers that are saved for future use. Although the Fed is in the process of dialing back monetary stimulus, it will be a while before the fed funds rate reaches a level that restrains economic activity. In the meantime, the lagged effects of extraordinarily stimulative monetary and fiscal policy are likely to keep the economy growing above trend. Runaway inflation is the clear and present danger to our base-case view, and the war in Ukraine and a COVID outbreak in China could exacerbate inflationary pressures. We expect that equities and high-yield corporate bonds will outperform Treasuries and cash over the rest of the year, but inflation could spoil the party. It's Not A Spiral Yet It's Not A Spiral Yet It's Not A Spiral Yet Bottom Line: We remain constructive on the economy and financial markets over a six-to-twelve-month timeframe, though we have more conviction in our view at the near end of the range. We fully expect that the Fed will kill this expansion, but not before the middle of 2023 unless geopolitics and/or China’s COVID response accelerate the timetable. Feature Policymakers versus the virus, and our conviction that the Fed and Congress had the means and the will to do whatever it took to protect the economy from the ravages of COVID, proved to be the right macro template for making investment decisions in 2020 and 2021. Now a new battle has been joined – the Fed versus inflation – and we anticipate that it will end in a recession and an equity bear market. Before Russia invaded Ukraine, crimping global supplies of grains, base metals, crude oil, natural gas and coal, and China began experiencing its worst COVID outbreak, imperiling the nascent improvement in global supply chains, we were confident that the party wouldn’t break up before the second half of 2023 at the earliest. Although we remain constructive over a cyclical 3-to-12-month timeframe, we recognize that Eurasian developments may foreshorten the current expansion. The Global Unknowns The indirect effects of the war in Europe are readily apparent but it is difficult to predict if Russian actions will lead to more sanctions and/or extend hostilities to a wider theater, deepening the European slowdown, exerting additional upward pressure on commodity prices and casting a larger shadow over global activity. China’s confrontation with COVID is riddled with unknowns: How effective is its Sinopharm vaccine against the currently dominant strain of the virus, and how effective will it be against subsequent mutations? When will China abandon its zero-tolerance policy? How stringent will lockdowns be? Could they be localized, allowing most industrial activity to continue, or will they be more sweeping? Is there any chance that the country will license the proven mRNA vaccine technology or the Pfizer pills that neutralize the severity of the disease in those who have become infected? The Eurasian factors are important, albeit hard to forecast, and we will have to monitor them in real time to get the soonest possible jump on their impacts. Several threats closer to home keep surfacing in our ongoing conversations with investors, however, and the rest of this week’s report examines them in the context of our constructive base-case view. The Wage-Price Spiral Employment data have consistently pointed to an increasingly tight labor market. Job openings are at record levels and consumer and small business surveys indicate that it is unusually easy for job seekers to find a job, and unusually difficult for employers to attract workers. All else equal, the dearth of labor supply strengthens workers’ bargaining power and supports further wage growth acceleration. With the US labor market already so tight that it squeaks, many observers are convinced that a wage-price spiral is a foregone conclusion. They can cite various wage series as evidence that a spiral might already have begun. The Atlanta Fed Wage Tracker and comprehensive measure of the Employment Cost Index are growing by 6% and 4.4% year-on-year, respectively. As large as the nominal gains are, however, they’re lagging the increase in consumer prices. Despite the voracious demand for workers, wage growth adjusted for inflation has decelerated since the early days of the pandemic, when front-line workers received the equivalent of combat pay in bonuses and temporary hourly increases, and has mostly contracted since last spring (Chart 1). Chart 1They're Not Exactly Chasing Each Other Higher Now They're Not Exactly Chasing Each Other Higher Now They're Not Exactly Chasing Each Other Higher Now Amidst the disruptions of the pandemic, many workers left the labor force. Census Department surveys attributed many of the departures to a lack of childcare or fear of infection, while print media and the Internet were awash with stories of people who’d re-examined their lives and determined that their existing work was unfulfilling. Supported by generous fiscal transfers, the subjects of the stories regularly professed indifference about returning to work. The Great Resignation narrative gained currency as an explanation of declining labor force participation and suggested that the shortage of workers might endure until today’s high school and college students grew old enough to step in themselves. Recent evidence undermines the idea that the Great Resignation marked a structural change in labor force participation. It looks much more like the decline was cyclical, tied to the ups and downs of infection rates and fiscal appropriations. The prime-age (25-to-54-year-old) participation rate has recovered to within a percentage point of its pre-pandemic high and appears to have plenty of momentum (Chart 2). Workers in the 55-to-64 age group, fueling the Great Retirement unit of the Great Resignation battalion, have come back to the workforce in droves, with the 55-to-59 cohort setting a 10-year participation high (Chart 3, middle panel) and its 60-to-64 peer group nearing one (Chart 3, bottom panel). Workers over 65 may remain on the sidelines, but the early retirement thesis is faltering as well. Chart 2The Great Resignation Is Unwinding ... The Great Resignation Is Unwinding ... The Great Resignation Is Unwinding ... Chart 3... And So Is The Early Retirement Wave ... And So Is The Early Retirement Wave ... And So Is The Early Retirement Wave     Finally, a resumption of more normal immigration patterns may also boost labor supply. The Department of Homeland Security states that it granted 228,000 lawful permanent residencies in the first quarter of 2022, a 72% increase from one year ago.1 Widespread pandemic business closures led some immigrants to return home, while keeping others who may have emigrated from crossing the border. We have no illusions that immigration is on the cusp of a step-function increase, but any uptick will help at the margin, especially in low and unskilled jobs where supply is especially strained. The bottom line for investors is that the labor market is tight, but real declines in wages and further supply relief may keep a wage-price spiral from taking root. It is too soon to conclude that wages and prices will chase each other higher in a repeat of the bad old days of the seventies. Inflation And The US Consumer Chart 4An Unprecedented Divergence An Unprecedented Divergence An Unprecedented Divergence Consumer confidence has been flagging, especially in the University of Michigan survey, which is approaching all-time lows two standard deviations below its mean (Chart 4, top panel). Though the Conference Board’s measure has come off of its pandemic highs, it is considerably more optimistic and remains above its mean (Chart 4, bottom panel). The Michigan survey places much more emphasis on inflation, which may explain why the two series are sending such sharply divergent messages. The implication is that high and/or rising inflation dents households’ confidence as it erodes their purchasing power, posing a dual threat to consumption and overall economic growth. In our view, the lagged effects of emergency pandemic stimulus measures have fortified households with enough dry powder (via fiscal transfers) and provided a powerful enough financial conditions tailwind (via low interest rates and asset appreciation) to ensure that their spending will underpin potent 2022 growth. We estimate that US households in the aggregate have $2.2 trillion in excess pandemic savings2 (Table 1). They have begun to deploy those savings, fueling consumption above our estimate of no-pandemic baseline consumption by $30 billion in both January and February, and they have ample capacity to spend more. The excess savings derive nearly equally from increased income and foregone consumption and are predominantly held by households in the bottom seven deciles of the income distribution because they received nearly all of the fiscal transfers that drove income increases across 2020 and the first half of 2021. Table 1Tracking Excess Savings Risks To Our View Risks To Our View Those households have a higher marginal propensity to consume than the wealthiest households, but the wealthy have benefitted mightily from the surge in the value of equities and other financial instruments. Most of the stellar eight-quarter increase in real household net worth (Chart 5) has thus been reserved to households in the top deciles but the home-price-appreciation boom has helped the two-thirds of households across the income distribution who own their homes (Chart 6). The bottom line is that American consumers are flush and the entire cross-section of households has shared in the bounty. The gains are unprecedented, just like the fiscal and monetary stimulus packages that gave rise to them, and they provide a buffer of dry powder that can withstand some purchasing power erosion from the 5.2% annualized increase in consumer prices since February 2020. Chart 5Household Wealth Has Never Grown So Much, So Fast ... Household Wealth Has Never Grown So Much, So Fast ... Household Wealth Has Never Grown So Much, So Fast ... Chart 6... And Ordinary Joes Benefitted, Too ... And Ordinary Joes Benefitted, Too ... And Ordinary Joes Benefitted, Too Quantitative Tightening Clients ask about the potential adverse effects of quantitative tightening (QT) in nearly every meeting, regularly citing the way the stocks swooned at the end of 2018, about a year into the FOMC’s previous balance sheet reduction foray. QT was at the scene of the crime in December 2018 and may well have been an accessory to the near murder of the equity bull market, but we would argue that a too-high fed funds rate was the true culprit. Although most investors recollect that the Fed ceased QT when equities hit an air pocket, the balance sheet continued shrinking until the summer of 2019, when the Fed resumed cutting rates. After the stock swoon, the Fed only stopped hiking the fed funds rate (at 2.5%). Related Report  US Investment StrategyHawks, Houses And Harried Workers As we discussed last week, we don’t think changes in the size of the Fed’s balance sheet lead to much more than marginal changes in the level of long-term interest rates. They fall a little when a large, price-insensitive buyer enters the marketplace, and they rise a little when it exits. Ultimately, we think asset purchases (QE) have the most impact as a signaling device: they communicate to investors and economic actors that zero interest rate policy will remain in place as long as QE continues and for some period after it ends. QE is therefore a leading indicator, while QT is no more than a coincident indicator, playing a nearly undetectable supporting role. QT may contribute to volatility in the rates market, but investors shouldn’t let it take their focus from the Fed’s more powerful fed funds rate lever. The Vulnerable Housing Market We discussed our constructive take on the housing market and residential investment last week, noting that homes are still affordable and mortgage rates are still low from a historical perspective, while the single-family home market remains undersupplied. Talk of a housing bubble has died down, but we still hear occasional references to housing’s role in the financial crisis and concerns about the economy’s vulnerability to a rate-induced decline in home prices. In our view, those concerns can easily be put to rest. Investors should remember that the subprime bust was principally a story about prodigally extended credit; houses just happened to be the collateral against which the loans were made. Chart 7Flight To Quality Risks To Our View Risks To Our View Those loans, the worst of which exceeded underlying property values and were extended to buyers who were not even remotely creditworthy, were tantamount to a house of cards by 2007. From 2004 through 2007 (Chart 7), more than a fifth of all new home mortgage originations went to near-prime (credit score between 620 and 659) and subprime (less than 620) borrowers, while not much more than half were issued to super-prime (greater than 720). Since the pandemic, near-prime and subprime borrowers have been limited to an average 5% share of loans, while super-primes have accounted for 84% of them and the upper tier of super-primes, with credit scores of 760 and above, have accounted for 70%. The change in lending standards can also be seen from using the Fed’s household balance sheet data to calculate an aggregate loan-to-value ratio (LTV) for the entire stock of owner-occupied single-family homes. The aggregate LTV currently stands at 31%, in the middle of the tight range it observed in the seventies and eighties, before policymakers began actively encouraging banks to make mortgage loans available to an expanded pool of borrowers (Chart 8). LTV exploded higher from 2006 through 2009 as lending peaked in 2006-7 and home values subsequently fell faster than mortgage balances in the 2008-9 bust. The record LTV of the subprime crisis, ginned up by loans that matched or exceeded underlying home values, amplified the distress from a downturn in home prices; today’s ‘70s-style LTV will help to absorb them. Chart 8High Prices Weren't The Problem, High LTVs Were High Prices Weren't The Problem, High LTVs Were High Prices Weren't The Problem, High LTVs Were Portfolio Construction Takeaways Our Global Fixed Income and US Bond Strategy services have adjusted their recommended tactical positioning on Treasuries and spread product and we are adjusting our ETF portfolio to align with their view with a slight exception. Our in-house bond strategists recommend a modest tactical overweight in Treasuries and we are curing our Treasury underweight while maintaining benchmark duration. We are reducing our allocation to hybrid debt securities by halving our position in variable-rate preferreds (VRP) on the rationale that we have less need for credit exposure and duration protection over the immediate term. We are trimming our high yield overweight (JNK) to a mere 100 basis points and allocating our sales proceeds that aren’t going to Treasuries into mortgage-backed securities (MBB) to reduce that underweight by 140 basis points. We are parting company with our fixed income team by maintaining a small high yield overweight on the grounds that above-trend economic growth will hold down delinquencies and defaults until a recession is nearly at hand. The position is vulnerable to spread widening, but we expect the positive carry over duration-matched Treasuries will allow high yield to generate positive excess returns for the rest of the year. All of the changes are detailed in Table 2 and will be reflected on BCA’s website soon after today’s New York open. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Associate Editor JenniferL@bcaresearch.com   Footnotes 1     https://www.dhs.gov/immigration-statistics/special-reports/legal-immigr…, accessed April 12, 2022. Data obtained from Table 1A. 2     Table 1 calculates household excess savings by subtracting our estimate of baseline no-pandemic savings from actual savings as compiled by the Bureau of Economic Analysis in its monthly Personal Income report. Our baseline estimate assumes that personal income would have grown at an annualized 4% pace (2% real trend growth plus 2% inflation) and that the savings rate would have remained constant at its 8.3% February 2020 level.

Executive Summary The unemployment rate in the US stands at 3.6%, 0.4 percentage points below the FOMC’s estimate of full employment. Historically, the Fed’s efforts to nudge up the unemployment rate have failed: The US has never averted a recession when the 3-month average of the unemployment rate has increased by more than a third of a percentage point. Despite this somber fact, there are reasons to think it will take longer for a recession to arrive than widely believed. Unlike in the lead-up to many past recessions, the US private sector is currently running a financial surplus. If anything, there are indications that both households and businesses are set to expand – rather than retrench – spending over the coming quarters. Investors should pay close attention to the housing market. As the most interest-rate sensitive sector of the economy, it will dictate the degree to which the Fed can raise rates. The US housing market has cooled, but remains in reasonably good shape, supported by rising incomes and low home inventories. Stocks will likely rise modestly over the next 12 months as inflation temporarily dips and the pandemic recedes from view. However, equities will falter towards the end of 2023. Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Bottom Line: The US may not be able to avoid a recession, but an economic downturn is unlikely until 2024. Stay modestly overweight stocks over a 12-month horizon.  Jobs Aplenty The US unemployment rate fell from 3.8% in February to 3.6% in March, bringing it close to its pre-pandemic low of 3.5%. Adding job openings to employment and comparing the resulting sum with the size of the labor force, the excess of labor demand over labor supply is now the highest since July 1969 (Chart 1). Chart 1Labor Demand Is Outstripping Labor Supply By The Largest Margin Since 1969 Is A Recession Inevitable? Is A Recession Inevitable? Granted, the labor force participation rate is still one full percentage point below where it was prior to the pandemic. If the participation rate were to rise, the gap between labor demand and supply would shrink. Some of the decline in the participation rate is permanent in nature, reflecting ongoing population aging, which has been compounded by an increase in early retirements during the pandemic (Chart 2). Some workers who dropped out will probably re-enter the workforce. Chart 3 shows that employment among low-wage workers has been slower to recover than for other groups. With expanded unemployment benefits no longer available, the motivation to find gainful employment will escalate. Chart 2Not All Of The Decline In Labor Participation During The Pandemic Was Due To Increased Early Retirements Not All Of The Decline In Labor Participation During The Pandemic Was Due To Increased Early Retirements Not All Of The Decline In Labor Participation During The Pandemic Was Due To Increased Early Retirements Chart 3Low-Wage Workers Have Not Returned In Full Force Low-Wage Workers Have Not Returned In Full Force Low-Wage Workers Have Not Returned In Full Force Nevertheless, it is doubtful that the entry of low-wage workers into the labor force will do much to reduce the gap between labor demand and supply. Low-wage workers tend to spend all of their incomes (Chart 4). Thus, while an increase in the number of low-wage workers will allow the supply of goods and services to rise, this will be counterbalanced by an increase in the demand for goods and services. Chart 4Richer Households Tend To Save More Than Poorer Ones Is A Recession Inevitable? Is A Recession Inevitable? To cool the labor market, the Fed will need to curb spending, and that can only be achieved by raising interest rates. Trying to achieve a soft landing in this manner is always easier said than done. The US has never averted a recession when the 3-month average of the unemployment rate has increased by more than a third of a percentage point. Rising unemployment tends to produce a negative feedback loop: A weaker labor market depresses spending. This, in turn, leads to less hiring and more firing, resulting in even higher unemployment. Where is the Choke Point? How high will interest rates need to rise to trigger such a feedback loop? Markets currently expect the Fed to raise rates to 3% by mid-2023 but then cut rates by at least 25 basis points over the subsequent months (Chart 5). So, the market thinks the neutral rate of interest – the interest rate consistent with a stable unemployment rate – is around 2.5%. The Fed broadly shares the market’s view. The median dot for the terminal Fed funds rate stood at 2.4% in the March Summary of Economic Projections (Chart 6). When the Fed first started publishing its dot plot in 2012, it thought the terminal rate was 4.25%. Chart 5The Markets See The Fed Funds Rate Reaching 3% Next Year Is A Recession Inevitable? Is A Recession Inevitable? Chart 6The Fed's Estimate Of The Terminal Rate Has Fallen Over The Years The Fed's Estimate Of The Terminal Rate Has FalLen Over The Years The Fed's Estimate Of The Terminal Rate Has FalLen Over The Years Low Imbalances Imply a Higher Neutral Rate We have discussed the concept of the neutral rate extensively in the past, so we will not regurgitate the issues here (interested readers should consult the Feature Section of our latest Strategy Outlook). Instead, it would be worthwhile to dwell on the relationship between the neutral rate and economic imbalances. Simply put, when an economy is suffering from major imbalances, it does not take much monetary tightening to push it over the edge. The private-sector financial balance measures the difference between what households and firms earn and spend. A recession is more likely to occur when the private-sector financial balance is negative — that is, when spending exceeds income — since households and firms are more prone to cut spending when they are living beyond their means. In the lead-up to the Great Recession, the private-sector financial balance hit a deficit of 3.9% of GDP in the US. Leading up to the 2001 recession, it reached a deficit of 5.4% of GDP. Today, the US private-sector financial balance, while down from its peak during the pandemic, still stands at a comfortable surplus of 3% of GDP. Rather than looking to retrench, households and businesses are poised to increase spending over the coming quarters (Chart 7). Private-sector financial balances are also positive in Japan, China, and most of Europe (Chart 8). Chart 7Consumers And Businesses Are Set To Spend More Consumers And Businesses Are Set To Spend More Consumers And Businesses Are Set To Spend More Chart 8Private-Sector Financial Balances Are Positive In Most Major Economies Is A Recession Inevitable? Is A Recession Inevitable? Watch Housing Chart 9Rising Interest Rates In The Early 1980s Had Much More Of A Negative Effect On Housing Than Business Investment Rising Interest Rates In The Early 1980s Had Much More Of A Negative Effect On Housing Than Business Investment Rising Interest Rates In The Early 1980s Had Much More Of A Negative Effect On Housing Than Business Investment At the 2007 Jackson Hole conference, Ed Leamer presented what turned out to be a very prescient paper. Titled “Housing is the Business Cycle,” Leamer concluded that “Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession.” Housing is a long-lived asset, and one that is usually financed with debt. To a much greater extent than nonresidential investment, the housing sector is very sensitive to changes in interest rates. When the Fed hiked rates in the early 1980s, residential investment collapsed but business investment barely contracted (Chart 9). The jump in mortgage yields has started to weigh on housing (Chart 10). Mortgage applications for home purchases have fallen by 25% from their highs. Pending home sales have dropped. Homebuilder confidence has dipped. Homebuilder stocks are down 29% year-to-date. Housing is likely to slow further in the months ahead, even if mortgage yields stabilize. Chart 11 shows that changes in mortgage yields lead home sales and housing starts by about six months. Chart 10The Jump In Mortgage Rates Has Weighed On The Housing Market The Jump In Mortgage Rates Has Weighed On The Housing Market The Jump In Mortgage Rates Has Weighed On The Housing Market Chart 11Swings In Mortgage Rates Explain Short-Term Fluctuations In Housing Activity Swings In Mortgage Rates Explain Short-Term Fluctuations In Housing Activity Swings In Mortgage Rates Explain Short-Term Fluctuations In Housing Activity The key question for investors is whether the housing market will enter a deep freeze or merely cool down. We think the latter is more likely. The 30-year fixed mortgage rate has increased nearly two percentage points since last August, but at around 5%, it is still below the average of 6% that prevailed during the 2000-2006 housing boom (Chart 12). Image Moreover, unlike during the housing boom, when homebuilders flooded the market with houses, the supply of new homes remains contained. The nationwide homeowner vacancy rate stands at record lows. Building permits are near cycle highs (Chart 13). Granted, real home prices are close to record highs. However, relative to incomes, US home prices have not broken out of their historic range (Chart 14). Chart 13The Homeowner Vacancy Rate Is Near Record Lows The Homeowner Vacancy Rate Is Near Record Lows The Homeowner Vacancy Rate Is Near Record Lows Chart 14Homes In The US Are Relatively Cheap Homes In The US Are Relatively Cheap Homes In The US Are Relatively Cheap Home affordability is much more stretched outside of the United States. The Bank of Canada, for example, has less scope to raise rates than the Fed. Chart 15Some Signs Of Easing In Supply-Side Pressures Some Signs Of Easing In Supply-Side Pressures Some Signs Of Easing In Supply-Side Pressures Investment Conclusions As investors, we need to be forward looking. The widespread availability of Paxlovid later this year — which, in contrast to the vaccines, is effective against all Covid strains — will help boost global growth while relieving supply-chain bottlenecks. Shipping costs, used car prices, and ISM supplier delivery times have already come down from their highs (Chart 15). Central banks have either started to raise rates or are gearing up to do so. However, monetary policy is unlikely to turn restrictive in any major economy over the next 12 months. Stocks usually go up outside of recessionary environments (Chart 16). Global equities are trading at 17-times forward earnings. The corresponding earnings yield is about 630 basis points higher than the real global bond yield – a very wide gap by historic standards (Chart 17). Chart 16Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Chart 17AThe Equity Risk Premium Remains Elevated (I) The Equity Risk Premium Remains Elevated (I) The Equity Risk Premium Remains Elevated (I) Chart 17BThe Equity Risk Premium Remains Elevated (II) The Equity Risk Premium Remains Elevated (II) The Equity Risk Premium Remains Elevated (II) Investors should remain modestly overweight equities over a 12-month horizon and look to increase exposure to non-US stock markets, small caps, and value stocks over the coming months. Government bond yields are unlikely to rise much over the next 12 months but will increase further over the long haul. The dollar should peak during this summer, and then weaken over the subsequent 12 months. A complete discussion of our market views is contained in our recently published Second Quarter Strategy Outlook.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Is A Recession Inevitable? Is A Recession Inevitable? Special Trade Recommendations Current MacroQuant Model Scores Is A Recession Inevitable? Is A Recession Inevitable?

Executive Summary Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Macroeconomic Outlook: Global growth will reaccelerate in the second half of this year provided a ceasefire in Ukraine is reached. Inflation will temporarily come down as the dislocations caused by the war and the pandemic subside, before moving up again in late 2023. Equities: Maintain a modest overweight in stocks over a 12-month horizon, favoring non-US equities, small caps, and value stocks. Look to turn more defensive in the second half of 2023 in advance of another wave of inflation. Fixed income: The neutral rate of interest in the US is around 3.5%-to-4%, which is substantially higher than the consensus view. Bond yields will move sideways this year but will rise over the long haul. Overweight Germany, France, Japan, and Australia while underweighting the US and the UK in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds over the next 12 months. Favor HY over IG and Europe over the US. Spreads will widen again in late 2023. Currencies: As a countercyclical currency, the US dollar will weaken later this year, with EUR/USD rising to 1.18. We are upgrading our view on the yen from bearish to neutral due to improved valuations. The CNY will strengthen as the Chinese authorities take steps to boost domestic demand. Commodities: Oil prices will dip in the second half of 2022 as the geopolitical premium in crude declines and more OPEC supply comes to market. However, oil and other commodity prices will start moving higher by mid-2023. Bottom Line: The cyclical bull market in stocks that began in 2009 is running long in the tooth, but the combination of faster global growth later this year and a temporary lull in inflation should pave the way for one final hurrah for equities.   Dear Client, Instead of our regular report this week, we are sending you our Quarterly Strategy Outlook, where we explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. Next week, please join me for a webcast on Monday, April 11 at 9:00 AM EDT (2:00 PM BST, 3:00 PM CEST, 9:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist P.S. You can now follow me on LinkedIn and Twitter.   I. Overview We continue to recommend overweighting global equities over a 12-month horizon. However, we see downside risks to stocks both in the near term (next 3 months) and long term (2-to-5 years). In the near term, stocks will weaken anew if Russia’s stated intentions to scale back operations in Ukraine turn out to be a ruse. There is also a risk that China will need to temporarily shutter large parts of its economy to combat the spread of the highly contagious BA.2 Omicron variant. While stocks could suffer a period of indigestion in response to monetary tightening by the Fed and a number of other central banks, we doubt that rates will rise enough over the next 12 months to undermine the global economy. This reflects our view that the neutral rate of interest in the US and most other countries is higher than widely believed. If the neutral rate ends up being between 3.5% and 4% in the US, as we expect, the odds are low that the Fed will induce a recession by raising rates to 2.75%, as the latest dot plot implies (Chart 1). Chart 1The Market Sees The Fed Raising Rates To Around 3% And Then Backing Off 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The downside of a higher neutral rate is that eventually, investors will need to value stocks using a higher real discount rate. How fast markets mark up their estimate of neutral depends on the trajectory of inflation. We were warning about inflation before it was cool to warn about inflation (see, for example, our January 2021 report, Stagflation in a Few Months?; or our February 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our view has been that inflation will follow a “two steps up, one step down” pattern. We are currently near the top of those two steps: US inflation will temporarily decline in the second half of this year, as goods inflation drops but service inflation is slow to rise. The decline in inflation will provide some breathing room for the Fed, allowing it to raise rates by no more than what markets are already discounting over the next 12 months. Unfortunately, the respite in inflation will not last long. By the end of 2023, inflation will start to pick up again, forcing the Fed to resume hiking rates in 2024. This second round of Fed tightening is not priced by the markets, and so when it happens, it could be quite disruptive for stocks and other risk assets. Investors should overweight equities on a 12-month horizon but look to turn more defensive in the second half of 2023.    II. The Global Economy War and Pestilence Are Near-Term Risks BCA’s geopolitical team, led by Matt Gertken, was ringing the alarm bell about Ukraine well before Russia’s invasion. Recent indications from Russia that it will scale back operations in Ukraine could pave the way for a ceasefire; or they could turn out to be a ruse, giving Russia time to restock supply lines and fortify its army in advance of a new summertime campaign against Kyiv. It is too early to tell, but either way, our geopolitical team expects more fighting in the near term. The West is not keen to give Putin an easy off-ramp, and even if it were, it is doubtful he would take it. The only way that Putin can salvage his legacy among his fan base in Russia is to decisively win the war in order to ensure Ukraine’s military neutrality.  For his part, Zelensky cannot simply agree to Russia’s pre-war demands that Ukraine demilitarize and swear off joining NATO unless Russian forces first withdraw. To give in to such demands without any concrete security guarantees would raise the question of why Ukraine fought the war to begin with.   The Impact of the Ukraine War on the Global Economy The direct effect of the war on the global economy is likely to be small. Together, Russia and Ukraine account for 3.5% of global GDP in PPP terms and 1.9% in dollar terms. Exports to Russia and Ukraine amount to only 0.2% of G7 GDP (Chart 2). Most corporations have little direct exposure to Russia, although there are a few notable exceptions (Chart 3). Chart 2Little Direct Trade Exposure To Russia And Ukraine 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral In contrast to the direct effects, the indirect effects have the potential to be sizable. Russia is the world’s second largest oil producer, accounting for 12% of annual global output (Chart 4). It is the world’s top exporter of natural gas. About half of European natural gas imports come from Russia. Russia is also a significant producer of nickel, copper, aluminum, steel, and palladium. Chart 3Only A Handful Of Firms Have Significant Sales Exposure To Russia 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 4Russia is The World's Second Largest Oil Producer Russia is The World's Second Largest Oil Producer Russia is The World's Second Largest Oil Producer Russia and Ukraine are major agricultural producers. Together, they account for a quarter of global wheat exports, with much of it going to the Middle East and North Africa (Chart 5). They are also significant producers of potatoes, corn, sugar beets, and seed oils. In addition, Russia produces two-thirds of all ammonium nitrate, the main source of nitrogen-based fertilizers. Largely as a result of higher commodity prices and other supply disruptions, the OECD estimates that the war could shave about 1% off of global growth this year, with Europe taking the brunt of the hit (Chart 6). At present, the futures curves for most commodities are highly backwardated (Chart 7). While one cannot look to the futures as unbiased predictors of where spot prices are heading, it is fair to say that commodity markets are discounting some easing in prices over the next two years. If that does not occur, global growth could weaken more than the OECD expects. Chart 5Developing Economies Buy The Bulk Of Russian And Ukrainian Wheat 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 6The War In Ukraine Could Shave One Percentage Point Off Of Global Growth 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 7Futures Curves For Most Commodities Are Backwardated 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral     Another Covid Wave Two years after “two weeks to flatten the curve,” the world continues to underappreciate the power of exponential growth. Suppose that it takes five days for someone with Covid to infect someone else. If everyone with Covid infects an average of six people, the cumulative number of Covid cases would rise from 1,000 to 10 million in around four weeks. Suppose you could cut the number of new infections in half to three per person. In that case, it would take about six weeks for 10 million people to be infected. In other words, mitigation measures that cut the infection rate by half would only extend how long it takes for 10 million people to be infected by two weeks. That’s not a lot.  The point is that any infection rate above one will generate an explosive rise in cases. In the pre-Omicron days, keeping the infection rate below one was difficult, but not impossible for countries with the means and motivation to do so. As the virus has become more contagious, however, keeping it at bay has grown more difficult. The latest strain of Omicron, BA.2, appears to be 40% more contagious than the original Omicron strain, which itself was about 4-times more contagious than Delta. BA.2 is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 8). In China, the authorities have locked down Shanghai, home to 25 million people. Chart 8Covid Cases Are On The Rise Again 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The success that China has had in suppressing the virus has left its population with little natural immunity; and given the questionable efficacy of its vaccines, with little artificial immunity as well. Moreover, as is the case in Hong Kong, a large share of mainland China’s elderly population remains completely unvaccinated. Chart 9New Covid Drugs Are Set To Hit The Market 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral This presents the Chinese authorities with a difficult dilemma: Impose severe lockdowns over much of the population, or let the virus run rampant. As the logic of exponential change described above suggests, there is not much of a middle ground. Our guess is that the Chinese government will choose the former option. China has already signed a deal to commercialize Pfizer’s Paxlovid. The drug is highly effective at preventing hospitalization if taken within five days from the onset of symptoms. Fortunately, Paxlovid production is starting to ramp up (Chart 9). China will probably wait until it has sufficient supply of the drug before relaxing its zero-Covid policy. While beneficial to growth later this year, this strategy could have a negative near-term impact on activity, as the authorities continue to play whack-a-mole with Covid.   Chart 10Inflation Is Running High, Especially In The US Inflation Is Running High, Especially In The US Inflation Is Running High, Especially In The US Central Banks in a Bind Standard economic theory says that central banks should adjust interest rates in response to permanent shocks, while ignoring transitory ones. This is especially true if the shock in question emanates from the supply side of the economy. After all, higher rates cool aggregate demand; they do not raise aggregate supply. The lone exception to this rule is when a supply shock threatens to dislodge long-term inflation expectations. If long-term inflation expectations become unanchored, what began as a transitory shock could morph into a semi-permanent one. The problem for central banks is that the dislocations caused by the Ukraine war are coming at a time when inflation is already running high. Headline CPI inflation reached 7.9% in the US in February, while core CPI inflation clocked in at 6.4%. Trimmed-mean inflation has increased in most economies (Chart 10). Fortunately, while short-term inflation expectations have moved up, long-term expectations have been more stable. Expected US inflation 5-to-10 years out in the University of Michigan survey stood at 3.0% in March, down a notch from 3.1% in January, and broadly in line with the average reading between 2010 and 2015 (Chart 11). Survey-based measures of long-term inflation expectations are even more subdued in the euro area and Japan (Chart 12). Market-based inflation expectations have risen, although this partly reflects higher oil prices. Even then, the widely-watched 5-year, 5-year forward TIPS inflation breakeven rate remains near the bottom of the Fed’s comfort range of 2.3%-to-2.5% (Chart 13).1  Chart 11Long-Term Inflation Expectations Remain Contained In The US... Long-Term Inflation Expectations Remain Contained In The US... Long-Term Inflation Expectations Remain Contained In The US... ​​​​​​ Chart 12... And In The Euro Area And Japan ... And In The Euro Area And Japan ... And In The Euro Area And Japan Chart 13The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone Goods versus Services Inflation Most of the increase in consumer prices has been concentrated in goods rather than services (Chart 14). This is rather unusual in that goods prices usually fall over time; but in the context of the pandemic, it is entirely understandable. Chart 14Goods Prices Have Been A Major Driver Of Overall Inflation 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The pandemic caused spending to shift from services to goods (Chart 15). This occurred at the same time as the supply of goods was being adversely affected by various pandemic-disruptions, most notably the semiconductor shortage that is still curtailing automobile production.   Chart 15AGoods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Chart 15BGoods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Looking out, the composition of consumer spending will shift back towards services. Supply chain bottlenecks should also abate, especially if the situation in Ukraine stabilizes. It is worth noting that the number of ships on anchor off the coast of Los Angeles and Long Beach has already fallen by half (Chart 16). The supplier delivery components of both the manufacturing and nonmanufacturing ISM indices have also come off their highs (Chart 17). Even used car prices appear to have finally peaked (Chart 18). Chart 16Shipping Delays Are Abating Shipping Delays Are Abating Shipping Delays Are Abating Chart 17Delivery Times Are Slowly Coming Down Delivery Times Are Slowly Coming Down Delivery Times Are Slowly Coming Down Chart 18Used Car Prices May Have Finally Peaked Used Car Prices May Have Finally Peaked Used Car Prices May Have Finally Peaked On the Lookout for a Wage-Price Spiral Could rising services inflation offset any decline in goods inflation this year? It is possible, but for that to happen, wage growth would have to accelerate further. For now, much of the acceleration in US wage growth has occurred at the bottom end of the income distribution (Chart 19). It is easy to see why. Chart 20 shows that low-paid workers have not returned to the labor market to the same degree as higher-paid workers. However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Chart 20More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work Chart 21More Workers Will Return To Their Jobs Once The Pandemic Ends More Workers Will Return To Their Jobs Once The Pandemic Ends More Workers Will Return To Their Jobs Once The Pandemic Ends The end of the pandemic should allow more workers to remain at their jobs. In January, during the height of the Omicron wave, 8.75 million US workers (5% of the total workforce) were absent from work due to the virus (Chart 21).   How High Will Interest Rates Eventually Rise? If goods inflation comes down swiftly later this year, and services inflation is slow to rise, then overall inflation will decline. This should allow the Fed to pause tightening in early 2023. Whether the Fed will remain on hold beyond then depends on where the neutral rate of interest resides. Chart 22The Yield Curve Inverted in Mid-2019 But Growth Accelerated The Yield Curve Inverted in Mid-2019 But Growth Accelerated The Yield Curve Inverted in Mid-2019 But Growth Accelerated The neutral rate, or equilibrium rate as it is sometimes called, is the interest rate consistent with full employment and stable inflation. If the Fed pauses hiking before interest rates have reached neutral, the economy will eventually overheat, forcing the Fed to resume hiking. In contrast, if the Fed inadvertently raises rates above neutral, unemployment will start rising, requiring the Fed to cut rates. Markets are clearly worried about the latter scenario. The 2/10 yield curve inverted earlier this week. With the term premium much lower than in the past, an inversion in the yield curve is not the powerful harbinger of recession that it once was. After all, the 2/10 curve inverted in August 2019 and the economy actually strengthened over the subsequent six months before the pandemic came along (Chart 22). Nevertheless, an inverted yield curve is consistent with markets expectations that the Fed will raise rates above neutral. That is always a dangerous undertaking. Raising rates above neutral would likely push up the unemployment rate. There has never been a case in the post-war era where the 3-month moving average of the unemployment rate has risen by more than 30 basis points without a recession occurring (Chart 23). Chart 23When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising   As discussed in the Feature Section below, the neutral rate of interest is probably between 3.5% and 4% in the US. This is good news in the short term because it lowers the odds that the Fed will raise rates above neutral during the next 12 months. It is bad news in the long run because it means that the Fed will find itself even more behind the curve than it is now, making a recession almost inevitable. The Feature Section builds on our report from two weeks ago. Readers familiar with that report should feel free to skip ahead to the next section. III. Feature: A Higher Neutral Rate Conceptually, the neutral rate is the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.2  Anything that reduces savings or increases investment would raise the neutral rate (Chart 24). Chart 24The Savings-Investment Balance Determines The Neutral Rate Of Interest 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral A number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 25). Household wealth has soared since the start of the pandemic (Chart 26). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 4% of GDP. Chart 25Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Chart 26Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 27). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. For the first time since the housing boom, mortgage equity withdrawals are rising. Banks are easing lending standards on consumer loans across the board. Chart 27US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated Chart 28Baby Boomers Have Amassed A Lot Of Wealth 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 28). As baby boomers transition from being savers to dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 29).Chart 29Fiscal Policy: Tighter But Not Tight 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.3 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 30). After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 31). Capex intention surveys remain upbeat (Chart 32). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 33). Chart 30Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Chart 31Positive Signs For Capex (I) Positive Signs For Capex (I) Positive Signs For Capex (I) Chart 32Positive Signs For Capex (II) Positive Signs For Capex (II) Positive Signs For Capex (II) Chart 33An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 34). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 34US Housing Is In Short Supply US Housing Is In Short Supply US Housing Is In Short Supply   The New ESG: Energy Security and Guns The war in Ukraine will put further upward pressure on the neutral rate, especially outside of the United States. After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 35). As Mathieu Savary points out in his latest must-read report on Europe, capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Germany has already announced plans to construct three new LNG terminals. The push to build out Europe’s energy infrastructure is coming at a time when businesses are looking to ramp up capital spending. As in the US, Europe’s capital stock has aged rapidly over the past decade (Chart 36). Chart 35European Capex Should Recover European Capex Should Recover European Capex Should Recover Chart 36European Machines Need More Than Just An Oil Change European Machines Need More Than Just An Oil Change European Machines Need More Than Just An Oil Change   Chart 37The War In Ukraine Calls For More Spending Across Europe The War In Ukraine Calls For More Spending Across Europe The War In Ukraine Calls For More Spending Across Europe Meanwhile, European governments are trying to ease the burden from rising energy costs. For example, France has introduced a rebate on fuel. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. European military spending will rise. Military spending currently amounts to 1.5% of GDP, well below NATO’s threshold of 2% (Chart 37). Germany has announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate Ukrainian refugees. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU.   A Smaller Chinese Current Account Surplus? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 38). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic infrastructure spending or raising household consumption. Notably, China’s credit impulse appears to have bottomed and is set to increase in the second half of the year. This is good news not just for Chinese growth but growth abroad (Chart 39). Chart 38Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Chart 39China's Credit Impulse Appears To Have Bottomed China's Credit Impulse Appears To Have Bottomed China's Credit Impulse Appears To Have Bottomed The IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. IV. Financial Markets A. Portfolio Strategy Chart 40The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles As noted in the overview, if the neutral rate turns out to be higher than currently perceived, the Fed is unlikely to induce a recession by raising rates over the next 12 months. That is good news for equities. A look back at the past four Fed tightening cycles shows that stocks often wobble when the Fed starts hiking rates, but then usually rise as long as rates do not move into restrictive territory (Chart 40). Unfortunately, a higher neutral rate also means that investors will eventually need to value stocks using a higher discount rate. It also means that any decline in inflation this year will not last. The US economy will probably start to overheat again in the second half of 2023. This will set the stage for a second, and more painful, tightening cycle in 2024. Admittedly, there is a lot of uncertainty over our “two steps up, one step down” forecast for inflation. It is certainly possible that the “one step down” phase does not last long and that the resurgence in inflation we are expecting in the second half of next year occurs earlier. It is also possible that investors will react negatively to rising rates, even if the economy is ultimately able to withstand them. As such, only a modest overweight to equities is justified over the next 12 months, with risks tilted to the downside in the near term. More conservative asset allocators should consider moving to a neutral stance on equities already, as my colleague Garry Evans advised clients to do in his latest Global Asset Allocation Quarterly Portfolio Outlook.   B. Fixed Income Stay Underweight Duration Over a 2-to-5 Year Horizon Our recommendation to maintain below-benchmark duration in fixed-income portfolios panned out since the publication of our Annual Outlook in December, with the US 10-year Treasury yield rising from 1.43% to 2.38%. We continue to expect bond yields in the US to rise over the long haul. Conceptually, the yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium. The term premium is the difference between the return investors can expect from buying a long-term bond that pays a fixed interest rate, and the return from rolling over a short-term bill. The term premium has been negative in recent years. Investors have been willing to sacrifice return to own long-term bonds because bond prices usually rise when the odds of a recession go up. The fact that monthly stock returns and changes in bond yields have been positively correlated since 2001 underscores the benefits that investors have received from owning long-term bonds as a hedge against unfavorable economic news (Chart 41). However, now that inflation has emerged as an increasingly important macroeconomic risk, the correlation between stock returns and changes in bond yields could turn negative again. Unlike weak economic growth, which is bad for only stocks, high inflation is bad for both bonds and stocks. Chart 41Correlation Between Stock Returns And Bond Yields Could Turn Negative Correlation Between Stock Returns And Bond Yields Could Turn Negative Correlation Between Stock Returns And Bond Yields Could Turn Negative If bond yields start to rise whenever stock prices fall, the incentive to own long-term bonds will decline. This will cause the term premium to increase. Assuming the term premium rises to about 0.5%, and a neutral rate of 3.5%-to-4%, the long-term fair value for the 10-year US Treasury yield is 4%-to-4.5%. This is well above the 5-year/5-year forward yield of 2.20%.   Move from Underweight to Neutral Duration Over a 12-Month Horizon Below benchmark duration positions usually do well when the Fed hikes rates by more than expected over the subsequent 12 months (Chart 42). Chart 42The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Given our view that US inflation will temporarily decline later this year, the Fed will probably not need to raise rates over the next 12 months by more than the 249 basis points that markets are already discounting. Thus, while a below-benchmark duration position is advisable over a 2-to-5-year time frame, it could struggle over a horizon of less than 12 months. Our end-2022 target range for the US 10-year Treasury yield is 2.25%-to-2.5%. Chart 43Bond Sentiment And Positioning Are Bearish Bond Sentiment And Positioning Are Bearish Bond Sentiment And Positioning Are Bearish Supporting our decision to move to a neutral benchmark duration stance over a 12-month horizon is that investor positioning and sentiment are both bond bearish (Chart 43). From a contrarian point of view, this is supportive of bonds.   Global Bond Allocation BCA’s global fixed-income strategists recommend overweighting German, French, Australian, and Japanese government bonds, while underweighting those of the US and the UK. They are neutral on Italy and Spain given that the ECB is set to slow the pace of bond buying. The neutral rate of interest has risen in the euro area, partly on the back of more expansionary fiscal policy across the region. In absolute terms, however, the neutral rate in the euro area is still quite low, and possibly negative. Unlike in the US, where inflation has risen to uncomfortably high levels, much of Europe would benefit from higher inflation expectations, as this would depress real rates across the region, giving growth a boost. This implies that the ECB is unlikely to raise rates much over the next two years. As with the euro area, Japan would benefit from lower real rates. The Bank of Japan’s yield curve control policy has been put to the test in recent weeks. To its credit, the BoJ has stuck to its guns, buying bonds in unlimited quantities to prevent yields from rising. We expect the BoJ to stay the course. Unlike in the euro area and Japan, inflation expectations are quite elevated in the UK and wage growth is rising quickly there. This justifies an underweight stance on UK gilts. Although job vacancies in Australia have climbed to record levels, wage growth is still not strong enough from the RBA’s point of view to justify rapid rate hikes. As a result, BCA’s global fixed-income strategists remain overweight Australian bonds. Finally, our fixed-income strategists are underweight Canadian bonds but are contemplating upgrading them given that markets have already priced in 238 basis points in tightening over the next 12 months. Unlike in the US, high levels of consumer debt will also limit the Bank of Canada’s ability to raise rates.   Modest Upside in High-Yield Corporate Bonds Credit spreads have narrowed in recent days but remain above where they were prior to Russia’s invasion of Ukraine. Since the start of the year, US investment-grade bonds have underperformed duration-matched Treasurys by 154 basis points, while high-yield bonds have underperformed by 96 basis points (Chart 44). The outperformance of high-yield relative to investment-grade debt can be explained by the fact that the former has more exposure to the energy sector, which has benefited from rising oil prices. Looking out, falling inflation and a rebound in global growth later this year should provide a modestly supportive backdrop for corporate credit. High-yield spreads are still pricing in a default rate of 3.8% over the next 12 months (Chart 45). This is well above the trailing 12-month default rate of 1.3%. Our fixed-income strategists continue to prefer US high-yield over US investment-grade. Chart 44Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Chart 45Spread-Implied Default Rate Is Too High 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral   European credit is attractively priced and should benefit from any stabilization in the situation in Ukraine. Our fixed-income strategists prefer both European high-yield and investment-grade bonds over their US counterparts. As with equities, the bull market in corporate credit will end in late 2023 as the Fed is forced to resume raising rates in 2024 in the face of an overheated economy.   C. Currencies Chart 46Widening Interest Rate Differentials Have Supported The Dollar Widening Interest Rate Differentials Have Supported The Dollar Widening Interest Rate Differentials Have Supported The Dollar The US Dollar Will Weaken Starting in the Second Half of 2022 Since bottoming last May, the US dollar has been trending higher. While the dollar could strengthen further in the near term if the war in Ukraine escalates, the fundamental backdrop supporting the greenback is starting to fray. If US inflation comes down later this year, the Fed is unlikely to raise rates by more than what markets are already discounting over the next 12 months. Thus, widening rate differentials will no longer support the dollar (Chart 46). The dollar is a countercyclical currency: It usually weakens when global growth is strengthening and strengthens when global growth is weakening (Chart 47). The dollar tends to be particularly vulnerable when growth expectations are rising more outside the US than in the US (Chart 48). Chart 47The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 48Better Growth Prospects Abroad Will Weigh On The US Dollar Better Growth Prospects Abroad Will Weigh On The US Dollar Better Growth Prospects Abroad Will Weigh On The US Dollar Global growth should rebound in the second half of the year once the pandemic finally ends and the situation in Ukraine stabilizes. Growth is especially likely to recover in Europe. This will support the euro, a dovish ECB notwithstanding. Chester Ntonifor, BCA’s Foreign Exchange Strategist, expects EUR/USD to end the year at 1.18.   The Dollar is Overvalued The dollar’s ascent has left it overvalued by more than 20% on a Purchasing Power Parity (PPP) basis (Chart 49). The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. PPP deviations from fair value have done a reasonably good job of predicting dollar movements over the long run (Chart 50). Chart 49USD Remains Overvalued 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 50Valuations Matter For FX Long-Term Returns Valuations Matter For FX Long-Term Returns Valuations Matter For FX Long-Term Returns Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply (Chart 51). Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 52). However, these inflows have ebbed significantly as foreign investors have lost their infatuation with US tech stocks. Chart 51The US Trade Deficit Has Widened The US Trade Deficit Has Widened The US Trade Deficit Has Widened Chart 52Net Inflows Into US Equities Have Dried Up Net Inflows Into US Equities Have Dried Up Net Inflows Into US Equities Have Dried Up Dollar positioning remains stretched on the long side (Chart 53). That is not necessarily an obstacle in the short run, given that the dollar tends to be a momentum currency, but it does suggest that the greenback could weaken over a 12-month horizon as more dollar bulls jump ship.     The Yen: Cheaper but Few Catalysts for a Bounce The trade-weighted yen has depreciated by 6.4% since the start of the year. The yen is 31% undervalued relative to the dollar on a PPP basis (Chart 54). In a nod to these improved valuations, we are upgrading our 12-month and long-term view on the yen from bearish to neutral. Chart 53Still A Lot of Dollar Bulls Still A Lot of Dollar Bulls Still A Lot of Dollar Bulls Chart 54The Yen Has Gotten Cheaper The Yen Has Gotten Cheaper The Yen Has Gotten Cheaper       While the yen is unlikely to weaken much from current levels, it is unlikely to strengthen. As noted above, the Bank of Japan has no incentive to abandon its yield curve control strategy. Yes, the recent rapid decline in the yen is a shock to the economy, but it is a “good” shock in the sense that it could finally jolt inflation expectations towards the BoJ’s target of 2%. If inflation expectations rise, real rates would fall, which would be bearish for the currency.   Favor the RMB and other EM Currencies The Chinese RMB has been resilient so far this year, rising slightly against the dollar, even as the greenback has rallied against most other currencies. Real rates are much higher in China than in the US, and this has supported the RMB (Chart 55). Chart 55Higher Real Rates In China Have Supported The RMB Higher Real Rates In China Have Supported The RMB Higher Real Rates In China Have Supported The RMB Chart 56The RMB Is Undervalued Based On PPP The RMB Is Undervalued Based On PPP The RMB Is Undervalued Based On PPP   Despite the RMB’s strength, it is still undervalued by 10.5% relative to its PPP exchange rate (Chart 56). While productivity growth has slowed in China, it remains higher than in most other countries. The real exchange rates of countries that benefit from fast productivity growth typically appreciates over time. China holds about half of its foreign exchange reserves in US dollars, a number that has not changed much since 2012 (Chart 57). We expect China to diversify away from dollars over the coming years. Moreover, as discussed earlier in the report, the incentive for China to run large current account surpluses may fade, which will result in slower reserve accumulation. Both factors could curb the demand for dollars in international markets. Chart 57Half Of Chinese FX Reserves Are Held In USD Assets 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral A resilient RMB will provide a tailwind for other EM currencies. Many EM central banks began to raise rates well before their developed market counterparts. In Brazil, for example, the policy rate has risen to 11.75% from 2% last April. With inflation in EMs likely to come down later this year as pandemic and war-related dislocations subside, real policy rates will rise, giving EM currencies a boost.   D. Commodities Longer-Term Bullish Thesis on Commodities Remains Intact BCA’s commodity team, led by Bob Ryan, expects crude prices to fall in the second half of the year, before moving higher again in 2023. Their forecast is for Brent to dip to $88/bbl by end-2022, which is below the current futures price of $97/bbl. Chart 58Dearth Of Oil Capex Will Put A Floor Under Oil Prices 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The risk to their end-2022 forecast is tilted to the upside. The relationship between the Saudis and the US has become increasingly strained. This could hamper efforts to bring more oil to market. Hopes that Iranian crude will reach global markets could also be dashed if, as BCA’s geopolitical strategists expect, the US-Iran nuclear deal falls through.  A cut-off of Russian oil could also cause prices to rise. While Urals crude is being sold at a heavy discount of $30/bbl to Brent (compared to a discount of around $2/bbl prior to the invasion), it is still leaving the country. In fact, Russian oil production actually rose in March over February. An escalation of the war would make it more difficult for Russia to divert enough oil to China, India, and other countries in order to evade Western sanctions. Looking beyond this year, Bob and his team see upside to oil prices. They expect Brent to finish 2023 at $96/bbl, above the futures price of $89/bbl. Years of underinvestment in crude oil production have led to tight supply conditions (Chart 58). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade.   Stay Positive on Metals As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by increased infrastructure spending. The shift towards green energy will also boost metals prices. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids.   Favor Gold Over Cryptos After breaking above $2,000/oz, the price of gold has retreated to $1,926/oz. In the near term, gold prices will be swayed by geopolitical developments. Longer term, real rates will dictate the direction of gold prices. Chart 59 shows that there is a very strong correlation between the price of gold and TIPS yields. If we are correct that the neutral rate of interest is 3.5%-to-4% in the US, real bond yields will eventually need to rise from current levels. Gold prices are quite expensive by historic standards, which represents a long-term risk (Chart 60). Chart 59Strong Correlation Between Real Rates And Gold Strong Correlation Between Real Rates And Gold Strong Correlation Between Real Rates And Gold Chart 60Gold Is Quite Pricey From A Historical Perspective Gold Is Quite Pricey From A Historical Perspective Gold Is Quite Pricey From A Historical Perspective That said, we expect the bulk of the increase in real bond yields to occur only after mid-2023. As mentioned earlier, the Fed will probably not have to deliver more tightening that what markets are already discounting over the next 12 months. Thus, gold prices are unlikely to fall much in the near term. In any case, we continue to regard gold as a safer play than cryptocurrencies. As we discussed in Who Pays for Cryptos?, the long-term outlook for cryptocurrencies remains daunting. Many of the most hyped blockchain applications, from DeFi to NFTs, will turn out to be duds. Concerns that cryptocurrencies are harming the environment, contributing to crime, and enriching a small group of early investors at the expense of everyone else will lead to increased regulatory scrutiny. Our long-term target for Bitcoin is $5,000.   E. Equities Equities Are Still Attractively Priced Relative to Bonds Corporate earnings are highly correlated with the state of the business cycle (Chart 61). A recovery in global growth later this year will bolster revenue, while easing supply-chain pressures should help contain costs in the face of rising wages. It is worth noting that despite all the shocks to the global economy, EPS estimates in the US and abroad have actually risen this year (Chart 62). Chart 61The Business Cycle Drives Earnings The Business Cycle Drives Earnings The Business Cycle Drives Earnings Chart 62Global EPS Estimates Have Held Up Reasonably Well 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 63Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds As Doug Peta, BCA’s Chief US Strategist has pointed out, the bar for positive earnings surprises for Q1 is quite low: According to Refinitiv/IBES, S&P 500 earnings are expected to fall by 4.5% in Q1 over Q4 levels. Global equities currently trade at 18-times forward earnings. Relative to real bond yields, stocks continue to look reasonably cheap (Chart 63). Even in the US, where valuations are more stretched, the earnings yield on stocks exceeds the real bond yield by 570 basis points. At the peak of the market in 2000, the gap between earnings yields and real bond yields was close to zero.   Favor Non-US Markets, Small Caps, and Value Valuations are especially attractive outside the US. Non-US equities trade at 13.7-times forward earnings. Emerging markets trade at a forward P/E of only 12.1. Correspondingly, the gap between earnings yields and real bond yields is about 200 basis points higher outside the US. In general, non-US markets fare best in a setting of accelerating growth and a weakening dollar – precisely the sort of environment we expect to prevail in the second half of the year (Chart 64). US small caps also perform best when growth is strengthening and the dollar is weakening (Chart 65). In contrast to the period between 2003 and 2020, small caps now trade at a discount to their large cap brethren. The S&P 600 currently trades at 14.4-times forward earnings compared to 19.7-times for the S&P 500, despite the fact that small cap earnings are projected to grow more quickly both over the next 12-months and over the long haul (Chart 66). Chart 64A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks Chart 65US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening Globally, growth stocks have outperformed value stocks by 60% since 2017. However, only one-tenth of that outperformance has come from faster earnings growth (Chart 67). This has left value trading nearly two standard deviations cheap relative to growth. Chart 66Small Caps Look Attractive Relative To Large Caps Small Caps Look Attractive Relative To Large Caps Small Caps Look Attractive Relative To Large Caps Chart 67Value Remains Cheap Value Remains Cheap Value Remains Cheap Chart 68Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Tech stocks are overrepresented in growth indices, while banks are overrepresented in value indices. US banks have held up relatively well since the start of the year but have not gained as much as one would have expected based on the significant increase in bond yields (Chart 68). With the deleveraging cycle in the US coming to an end, US banks sport both attractive valuations and the potential for better-than-expected earnings growth. European banks should also recover as the situation in Ukraine stabilizes. They trade at only 7.9-times forward earnings and 0.6-times book. On the flipside, structurally higher bond yields will weigh on tech shares. Moreover, as we discussed in our recent report entitled The Disruptor Delusion, a cooling in pandemic-related tech spending, increasing market saturation, and concerns about Big Tech’s excessive power will all hurt tech returns.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. 2     These savings can either by generated domestically or imported from abroad via a current account deficit. 3    Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. Global Investment Strategy View Matrix 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Special Trade Recommendations   Current MacroQuant Model Scores 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral

Listen to a short summary of this report.       Executive Summary Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth It is still possible that equities can outperform bonds over the next 12 months, but the risks to this are rising. Inflation may surprise further to the upside, amid rising commodity prices, pushing the Fed to tighten aggressively.  Tighter financial conditions augur badly for growth (see Chart).  We cut our recommendation for global equities to neutral and increase our allocation to cash. We continue to prefer the lower-beta US stock market over the euro zone and Emerging Markets. We are overweight defensive and structural growth sectors: Healthcare, Consumer Staples, IT and Industrials. Government bond yields have limited upside from here to year-end. We are neutral duration. US high-yield bonds are attractive: They are pricing in a big rise in defaults this year, which we see as unlikely. Recommendation Changes Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious   Bottom Line: Rising uncertainty warrants a more defensive stance. Prudent investors should have only a benchmark weight in equities, and look for other hedges against downside risk. Overview Recommended Allocation Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Rather like Arnold Toynbee’s definition of history, markets in the past few months have been hit by “just one damned thing after another”. But, despite war in Ukraine, big upward surprises to inflation, and a swift aggressive turn by the Fed, global equities are only 6% off their all-time high. It is still possible that equities may outperform bonds over the next 12 months and that the global economy will avoid recession (Chart 1). But the risks to this are rising. We recommend, therefore, that prudent investors reduce their equity holdings to benchmark weight and generally have somewhat defensive portfolio positioning. We put the money raised from going neutral on equities into cash, not bonds. What are the risks? Inflation could surprise further to the upside. Inflation has spread beyond a few pandemic-related items to goods where prices are usually sticky (Chart 2). There are now clear signs that price rises are feeding through to wage increases in the US, UK and Canada – though not yet in the euro area, Japan or Australia (Chart 3). The supply response that we expected to see emerge later this year may be delayed because of Covid lockdowns in China and disruptions in supply from Russia and Ukraine (Chart 4). Consensus forecasts for US core PCE inflation see it coming down to 2.5% by next year. The risk is that it could exceed that. The Fed has got way behind the curve. In retrospect, it should have raised rates last summer – and it now understands its error. Its first hike this cycle came only when the economy had already overheated (Chart 5). The Fed may, therefore, be tempted to get rates up very quickly – something the futures market is now pricing in, since it implies that the year-end Fed Funds Rate will be 2.5%. An aggressive Fed cycle – propelled by inflation fears – is not a good environment for risk assets. Chart 1Can Stocks Keep On Outperforming Bonds? Can Stocks Keep On Outperforming Bonds? Can Stocks Keep On Outperforming Bonds? Chart 2Even Sticky Prices Are Now Rising Even Sticky Prices Are Now Rising Even Sticky Prices Are Now Rising Chart 3Price Rises Feeding Through To Wages In Some Regions Price Rises Feeding Through To Wages In Some Regions Price Rises Feeding Through To Wages In Some Regions Chart 4Supply Chains Remain Disrupted Supply Chains Remain Disrupted Supply Chains Remain Disrupted Financial conditions had already tightened before the Fed hiked because of higher long-term rates, widening credit spreads, and a strengthening dollar. The Goldman Sachs Financial Conditions Index points to the ISM Manufacturing Index falling below 50 later this year (Chart 6). That is the level that historically has been the dividing line between stocks outperforming bonds year-over-year (Chart 7). In particular, the sharp rise in long-term rates (the US 10-year Treasury yield has risen by 110 BPs, and the German yield by 93 BPs over the past seven months) could start to put some pressure on housing markets (Chart 8). Chart 5The Fed Hiked Too Late Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Chart 6Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth Chart 7Will PMIs Fall Below 50? Will PMIs Fall Below 50? Will PMIs Fall Below 50? Chart 8Rising Rates Might Dampen The Housing Market Rising Rates Might Dampen The Housing Market Rising Rates Might Dampen The Housing Market The war in Ukraine is unlikely to be a risk in itself. BCA Research’s geopolitical strategists think it very improbable that the conflict will spill beyond the borders of Ukraine – though there remains tail risk of a mistake. But the war is having a big impact on energy prices, especially electricity prices in Europe (Chart 9). The oil price could remain high while Russian oil, which used to be consumed in Europe, is diverted elsewhere. Our Commodity & Energy Strategy service expects that increased supply from OPEC members will bring Brent crude down to around $90 a barrel by year-end. But, as our Client Question on page 14 details, that calculation relies on many assumptions, and the risk is that the oil price stays high. A doubling of the oil price year-on-year (which currently equates to $120/barrel) has historically often been followed by recession (Chart 10). Chart 9Europe's Electricity Prices Have Soared Europe's Electricity Prices Have Soared Europe's Electricity Prices Have Soared Chart 10Oil Price Is Close To The Risk Level Oil Price Is Close To The Risk Level Oil Price Is Close To The Risk Level China has been easing fiscal and monetary policy. But it is questionable how effective its stimulus will be this time. Confidence in the real estate market remains damaged. And the pick-up in credit growth has been limited to local government bond issuance; there is little sign that the private sector has appetite to borrow (Chart 11). Already some of these risks are affecting economic data. Consumer confidence has collapsed, presumably because of the rising cost of living (Chart 12). Although US activity indicators such as the manufacturing ISM remain elevated (see Chart 6 above), data in Europe is showing notable weakness (Chart 13).   Chart 11China's Stimulus Not Helping The Private Sector China's Stimulus Not Helping The Private Sector China's Stimulus Not Helping The Private Sector Chart 12Consumer Confidence Has Been Hit Consumer Confidence Has Been Hit Consumer Confidence Has Been Hit The yield curve is also getting close to signaling recession. There has been much debate of late about which yield curve to use, with Fed Chair Jerome Powell arguing for the 3-month/3-month 18-month forward curve, rather than the more usual 2/10 year or 3 month/10 year curves (Chart 14). The 2/10 is close to inverting, while the others are still a long way away. All measures of the yield curve have historically given reliable recession signals; the difference is simply a matter of timing, with the 2/10 giving the longest lead time.1 If the Fed ends up tightening as much as it intends, all the yield curves will likely invert within the next year or so. Chart 13European Data Starting To Weaken European Data Starting To Weaken European Data Starting To Weaken Chart 14It Depends On Which Yield Curve You Look At It Depends On Which Yield Curve You Look At It Depends On Which Yield Curve You Look At And, despite all these warning signals, forecasts for economic and earnings growth have not been revised down much.  Economists still expect 3.4-3.5% real GDP growth in the US and euro zone this year, well above trend (Chart 15). And, despite the drop in GDP forecasts, earnings forecasts have actually been revised up since the start of the year, with analysts now expecting 9.6% EPS growth in the US and 8.2% in the euro zone (Chart 16). Chart 15GDP Growth Is Still Expected To Be Above Trend... GDP Growth Is Still Expected To Be Above Trend... GDP Growth Is Still Expected To Be Above Trend... Chart 16...And Earnings Have Not Been Revised Down At All ...And Earnings Have Not Been Revised Down At All ...And Earnings Have Not Been Revised Down At All This all seems too much uncertainty for most asset allocators to want to stay fully risk-on. There are valid arguments that equities and other risk assets can continue to perform (which we outline in the following section, Risks To Our View). But the risks have shifted enough since the start of the year that a more defensive stance is now warranted. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Risks To Our View Chart 17Fed Feedback Loop Back In Action? Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Since our main scenario is somewhat cautious – and sentiment towards risk assets pretty pessimistic – we need to consider what could cause upside surprises to the economy and market. The most likely would be if the Fed were to turn more dovish. But the main trigger for this would be if the stock market fell sharply or growth showed clear signs of slowing – which would obviously be negative for stocks first. This scenario could produce the sort of Fed feedback loop we saw in 2015-17, when tightening financial conditions caused the Fed to ease back on rate hikes (Chart 17). More benign would be a gradual easing of inflation over the summer which would mean that the Fed could eventually hike a little less than the market currently expects. The economy may also not be as vulnerable to higher energy prices and higher rates as we fear. Food and energy are now a much smaller part of the consumption basket than they were in the 1970s (Chart 18). Rates may have a limited impact on the housing market, given the low inventory of new houses, strong household formation, and the fact that, in the US at least, some 90% of mortgages are 30-year fixed rate. Consumers continue to hold large amounts of excess savings – more than $2 trillion in the US alone. This should keep retail sales growth strong, though there might be some shift from spending on goods to spending on services as Covid fears recede (Chart 19). Chart 18Consumers Are Less Sensitive To Food And Energy Prices... Consumers Are Less Sensitive To Food And Energy Prices... Consumers Are Less Sensitive To Food And Energy Prices... Chart 19...And So May Keep On Spending ...And So May Keep On Spending ...And So May Keep On Spending Other upside risks include: A ceasefire and settlement in Ukraine (unlikely soon, since Russia will not withdraw without taking over Crimea and the Donbass, something Ukraine could not accept); more aggressive stimulus in China (possible, but only if Chinese growth weakened much further); and a sharp fall in the oil price caused by new supply coming onto the market from Saudi Arabia and North American shale fields, and possibly also Iran and Venezuela. What Our Clients Are Asking What Is The Risk Of Stagflation? Chart 20The Combination Of High Inflation And High Unemployment Was The Key Problem In The 1970s Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Several clients have asked about the risk of stagflation, and how the current episode compares to the 1970s. We can begin by dispelling some myths about the 1970s. There is a notion that this was a decade of poor growth for the US. That is simply not true. Real GDP grew by a solid 3.3% annual rate during the 1970s, higher than in any post-WW2 decade other than the 1990s and the 1960s (Chart 20, panel 1). The underlying problem during the 1970s was the combination of high inflation and a poor labor market. Despite solid growth, the unemployment rate kept grinding higher as inflation was increasing, never dropping below 4.5% even at the peaks of the expansions (Chart 20, panel 2). This situation went against the commonly held belief that it was not possible for both these variables to remain high at the same time for an extended period. With the economy plagued by both high inflation and high unemployment, the Fed faced a difficult dilemma: Keep interest rates too high and the already weak labor market would worsen; keep interest rates too low and inflation would spiral out of control. Throughout the decade, the Fed chose the latter option, causing inflation expectations to become unmoored. Chart 21Demographic Shocks And The Structure Of The Labor Force Led To A Weak Labor Market Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Why was there so much slack in the labor market? Demographics were one of the main culprits. The entrance of baby boomers into the workforce dramatically increased the pool of workers. At the same time, prime-age female participation rose at the fastest pace on record, adding additional supply to the labor force (Chart 21, panel 1). The structure of the labor market also played a key role. Almost a third of employees belonged to a union and most of their salaries were indexed to inflation (Chart 21, panels 2 & 3). This made for a rigid labor market where neither employment nor wages could adjust properly to the economic cycle. True, the oil shocks of 1974 and 1979 exacerbated inflationary pressures. But what made inflation truly pernicious during the 1970s was the inability of the Fed to fight it without compromising its employment mandate. Today the economic picture is very different. Union membership stands at only 10% and cost of living adjustments have essentially disappeared. There is also no labor supply shock on the horizon comparable to the baby boomers or women entering the labor force. This makes the calculus for the Fed easy. With its employment mandate already met, it will simply keep raising rates until inflation is back under control. As a result, the risk that it keeps policy too easy and unleashes further inflationary pressures is relatively low over the next 12 months.     How Will The War In Ukraine Affect The World Economy? Chart 22The Ukrainian War Has Impacted The Global Economy Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Global growth, monetary policy, and employment were projected to return to pre-pandemic trends in 2023. In January, the IMF projected global growth of 4.4% in 2022, but now it is poised to cut its forecast due to the war in Ukraine. According to OECD estimates, global economic growth could be 1% lower than what was previously predicted (Chart 22, panel 1). The conflict is putting fresh strain on overstretched global supply chains, causing the price of many commodities to surge. Russia and Ukraine are relatively small in terms of economic output (together they comprise only 1.9% of global GDP in US dollar terms). But they are very big producers and exporters of energy, metals, and key food items. Russia, for example, produces 12% of global oil, one-third of palladium, and (with Belarus) 40% of potash (used in fertilizers). Ukraine is also a major producer of auto parts, such as wire harnesses. Some European car manufacturers have had to idle factories due to a lack of components.  Global central banks have been increasing interest rates to battle inflation. But higher energy and food prices will require additional rate hikes to ensure price stability. The war in Ukraine could push up world inflation by around 2.5% this year, according to the OECD. Developing economies are in a particularly tight spot, being hit with high inflation in food and basic commodities. Their consumer price indices are very sensitive to these items. Russia and Ukraine are the main global exporters of several agricultural items (for example, they together account for a quarter of global wheat exports) which could cause global food insecurity to increase (Chart 22, panel 2). International sanctions on Russia create a risk for foreign companies with operations there. Withdrawal could have a meaningful effect on earnings. Most multinationals have only limited exposure to Russia, but a small number of prominent names make more than 5% of global revenues from the country (Chart 22, panel 3).   Chart 23AOPEC Is Able To Cover Supply Shortages... OPEC Is Able To Cover Supply Shortages... OPEC Is Able To Cover Supply Shortages... Chart 23B...Unlike Other Countries... ...Unlike Other Countries... ...Unlike Other Countries... Chart 23CTo Restore A Balanced But Tight Market To Restore A Balanced But Tight Market To Restore A Balanced But Tight Market What Is The Risk That The Oil Price Stays High? Our Commodity & Energy strategists see 1.3mm b/d of supply from OPEC coming onto the market beginning in May. Because of this, they expect the price of Brent crude to fall back, to average $93 per barrel this year and next. OPEC core producers fear that low inventories and an oil price above $100 per barrel will lead to demand destruction. They will therefore aim to bring prices down. They have enough spare capacity (approximately 3.2mm b/d) to cover physical deficits in global markets (Chart 23A). However, the risk to this view is tilted to the upside. The key question is whether OPEC producers will in fact ramp up production. The OPEC meeting held on March 2, 2022 noted that current market volaility is a function of geopolitical developments and does not reflect changes in market fundamentals: This could imply a reluctance to increase production as quickly as we expect. Saudi Arabia’s interest in exploiting yuan-settled oil trades with China adds an element of uncertainty. With OPEC’s intention to increase production in question, and Russian oil sanctioned and unlikely to be rerouted easily and quickly, there remains little alternative supply: Countries such as Iraq and Venezuela are unlikely to make up for supply deficits (Chart 23B). The US-Iran talks also add downside uncertainty to our price outlook. Our commodity strategists have recently ended their forecast of a return of 1-1.3mm b/d of Iranian oil (Chart 23C). A no-deal scenario is likely to lead to an escalation in tensions and volatility, warranting higher oil prices in the short term. Nevertheless, there remains the possibility that the US administration will be keen on striking a deal with Iran to reduce the risk of a global oil supply shock. This would, in turn, reduce the risk of military conflict, at least in the short-term, and remove some risk premium from oil prices. It might also lead to further increases in production from the Gulf states to prevent Iran from stealing market share, putting further downward pressure on the oil price.   Chart 24Is It Time To Favor EMU Equities? Is It Time To Favor EMU Equities? Is It Time To Favor EMU Equities? When Will Euro Area Stocks Rebound?  Chinese policy makers have sounded more aggressive of late in terms of supporting the Chinese economy and stock market, especially property and tech shares. This is a positive development for euro area equities given the region’s strong reliance on the Chinese economy (Chart 24, panel 1).  Euro area equities have been in a structural downtrend relative to US equities, but have historically staged occasional counter-trend rallies (Chart 24, panel 2). It’s possible that stocks in this region may stage another short-term rebound at some point because they are technically oversold, and valuation is extremely cheap (Chart 24, panel 3).  Investors with a longer-term investment horizon, however, should remain underweight euro area stocks until there are more signs that the region is out of its stagflation state. As we argue in the Global Equities section on page 18, the key factor to watch over the next 9-12 months is profitability. Global earnings growth will slow significantly this year in response to higher input costs and lower revenue growth.  As a net importer of energy and industrial metals, euro area earnings growth will continue to slow more than in the US (Chart 24, panel 4). In addition, in times of high uncertainty, we prefer to shelter in less volatile markets. The euro area has a much higher beta than the US (Chart 24, panel 5). Bottom Line: While there could be an opportunity to overweight euro area stocks versus the US tactically, long-term investors should continue to favor the US.   Global Economy Chart 25Global Growth Remains Robust... Global Growth Remains Robust... Global Growth Remains Robust... Overview: Global growth has been strong. But this has triggered a surge in inflation, which is pushing central banks to tighten policy more quickly than was expected even three months ago. At the same time, higher prices – and falling real wages – have started to hurt consumer confidence. This raises the risk of stagflation, particularly if disruptions caused by the war in Ukraine push commodity prices up further. A recession is still unlikely over the next 12-18 months, but the risk of one has clearly risen. US economic growth has remained robust, led by consumption and capex. GDP growth in Q4 was 5.6% QoQ annualized. The ISMs remain strong, with manufacturing at 58.5 and services 58.9 (Chart 25, panel 2). However, there are some early signs of slowdown. The Atlanta Fed Nowcast points to only 0.9% annualized growth in Q1. The effect of higher inflation (with headline CPI at 7.9% YoY) might hurt consumer confidence, since average hourly earnings growth lags behind inflation at only 5.1%. Higher rates could also dampen the housing market. With the average mortgage rate rising to 4.5%, from 3.3% at the end of last year, there are signs of a slowdown in house sales (which fell 9.5% YoY in January). Euro Area: Growth remains decent, with Q4 GDP 4.6% QoQ annualized, and robust PMIs (manufacturing at 57.0 and services at 54.8). However, wage growth lags that in the US (negotiated wages rose only 1.5% YoY in Q4), and the impact of a sharp jump in energy prices (exacerbated by the war in Ukraine) could dent consumption. Recent data have deteriorated noticeably: Consumer confidence collapsed to -18.7 in March, and the March ZEW survey (Chart 26, panel 1) fell to -38.7 (from +48.6 in February). With weak underlying growth, and core CPI inflation a relatively modest 2.7%, the ECB will not need to rush to raise rates. Chart 26...But Higher Inflation Is Starting To Damage Confidence ...But Higher Inflation Is Starting To Damage Confidence ...But Higher Inflation Is Starting To Damage Confidence Japan: Economic growth remains rather anemic. Manufacturing is supported by exports (which rose by 19.1% YoY in January), helping the manufacturing PMI to stay in positive territory at 53.2. But wage growth remains stagnant (0.9% YoY) and the rise in oil prices has pushed up headline inflation to 0.9%, leading to a weakening of consumer sentiment. The services PMI is a weak 48.7. There are hopes that this year’s shunto wage round will lead to strong wage rises (the government is lobbying businesses to raise wages by 3%) but this seems unlikely. With inflation ex food and energy languishing at -1.9% (even if that is distorted by cuts in mobile phone charges), there seems little need for the Bank of Japan to tighten policy. Emerging Markets: Chinese economic indicators remain depressed (Chart 26, panel 3), even though global demand for manufactured goods means exports are rising 16.4% YoY. The authorities have been easing policy, which has led to a mild uptick in credit growth. But there are questions on how effective stimulus will be, since the housing market has been damaged by the problems at Evergrande and other developers, and because China seems to be sticking to its zero-Covid policy. Some other EMs will be helped by the rise in commodity prices: South Africa, for example, saw 4.9% annualized GDP growth in Q4. But many developed countries were forced to raise rates sharply last year because of inflation and this may slow growth in 2022. Brazil’s policy rate, for example, has risen to 11.75% from 2% last April, and that has dampened activity: Brazilian industrial production is falling 7.2% YoY, and retail sales are -1.9% YoY. Interest Rates: Recorded inflation and inflation expectations (Chart 26, panel 4) have risen sharply everywhere. Slowing demand for manufactured goods and a supply-side response should allow monthly inflation to peak over the next few months – although the risks remain to the upside if commodity prices continue to rise. The surge in inflation has pushed up long-term rates, with the US 10-year Treasury yield rising by 82 BPs year-to-date and that in Germany by 73 BPs. However, the market is now pricing in very aggressive tightening by central banks through year-end: 214 BPs of further hikes by the Fed, and even 75 BPs by the ECB. The probability is that neither will do quite that much, and therefore the upside for long-term government bond yields is probably capped around its current level for the next 6-9 months.   Global Equities Chart 27Watch Earnings Revisions Closely Watch Earnings Revisions Closely Watch Earnings Revisions Closely Watch Earnings Closely: Global equities suffered a loss of 4% in Q1/2022 despite strong earnings growth. Except for the Utilities sector, all other sectors have positive 12-month trailing and forward earnings growth. Consequently, overall equity valuation, based on forward PE, is no longer stretched (Chart 27). Going forward, however, the macro backdrop of rising inflation and a slowing economy does not bode well for earnings growth, with the profit margin in developed markets already at a historical high. Rising input costs from both materials and wages will put downward pressure on profit margins while revenue growth slows. BCA Research’s global earnings model suggests that earnings growth will slow significantly this year. As such, we downgrade equities to neutral from overweight at the asset class level (see Overview section on page 2). Within equities, we maintain our already cautious country allocation, which served us well in both 2021 and Q1/22. The out-of-consensus overweight on the US and underweight on the euro area panned out well in Q1 2022, as the US outperformed the euro area by 5.9%. After the more defensive adjustment between the UK and Canada in the March Monthly Update, our country allocation portfolio has been well positioned, with overweights in the US and UK, underweights in the euro area, Canada and emerging markets excluding China, while neutral Australia, Japan, and China. In line with the shift of our structural view on industrial commodities, we upgrade the Materials sector to neutral from underweight at the expense of Real Estate and Communication Services. After these adjustments and the added defensive tilt that we took in the February Monthly Update, our global sector portfolio has a tilt towards defensive and structural growth by being overweight Tech, Industrials, Healthcare and Consumer Staples, underweight Consumer Discretionary, Utilities, and Communication Services, while neutral Materials, Financials, Energy and Real Estate. Chart 28Sector Adjustments Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Sector Allocation: Upgrade Materials To Neutral, Downgrade Real Estate to Neutral, Downgrade Communication Services to Underweight. Russia’s war on Ukraine is a watershed moment for industrial metals. It has altered the dynamics of the metals market which used to be dominated by Chinese demand. We had a structural underweight in the Materials sector because China was undergoing a deleveraging process. Now the Russian-Ukrainian war has demonstrated how dangerous it is for Europe to rely on Russia for energy supply and how important it is for Europe to have a strong military defense system.  Rebuilding Europe’s defense will compete with energy diversification initiatives to boost demand for metals. Such a structural shift no longer warrants an underweight in Materials (Chart 28, panel 1).  In addition, relative valuation in the Materials sector is as low as it was in the early 2000s, right before the multi-year upcycle in Materials’ relative performance (Chart 28, panel 2).  Why not go overweight then? The concern is that the sector is technically overbought due to the sharp rises in metal price. Covid lockdowns in China have disrupted the supply chain in metals, and the Russian-Ukrainian war has further intensified the rise in metals prices due to extremely low inventories. We will watch closely for a better entry point to upgrade this sector to overweight. To finance this upgrade, we downgrade Real Estate to neutral from overweight, and Communication Services to underweight from neutral. Both downgrades are driven by a deteriorating relative earnings growth outlook as shown in Chart 28, panels 4 and 5. Rising mortgage rates do not bode well for the Real Estate sector. “Reopening from Covid lockdowns” reduces the “work from home” tailwind for the Communication Services sector, where relative valuation is also stretched.    Government Bonds Chart 29WILL INFLATION COME DOWN IN 2022? WILL INFLATION COME DOWN IN 2022? WILL INFLATION COME DOWN IN 2022? Maintain At-Benchmark Duration. The first quarter of 2022 had seen a steady rise in global bond yields even before the Russian-Ukrainian war, in response to a higher inflation outlook. The negative shock to bond yields from the war was quickly reversed and bond yields continued to march higher as the supply shortage in the commodity complex further pushed up commodity prices and inflation expectations. The US 10-year TIPS breakeven inflation rate has risen above the 2.3-2.5% range that is consistent with the Fed’s 2% PCE target. However, the 5-year/5-year forward breakeven inflation rate, the measure that the Fed pays more attention to, is only slightly above 2.3% (Chart 29, panel 2). The base case of BCA Research’s Fixed Income Strategists is that inflation will moderate in the coming months so that there should be limited upside for bond yields. We already upgraded duration to at-benchmark from below-benchmark, and government bonds to neutral from underweight within the bond asset class in the March Portfolio Update. These are still appropriate going forward with the US 10-year Treasury yield currently standing at 2.33%. Inflation-linked bonds are not cheap anymore. We maintain a neutral stance to hedge against the tail risk of a further rise in inflation.   Corporate Bonds Chart 30Continue To Favor High-Yield Credit Continue To Favor High-Yield Credit Continue To Favor High-Yield Credit Since the beginning of the year, investment-grade bonds have underperformed duration-matched Treasurys by 191 basis points, while high-yield bonds have underperformed duration-marched Treasurys by 173 basis points. Even with spreads widening, we continue to underweight investment-grade credits within the fixed-income category. Spreads currently do not offer enough value to warrant a neutral shift. Moreover, investment-grade corporate bonds have been performing poorly compared to high-yield corporate bonds (Chart 30, panel 1). But shouldn’t one expect lower-rated bonds to perform worse in bear markets, and better in bull markets? Our US Bond Service believes that one explanation for the poor performance of investment-grade compared to high-yield bonds is that the industry composition of the two categories is quite different. High-yield has a large concentration in the Energy sector while investment-grade bonds have a larger weighting in Financials. And with the recent surge in oil prices, it’s possible that the strong performance of Energy credits is the reason behind that return divergence. We continue to overweight high-yield bonds, as there is likely to be no material increase in corporate default risk. The market currently implies that defaults will rise to 3.7% during the next 12 months, from 1.2% over the past 12 months (Chart 30, panel 2). That seems too high. What about European credit? The ECB’S hawkish turn and then the Ukranian crisis made yields almost double this year. The spreads for both investment-grade and high-yield corporate bonds have been widening since the beginning of the year (Chart 30, panel 3). Their valuations seem to offer an attractive entry point but investors should be cautious as spreads could continue to widen in response to the negative news from the Ukranian crisis.   Commodities Chart 31Risks To Oil Price Are To The Upside Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Energy (Overweight): Oil prices surged to $120 – the highest level since 2013 – in the aftermath of Russia’s invasion of Ukraine, pricing in sanctions against the nation’s oil producers and an estimated 3-5 mm b/d of supply disruptions (Chart 31, panel 1). While the actual hit to Russian production might end up being lower, Russia accounts for over 10% of global production, almost half of which is exported (Chart 31, panel 2). The price shock was slightly offset by a marginal demand weakness from China amid another outbreak of Covid-19. However, uncertainty regarding how quickly core OPEC producers will ramp up production to fill supply shortages – as well as the breakdown in the US-Iranian talks – continue to keep oil prices jittery. Our Commodity & Energy strategists see 1.3mm b/d of increased supply from OPEC coming onto the market beginning in May. This should bring the price of Brent crude down to average $93 per barrel this year and next. The risks to this view however remain tilted to the upside. For more details, see What Our Clients Are Asking on page 14. Industrial Metals (Neutral): Russia is a major player in the metals market, providing more than a third of the world’s palladium output; it is also the third biggest producer of nickel (Chart 31, panel 3). The prices of those metals, as well as the broad industrial metals complex, have shot up following the invasion: Industrial metals had the largest weekly price change since 1990 in the week following the invasion. The outlook for industrial metals prices is tilted to the upside. Inventories for some of the industrial metals required for the energy transition are low. Moreover, if China implements significant stimulus – and supply remains tight – prices are likely to stay elevated. Precious Metals (Neutral): Gold prices reacted in line with the moves in US real rates over the first quarter of this year, initially relatively flat, before rising in the past few weeks as real rates came down. The upward move in gold prices was further amplified by Russia’s invasion of Ukraine, which pushed the bullion’s price close to $2040, just shy of its all-time high in late 2020. This comes as no surprise: The metal is known (despite its volatility) for its safe-haven and inflation-hedging characteristics. We maintain our neutral exposure to gold. Real rates should start to rise as inflation pressures abate in the second half of the year. Gold is also somewhat expensively valued, with the price in inflation-adjusted terms close to its record high (Chart 31, panel 4).   Currencies Chart 32Don't Turn Bearish On The Dollar Yet Don't Turn Bearish On The Dollar Yet Don't Turn Bearish On The Dollar Yet US Dollar: The DXY index has risen by 2.3% this quarter. We are maintaining our neutral stance on the US dollar. While the dollar is expensive by more than 20% according to purchasing power parity (PPP), positive momentum continues to be too strong to take an outright bearish position (Chart 32, panels 1 and 2). We will look to downgrade the dollar to underweight when momentum starts to weaken and when there is clear evidence that the Fed will have to back off from its tightening path. Japanese Yen: With stock markets rebounding and expectations of interest-rate hikes rising in the US, the yen has fallen by more than 18% since the beginning of the year. Still, we reiterate the overweight that we placed at the beginning of March. The yen should act as a hedge if global stock markets sell off anew. Moreover, we believe there is now limited upside for US yields, given that there are now more than 250 basis points of Fed hikes priced over the next 12 months. This should put a cap on USDJPY, as this cross is closely tied to the relative expectations of tightening between the US and Japan (Chart 32, panel 3). Canadian Dollar: We are currently underweight the Canadian dollar. Our Commodity and Energy Strategists believe that oil should come down to around $90/barrel by the end of the year. Additionally, the BoC won’t be able to follow along with the Fed in its tightening cycle, given that household debt is much higher in Canada than in the US. Both developments should put downward pressure on the CAD over the next 12 months.   Alternatives Chart 33Prepare To Turn To Defensive Alternatives Prepare To Turn To Defensive Alternatives Prepare To Turn To Defensive Alternatives Return Enhancers: We previously suggested that private equity tends to outperform other alternative assets in the early years of expansions as it benefits from cheaper financing opportunities and attractive entry valuations. This view has been correct: Following the large drawdown in Q1 2020 due to Covid, PE returns have significantly outperformed those of hedge funds (Chart 33, panel 1). However, financing conditions are tightening and could weigh down on economic activity and PE returns going forward (Chart 33, panel 2). Preliminary results for Q3 2021 show PE funds returning only around 6% compared to an average quarterly return of 10% since the beginning of the pandemic. Given the time it takes to move allocations in the illiquid space, investors should prepare to pare back exposure from PE, and look for more defensive alternative assets, such as macro hedge funds. Inflation Hedges: We have been of the view that inflation will follow a “two steps up, one step down” trajectory: More likely than not, we are near the top of those two steps. Accordingly, we were positioned to favor real estate over commodities; real estate tends to outperform when inflation is more subdued (close to 2%-3%). Inflation, globally, however has turned out to be stickier than expected and recent economic and political developments have propelled another surge in commodity prices. Scarce inventories, lingering inflation, and a potential significant Chinese stimulus imply, at least in the short-term, that commodity prices have room to run (Chart 33, panel 3). Volatility Dampeners: Timberland and Farmland remain our long-time favorite assets within this bucket. We have previously shown that both assets outperform other traditional and alternative assets during recessions and equity bear markets. Farmland particularly continues to offer an attractive yield of approximately 2.8% (Chart 33, panel 4).   Footnotes 1   Please see BCA Research Special Report, "The Yield Curve As An Indicator," for a detailed analysis of this.   Recommended Asset Allocation Model Portfolio (USD Terms)

Executive Summary China’s Business Cycle Has Not Bottomed China's Business Cycle Has Not Bottomed China's Business Cycle Has Not Bottomed Recent data showed a substantial improvement in the economy in the first two months of the year. However, the optimism is not well supported by other industry and high-frequency data. China’s exports were resilient, while infrastructure investment also rebounded sharply on the back of front-loaded fiscal stimulus. Nonetheless, domestic demand in China remains in the doldrums. Housing market indicators show a further deterioration in home sales and prices in January and February. Consumption in tourism during the Chinese New Year and service sector activities were also weaker compared with the same period last year. While we expect policymakers to roll out more measures to shore up domestic demand, China’s economy will likely have a choppy bottom in the first half of 2022. We maintain our neutral position on Chinese onshore stocks in a global portfolio. In absolute terms, we are cautious and are looking for a better price entry point in Q2. Bottom Line: Economic data in the first two months of the year sent mixed signals, which suggests that China’s economy has not reached a solid bottom. Feature Newly released economic data from January and February (i.e. industrial production, fixed-asset investment, retail sales and property investment) all generated sizable positive surprises. However, other industry and high-frequency data sent conflicting messages. The improvement in China’s total social financing (TSF) in the past few months has been due to local government (LG) bond issuance (Chart 1). Corporate credit showed little advancement, while household loans were extremely weak (Chart 2). In addition, further contracting home sales paint a bleak picture of housing demand. Soft readings in the service sector Purchasing Managers' Index (PMI) and core consumer price index (CPI) suggest that consumption remains sluggish. Chart 1The Credit Impulse Continued To Trend Down (Excluding LG Bond Issuance) The Credit Impulse Continued To Trend Down (Excluding LG Bond Issuance) The Credit Impulse Continued To Trend Down (Excluding LG Bond Issuance) Chart 2No Improvement In Corporate Or Household Demand For Credit No Improvement In Corporate Or Household Demand For Credit No Improvement In Corporate Or Household Demand For Credit Beijing is stepping up its pro-growth stimulus, particularly on the fiscal front. However, the country will unlikely undergo a strong recovery in its business cycle without a major reversal in the housing market and an improvement in demand from the private sector. Moreover, recent lockdowns to tame surging domestic COVID-19 cases amid China’s zero-tolerance pose major downside risks to the near-term economic outlook. Chinese equities sold off in response to lockdown news despite the release of better economic data earlier this month, highlighting investors’ weak sentiment. Chart 3China's Business Cycle Has Not Bottomed China's Business Cycle Has Not Bottomed China's Business Cycle Has Not Bottomed We maintain our neutral view on China’s onshore stocks relative to their global peers, but we are cautious on Chinese equities in absolute terms.  On a cyclical time horizon (6 to 12 months), there are increasing odds that Chinese policymakers will stimulate the economy more aggressively, particularly in the 2nd half of the year. However, it is too early to turn bullish on Chinese equities (Chart 3). The ongoing war in Ukraine and elevated oil prices, coupled with risks of further lockdowns in China and a prolonged downturn in domestic demand, present significant near-term risks to the performance of Chinese equities. Investors should closely watch for more reflationary efforts from Beijing and we believe a better entry point to upgrade Chinese stocks may emerge in Q2.   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Near-Term Outlook For The Housing Market Remains Bleak Real estate investment growth in January-February was surprisingly strong, according to data from China’s National Bureau of Statistics. However, headline growth in real estate investment deviates from the continued weaknesses in other housing market indicators (Chart 4). In addition, data on the production of some key construction materials showed little improvement (Chart 5). Chart 4Conflicting Signals From The January-February Housing Market Indicators Conflicting Signals From The January-February Housing Market Indicators Conflicting Signals From The January-February Housing Market Indicators Chart 5Data On Building Materials Also Deviate From Strong Investment Growth In Real Estate Data On Building Materials Also Deviate From Strong Investment Growth In Real Estate Data On Building Materials Also Deviate From Strong Investment Growth In Real Estate Demand for housing remains lackluster. February’s medium- to long-term household loan growth, which is mainly mortgage loans and is highly correlated with home sales, plunged to an all-time low (Chart 6). Meanwhile, the deep contraction in home sales growth continued in February, and sentiment among home buyers remains downbeat (Chart 6, bottom panel) Chart 6Demand For Housing Remains In The Doldrums Demand For Housing Remains In The Doldrums Demand For Housing Remains In The Doldrums Chart 7Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Although authorities have reiterated that they want to stabilize the property market, the policy measures have been only fine-tuned. Regional governments have been allowed to initiate their own housing policies and some cities have eased processes for home purchases.1 However, given that maintaining stable home prices is an overarching goal and China’s leadership is trying to avoid further inflating the home price bubble, it is doubtful that the government will allow significant re-leveraging in the property market (Chart 7). Chart 8 shows that funds to real estate developers have slowed to the lowest level since 2010, which will further dampen housing construction. Chart 8Housing Construction Activities Will Weaken Further In 1H22 Housing Construction Activities Will Weaken Further In 1H22 Housing Construction Activities Will Weaken Further In 1H22 Chart 9The Latest Spike In Domestic COVID Cases Will Weigh On Home Sales The Latest Spike In Domestic COVID Cases Will Weigh On Home Sales The Latest Spike In Domestic COVID Cases Will Weigh On Home Sales Moreover, high-frequency floor space sold data shows a broad-based decline in housing sales in tier-one, two and three cities through mid-March (Chart 9). The latest spike in China’s domestic COVID-19 cases and regional lockdowns will likely weigh on home sales in the short term. Property investment and construction will remain at risk without a decisive rebound in home sales. A Disrupted Recovery In Household Consumption Both retail and online sales of consumer goods held up better than expected in January and February (Chart 10). However, the subdued underlying data highlight that the strong reading in retail sales in the first two months of the year may be less than meets the eye. Chart 10Although Growth In Retail Sales Rebounded In January-February... Although Growth In Retail Sales Rebounded In January-February... Although Growth In Retail Sales Rebounded In January-February... Chart 11...Service Sector Activities Still Struggle To Return To Pre-Pandemic Levels ...Service Sector Activities Still Struggle To Return To Pre-Pandemic Levels ...Service Sector Activities Still Struggle To Return To Pre-Pandemic Levels Service sector and passenger activities are still well below their pre-pandemic levels, two years after the first COVID lockdowns in early 2020 (Chart 11). Consumption in tourism during the Chinese New Year holiday was weaker than last year. Households’ propensity to spend also showed few signs of rebounding (Chart 12 & 13). Chart 12Travel Consumption Was Weak During The Chinese New Year Travel Consumption Was Weak During The Chinese New Year Travel Consumption Was Weak During The Chinese New Year Chart 13Households’ Propensity To Consume Continues To Trend Down Households' Propensity To Consume Continues To Trend Down Households' Propensity To Consume Continues To Trend Down Furthermore, both core and service CPI weakened in February, reflecting lackluster demand from consumers (Chart 14). Labor market dynamics have also worsened and the unemployment rate, particularly among young workers, has risen rapidly since the beginning of the year (Chart 15).  Chart 14Weak Core And Service CPIs In February Suggest Lackluster Household Demand Weak Core And Service CPIs In February Suggest Lackluster Household Demand Weak Core And Service CPIs In February Suggest Lackluster Household Demand Chart 15Labor Market Situation Is Worsening Labor Market Situation Is Worsening Labor Market Situation Is Worsening The ongoing fight against mounting new COVID cases in China will likely drag down service sector activities in the coming months (Chart 16A & 16B). Importantly, the new round of lockdowns and mobility restrictions are primarily in busier and more developed coastal metropolitans, such as Shenzhen and Shanghai. Therefore, the negative impact from social activity restrictions will be more substantive compared with previous lockdowns. Chart 16AEscalating New Cases In China Will Constrain Domestic Consumption Escalating New Cases In China Will Constrain Domestic Consumption Escalating New Cases In China Will Constrain Domestic Consumption Chart 16BEscalating New Cases In China Will Constrain Domestic Consumption Escalating New Cases In China Will Constrain Domestic Consumption Escalating New Cases In China Will Constrain Domestic Consumption Strong Rebound In Manufacturing Investment Growth In January-February Probably Not Sustainable A strong rebound in the growth of manufacturing investment helped to support overall fixed-asset investment in the first two months of the year (Chart 17). Robust external demand for China’s manufacturing goods has likely contributed to the pickup in manufacturing output and helped to sustain Chinese manufacturers’ near-maximum capacity (Chart 18). Chart 17Strong Pickup In Manufacturing Investment Growth Strong Pickup In Manufacturing Investment Growth Strong Pickup In Manufacturing Investment Growth Chart 18Robust Exports Support Chinese Manufacturing Output And Capacity Utilization Robust Exports Support Chinese Manufacturing Output And Capacity Utilization Robust Exports Support Chinese Manufacturing Output And Capacity Utilization While the volume of manufacturing output increased, prices that producers charge consumers have rolled over (Chart 19). Historically, prices have been more important in driving corporate profits than the volume of output. In addition, a strong RMB and sharply climbing shipping costs will also weigh on Chinese exporters’ profitability (Chart 20). Chart 19Manufacturing Output Picked Up While Prices Rolled Over Manufacturing Output Picked Up While Prices Rolled Over Manufacturing Output Picked Up While Prices Rolled Over Chart 20Strong RMB And Rising Shipping Costs Will Reduce Chinese Exporters' Profitability Strong RMB And Rising Shipping Costs Will Reduce Chinese Exporters' Profitability Strong RMB And Rising Shipping Costs Will Reduce Chinese Exporters' Profitability Chart 21Manufacturing Sector's Profit Margins Will Be Further Squeezed Manufacturing Sector's Profit Margins Will Be Further Squeezed Manufacturing Sector's Profit Margins Will Be Further Squeezed The elevated prices of oil and global industrial metals will continue to disproportionally benefit upstream industries, which are mainly composed of commodity producers. Meanwhile, the manufacturing sector’s profit margins will be squeezed by rising input costs and sluggish final demand (Chart 21). Chinese manufacturers’ profit growth will likely weaken through 1H22 and the downtrend may be exacerbated by the ongoing struggle to contain COVID cases.  The impact from recent lockdowns in the northern city of Jilin (an auto production center), Shenzhen (a high-tech manufacturing production and export hub), and Shanghai (a city with major ports and a key logistics provider) will disrupt China’s manufacturing production and curb investment in the near term. Infrastructure Sector Will Remain A Bright Spot Through 1H22 Related Report  China Investment StrategyAiming High, Lying Low Infrastructure investment staged a strong recovery in January-February on the back of front-loaded fiscal stimulus (Chart 22). LG bond issuance started to accelerate last November and will boost both traditional and new-economy infrastructure spending at least through 1H22. Our calculations suggest that fiscal thrust will rise to more than 2% of GDP this year, a sharp reversal from last year’s negative impulse of 2% (Chart 23). Chart 22Fiscal Stimulus Is At Work Fiscal Stimulus Is At Work Fiscal Stimulus Is At Work Chart 23Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Chart 24Subdued Shadow Bank Activities Will Limit The Magnitude Of Rebound In Infrastructure Investment Subdued Shadow Bank Activities Will Limit The Magnitude Of Rebound In Infrastructure Investment Subdued Shadow Bank Activities Will Limit The Magnitude Of Rebound In Infrastructure Investment However, shadow bank activity, which historically had a tight correlation with infrastructure investment, remains downbeat (Chart 24). February’s reading of shadow bank credit was extremely weak, highlighting that local governments still face constraints in off-balance sheet leveraging through local government financing vehicles (LGFVs). The trend in shadow bank loans bears close attention in the coming months because it will signal whether the central government will allow more backdoor financing to help local governments fund their infrastructure projects. A continued soft reading in shadow bank activities will likely limit the upside in infrastructure investment growth. Table 1China Macro Data Summary A Choppy Bottom A Choppy Bottom Table 2China Financial Market Performance Summary A Choppy Bottom A Choppy Bottom     Footnotes 1     Guangzhou lowered its down-payment ratio from 30% to 20%, along with a 20bp cut in mortgage rates. Zhengzhou marginally relaxed home purchase restrictions by allowing families who bring elderly relatives to live in the city to buy one extra home and also lifted the “definition of second home ownership by physical unit & mortgage history”. ​​​​​​​ Strategic Themes Cyclical Recommendations

Executive Summary Fed Chair Powell is attempting to steer the US economy between the Scylla of a recession and the Charybdis of entrenched high inflation. In the benign soft-landing outcome, the economy will continue to grow well above trend while inflation abates as spending transitions from goods to services, supply chains are untangled and base effects offer arithmetic relief. Entrenched high inflation would yield the most bearish outcome as it would leave the Fed with no choice but to squash the economy to stuff the inflation genie back into the bottle. We expect that rate hikes will eventually short-circuit the expansion and the equity bull market, but not for at least another year. Disruptions from the Ukraine conflict and China’s COVID surge place the most bullish case out of reach but the bearish end of the continuum is overly defeatist. The biggest threats to our constructive view are worsening Russia-Ukraine shortages, a conflict with Russia beyond Ukraine, new COVID obstacles and a consumer retreat. The Rates Market Thinks The Fed's Overly Ambitious The Rates Market Thinks The Fed's Overly Ambitious The Rates Market Thinks The Fed's Overly Ambitious Bottom Line: We continue to recommend overweighting equities and credit over our cyclical 6-12-month timeframe, but risks are heightened and we will change course if conditions dictate. Feature As telegraphed, the Fed began its rate hiking campaign at last week’s FOMC meeting. It lifted its target range for the fed funds rate 25 basis points (bps) from 0 – 0.25% to 0.25 – 0.5%. In addition to making the nearly unanimously expected 25-bps hike, it indicated that the median FOMC participant expects the funds rate to rise by 25 bps at each of the year’s six remaining meetings and by 87.5 bps in 2023, though Chair Powell stressed the projections are merely a baseline expectation subject to change as economic conditions evolve. Both projections slightly exceeded market expectations going into the meeting. After it ended, the fed funds rate implied by the December 2022 futures contract rose 15 bps to align with the median FOMC voter and the rate implied by the December 2023 fed funds contract rose 18 bps, though it remains about a quarter-point hike shy of the median FOMC projection (Chart 1). Chart 1It Looks Like The Fed Can Only Surprise Hawkishly It Looks Like The Fed Can Only Surprise Hawkishly It Looks Like The Fed Can Only Surprise Hawkishly Chart 2The Dots Turn More Hawkish Between A Rock And A Hard Place Between A Rock And A Hard Place Widening the lens to consider the entire distribution of projected rate hikes (the Fed’s dots), and considering the mean value instead of the median, the dots get slightly more ambitious, revealing that disappointingly high inflation readings would prod the committee to ramp up the pace of its 2022 hikes. Seven of the sixteen FOMC participants expect at least 200 bps of hikes in 2022, with the mean funds rate projection nudging up to 2.05% (Chart 2, top panel). The rates market has the funds rate topping out between 2½ and 2⅝%, about one 25-bps hike below the average participant’s 2.81% and 2.75% year-end 2023 (Chart 2, middle panel) and 2024 (Chart 2, bottom panel) projections. With five FOMC voters expecting a terminal rate of 3% or above, there is scope for an upside surprise if inflation comes in hotter or lasts longer than anticipated. The other changes in the Summary of Economic Projections related to the committee’s GDP and inflation outlook. Participants marked down their median real 2022 GDP growth projection to 2.8% from 4% while increasing their headline and core PCE price index projections about one-and-a-half percentage points to 4.3% and 4.1%, respectively. 2023 and 2024 real GDP growth forecasts were unchanged while inflation expectations were bumped a little higher. The FOMC’s outlook has dimmed slightly, though it is still calling for a soft landing with the economy growing at an above-trend rate and supporting full employment while inflation eases to near its target level. You Can’t Get There From Here Any central bank’s long-run projections will show the economy moving toward its desired target conditions. One probably wouldn’t toil as a central banker if s/he didn’t think the bank’s tools would work and couldn’t say it out loud (even when voting anonymously) if s/he doubted that they might. An investor should therefore never place too much stock in the FOMC’s projections for key economic indicators two and three years out. “[A]ppropriate[ly] firming … monetary policy” is easier said than done, even in the best of times. Related Report  US Investment StrategyThe Last Line Of Inflation Defense (Is Holding Fast) The combination of monetary and fiscal largesse almost certainly staved off a COVID recession, at the cost of fostering some asset-market excesses while quite possibly overstimulating aggregate demand over the intermediate term. The Fed is now left to confront the aftermath with blunt policy tools that work with long and variable lags. It is always a tall order to steer an economy smoothly through the ups and downs of the business cycle; sticking the landing after the pandemic’s emergency monetary and fiscal routines involves a much higher degree of difficulty. Chair Powell put on a brave face in his post-meeting press conference, but he and his colleagues are embarking on this rate hiking cycle under less-than-ideal conditions. “In hindsight, yes, it would have been appropriate to move [to hike rates] earlier. … No one wants to have to put really restrictive monetary policy on in order to get inflation back down. So, frankly, [we] need … [to] … get rates back up to more neutral levels as quickly as we practicably can and then mov[e] beyond [neutral], if [it] turns out to be appropriate.” Bottom Line: Having to move as quickly as is practicable implies that the committee and financial markets might be in for some white-knuckle moments in the months ahead. Soft landings are more common in theory than in practice and it will be especially hard to pull one off now. A Recession Is Not Likely … A narrow margin for error does not mean the Fed is walking a tightrope over two negative extremes, however, and we believe the risks of a growth shortfall are modest. We share Powell’s view that “the probability of a recession within the next year is not particularly elevated.” Aggregate demand is strong and will be supported by households’ and businesses’ fortified balance sheets while the labor market has strength to burn. We think the chair had it just right when he said, “all signs are that this is a strong economy and, indeed, one that will be able to flourish … in the face of less accommodative monetary policy.” Our simple recession indicator, built from components that have reliably provided advance warning, reinforces Powell’s conclusion. The 3-month/10-year segment of the yield curve is not yet close to inverting1 (Chart 3). The year-over-year change in the Conference Board’s Leading Economic Index is way above the zero line that has signaled past recessions (Chart 4). The fed funds rate is nowhere near its equilibrium/neutral level, which we judge to be north of 3%, and it is highly unlikely to get there by the end of the year (Chart 5). Ex-the pandemic, recessions over the last 50-plus years have only occurred when all three components sound the alarm; not one is flashing red now and not one is likely to do so during 2022. Chart 3Recessions Occur When The Yield Curve Inverts, ... Recessions Occur When The Yield Curve Inverts, ... Recessions Occur When The Yield Curve Inverts, ... Chart 4... The Year-Over-Year Change In The LEI Turns Negative ... ... The Year-Over-Year Change In The LEI Turns Negative ... ... The Year-Over-Year Change In The LEI Turns Negative ... Chart 5... And The Target Fed Funds Rate Is Above Its Equilibrium Level ... And The Target Fed Funds Rate Is Above Its Equilibrium Level ... And The Target Fed Funds Rate Is Above Its Equilibrium Level … But Inflation Is A Pressing Concern The Fed is right to take action to try to stem inflation, which has found especially fertile soil. Extraordinary monetary and fiscal stimulus have given demand a persistent tailwind; social distancing funneled spending to goods while rolling global COVID surges slowed production and hampered transport, crimping supply; and domestic COVID infections limited labor force participation, tightening the labor market and exerting upward pressure on wages. Just when COVID was finally relaxing its grip, Russia invaded Ukraine, taking major sources of crude oil, natural gas, wheat, corn and several base metals offline while creating new cargo and shipping bottlenecks. The Omicron variant’s emergence in China could bring new supply disruptions. The upshot is that the Ukraine invasion and COVID’s Asian revival could keep inflation elevated, obscuring mitigating factors like a consumption shift from goods to services (Chart 6), diminishing shipping backlogs (Chart 7), increasing labor force participation and more forgiving year-over-year comparisons (base effects). Upside inflation surprises could open the door to a faster pace of rate hikes than markets have already discounted, especially if stubbornly high inflation begins to push up longer-run inflation expectations. Despite their recent rise, long-run expectations remain well anchored for now (Chart 8), while households’ sizable savings cushion better positions them to withstand higher prices. Chart 6A Transitory Inflation Catalyst A Transitory Inflation Catalyst A Transitory Inflation Catalyst ​​​​​ Chart 7Shipping Bottlenecks Had Been Easing Shipping Bottlenecks Had Been Easing Shipping Bottlenecks Had Been Easing ​​​​​ Chart 8Long-Run Inflation Expectations Are Still Manageable Long-Run Inflation Expectations Are Still Manageable Long-Run Inflation Expectations Are Still Manageable Financial Market Impacts Equities took heart from Powell’s talk of the Fed’s commitment to prevent high inflation from becoming entrenched, but his comments were not uniformly reassuring. He specifically called out the red-hot labor market, a key pillar of the favorable growth outlook, as a source of concern. “[I]f you take a look … at today’s labor market, what you have is 1.7-plus job openings for every unemployed person (Chart 9). So that’s a very, very tight labor market, tight to an unhealthy level, I would say.” The Phillips Curve trade-off between growth and inflation still applies after all, but after a dozen years when policymakers and investors were able to ignore it, equity multiples, credit spreads and Treasury yields may no longer account for it. They seem to still be discounting a have-your-cake-and-eat-it-too environment in which growth, even when it’s above trend, is continuously goosed by accommodative policy. Chart 9Too Tight For The Fed Chair Too Tight For The Fed Chair Too Tight For The Fed Chair There’s also the issue that the Fed’s tools are not suited to fine-tuning economic outcomes. One does not have to be a card-carrying Austrian to harbor some skepticism about central bankers' ability to make targeted tweaks. “[I]n principle, … the idea is we’re trying to better align demand and supply[.] [I]n the labor market, … if you were just moving down the number of job openings so that they were more like one to one, you would have less upward pressure on wages. You would have a lot less of a labor shortage. … And basically across the economy, we’d like to slow demand so that it’s better aligned with supply. … Of course, the plan is to restore price stability while also sustaining a strong labor market. That is our intention, and we believe we can do that. But we have to restore price stability.” It’s a happy circumstance when attaining a goal doesn’t involve a sacrifice, but no pain, no gain is adulthood’s default condition. To paraphrase Powell’s press conference guidance, price stability with full employment would be really nice, but if push comes to shove, price stability has to take precedence. The tight monetary policy needed to restore lost price stability would constitute a major headwind for risk assets and the economy. It would spell the end of the equity and credit bull markets while ushering in the next recession. It is our view that the perception that price stability sacrifices are inevitable is still far away enough that risk assets have roughly nine to twelve good months ahead of them, although we hold it with less conviction than we did before Russia attacked Ukraine and Omicron reached China. Both events have the potential to hasten the end of monetary accommodation and drive investors to reconsider their terminal (peak) fed funds rate expectations. We do not expect that investors will revisit their terminal rate expectations until they can glean some empirical evidence of how the economy behaves when the funds rate exceeds 2.25%. If it takes the FOMC at least a year to get to that level, we expect that any major repricing of longer-term Treasury yields is over a year away. The bottom line is that we remain constructive on financial markets and the US economy over our six-to-twelve-month cyclical timeframe, but the clock is ticking and European fighting and Asian COVID infections are threats to our view. We believe that the decline in equity prices and the widening of high-yield credit spreads adequately compensate investors for the increased potential pitfalls, but we remain vigilant and are maintaining our tactically cautious ETF portfolio positioning until some of the clouds lift.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      We use the 3-month/10-year segment instead of the more common 2-year/10-year because the 3-month bill is a cleaner proxy for short rates than the 2-year note, which embeds estimates of the Fed’s future actions. 2s/10s also fail to measure up empirically, inverting even earlier than the habitually premature 3-month/10-year.

Executive Summary Investors Think The Fed Will Not Be Able To Raise Rates Much Above 2% Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? The neutral rate of interest is 3%-to-4% in the United States. This is substantially higher than the market estimate of around 2%. It is also higher than the central tendency range for the Fed’s terminal interest rate dot, which remained at 2.3%-to-2.5% following this week’s FOMC meeting. If the neutral rate turns out to be higher than expected, this is arguably good news for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value equities using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. Bottom Line: Global equities will rise over the next 12 months as the situation in Ukraine stabilizes, commodity prices recede, and inflation temporarily declines. Stocks will peak in the second half of 2023 in advance of a second, and currently unexpected, round of Fed tightening beginning in late-2023 or 2024.   Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the geopolitical implications of the war in Ukraine. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, April 7th. Best regards, Peter Berezin Chief Global Strategist https://www.linkedin.com/in/peter-berezin-1289b87/ https://twitter.com/BerezinPeter A Two-Stage Fed Tightening Cycle The FOMC raised rates by 25 basis points this week, the first of seven rate hikes that the Federal Reserve has telegraphed in its Summary of Economic Projections for the remainder of 2022. We expect the Fed to follow through on its planned rate hikes this year, but then go on pause in early-2023, as inflation temporarily comes down. However, the Fed will resume raising rates in late-2023 or 2024 once inflation begins to reaccelerate and it becomes clear that monetary policy is still too easy. This second round of monetary tightening is currently not anticipated by market participants. If anything, investors think the Fed is more likely to cut rates than raise rates towards the end of next year (Chart 1). The Fed’s own views are not that different from the markets’: The central tendency range for the Fed’s terminal interest rate dot remained at 2.3%-to-2.5% following this week’s FOMC meeting, with the median dot actually ticking lower to 2.4% from 2.5% (Chart 2). Image Chart 2The Fed Is Still In The Secular Stagnation Camp The Fed Is Still In The Secular Stagnation Camp The Fed Is Still In The Secular Stagnation Camp A Higher Neutral Rate Image Our higher-than-consensus view of where US rates will eventually end up reflects our conviction that the neutral rate of interest is somewhere between 3% and 4%. One can think of the neutral rate as the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.1 Anything that reduces savings or increases investment would raise the neutral rate (Chart 3). As we discussed last month, a number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 4). Household wealth has soared since the start of the pandemic (Chart 5). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by nearly 4% of GDP. Image Chart 5Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 6). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. Banks are easing lending standards on consumer loans across the board. Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 7). As baby boomers transition from savers to dissavers, national savings will decline. Chart 6US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated Chart 7Baby Boomers Have Amassed A Lot Of Wealth Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 8). On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.2 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 9). Chart 8Fiscal Policy: Tighter But Not Tight Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Chart 9Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 10). Capex intention surveys remain upbeat (Chart 11). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 12). Chart 10Positive Signs For Capex (I) Positive Signs For Capex (I) Positive Signs For Capex (I) Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 13). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 11Positive Signs For Capex (II) Positive Signs For Capex (II) Positive Signs For Capex (II) Chart 12An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Chart 13Housing Is In Short Supply Housing Is In Short Supply Housing Is In Short Supply The New ESG: Energy Security and Guns The war in Ukraine will put further pressure on the neutral rate, especially outside of the United States. Chart 14European Capex Should Recover European Capex Should Recover European Capex Should Recover After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 14). Capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Meanwhile, European governments are trying to ease the burden from rising energy costs. France has introduced a rebate on fuel starting on April 1st. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. Other countries are considering similar measures. European military spending will also rise. Germany has already announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate potentially several million Ukrainian refugees. A Smaller Chinese Current Account Surplus? Chart 15Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 15). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic investment on infrastructure and/or consumption. Notably, the IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. The Path to Neutral: The Role of Inflation If one accepts the premise that the neutral rate in the US is higher than widely believed, what will the path to this higher rate look like? Image The answer hinges critically on the trajectory of inflation. If inflation remains stubbornly high, the Fed will be forced to hike rates by more than expected over the next 12 months. In contrast, if inflation comes down rapidly, then the Fed will be able to raise rates at a more leisurely pace. As late as early February, one could have made a strong case that US inflation was set to fall. The demand for goods was beginning to moderate as spending shifted back towards services. On the supply side, the bottlenecks that had impaired goods production were starting to ease. Chart 16 shows that the number of ships anchored off the coast of Los Angeles and Long Beach has been trending lower while the supplier delivery components of both the ISM manufacturing and nonmanufacturing indices had come off their highs. Since then, the outlook for inflation has become a lot murkier. As we discussed last week, the war in Ukraine is putting upward pressure on commodity prices, ranging from energy, to metals, to agriculture. BCA’s geopolitical team, led by Matt Gertken, expects the war to worsen before a truce of sorts is reached in a month or two. Meanwhile, a new Covid wave is gaining momentum. New daily cases are rising across Europe and have exploded higher in parts of Asia (Chart 17). In China, the number of new cases has reached a two-year high. The government has already locked down parts of the country encompassing 37 million people, including Shenzhen, a major high-tech hub adjoining Hong Kong. Chart 17Covid Cases Are On The Rise Again In Some Countries Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Most new cases in China and elsewhere stem from the BA.2 subvariant of Omicron, which appears to be at least 50% more contagious than Omicron Classic. Given its extreme contagiousness, China may be forced to rely on massive nationwide lockdowns in order to maintain its zero-Covid strategy. While such lockdowns may provide some relief in the form of lower oil prices, the overall effect will be to worsen supply-chain disruptions. Watch For Signs of a Wage-Price Spiral As the experience of the 1960s demonstrates, the relationship between inflation and unemployment is inherently non-linear: The labor market can tighten for a long time with little impact on prices and wages, only for a wage-price spiral to suddenly develop once unemployment falls below a certain threshold (Chart 18). Chart 18A Wage-Price Spiral Was Ignited By Very Low Unemployment Levels In The 1960s Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution For the time being, a wage-price spiral does not appear imminent. While wage growth has picked up, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 19). Chart 20More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work Low-wage workers have not returned to the labor force to the same extent as higher-wage workers (Chart 20). However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. An influx of workers back into the labor market will cap wage growth, at least for this year. Long-Term Inflation Expectations Still Contained A sudden increase in long-term inflation expectations can be a precursor to a wage-price spiral because the expectation of higher prices can induce consumers to shop now before prices rise further, while also incentivizing workers to demand higher wages. Reassuringly, long-term inflation expectations have not risen that much. Expected inflation 5-to-10 years out in the University of Michigan survey registered 3.0% in March, down a notch from 3.1% in February (Chart 21). While the widely followed 5-year, 5-year forward TIPS inflation breakeven rate has climbed to 2.32%, it is still at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 22).3 Chart 21Long-Term Inflation Expectations Remain Contained (I) Long-Term Inflation Expectations Remain Contained (I) Long-Term Inflation Expectations Remain Contained (I) Chart 22Long-Term Inflation Expectations Remain Contained (II) Long-Term Inflation Expectations Remain Contained (II) Long-Term Inflation Expectations Remain Contained (II) Chart 23The Magnitude Of Damage Depends On How Long The Commodity Price Shock Lasts Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Moreover, the jump in market-based inflation expectations since the start of the war in Ukraine has been fueled by rising oil prices. The forwards are pointing to a fairly pronounced decline in the price of crude and most other commodity prices over the next 12 months (Chart 23). If that happens, inflation expectations will dip anew. Investment Implications The neutral rate of interest is higher in the United States than widely believed. A higher neutral rate is arguably good for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value stocks using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. While the war in Ukraine and yet another Covid wave could continue to unsettle markets for the next month or two, global equities will be higher in 12 months than they are now. With inflation in the US likely to temporarily come down in the second half of the year, bond yields probably will not rise much more this year. However, yields will start moving higher in the second half of next year as it becomes clear that policy rates still have further to rise. The bull market in stocks will end at that point.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  These savings can either by generated domestically or imported from abroad via a current account deficit. 2  Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. 3  The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. View Matrix Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Special Trade Recommendations Current MacroQuant Model Scores Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks?

Executive Summary For the Fed, maintaining its credibility with a long sequence of rate hikes that does not crash the economy, real estate market, and stock market is akin to the ‘Hail Mary’ move of (American) football. The likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Hence, today we are opening a new trade. Go long the September 2023 Eurodollar futures contract. Additionally, stay underweight Treasury Inflation Protected Securities (TIPS) versus T-bonds. And on a 12-month horizon, underweight the commodity complex, whose elevated prices are highly vulnerable to a near-certain upcoming demand destruction. Fractal trading watchlist: US interest rate futures, 3-year T-bond, Canada versus Japan, AUD/KRW, and EUR/CHF. Spending On Goods Looks Like An Earthquake On A Seismograph Spending On Goods Looks Like An Earthquake On A Seismograph Spending On Goods Looks Like An Earthquake On A Seismograph Bottom Line: The likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Feature Amid the uncertainties of the Ukraine crisis, there is one certainty. The latest surge in energy and grain prices is a classic supply shock. Prices have spiked because vital supplies of Russian and Ukrainian energy and grains have been cut. This matters for central banks, because to the extent that they can bring down inflation, they can do so by depressing demand. They can do nothing to boost supply. In fact, depressing demand during a supply shock is a sure way to start a recession. But what about the inflation that came before the Ukraine crisis, wasn’t that due to excess demand? No, that inflation came not from a demand shock, but from a displacement of demand shock – as consumers displaced their firepower from services to goods on a massive scale. This matters because central banks are also ill placed to fix such a misallocation of demand. Chart I-1 looks like a seismograph after a huge earthquake, and in a sense that is exactly what it is. The chart shows the growth in spending on durable goods, which has just suffered an earthquake unlike any in history. Zooming in, we can see the clear causality between the surges in spending on durables and the surges in core inflation. The important corollary being that when the binge on durables ends – as it surely must – or worse, when durable spending goes into recession, inflation will plummet (Chart I-2). Chart I-1Spending On Goods Looks Like An Earthquake On A Seismograph Spending On Goods Looks Like An Earthquake On A Seismograph Spending On Goods Looks Like An Earthquake On A Seismograph Chart I-2The Goods Binges Caused The Core Inflation Spikes The Goods Binges Caused The Core Inflation Spikes The Goods Binges Caused The Core Inflation Spikes But, argue the detractors, what about the uncomfortably high price inflation in services? What about the uncomfortably high inflation expectations? Most worrying, what about the recent surge in wage inflation? Let’s address these questions. Underlying US Inflation Is Running At Around 3 Percent In the US, the dominant component of services inflation is housing rent, which comprises 40 percent of the core consumer price index. Housing rent combines actual rent for those that rent their home, with the near-identically behaving owners’ equivalent rent (OER) for those that own their home. Given the state of the jobs market, there is nothing unusual in the current level of rent inflation. Housing rent inflation closely tracks the tightness of the jobs market, because you need a job to pay the rent. With the unemployment rate today at the same low as it was in 2006, rent inflation is at the same high as it was in 2006: 4.3 percent. In other words, given the state of the jobs market, there is nothing unusual in the current level of rent inflation (Chart I-3). Chart I-3Given The Jobs Market, Rent Inflation Is Where It Should Be Given The Jobs Market, Rent Inflation Is Where It Should Be Given The Jobs Market, Rent Inflation Is Where It Should Be Given its dominance in core inflation, rent inflation running at 4.3 percent would usually be associated with core inflation running at around 3 percent – modestly above the Fed’s target, rather than the current 6.5 percent (Chart I-4). Confirming that it is the outsized displacement of spending into goods, and its associated inflation, that is giving the Fed and other central banks a massive headache. Yet, to repeat, monetary policy is ill placed to fix such a misallocation of demand. Chart I-4Given Rent Inflation, Core Inflation Should Be 3 Percent Given Rent Inflation, Core Inflation Should Be 3 Percent Given Rent Inflation, Core Inflation Should Be 3 Percent Still, what about the surging expectations for inflation? Many people believe that these are an independent and forward-looking assessment of how inflation will evolve. Yet nothing could be further from the truth. The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. And at that, an extremely short period of historic inflation, just six months.1  The upshot is that when the backward-looking six month inflation rate is low, like it was in the depths of the global financial crisis in late 2008 or the pandemic recession in early 2020, the market assumes that the forward-looking ten year inflation rate will be low. And when the backward-looking six-month inflation rate is high, like early-2008 or now, the bond market assumes that the forward-looking ten year inflation rate will be high. In other words: Inflation expectations are nothing more than a reflection of the last six months’ inflation rate (Chart I-5). Chart I-5Inflation Expectations Are Just A Reflection Of The Last Six Months' Inflation Rate Inflation Expectations Are Just A Reflection Of The Last Six Months' Inflation Rate Inflation Expectations Are Just A Reflection Of The Last Six Months' Inflation Rate Turning to wage inflation, with US average hourly earnings inflation running close to 6 percent, it would appear to be game, set, and match to ‘Team Inflation.’  Except that this is a flawed argument. To the extent that wages contribute to inflation, it must come from the inflation in unit labour costs, meaning the ratio of hourly compensation to labour productivity. After all, if you get paid 6 percent more but produce 6 percent more, then it is not inflationary (Chart I-6). Chart I-6If You Get Paid 6 Percent More But Produce 6 Percent More, Then It Is Not Inflationary If You Get Paid 6 Percent More But Produce 6 Percent More, Then It Is Not Inflationary If You Get Paid 6 Percent More But Produce 6 Percent More, Then It Is Not Inflationary In this regard, US unit labour costs increased by 3.5 percent through 2021, and slowed to just a 0.9 percent (annualised) increase in the fourth quarter.2 Still, 3.5 percent, and slowing, is modestly above the Fed’s inflation target, and could justify a slight nudging up of the Fed funds rate. But it could not justify the straight sequence of eight rate hikes which the market is now pricing. The Fed Is Praying For A ‘Hail Mary’ Fortunately, the bond market understands all of this. How else could you say 7 percent inflation and 2 percent long bond yield in the same breath?! This is crucial, because it is the long bond yield that drives rate-sensitive parts of the economy, such as housing and construction. And it is the long bond yield that sets the level of all asset prices, including real estate and stocks. Although the Fed cannot admit it, the central bank also understands all of this and hopes that the bond market continues to ‘get it.’ Meaning that it hopes that the long end of the interest rate curve does not lift too far and crash the economy, real estate market, and stock market. So why is the Fed hiking the policy interest rate? The answer is that there will be a time in the future when it does need to lift the entire interest rate curve, and for that it will need its credibility intact. Not hiking now could potentially shred the credibility that is the lifeblood of any central bank. Still, to maintain its credibility without crashing the economy the Fed will have to make the ‘Hail Mary’ move of (American) football. For our non-American readers, the Hail Mary is a high-risk desperate move with little hope of completion. Go long the September 2023 Eurodollar futures contract. To sum up, the likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Hence, today we are opening a new trade. Go long the September 2023 Eurodollar futures contract (Chart I-7). Chart I-7The Likelihood That The Fed Completes A Straight Sequence Of Eight Rate Hikes Seems Low The Likelihood That The Fed Completes A Straight Sequence Of Eight Rate Hikes Seems Low The Likelihood That The Fed Completes A Straight Sequence Of Eight Rate Hikes Seems Low Additionally, stay underweight Treasury Inflation Protected Securities (TIPS) versus T-bonds (Chart I-8). Chart I-8Underweight TIPS Versus T-Bonds Underweight TIPS Versus T-Bonds Underweight TIPS Versus T-Bonds And on a 12-month horizon, underweight the commodity complex, whose elevated prices are highly vulnerable to a near-certain upcoming demand destruction. Fractal Trading Watchlist Confirming the fundamental analysis in the preceding sections, the strong trend in both the 18 month out US interest rate future and the equivalent 3 year T-bond has reached the point of fragility that has identified previous turning-points in 2018 and 2021 (Chart I-9 and Chart I-10). This week we are also adding to our watchlist the commodity plays Canada versus Japan and AUD/KRW, whose outperformances are vulnerable to reversal. From next week you will be able to see the full watchlist of investments that are vulnerable to reversal on our website. Stay tuned. Finally, the underperformance of EUR/CHF has reached the point of fragility on its 260-day fractal structure that has identified the previous major turning-points in 2018 and 2020 (Chart I-11). Accordingly, this week’s recommended trade is long EUR/CHF, setting a profit target and symmetrical stop-loss at 3.6 percent. Chart I-9The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart I-10The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart I-11Go Long EUR/CHF Go Long EUR/CHF Go Long EUR/CHF Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The expected 10-year inflation rate = (deviation of 6-month annualized inflation from 1.6)*0.2 + 1.6. 2  Source: Bureau of Labor Statistics Fractal Trading System Fractal Trades The Fed Needs A ‘Hail Mary’ To Maintain Credibility Without Crashing The Economy The Fed Needs A ‘Hail Mary’ To Maintain Credibility Without Crashing The Economy The Fed Needs A ‘Hail Mary’ To Maintain Credibility Without Crashing The Economy The Fed Needs A ‘Hail Mary’ To Maintain Credibility Without Crashing The Economy 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations