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Highlights The bipartisan Infrastructure Investment and Jobs Act will increase US government non-defense spending to around 3% of GDP, a level comparable to the 1980s-90s and larger than the 2010s.   Democrats are increasingly likely to pass their ~$1.75 trillion social spending bill, with odds at 65%. The budget reconciliation process necessary to pass this bill is also necessary to raise the national debt limit by December 3, so Congress is unlikely to fail.    The Democratic spending bills will reduce fiscal drag very marginally in 2022-24 and will occasionally increase fiscal thrust thereafter. Republicans are unlikely to repeal much of the spending in coming years. Limited Big Government is a new strategic theme. The federal government is permanently taking a larger role in the economy – but this role will still be limited by voters, who do not favor socialism. Biden’s approval rating will stabilize at a low level. Immigration, crime, and especially inflation will determine the Democrats’ fate in the 2022 midterms. Gridlock is likely. The stock market has already priced the infrastructure bill and it will continue to rally on the rumor that reconciliation will pass. But growth has outperformed value, contrary to expectations. Feature Democrats in the House of Representatives finally passed the $1.2 trillion Infrastructure Investment and Jobs Act, which consists of $550 billion in brand new spending and $650 billion in a continuation of existing levels of spending to cover the next ten years. The legislation passed with 228 votes in the House, ten more than needed, due to 13 Republican votes, making it “bipartisan” (Chart 1). The contents of the bill are shown in Table 1. Republicans supported the bill because of its focus on traditional infrastructure – roads, bridges, ports – but they also agreed to more modern elements such as $65 billion on broadband Internet and $36 billion on electric vehicles and environmental remediation. Implementation of the bill will be felt in 2023-24, in time for the presidential election, as committees will need to be set up to identify and approve projects. Chart 1 Table 1Itemized Infrastructure Plan Closing The Loop On Infrastructure Closing The Loop On Infrastructure While $550 billion is not a lot in a world of multi-trillion dollar stimulus bills, nevertheless it makes for a 34% increase in federal non-defense investment to levels consistent with the 1980s-90s (Chart 2). Chart 2 The new government spending will amount to 3% of GDP per year over the next ten years, a non-trivial amount of stimulus even though the big picture of the budget deficit remains about the same (Chart 3). Chart 3 The passage of the infrastructure bill will increase, not decrease, the odds of Biden and the Democrats passing their $1.75 trillion social spending bill via the partisan budget reconciliation process. Subjectively we put the odds at 65% in the wake of infrastructure, although recent events suggest that the odds could be put even higher. While left-wing Democrats failed to link the infrastructure and social spending bills, as we argued, nevertheless the passage of infrastructure was a requirement for the key swing voter in the Senate, Joe Manchin of West Virginia. Manchin is negotiating on the reconciliation bill, suggesting he will vote for it, and he will ultimately capitulate because he will not want to be blamed for a default on the US national debt. The US will hit the national debt ceiling on December 3 and the only reliable means for the Democrats to raise the ceiling is reconciliation. The other critical moderate Democratic senator, Kyrsten Sinema of Arizona, seems to have capitulated, after securing a removal of corporate and high-income individual tax hikes from the bill. Far-left senators might make a last stand, holding up reconciliation and winning some last-minute concession. Six House Democrats refused to vote for the infrastructure bill (including New York House member Alexandria Ocasio-Cortez). However, progressives lost leverage after the Democrats’ losses in the off-year elections. Moreover the debt ceiling will force the hand of the progressives as well as the moderates. Any such hurdles will ultimately be steamrolled by the president and Democratic Party leaders. Combined with infrastructure, the net deficit impact of the infrastructure and reconciliation bills will range from $461 billion to $1 trillion (Table 2). Our scenarios vary based on how much credence we give to Democratic revenue raisers, since many of these are gimmicks and accounting tricks to make the bill look more fiscally responsible than it really is. At the most the US is looking at an increase in the budget deficit of less than 0.5% of GDP per year in the coming years. Table 2Biden Administration Tax-And-Spend Scenarios Closing The Loop On Infrastructure Closing The Loop On Infrastructure Investors should think of Biden’s legislative efforts as very marginally reducing fiscal drag rather than increasing fiscal thrust, at least in the short run. The budget deficit is normalizing after hitting unprecedented peacetime extremes at the height of the global pandemic and social lockdowns. The shrinking deficit subtracts from aggregate demand in 2022-2024. But the new spending bills will remove a small part of that drag during these years, as highlighted in Chart 4. More importantly the US Congress is signaling that fiscal policy is back in action and that fiscal retrenchment is a long way off. Over the long run, new spending will add marginally to fiscal thrust and aggregate demand, suggesting that the US government’s contribution to the economy will grow a bit in the latter part of the 2020s, namely if Democratic legislation survives the 2024 election. For the most part it probably will, as it is very difficult to repeal entitlements or slash government spending even with Republican majorities, as witnessed with the Affordable Care Act (Obamacare) in 2017. Chart 4 Chart 5Polarization Of Economic Sentiment Declining Polarization Of Economic Sentiment Declining Polarization Of Economic Sentiment Declining The polarization of economic sentiment – i.e. divergence in partisan views of the economy – has fallen since the pandemic and will likely continue to fall as the business cycle continues (Chart 5). Both presidential candidates offered infrastructure packages – they only differed on how to fund it. With the government taking a larger role in the economy – and yet the Republicans likely to rebound in future elections – the result is one of our new strategic themes: limited big government. The heyday of “limited government,” from President Ronald Reagan through George W. Bush, has ended. But the new popular and elite consensus in favor of “Big Government” can be overrated – the US political system is defined by checks and balances that will limit the pace and magnitude of the big government trend, and at times even seem to reverse it. Hence investors should think of US fiscal policy and government role in the economy as limited big government. Political Implications Of Bipartisan Infrastructure President Biden’s approval rating has collapsed since this summer when he suffered from perceptions of incompetence on both the delta variant of COVID-19 and the withdrawal from Afghanistan. Democratic infighting, which delayed the passage of his legislation, also hurt him (Chart 6). However, these are all passing narratives, with the exception of the incompetence narrative, which could become a lasting threat to Biden if not addressed. Biden’s signing of the infrastructure bill will stabilize his approval rating. Biden will probably end up somewhere between Presidents Obama and Trump. Voters will most likely upgrade their assessment of his handling of the economy over the coming year, at least marginally. But on foreign policy he will remain extremely vulnerable since he faces numerous immediate crises in coming years. American presidential disapproval has trended upwards since the 1950s of President Eisenhower. Disapproval peaks during recessions and wars. As the economy improves, Biden’s disapproval will fall, but foreign crises and wars are likely in today’s fraught geopolitical environment (Chart 7). Chart 6 Chart 7 A few opinion polls suggest that Republicans have taken the lead over the Democrats in generic opinion polling regarding support for the parties in Congress. These polls are outliers and may or may not become the norm over the next year. Democrats have fallen from their peaks but Republicans still suffer from significant internal divisions (Chart 8). Chart 8 Voters continue to identify mostly as political independents, with a notable downtrend in the share of voters who see themselves as Republicans or Democrats in recent years (Chart 9). Independent voters have marked leanings, right or left. While the leftward lean of independents has peaked, they are not leaning to the right. The infrastructure bill and even reconciliation bill will support Democratic identification. But the sharp rise in immigration, crime, and potentially persistent inflation will support Republicans. These last will become the critical political issues going forward. The democratic socialist or progressive agenda has already been checked by voters and Democrats can only double down on that agenda at their own peril. The infrastructure bill’s passage may give a boost to perceptions of Democratic odds of maintaining the Senate in the 2022 midterm elections – that question is still up in the air, even as the House is very likely to return to Republican control (Chart 10). Chart 9Independent Voters Still Rule Independent Voters Still Rule Independent Voters Still Rule An under-the-radar beneficiary of the bipartisan infrastructure bill is Congress itself. Since 2014, public approval of Congress has gradually recovered from historic lows. The level is still low, at 27%, but the upward trend is notable for suggesting that a fiscally active Congress gains popular approval (Chart 11). New social spending will also increase Congress’s image, first for “doing something,” and second for expanding the social safety net, which more than half of voters will approve.  Chart 10 Chart 11 Partisan gridlock after 2022 could reverse the trend, as Republicans may find or invent a reason to impeach President Biden in retribution for President Trump’s impeachments. But our best guess is that Congress will remain above its low point as long as fiscal support – limited big government – remains intact. Aggressive tax hikes or spending cuts, or a national debt default, could reverse the recovery of this institution. Investment Takeaways The infrastructure bill’s passage may have supported the recent rally in stocks but it is not the main driver. Infrastructure stocks had largely discounted the bill’s passage by spring and our BCA Infrastructure Basket has underperformed the broad market since then. In absolute terms, infrastructure stocks have reached new highs and show a rising trajectory (Chart 12). The infrastructure bill has not delivered as expected when it comes to sectors or investment styles. Cyclicals have outperformed defensives, as expected. But value stocks have hit new lows relative to growth stocks, contrary to our expectation this year (Chart 13). Chart 12Infrastructure Was Already Priced Infrastructure Was Already Priced Infrastructure Was Already Priced Chart 13Wall Street Looks Well Beyond Infrastructure Wall Street Looks Well Beyond Infrastructure Wall Street Looks Well Beyond Infrastructure External factors – namely China’s policy tightening and bumps in the global recovery – weighed on cyclicals and value plays, especially relative to Big Tech (Chart 14). Growth stocks have surged yet again on low bond yields, positive earnings surprises, and secular trends like innovation and digitization. The American economy looks robust as the year draws to a close. The service sector is recovering smartly from the delta variant. Non-manufacturing business activity is surging and new orders are exploding upward relative to inventories (Chart 15). Service sector employment has suffered from shortages. Chart 14External Factors Weigh On Infrastructure Plays External Factors Weigh On Infrastructure Plays External Factors Weigh On Infrastructure Plays Chart 15Service Sector Recovery Underway Service Sector Recovery Underway Service Sector Recovery Underway Inflation risks are trickling into consumer and voter consciousness as Christmas approaches and prices rise at the pump (Chart 16). The Democrats’ two big bills will mitigate the damage they face in next year’s midterm elections – the Senate is still in competition. But a persistent inflation problem will overwhelm their legislative accomplishments. Voters will connect the dots between large deficit spending and inflationary surprises (not to mention any Democratic changes that reinforce the extremely dovish stance of the Fed). The normal political cycle will count heavily against the Democrats in 2022 regardless of inflation. But voters simultaneously face historic spikes in immigration and crime – and the former, at least, will get worse and not better over the next 12 months. Predicting inflation is a mug’s game but wage growth suggests it will remain a substantial risk in 2022 – and the structural shift in favor of big government, even if it is limited big government due to the political cycle, is inflationary on the margin. Chart 16Voters Awakening To Inflation Voters Awakening To Inflation Voters Awakening To Inflation   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Image Image Image Image   Image Image Image Image

  Nearly two-thirds of the S&P 500 companies reported their Q3 earnings, and the earnings season is drawing to a close. 83% of companies have beaten the street expectations with an average earnings surprise standing at 11% (40% earnings growth vs. 29% expected on October 1, 2021). Sales beats are only marginally worse: 77% of the companies have exceeded expectations with an average sales surprise of 3%. Quarter-on-quarter earnings growth is 0.25% exceeding expected 6% contraction. Compared to Q3-2019, eps CAGR is 12%. Chart 1 Approaching The Finish Line Approaching The Finish Line Financials, Energy, and Health Care have delivered the largest earnings surprises. Financials have done well on the back of the robust M&A activity, while the unfolding energy crisis has lifted the overall S&P 500 Energy complex. Pent-up demand for the elective medical procedures has translated into strong Health Care earnings.   Industrials and Materials were amongst the worst: China-related headwinds continue to weigh on both of these sectors. However, some analysts expect China to ease in Q1-2022, providing a tailwind for these sectors.  Most companies commented that supply chain bottlenecks and soaring shipping costs are the major headwinds. However, as we see, most have navigated a challenging economic environment swimmingly. Strong pricing power and operating leverage have preserved margins and earnings so far. Looking ahead, companies’ ability to raise prices further is waning (Chart 1), while costs continue marching up. These factors are the ubiquitous reasons for a negative guidance – 52.6% of companies are guiding lower for Q4-2021 (compare that to 32.7% previous quarter). Bottom Line: Companies are exceeding analysts’ expectations both in terms of sales and earnings growth.     Chart

With 119 S&P 500 companies having reported Q3-2021 earnings, it’s time to take a pulse of the interim results. So far, the blended earnings growth rate is 34.8% while actual reported growth rate is 49.9%. The blended sales growth rate is 14.4%, while the actual reported rate is 16.6%. Analysts expected Q3-2021 earnings to be 6% below the Q2-2021 level. As of now, this quarter’s earnings are only 3% lower. Most of the companies that have reported are beating analysts’ forecasts are surprising to the upside. Currently, 83% of companies reported EPS above expectations, with five out of eleven sectors delivering an impressive 100% beat score. In terms of the magnitude of the beats, the overall number currently stands at 14% with Financials and Technology leading the pack. However, these results are bound to change as more companies report: less than 5% of the market cap has reported within the Energy, Materials, Real Estate, and Utilities sectors. The big theme for the current earnings season is input cost inflation. Many industrial giants, including Honeywell (HON), are complaining about supply-chain cost increases, and their potential adverse effect on margins. As a result, many companies are reducing guidance for the fourth quarter. So far, there are 59 positive pre-announcements, and 45 negative. On the bright side, the majority of companies are reporting that demand for their products remains strong, potentially offsetting some of the cost increases. This is especially the case with consumer demand: a few consumer staples companies, such as P&G, commented that their recent price hikes have not dampened demand for their products and have fortified their bottom line against rising costs. Bottom Line: The earnings season is gaining speed, and so far, it appears that Q3-2021 growth expectations are set at a low bar, that is easy to clear for most companies. Chart

Who Likes A Flattening Yield Curve? Who Likes A Flattening Yield Curve? In a recent daily report, we analyzed relative performance of the S&P 500 sectors and styles under different US 10-year Treasury yield (UST10Y) regimes. Today we expand our analysis and map relative performance of the S&P 500 sectors and styles under the distinct US Treasury yield curve regimes, defined as a three-months change between 10-year and 2-year yields. To analyze sector and style performance by regime, we calculate contemporaneous three-months relative returns of sectors and styles. To summarize the results, we calculate median relative return of each sector/style in each regime. We subtract total period median to remove the sector and style biases in the long-term performance. In a flattening yield curve environment, Defensives, Quality, and Growth tend to outperform, as it indicates scarcity of growth. Accordingly, Real Estate, Technology, Utilities, and Communications Services also outperform. Yield curve steepening is usually associated with growth acceleration. This regime gives boost to more economically sensitive and capex intensive sectors and styles: Value, Small caps, and Cyclicals. Bottom Line: The shape of the US Treasury yield curve will be an important variable to monitor going forward, as it has a substantial effect on relative sector and style performance. ​​​​​​​

Foreword Today we are publishing a charts-only report focused on the S&P 500, and GICS 1 sectors.  Many of the charts are self-explanatory; to some, we have added a short commentary. The charts cover macro, valuations, fundamentals, technicals, and the uses of cash. Our goal is to equip you with all the data you need to make investment decisions along these sector dimensions. We also include performance, valuations and earnings growth expectation tables for all styles, sectors, industry groups, and industries (GICS 1, 2 and 3). We hope you will find this publication useful. We alternate between Styles and Sector chart pack updates on a bi-monthly basis. Changes In Positioning Downgrade Growth to an equal weight and upgrade Value to an equal weight.  Upgrade Small to an overweight and downgrade Large to an underweight. Downgrade Technology to equal weight by reducing overweight in Software and Services.  We remain overweight Semiconductors and Equipment. We are on board with the ongoing market rotation: We were waiting for a decisive shift in rates and a dissipation of the Covid-19 scare as a signal to initiate this repositioning (Chart 1). Chart 1Performance Of S&P 500 Sectors And Styles US Equity Chart Pack US Equity Chart Pack Overarching Investment Themes: Rotation Has Begun! Taper Tantrum 2.0: With tapering imminent and monetary tightening around the corner, both real yields and nominal yields are up sharply over the past couple of weeks (Chart 2A).  Chart 2ARates Are Up Sharply Rates Are Up Sharply Rates Are Up Sharply Chart 2BProbability Of Two Rate Hikes In 2022 Has Been Climbing Probability Of Two Rate Hikes In 2022 Has Been Climbing Probability Of Two Rate Hikes In 2022 Has Been Climbing Market expects two rate hikes by the end of 2022: Although Chairman Powell has explicitly separated the decision to taper from the timing of the first rate hike, which he conditioned on full employment and which is “a long way off,” the market is still spooked by the timing and the speed of rate hikes. Currently, the probability of two rate hikes in 2022 stands at around 40%, rising sharply over the past two weeks (Chart 2B). The BCA house view is that the Fed will start hiking in December of 2022. Market rotation is on: Rising yields and a recent decline in Delta variant infections have triggered a fast and furious style and sector rotation. Higher rates put pressure on rate-sensitive sectors and styles, such as Growth, Technology, Communication Services, and Real Estate. While the “taper tantrum” pullback affects the entire US equity market, areas most geared to rising rates, such as Cyclicals, Financials, and Small Caps fare the best (Chart 3). An easing of the Delta scare has led to the “reopening” trade outperforming the ”work-from-home” trade.   Chart 3Rotation Away From Rate-sensitive Sectors And Styles US Equity Chart Pack US Equity Chart Pack Macro Economic slowdown is finally priced in: At long last, deteriorating economic data is fully digested by investors. The Citigroup Economic Surprise index is still in negative territory (Chart 4A) but has turned decisively. The markets move on the second derivative and a “less bad” economic surprise is a major positive for the markets. Chart 4ADeterioration Of Economic Data Is Finally Priced In Deterioration Of Economic Data Is Finally Priced In Deterioration Of Economic Data Is Finally Priced In Chart 4BSupply Bottleneck Are Not Easing Supply Bottleneck Are Not Easing Supply Bottleneck Are Not Easing Supply-chain disruptions are not abating: Shipping costs continue their ascent. The average delay of cargo ships traveling between the Far East and North America is 12 days – compare that to 1 day in January 2020.1 The ISM PMI Supplier Performance index increased from 69.5 in August to 73.4 indicating that supply bottlenecks are not easing (Chart 4B). There are also significant backlogs of goods (Chart 5A), and plenty of new orders. It will take time for supply chains to normalize, with most industry participants expecting the situation to improve only in 2022. Chart 5AManufacturers Are Overwhelmed Manufacturers Are Overwhelmed Manufacturers Are Overwhelmed Chart 5BA Whiff Of Stagflation? A Whiff Of Stagflation? A Whiff Of Stagflation? Labor shortages: Companies are still struggling to fill job openings. According to the US Census Survey, “pandemic layoff” or “caring for children” were the top reasons for not working. The number of people not working because of Covid-19 infections or fear of Covid spiked at the end of August.2  This explains the August jobs report. The ugly “S” word: With the ubiquitous shortage of input materials and labor, along with transportation delays, suppliers are simply unable to meet demand for goods, pushing prices higher.  Stagflation may be rearing its ugly head: The Dallas Fed manufacturing index is showing a divergence, with prices moving higher while business activity is shifting lower. This is not the case with the ISM PMI index components, but investors need to be vigilant (Chart 5B). Americans are in a worse mood: Consumer confidence survey readings continue on a downward path. The combination of higher prices for everyday goods, the loss of purchasing power, the discontinuation of supplementary unemployment benefits, and paychecks not adjusted for inflation weigh on consumer sentiment. On the positive side, jobs are still plentiful.  Valuation And Profitability Despite recent turbulence and rotations across sectors and styles, consensus is still expecting 15% YoY earnings growth over the next 12 months. However, QoQ growth rates look very different as we remove the base effect: Growth is expected to dip this coming quarter (Q3, 2021), and stay modest for most of 2022. This is a low bar that should be easy for companies to clear, although supply disruptions may dent corporate earnings. In the meantime, valuations remain elevated at 20.7 forward earnings (Chart 6). Chart 6Earnings Growth Expectations Are Modest US Equity Chart Pack US Equity Chart Pack Sentiment There are still inflows into US equities, but they are easing. This can be explained by FOMO (fear of missing out), and lots of cash sitting on the sidelines that many retail investors aim to park in US equities.  (Chart 7A). However, this is changing as rising rates render the TINA (“there is no alternative”) trade much less attractive. Chart 7AInflows Into US Equities Are Easing Inflows Into US Equities Are Easing Inflows Into US Equities Are Easing Chart 7BCapex Is On The Rise Capex Is On The Rise Capex Is On The Rise Uses Of Cash Capex: Capital goods orders are soaring, pointing to robust capex.  The latest S&P estimates suggest that capex will rise 13% this year.3 This points to economic normalization, and attests to corporate confidence in economic growth. It is also a likely byproduct of shortages that plague the US supply chain – companies are expanding their capacity. (Chart 7B). Investment Implications Low for longer is over: The Fed has committed to tapering within the next 2-3 months.  Unless this intention is derailed by another Covid scare or a significant deterioration in economic growth, we are now convinced that rates will move up to hit the BCA house view of 1.7%-1.9% by year-end. S&P 500:  There is plenty of rotation under the hood; yet we expect US equities to hold their own into the balance of the year as, for now, monetary and fiscal policy remain easy, and earnings growth is likely to surprise on the upside. Severe and prolonged supply disruptions are a key risk to this view, as they chip away from economic growth, and cut into companies sales growth and profitability. Growth vs. Value: With rates rising into year-end, interest-rate sensitive stocks, such as Growth and the Technology sector, are under pressure.  Since we opened overweight Growth and underweight Value position on June 14, Growth has outperformed S&P 500 by 4.1%, and Value underperformed by 4.5%.  We do not want to overstay our welcome, and are neutralizing both sides of the trade, bringing positioning to an equal weight.  Technology has beaten the S&P 500 by 2.2%, and we are shifting to an equal weight positioning by reducing overweight of the Software Industry Group. We remain overweight Semiconductors and Equipment. We are closing our overweight to Growth and underweight to Value allocation. We reduce overweight to Technology. Chart 7C US Equity Chart Pack US Equity Chart Pack Cyclicals vs. Defensives:  The onset of the Delta variant is dissipating, and we expect consumer cyclicals to rebound as more people are willing to travel and eat out. We also believe that the parts of the Industrials sector most exposed to restocking of inventories, infrastructure, and construction will perform strongly. Small vs. Large: We are upgrading Small from neutral to an overweight, and downgrade Large to an underweight. Small is highly geared to rising rates. It is also cheaper than Large, and most of the earnings downgrades are already in the price. We are now constructive on this asset class.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   S&P 500 Chart 8Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 9Profitability Profitability Profitability Chart 10Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 11Uses Of Cash Uses Of Cash Uses Of Cash Communication Services Chart 12Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 13Profitability Profitability Profitability Chart 14Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 15Uses Of Cash Uses Of Cash Uses Of Cash Consumer Discretionary Chart 16Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 17Profitability Profitability Profitability Chart 18Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 19Uses Of Cash Uses Of Cash Uses Of Cash Consumer Staples Chart 20Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 21Profitability Profitability Profitability Chart 22Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 23Uses Of Cash Uses Of Cash Uses Of Cash Energy Chart 24Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 25Profitability Profitability Profitability Chart 26Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 27Uses Of Cash Uses Of Cash Uses Of Cash Financials Chart 28Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 29Profitability Profitability Profitability Chart 30Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 31Uses Of Cash Uses Of Cash Uses Of Cash Health Care Chart 32Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 33Profitability Profitability Profitability Chart 34Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 35Uses Of Cash Uses Of Cash Uses Of Cash Industrials Chart 36Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 37Profitability Profitability Profitability Chart 38Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 39Uses Of Cash Uses Of Cash Uses Of Cash Information Technology Chart 40Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 41Profitability Profitability Profitability Chart 42Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 43Uses Of Cash Uses Of Cash Uses Of Cash Materials Chart 44Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 45Profitability Profitability Profitability Chart 46Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 47Uses Of Cash Uses Of Cash Uses Of Cash Real Estate Chart 48Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 49Profitability Profitability Profitability Chart 50Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 51Uses Of Cash Uses Of Cash Uses Of Cash Utilities Chart 52Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 53Profitability Profitability Profitability Chart 54Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 55Uses Of Cash Uses Of Cash Uses Of Cash       Footnotes 1     Source: eeSea 2     US Census Household Pulse Survey, Employment Table 3. 3    S&P Global Market Intelligence, S&P Global Ratings; Universe is Global Capex 2000   Recommended Allocation

Chart 1Cyclicals Styels and Sectors Outperform In The Rising Rates Environment Treasury Rates Vs. Sector And Style Performance Treasury Rates Vs. Sector And Style Performance In a recent daily report, we analyzed performance of the S&P 500 sectors before and after the 2013 tapering announcement. Today we expand our analysis and map relative performance of the S&P 500 sectors and styles under the different US 10-year Treasury yields (UST10Y) regimes, i.e., rates rising vs rates falling.1  As expected, deep cyclicals, such as Energy, Financials, and Industrials fare best in a rising rates environment, while Communication Services and Health Care outperform when rates head south (Chart 1, top panel). Styles’ performance across regimes is broadly consistent with the sector performance. Specifically, Small Caps, thanks to their high exposure to deep cyclicals, post the best performance when UST10Y is rising. Meanwhile, defensives are a mirror image of Small Caps and outperform once global growth starts softening (Chart 1, bottom panel). Finally, we bring one more dimension to our analysis and calculate the performance of the long-duration Technology and Health Care sectors, under different rates and yield curve regimes (Chart 2).  To do so, we overlap rates and yield curve regimes and calculate median performance of each cell. Both Technology and Health Care underperform when rates are rising, and the yield curve is steepening: Long end of the curve is most important for discounting cash flows. Chart 2Performance of Technology and Health Care Sectors Is Also A Function Of Changes Of The Yield Curve Treasury Rates Vs. Sector And Style Performance Treasury Rates Vs. Sector And Style Performance The current environment of rising rates and flattening yield curve is empirically a goldilocks scenario for these sectors as a flattening yield curve signifies that the long-term rate, which is more important for discounting future cash flows, is falling and the P/E contraction phase will be limited.  It will also be offset by the growth in earnings as rising long rates indicate higher growth. Falling rates are also good for Tech stocks regardless of the direction of change in the yield curve.  The Health Care sector behaves somewhat differently: It tends to underperform when rates are falling but the yield curve is steepening as such scenario is not dire enough for Defensives to outperform. Bottom Line: Cyclical sectors and high beta styles tend to outperform in a rising rates environment. At the same time, the performance of Technology and Health Care stocks is more nuanced: rising Treasury rates are not necessarily bad for these sectors if the yield curve is flattening.   Footnotes 1 Methodology: We calculate three months change in UST10Y and calculate median of three months contemporaneous relative returns for each sector at each regime.  To remove historical performance biases, we subtract sector median relative return for the whole period.  

August PPI reading came in at 8.3%. Naturally, many investors are wondering whether the companies will be able to pass their soaring input costs to the customers. An in-depth analysis of margins and pricing power requires a significant research effort. However, below are some examples illustrating our thinking process on the topic. We also included pricing power sector charts in the Appendix.   Companies’ ability to hike prices is a function of the elasticity of demand, which is heterogeneous across industries and products. It also depends on product differentiation and competition in the industry. For some categories, such as consumer durables, pricing power has declined as prices reached the upper limit of affordability (Chart 1). As a result, durables goods manufacturers’ pricing power has peaked, and this sector is at a higher risk of margin squeeze. Margins of the Health Care sector have been under pressure for years (Chart 2). This can be tied back to Pharma being under perennial pressure from both politicians aiming to lower prescription drug prices, and from competition from the generics. Meanwhile, the Consumer Discretionary sector is in better shape thanks to pent-up demand for services and discretionary goods – consumers are in good financial health and are able to tolerate marginal prices increases. We expect discretionary and services industries to be able to maintain their margins. Bottom Line: The ability to exert pricing power and pass on costs to customers is highly industry-specific and can not be generalized. CHART 1 CHART 1 CHART 1 CHART 2 CHART 2 CHART 2 Appendix CHART 3 CHART 3 CHART 4 CHART 4  

Highlights The Evergrande crisis is not China’s Lehman moment. Nonetheless, Chinese construction activity will decelerate further in response to this shock. Global equities are frothy enough that a weaker-than-expected Chinese construction sector will remain a near-term risk to stocks prices. European markets are more exposed to this risk than US ones. Tactically, this creates a dangerous environment for cyclicals in general and materials in particular. Healthcare and Swiss stocks would be the winners. Despite these near-term hurdles, we maintain a pro-cyclical portfolio stance, which we will protect with some temporary hedges. We will lift these hedges if the EURO STOXX corrects into the 430-420 zone. A busy week for European central banks confirms our negative stance on EUR/GBP, EUR/SEK, and EUR/NOK. While EUR/CHF has upside, Swiss stocks should outperform Euro Area defensives. Stay underweight UK Gilts in fixed-income portfolios. Feature The collapse of property developer Evergrande creates an important risk for European markets. It threatens to slow Chinese construction activity further, which affects European assets that are heavily exposed to the Chinese real estate sector, directly and indirectly. This risk is mostly frontloaded, as Chinese authorities cannot afford a complete meltdown of the domestic property sector. Moreover, this economy has slowed significantly and more policy support is bound to take place. Additionally, forces outside China create important counterweights that will allow Europe to thrive despite the near-term clouds. While we see more short-term risk for European stocks and cyclical sectors, the 18-month cyclical outlook remains bright. Similarly, European stocks will not outperform US ones when Chinese real estate activity remains a source of downside surprise; but they will afterward. China’s Construction Slowdown Is Not Over The Evergrande crisis is not China’s Lehman moment. Beijing has the resources to prevent a systemic meltdown and understands full well what is at stake. At 160% of GDP, China’s nonfinancial corporate debt towers well above that of other major emerging markets and even that of Japan in the 1980s (Chart 1). If an Evergrande bankruptcy were allowed to topple this debt mountain, China would experience the kind of debt-deflation trap that proved so disastrous in the 1930s. A further deterioration of conditions in Chinese real estate activity is nonetheless in the cards, even if the country avoids a global systemic financial shock. First, the inevitable restructuring of Evergrande will result in losses for bond holders, especially foreign ones. Consequently, risk premia in the Chinese off-shore corporate bonds market will remain wide following the resolution of the Evergrande debacle. While Chinese banks are likely to recover a large proportion of the funds they lent to the real estate giant, they too will face higher risk premia. At the margin, the rising cost of capital will curtail the number of projects real estate developers take on over the coming two to three years. Second, the eventual liquidation of Evergrande will hurt confidence among real estate developers. This process may take many forms, but, as we go to press, the most discussed outcome is a breakup and restructuring where state-owned enterprises and large local governments absorb Evergrande’s operations. Evergrande’s employees, suppliers, and clients who have deposited funds while pre-ordering properties will be made whole one way or the other. However, shareholders and management will not. Wiping out shareholders and senior management will send a message to the operators of other developers, which will negatively affect their risk taking (Chart 2). Chart 1China Cannot Afford A Lehman Moment China Cannot Afford A Lehman Moment China Cannot Afford A Lehman Moment Chart 2Downside To Chinese Construction Activity Downside To Chinese Construction Activity Downside To Chinese Construction Activity   Third, one of President Xi Jinping’s key policy objectives is to tame rampant income inequality in the Chinese economy. Rapidly rising real estate prices and elevated unaffordability only worsen this problem. Hence, Beijing wants to avoid blind stimulus that mostly pushes house prices higher but that would have also boosted construction activity. Thus, if credit growth is pushed through the system, the regulatory tightening in real estate will not end. This process is likely to result in further contraction in floor space sold and started. Bottom Line: The Evergrande crisis is unlikely to morph into China’s Lehman moment. However, its fallout on the real estate industry means that Chinese construction activity will continue to contract in the coming six to twelve months or so. Chinese Construction Matters For European Equities The risk of further contraction in Chinese construction activity implies a significant near-term risk for European equities, especially relative to US ones. Even after the volatility of the past three weeks, global equities remain vulnerable to more corrective action. Speculative activity continues to grip the bellwether US market. Our BCA Equity Speculation Index is still around two sigma. Previous instances of high readings did not necessarily herald the end of bull markets; however, they often resulted in sideways and volatile trading, until the speculative excesses dissipated (Chart 3). The case for such volatile trading is strong. The Fed is set to begin its taper at its November meeting. Moreover, an end of the QE program by the middle of next year and the upcoming rotation of regional Fed heads on the FOMC will likely result in a first rate hike by the end of 2022. Already, the growth rate of the global money supply has declined, and the real yield impulse is not as supportive as it once was. Therefore, the deterioration in our BCA Monetary Indicator should perdure (Chart 4), which will heighten the sensitivity of global stocks to bad news out of China. Chart 3Rife With Speculation Rife With Speculation Rife With Speculation Chart 4Liquidity Deterioration At The Margin Liquidity Deterioration At The Margin Liquidity Deterioration At The Margin Chart 5Still Too Happy Still Too Happy Still Too Happy Investor sentiment is also not as washed out as many news stories ascertain. The AAII survey shows that the number of equity bulls has fallen sharply, but BCA’s Complacency-Anxiety Index, Equity Capitulation Indicator and Sentiment composite are still inconsistent with durable market bottoms. Moreover, the National Association of Active Investment Managers’ Exposure Index is still very elevated. When this gauge is combined with the AAII bulls minus bears indicator, it often detects floors in the US dollar-price of the European MSCI index (Chart 5). For now, this composite sentiment measure is flashing further vulnerability for European equities, especially if China remains a source of potential bad news in the coming months. Economic linkages reinforce the tactical risk to European stocks. Chinese construction activity affects the Euro Area industrial production because machinery and transportation goods represent 50% of Europe’s export to China (Chart 6). This category is very sensitive to Chinese real estate activity. Moreover, Europe’s exports to other nations are also indirectly affected by the demand from Chinese construction. Financial markets bear this footprint. Excavator sales in China are a leading indicator of construction activity. Historically, they correlate well with both the fluctuations of EUR/USD and the performance of Eurozone stocks relative to those of the US (Chart 7). Hence, if we anticipate that the problems Evergrande faces will weigh on excavator sales in the coming months, then the euro will suffer and Euro Area stocks could continue to underperform. Chart 6Europe's Exports To China Are Sensitive To Construction Activity Europe's Exports To China Are Sensitive To Construction Activity Europe's Exports To China Are Sensitive To Construction Activity Chart 7A Near-Term Risk To European Assets A Near-Term Risk To European Assets A Near-Term Risk To European Assets   Similarly, the fallout from Evergrande’s problem will extend to the performance of European equity sectors. The sideways corrective episode in cyclical relative to defensive shares is likely to continue in the near term. This sector twist remains frothy, and often declines when Chinese credit origination is soft (Chart 8). Materials stocks are the most likely to suffer due to their tight correlation with Chinese excavator sales (Chart 9); meanwhile, healthcare equities will reap the greatest benefit as a result of their appealing structural growth profile and their strong defensive property. Geographically, Swiss stocks should perform best (Chart 9, bottom panel), because they strongly overweigh healthcare and consumer staple names. Moreover, as we recently argued, the SNB’s monetary policy is an advantage for Swiss stocks compared to Eurozone defensives.1 Additionally, Dutch equities, with their 50% weighting in tech and their small 12% combined allocation to industrials and materials, could also enjoy a near-term outperformance as investors digest the sectoral impact of weaker Chinese construction activity. Chart 8The Vulnerability Of Cyclicals/Defensives Remains The Vulnerability Of Cyclicals/Defensives Remains The Vulnerability Of Cyclicals/Defensives Remains Chart 9Responses To Weaker Construction Responses To Weaker Construction Responses To Weaker Construction   Bottom Line: No matter how the Evergrande story unfolds, its consequence on Chinese construction activity may still cause market tremors. Global equity benchmarks may be rebounding right now, but, ultimately, they remain vulnerable to this slowdown. Any negative surprise out of China is likely to cause Europe to underperform because of its greater exposure to Chinese construction activity. Investment Conclusion: This Too Shall Pass The risks to the European equity market and its cyclicals sectors will prove transitory and will finish by the end of the year. Beijing will tolerate some pain to the real estate sector, but the stakes are too high to let the situation fester for long. The main problem is China’s large debt. Already sequential GDP growth in the first half of 2021 was worse than the same period in 2020, and credit accumulation is just as weak as in early 2018 (Chart 10). In this context, if real estate activity deteriorates too much, aggregate profits will contract and, in turn, will hurt the corporate sector’s ability to service its debt. Employment and social tensions create another stress point that will force Beijing’s hand. At 47, the non-manufacturing PMI employment index is already well into the contraction zone (Chart 11). Weakness in construction activity will hurt the labor market further. In an environment where protests have been springing up all over China, the Communist Party does not want to see more stress applied to workers. Chart 10In The End, Stimulus Will Come In The End, Stimulus Will Come In The End, Stimulus Will Come Chart 11Worsening Chinese Employment Conditions Worsening Chinese Employment Conditions Worsening Chinese Employment Conditions   These two constraints will force Beijing to alleviate the pain caused by a weaker construction sector. As a result, we still expect the Chinese credit and fiscal impulse to re-accelerate by Q2 2022. Developments outside of China will create another important offset that will allow risk assets to thrive once their immediate froth has receded. Strong DM capex will be an important driver of global activity next year. As Chart 12 shows, capex intentions in the US and the Euro Area are rapidly expanding, which augurs well for global investments. Moreover, re-building depleted inventories (Chart 13) will be a crucial component of the solution to global supply bottlenecks. Both activities will add to global demand. As an example, ship orders are already surging. Chart 12DM Capex Intentions Are Firming DM Capex Intentions Are Firming DM Capex Intentions Are Firming Chart 13Don't Forget About Inventories Don't Forget About Inventories Don't Forget About Inventories     We maintain a pro-cyclical stance in European markets after weighing the near-term negatives against the underlying positive forces. For now, hedging the tactical risk still makes sense and our long telecommunication / short consumer discretionary equities remain the appropriate vehicle – so does being long Swiss stocks versus Euro Area defensives. However, we will use any correction in the EURO STOXX (Bloomberg: SXXE Index) to the 430-420 zone to unload this protection. Bottom Line: The potential market stress created by a slowdown in Chinese construction activity will be a temporary force. Beijing will not tolerate a much larger hit to the economy, especially as tensions are rising across the country. Thus, even if the stimulus response to the Evergrande crisis will not be immediate, it will eventually come, which will support Chinese economic activity. Additionally, the capex upside and inventory rebuilding in advanced economies will create an offset for slowing Chinese growth. Consequently, while we maintain a pro-cyclical bias over the medium term, we are also keeping in place our hedges in the near term, looking to shed them if SXXE hits the 430-420 zone. A Big Week For Central Banks Chart 14The BoE's Is Listening To The UK's Economic Conditions... The BoE's Is Listening To The UK's Economic Conditions... The BoE's Is Listening To The UK's Economic Conditions... Last week, four European central banks held their policy meetings: The Riksbank, the Swiss National Bank, the Norges Bank, and the Bank of England. No major surprises came out of these meetings, with central banks discourses and policy evolving in line with their respective economies. The BoE veered on the hawkish side, highlighting that rates could rise before its QE program is over. This implies a small possibility of a rate hike by the end of 2021. However, our base case remains that the initial hike will be in the first half of 2022. The BoE is behaving in line with the message from our UK Central Bank Monitor (Chart 14). Moreover, the combination of rapid inflation and strong house price appreciation is incentivizing the BoE to remove monetary accommodation, especially because UK financial conditions are extremely easy (Chart 14, bottom panel). One caution advanced by the MPC is the uncertainty surrounding the impact of the end of the job furlough scheme this month. However, the global economy will be strong enough next spring to mitigate the risks to the UK. The results of last week’s MPC meeting and our view on the global and UK business cycles support the short EUR/GBP recommendation of BCA’s foreign exchange strategist,2 as well as the underweight allocation to UK Gilts of our Global Fixed Income Strategy group.3 The Norges Bank is the first central bank in the G-10 to hike rates and is likely to do so again later this year. While Norwegian core inflation remains low, house prices are strong, monetary conditions are extremely accommodative, and our Norway Central Bank Monitor is surging (Chart 15). The Norwegian central bank will continue to focus on these positives, especially in light of our Commodity and Energy team’s view that Brent will average more than $80/bbl by 2023.4 In this context, we anticipate the NOK to outperform the euro over the coming 24 months. Nonetheless, the near-term outlook for Norwegian stocks remains fraught with danger. Materials account for 17% of the MSCI Norway index and are the sector most vulnerable to a deterioration in Chinese construction activity. The Riksbank continues to disregard the strength of the Swedish economy. Relative to economic conditions, it is one of the most dovish central banks in the world. The Swedish central bank is completely ignoring the message from our Sweden Central Bank Monitor, which has never been as elevated as it is today (Chart 16). Moreover, the inexpensiveness of the SEK means that Swedish financial conditions are exceptionally accommodative. At first glance, this picture is bearish for the SEK. However, easy monetary conditions will cause Sweden’s real estate bubble to expand. Expanding real estate prices and transaction volumes will boost the profits of Swedish financials, which account for 27% of the MSCI Sweden index. Moreover, Swedish industrials remain one of our favorite sectors in Europe, and they represent 38% of the same index. As a result, equity flows into Sweden should still hurt the EUR/SEK cross. Chart 15...And The Norges Bank, To Norway's ...And The Norges Bank, To Norway's ...And The Norges Bank, To Norway's Chart 16The Riksbank Is Blowing Real Estate Bubbles The Riksbank Is Blowing Real Estate Bubbles The Riksbank Is Blowing Real Estate Bubbles Chart 17The CHF Still Worries The SNB The CHF Still Worries The SNB The CHF Still Worries The SNB Finally, the SNB proved reliably dovish. Our Switzerland Central Bank Monitor is rising fast as inflation and house prices improve (Chart 17). However, the SNB is rightfully worried about the expensiveness of the CHF, which generates tight Swiss financial conditions (Chart 17, bottom panel). Consequently, the SNB will keep fighting off any depreciation in EUR/CHF. Thus, the SNB will be forced to expand its balance sheet because the ECB is likely to remain active in asset markets longer than many of its peers. This process will be key to the outperformance of Swiss stocks relative to other European defensive equities.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1 Please see European Investment Strategy “The ECB’s New Groove,” dated July 19, 2021, available at eis.bcarsearch.com 2 Please see Foreign Exchange Strategy “Why Are UK Interest Rates Still So Low?,” dated March 10, 2021, available at fes.bcarsearch.com 3 Please see European Investment Strategy “The UK Leads The Way,” dated August 11, 2021, available at eis.bcarsearch.com 4 Please see Commodity & Energy Strategy “Upside Price Risk Rises For Crude,” dated September 16, 2021, available at fes.bcarsearch.com   Tactical Recommendations Europe’s Evergrande Problem Europe’s Evergrande Problem Cyclical Recommendations Europe’s Evergrande Problem Europe’s Evergrande Problem Structural Recommendations Europe’s Evergrande Problem Europe’s Evergrande Problem Closed Trades Europe’s Evergrande Problem Europe’s Evergrande Problem Currency Performance Fixed Income Performance Equity Performance

Today we take a close look at the historical GICS1 level performance following the taper event in 2013.  Chart 1 provides an overview of a price action of the 10-year US Treasury yield, the US dollar, and gold to provide context, while Charts 2 - 4 summarize performance of the S&P sectors.   Chart 1 CHART 1 CHART 1 Chart 2 CHART 2 CHART 2 Chart 3 CHART 3 CHART 3 Chart 4 CHART 4 CHART 4 The Fed’s decision to modestly reduce the pace of its asset purchases in December of 2013 was a risk-off event which triggered a decline in Treasury yields and put upward pressure on the dollar. S&P 500 sectors followed the script from a risk-off “playbook” with Technology outperforming on the back of falling Treasury rates, while Financials underperformed.  A spike in USD also led to underperformance of the Energy sector. The Consumer Discretionary sector was a notable outlier underperforming the S&P 500 by 6%.  However, empirical analysis is hardly helpful in this case as in 2013 Amazon constituted 7.05% of the sector weight compared to 40% today. Finally, the performance of the defensive sectors was mixed as while tapering was perceived by the market as a clear risk-off event, it was also a sign that the economy is strong, and the Fed is comfortable with withdrawing the liquidity crutch. Bottom Line: Investors should not worry about the Fed and tapering as in the US its effect was short-lived and many more years of the bull market have ensued after it.