Recession-Hard/Soft Landing

Executive Summary The constructive economic view that has us at odds with the consensus rests on three premises: excess pandemic savings will allow consumption to grow at trend, despite inflation; inflation will soon peak, moving to around 4% by year end; and inflation expectations will remain well anchored, keeping the Fed from moving immediately to stifle the economy. Our consumption thesis remains intact. Real consumption has kept pace despite falling real incomes, thanks to a steady, modest drawdown of excess savings. Though our calls for an inflation peak have been consistently premature, recent data suggest that inflation pressures are abating. Gasoline prices have been falling for seven weeks; the fever has broken in ISM survey price measures; and the labor market, notwithstanding July's potent employment report, is becoming less tight. Longer-run inflation expectations have resisted becoming unmoored despite soaring measured inflation and a breakout does not appear to be imminent. A Mighty Savings Cushion A Mighty Savings Cushion A Mighty Savings Cushion Bottom Line: We continue to expect the economy will be surprisingly resilient, allowing equities to rally further before the Fed squashes the expansion. We doubt the rally will persist very far into 2023, however, so we are reducing equities to equal weight over a twelve-month timeframe. Feature We will be holding our quarterly webcast next Monday, August 15th at 9:00 a.m. Eastern time in lieu of publishing a Weekly Report. Please join us with your questions to make it a fully interactive event. We will resume our regular publication schedule on the 22nd. Last week, an investor we were meeting for the first time asked us how anyone could have published on a weekly basis this year. “Things are so uncertain and they’re moving so fast, how do you keep up? What have you been writing about?” At long last, we felt seen. Feeding the weekly beast is not easy under the best of circumstances and investors know that this year has been far from ideal. Related Report  US Investment StrategyThe High Bar For Getting Worse Once the warm glow of unexpected empathy receded, we replied that we’ve been doing our best to anticipate how the key macro issues will impact financial markets over our cyclical 3-to-12-month timeframe, paying particular attention to consumers, inflation and the Fed. The outlook for consumption has been our primary focus from a growth perspective; we’ve been trying to assess how representative the key drivers of inflation are and how persistent they’ll be; and we’ve continuously monitored longer-run inflation expectations to determine if inflation has gotten far enough into economic agents’ heads to become self-reinforcing and compel the Fed to dislodge it, no matter the near-term economic cost. We review what we see on all three fronts in today’s report, and how events are unfolding relative to our expectations. The direction remains especially uncertain, but our theses remain intact, and we are sticking with our constructive outlook on risk assets and the economy for the rest of the year. We are pulling in our horns on our twelve-month optimism, however, in line with the BCA house view and the dawning realization that twelve months of equity outperformance is overly ambitious. We continue to believe the recession will arrive too late for the gloomy consensus of investors judged by their quarterly performance, forcing them back into risk assets, but the rebound may not persist beyond the FOMC’s first 2023 meeting at the beginning of February. The Consumer’s Staying Power Since CARES Act transfer payments began driving a surge in personal savings, we have viewed them as dry powder to support consumption once households regained the freedom to spend as they see fit. When the payments stopped flowing and the pandemic continued to delay a return to normal, that view came under some fire. We are of the mind that households merely deferred much of the services demand they would otherwise have slaked in 2020 and 2021; others argue that consumption deferred is consumption destroyed, as households will be reluctant to spend windfall transfers that they’d mentally sorted as savings. While it will take a while for data to confirm either thesis, we are encouraged by what we’ve seen so far. The savings rate has declined considerably so far in 2022, supporting the view that households would be willing to reach into their savings to maintain trend consumption (Chart 1). It dipped to 5.2% in the second quarter from 5.6% in the first quarter, well below February 2020’s 8.3% pre-pandemic level and 2011 to 2019’s 7.4% quarterly mean (Chart 2). Based on the series’ stability over the previous nine years, 2020’s and 2021’s forced savings rates amounted to 11- and 6-sigma post-crisis events and this year’s approximately -2.5-sigma drawdown suggests the pendulum has further to swing in the direction of dissaving. We disagree with knee-jerk conclusions that spending in excess of income is unsustainable – it’s plenty sustainable for households who socked away a mountain of savings over the previous eight quarters while bars, restaurants, stadiums, concert venues and resorts were idled. Chart 1Right On Target Right On Target Right On Target Chart 22020 And 2021 Savings Were Enormous 2020 And 2021 Savings Were Enormous 2020 And 2021 Savings Were Enormous The estimates of excess savings that we’ve been calculating every month since the summer of 2020 peaked just above $2.3 trillion last August and remained around that level before embarking on a steady decline in the first half to reach our current estimate above $2 trillion (Chart 3, bottom panel). Quoting that figure has been nagging at us lately, however, as one of the two assumptions we used to calculate households’ no-pandemic savings baseline – annualized disposable income growth of 4% – took 2% annual inflation as given, a condition that no longer applies after a twelve-month stretch in which year-over-year CPI inflation has averaged 7.1%. Chart 3Nominal Excess Savings Taking Stock Taking Stock To determine how much households' purchasing power has eroded, we deflated our monthly excess savings estimates to a level equating to 2% annualized inflation (Chart 4, top panel). The adjustment knocked $450 billion off our current estimate, trimming it to $1.6 trillion (Chart 4, bottom panel). Perhaps more importantly for the outlook, our adjustment doubled the year-to-date burn rate to $500 billion. We have always worked with the (deliberately conservative) assumption that households would spend half of their excess savings; if inflation doesn’t decelerate soon, their cushion may not last very far beyond the end of the year. Chart 4Adjusted Excess Savings Taking Stock Taking Stock Bottom Line: Households have been willing to dip into savings to maintain trend consumption so far this year, in line with our hypothesis. We expect they will continue to do so, and the savings rate will remain around 5% or fall even lower, but inflation has eaten up some of their dry powder. Will Inflation Ever Peak? Shredding widely shared expectations that inflation would peak sometime in the first half, the year-over-year increase in headline CPI has kept climbing, all the way to 9% in June. July should finally provide some relief, as the average national retail gasoline price has fallen for seven consecutive weeks and ended July 13% below its June 30 level (Chart 5). Last week’s ISM manufacturing and services PMIs also suggested that inflation has begun to ease its grip somewhat, with the manufacturing input prices series plunging by nearly 20 points to its two-decade mean (Chart 6, top panel) and the services prices component cooling by 8 points, though it remains quite high (Chart 6, bottom panel). Chart 5Four Bucks A Gallon Is High, But Not Unfamiliar Four Bucks A Gallon Is High, But Not Unfamiliar Four Bucks A Gallon Is High, But Not Unfamiliar Chart 6The Fever May Have Broken ... The Fever May Have Broken ... The Fever May Have Broken ... ​​​​​​ Chart 7... Though The Job Market Is Still Quite Hot ... Though The Job Market Is Still Quite Hot ... Though The Job Market Is Still Quite Hot ​​​​​ The tight-as-a-drum labor market has been a fertile source of inflation worries, but there are signs that it is becoming less tight. Job openings remain 40% above their pre-COVID high but declined by 600,000 in June and are 10% off of March’s all-time peak (Chart 7). Elevated quits reveal that it's still easy to get a job, but the net share of small businesses in the NFIB survey planning to hire in the next three months is down 40% from its peak last summer (Chart 8). The July employment report challenged the under-the-radar indicators’ implication that the labor market is cooling, as net payroll expansion reaccelerated along with average hourly earnings growth (Chart 9). We are confident that net payroll growth will slow but compensation clearly has the cyclical wind at its back, and it is not certain that labor’s structural headwind will largely offset it, as per our thesis.   Chart 8Hiring Intentions Are Back To More Normal Levels ... Hiring Intentions Are Back To More Normal Levels ... Hiring Intentions Are Back To More Normal Levels ... Chart 9... But Wage Growth Remains Elevated ... But Wage Growth Remains Elevated ... But Wage Growth Remains Elevated Inflation Expectations Longer-run inflation expectations are a critical piece of the puzzle because they are the pathway for rising inflation to become self-reinforcing. If they expect persistently higher inflation, workers will negotiate more fiercely for larger compensation increases to stay ahead of it; businesses will push more vigorously to pass on their increased costs to preserve profit margins; lenders and bond investors will demand higher interest rates to protect their real returns; and consumers will seek to buy more now to get the most from their dwindling purchasing power, exacerbating supply-demand imbalances and keeping the heat on near-term inflation readings. We are therefore closely watching inflation expectations. Market-based measures like TIPS break-evens and CPI swaps shed some light on investor and business expectations, while the monthly University of Michigan consumer sentiment survey offers insight into households’ views. Market-based measures remain well-anchored: intermediate-term expectations as implied by TIPS break-evens are just nosing above the top of the Fed’s preferred 2.3-2.5% range (Chart 10, middle panel) while long-term expectations remain below it, as they have for most of the year (Chart 10, bottom panel). Intermediate- and long-term expectations derived from CPI swaps remain 20 to 30 basis points higher but are in the same position relative to their year-to-date path (Chart 11, bottom two panels). Chart 10Market-Based Inflation Expectations ... Market-Based Inflation Expectations ... Market-Based Inflation Expectations ... ​​​​​​ Chart 11... Are Not Problematic ... Are Not Problematic ... Are Not Problematic ​​​​​​ Chart 12Just Say No (To Bottleneck Prices) Just Say No (To Bottleneck Prices) Just Say No (To Bottleneck Prices) The Michigan survey doesn’t betray any pressing long-run concerns. The preliminary 3.3% June reading hinting at a breakout turned out to be a false alarm, as June’s final figure was 3.1% and July’s was 2.9%. Survey respondents continue to shun big-ticket purchases because they expect prices will fall from their current levels (Chart 12). 2-year TIPS and swaps price in an optimistic near-term outlook that is likely to be disappointed, as we think inflation will prove to be sticky around the 4% level, and that disappointment could bleed into higher longer-run expectations. While expectations are not problematic now, investors will need to watch them carefully going forward. Investment Implications It was policy, monetary and fiscal, that inspired our bullish turn in 2020 once we digested the COVID shock. We thought the macro backdrop would come down to policymakers versus the virus and our money was on the former. We remained bullish across 2021 on the idea that monetary and fiscal support would remain in place well after they ceased to be necessary. Mindful that there is no such thing as a free lunch, we expected that the emergency pandemic measures would ultimately have the effect of overstimulating demand, but we entered 2022 thinking that equities and credit would enjoy one more year of sizable excess returns over Treasuries and cash before the overstimulation manifested itself. Overweighting (underweighting) equities in a multi-asset portfolio is our default position when monetary policy is easy (tight), though we will override that default when appropriate. We have no appetite for overriding it once it becomes clear that market expectations for 2023 rate cuts are going to be disappointed and tight policy is just around the bend. Given our view that inflation will linger around 4% after easing smartly over the rest of this year, we expect that the Fed will impose restrictive monetary policy settings by the second half of 2023 in its quest to drive inflation back down to its 2% target. Markets’ overly rosy Fed expectations look sure to be disappointed and they could face a reckoning after the FOMC’s January 31-February 1 meeting. Chart 13Consolidation Now, 10%+ By The End Of The Year Consolidation Now, 10%+ By The End Of The Year Consolidation Now, 10%+ By The End Of The Year That meeting could herald an inflection for risk assets’ relative performance and we are therefore joining our colleagues in adopting a neutral 12-month view on equities. We continue to differ from the BCA consensus, however, in expecting a meaningful equity rally before year end. While we expect technical resistance at 4,200 will restrain the S&P 500 in the immediate term (Chart 13), we think it will find its way back into the mid-to-high 4,000s before the Fed signals that it will take the funds rate to 4% or above, dashing hopes for a February peak around 3.5%. We still want to overweight equities in multi-asset portfolios, but only until year-end or 4,500 to 4,600, whichever comes first.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

Listen to a short summary of this report.     Executive Summary The Euro And The Chinese Credit Impulse The Euro And The Chinese Credit Impulse The Euro And The Chinese Credit Impulse The US dollar has bounced off its 50-day moving average. In the recent past, that had led to a period of cyclical strength. The yen rally can be explained by the decline in Treasury yields and the fall in energy prices. Where next for the yen will depend on the time horizon. For investors trying to time the bottom, the euro is not yet a buy, but the common currency is incredibly cheap. Much depends on global/Chinese growth (Feature Chart). One of the key drivers of the dollar is volatility, and the correlation with the MOVE index. Less uncertainty will ease safe-haven demand. Stay short EUR/JPY and CHF/JPY. Remain long EUR/GBP. Maintain a limit sell on CHF/SEK at 10.76. RECOMMENDATIONS inception date RETURN Short EUR/JPY 2022-07-21 3.68 Bottom Line: We are tactically neutral the dollar but will be sellers on strength. Questions And Answers Chart 1Currencies And Yield Differentials Currencies And Yield Differentials Currencies And Yield Differentials It is rare that we receive clients in our Montreal office. This has obviously been doubly the case due to the pandemic and the general hassle of travel nowadays. But when we do, it is a delight. In this week’s report, we got asked a few difficult questions on a tea date. The most important was not surprisingly the dollar view, but also our highest conviction trades in FX markets. We enjoyed the conversation and the intellectual debate, so we thought we would share this with our clients. Hopefully, this answers some of the most pressing questions. We have sliced this into as brief and concise a conversation as we could. Question: It is hard not to notice the steep decline in the dollar over the last few weeks. Should we fade this decline or lean into it? That is a tough question, but our educated guess is to fade it for now. That said, longer-term asset allocators should really be looking at buying extremely cheap G10 currencies on any declines. The drivers of dollar downside have been clear. First, long-term interest rates in the US have fallen substantially. The US 10-year Treasury yield has fallen from 3.5% to 2.7%. In real terms, they have also declined. The 10-year TIPS yield has fallen from 0.85% to 0.23%. On a relative basis, the market is also pricing in that the Fed will cut interest rates next year much faster than other central banks. More simply put, 2-year real bond yields in the US are rolling over, relative to the euro area and Japan, the biggest components of the DXY index (Chart 1). Related Report  Foreign Exchange StrategyHow Deep A Recession Is The Dollar Pricing In? Specific to Japan and the euro area, there has also been another critical factor – the decline in energy import costs. Germany’s trade balance improved markedly in June (Chart 2). This has been the first genuine improvement in a year. There is also discussion to extend the life of existing nuclear power plants, which will help assuage energy import costs. In Japan, trade balance data comes out on Monday next week, so we will see what it reveals. But what has been clear is a political drive to restart nuclear power and wean the Japanese economy off its dependence on oil and gas (Chart 3). Japanese prime minister Fumio Kishida has been very vocal about this in recent speeches. Chart 2Euro Area And Japanese Trade Balances Are Improving Euro Area And Japanese Trade Balances Are Improving Euro Area And Japanese Trade Balances Are Improving Chart 3A Nuclear Renaissance In Japan? A Nuclear Renaissance In Japan? A Nuclear Renaissance In Japan? Turning to the more important part of your question, should we fade the decline or lean into it? We are of two minds on this to be honest, and here is why. The DXY has bounced off its 50-day moving average, which has been a sign in the past that the rally is not over (Chart 4). Our Geopolitical and Commodity & Energy colleagues are telling us not to trust the decline in oil prices. Our bond strategists think US yields are heading higher, with a whisper floor of 2.5%. Chart 4The DXY Has Support At The 50-Day Moving Average The DXY Has Support At The 50-Day Moving Average The DXY Has Support At The 50-Day Moving Average Given these crosscurrents, there are many better opportunities that exist in FX at the crosses, rather than playing the dollar outright. But of course, the dollar call is critical. We would be neutral over the next three-to-six months but be incremental sellers of the dollar on strength. Question: Okay, neutral dollar for now, but bearish long term. We tend to consider longer-term investments as well, and we are confused about the euro, but even more so about the yen. Would you buy the yen today? If so, why? Our starting point for many currencies is valuation. On this basis, the yen is incredibly cheap. So, if you have a five-to-ten-year horizon, you can unlock incredible value in Japan, simply on a buy-and-hold basis. Our in-house curated model shows that the yen is at a multi-general low in value terms (Chart 5). Currencies mean-revert. Consider this for a minute – we are not equity experts, but Toyota trades at a P/E of 10.75, while Tesla trades at a P/E of 109.15. And yes, Toyota has electric cars. Chart 5The Japense Yen Is Incredibly Cheap The Japense Yen Is Incredibly Cheap The Japense Yen Is Incredibly Cheap Chart 6The Yen Is A Favorite Short The Yen Is A Favorite Short The Yen Is A Favorite Short It is true that a winner-takes-all mantra can be attributed to Tesla’s valuation over Toyota, but our colleagues in the Global Investment Strategy are telling us this era is over. As such, at a 40% discount, the yen is a long-term buy in our books. Interestingly, nobody likes the yen, at least by our preferred measure – net speculative positions. It is one of the most shorted G10 currencies (Chart 6). A cheap currency that is the most shorted ranks quite well in our evaluation of bargains in currency markets. Given my discussion above about the dollar, we have played the yen at the crosses. We are short EUR/JPY and CHF/JPY. On the euro, Japanese car manufacturers are simply becoming more competitive than their eurozone or US counterparts. This is not only related to the car industry, but according to the OECD, EUR/JPY is expensive on a purchasing power parity basis (Chart 7). Meanwhile, a short EUR/JPY trade is a perfect hedge for a pro-cyclical portfolio. The DXY index has historically traded in perfect inverse correlation to the euro-yen exchange rate (Chart 8). This suggests the collapse in the yen, relative to the euro, is very much overdone. In a risk-off environment, EUR/JPY will sell off. Meanwhile, there are also fundamental reasons to suggest that the yen should trade higher vis-à-vis the euro. Chart 7Remain Short ##br##EUR/JPY Remain Short EUR/JPY Remain Short EUR/JPY Chart 8The DXY And EUR/JPY Usually Track Each Other The DXY And EUR/JPY Track Each Other EUR/JPY And The DXY: Unsustainable Gap The DXY And EUR/JPY Track Each Other EUR/JPY And The DXY: Unsustainable Gap Question: Okay, let’s switch to the euro. I know you are short EUR/JPY, which has been working out well in the last few days. But the euro touched parity and I get a sense that it has bottomed. You have often mentioned that the euro has priced in one of the deepest recessions in the eurozone. I am surprised you are not trumpeting this currency and a once-in-a-lifetime buying opportunity. We agree somewhat with your conclusion but not the premise. Let’s consider the narrative over the last few months in the media. The first was that eurozone inflation will never catch up to the US, because the economy was structurally weak. Well, it did, albeit due to an exogenous shock.  So, among a ranking of stagflationary candidates, the euro area is a top contender. If you believe in the idea that currencies are driven by real interest rates, rising inflation, and falling growth are an anathema for the exchange rate. When we typically have doubts about the euro area economy, and the outlook for its financial markets, we consult with our European Investment Strategy colleagues. We did just that and Mathieu Savary, who heads the service, mentioned two things: one – Chinese import volumes are imploding. For net creditor nations, this is a negative as their source of income is waning. The euro area falls into that category. The second thing to consider is that the dollar is a momentum currency. So is the euro. We mentioned earlier that the dollar bounced off its 50-day moving average, which explains euro weakness in recent trading days. In the end, Mathieu and the FX team did not really disagree, but I highlighted two charts to track. The euro tracks the Chinese credit impulse due to the importance of Chinese import demand for the euro area. It looks like our measure of that impulse has bottomed (Chart 9). If it has, you buy the euro on a long-term view. Relatedly, financial conditions are easing in China. As the Chinese bond market becomes more open and liberalized, bond yields become a financial conditions valve. That has been the case and has perfectly tracked the propensity for imports in the last few years (Chart 10). Chart 9The Euro And The Chinese Credit Impulse The Euro And The Chinese Credit Impulse The Euro And The Chinese Credit Impulse Chart 10Financial Conditions Are Easing In China Financial Conditions Are Easing In China Financial Conditions Are Easing In China In short, we will buy the euro if it touches parity, and even more so below parity with a 5–10-year view, but we think EUR/USD could touch 0.95 in the near term. I guess what we are saying is that a 5%-7% move is big in FX markets, but a 26% move (the undervaluation of the euro) is a whale. We do not see the catalyst for a whale in our current compass. Question: We have talked about the yen and the euro. I do not want to get into the pound, Australian dollar, and other currencies as you have told me your team has upcoming reports on those. But the Chinese yuan is very important in my investment portfolio. Any ideas on its next move? USD/CNY topped out near 6.8 in May. Since then, it has been in a trading range despite the DXY breaking to multi-decade highs (Chart 11). When a pattern like this emerges, it is always useful to revisit fundamentals. Those fundamentals are real interest rate differentials. We care about the yuan because China is a big trading partner of the US. As such, it is also a huge weight in the broad trade-weighted dollar index. China has huge problems, especially related to the property market, which need to be resolved. Bond yields have also collapsed. But the real interest rate in China is very attractive (Chart 12). It is also important to consider that if the dollar is the global safe haven, that means that the yuan could be becoming the haven in Asia. So, yuan downside is not a big risk for our long-term dollar bearish call. That said, we will be short CNY versus the yen, but not the dollar. Chart 11The RMB Has Been Relatively Resilient The RMB Has Been Relatively Resilient The RMB Has Been Relatively Resilient Chart 12The RMB Has Undershot Real Rate Differentials The RMB Has Undershot Real Rate Differentials The RMB Has Undershot Real Rate Differentials Question: I think I could sit with you all morning to discuss other aspects of FX,  but I respect you have a tight stop due to the BLU meeting. Any concluding thoughts? I have one. Very often, we debate with our colleagues about capital flows. The dollar rises (in general), as capital inflows accelerate into the US and vice versa. It is often said that getting the dollar call right gets everything else right. So, if you can predict the path of the dollar, the performance of, say, US versus non-US equities becomes easy. Chart 13The Dollar And Earnings Revisions The Dollar And Earnings Revisions The Dollar And Earnings Revisions We agree that the dollar is a real-time indicator of relative fundamentals. But here is one important observation: relative earnings revisions are deteriorating in the US vis-à-vis other countries (Chart 13). That has historically had an impact on exchange rates, as it affects equity capital flows. If the Federal Reserve also cut rates next year as the market is predicting, that will also be a negative for bond inflows. We think the global economy will avoid a deep recession, and that will allow growth to pick up outside the US. When the euro area and China bottom, then the dollar will truly peak, as capital flows to these economies will accelerate. So we are watching relative earnings and bond yield differentials closely.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Counterpoint’s August schedule: Next week, I am travelling to see clients in Australia, New Zealand, and Singapore, so we will send you a report on China’s 20th National Party Congress written by our Chief Geopolitical Strategist, Matt Gertken. Given that the outlook for the $100 trillion Chinese real estate market is crucial for the global economy and markets, Matt’s insights will be very interesting. Then on August 18, I will host the monthly Counterpoint webcast, which I hope you can join. We will then take a week’s summer holiday and return with a report on September 1. Executive Summary In the topsy-turvy recession of 2022, real wages have collapsed. This means profits have stayed resilient and firms have not laid off workers. Making this recession a ‘cost of living crisis’ rather than a ‘jobs crisis’. If inflation comes down slowly, then the ‘cost of living crisis’ will persist. But if inflation comes down quickly while wage inflation remains sticky, firms will lay off workers to protect their profits, turning the ‘cost of living crisis’ into a ‘jobs crisis’. Either way, this will keep a choke on consumer spending, and particularly the spending on goods, which is likely to remain in recession. Meanwhile, until mortgage rates move meaningfully lower, housing investment will also remain in recession.  The double choke on growth means that the bear market in the 30-year T-bond is likely over. This suggests that the bear market in stock market valuations is also over, but that ‘cyclical value’ is now vulnerable to profit downgrades. Hence, equity investors should stick with ‘defensive growth’, specifically healthcare and biotech. Fractal trading watchlist: GBP/USD and Hungarian versus Polish bonds. In The 2008 Recession, Real Wage Rates ##br##Went Up So Employment Went Down… In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... …But In The 2022 Recession, Real Wage Rates##br##Went Down So Employment Went Up! ...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! ...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! Bottom Line: The bear market in the 30-year T-bond and stock market valuations is likely over, but equity investors should stick with ‘defensive growth’, specifically healthcare and biotech. Feature The US economy has just contracted for two consecutive quarters, meeting the rule-of-thumb definition of a recession. Other major economies are likely to follow. Yet many economists and strategists are in denial. This cannot be a ‘proper’ recession, they say, because the economy remains at full employment. But the recession-deniers are wrong. It is a recession, albeit it is a ‘topsy-turvy’ recession in which employment remains high (so far) because real wage rates have collapsed, circumventing the need for lay-offs. This contrasts with a typical recession when real wage rates remain high, forcing the need for lay-offs.1 The Topsy-Turvy Recession Of 2022 When do firms lay off workers? The answer is, when they need to protect their profits. Profits are nothing more than revenues minus costs, and in a typical recession revenues slow much faster than the firms’ biggest cost, the wage bill. In this event, the only way that firms can protect their profits is to lay off workers. Chart I-1 confirms that every time that nominal sales have shrunk relative to wage rates, the unemployment rate has gone up. Without exception. Chart I-1Unemployment Goes Up Whenever Firms' Wage Rates Rise Faster Than Their Revenues... Unemployment Goes Up Whenever Firms' Wage Rates Rise Faster Than Their Revenues... Unemployment Goes Up Whenever Firms' Wage Rates Rise Faster Than Their Revenues... But what happens during a recession in which nominal sales do not shrink relative to wage rates? In this event, profits stay resilient, so firms do not need to lay off workers. Welcome to the topsy-turvy recession of 2022! In the topsy-turvy recession of 2022, there has been much greater inflation in consumer prices and nominal sales than in nominal wage rates (Chart I-2). The result is that real wage rates have collapsed, profits have stayed resilient, and firms have not needed to lay off workers… so far. Chart I-2...But In The 2022 Recession, Wage Rates Have Risen Slower Than Revenues, So Unemployment Hasn't Gone Up ...But In The 2022 Recession, Wage Rates Have Risen Slower Than Revenues, So Unemployment Hasn't Gone Up ...But In The 2022 Recession, Wage Rates Have Risen Slower Than Revenues, So Unemployment Hasn't Gone Up In a typical recession, the pain falls on the minority of workers who lose their jobs, as well as on profits. Paradoxically, for the majority that keep their jobs, real wages go up. This is because sticky wage inflation tends to hold up more than collapsing price inflation. For example, in the 2008 recession, the real wage rate surged by 4 percent (Chart I-3), and in the 2020 recession it rose by 2 percent. Chart I-3In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... Yet in the 2022 recession, the real wage rate has shrunk by 4 percent, meaning that the pain of the recession has fallen on all of us (Chart I-4). In one sense therefore, this recession is ‘fairer’ because ‘we’re all in it together’. This is confirmed by the current malaise being characterised not as a ‘jobs crisis’, but as a ‘cost of living crisis’. In another sense though, the recession is unfair because the pain has not been shared by corporate profits, which have remained resilient… so far. Chart I-4...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! ...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! ...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! The crucial question is, what happens next? Using the US as our template, wage rates are growing at 5-6 percent, and this growth rate is typically stickier than sales growth. Assuming inflation drifts lower, nominal sales growth will also drift lower from its current 7 percent clip, meaning that it could soon dip below sticky wage growth. Once the growth in firms’ revenues has dipped below that in nominal wage rates, profits will finally keel over. To repeat, profits are nothing more than revenues minus costs, where the biggest cost is the wage bill (Chart I-5).2 Chart I-5Profits Are Nothing More Than Revenues Minus Costs Profits Are Nothing More Than Revenues Minus Costs Profits Are Nothing More Than Revenues Minus Costs At this point, the downturn will become more conventional. To protect profits, firms will be forced to lay off workers who will bear the pain of the downturn alongside falling profits. Meanwhile, with inflation easing, real wage growth for the majority that keep their jobs will turn positive. But to repeat, this is the typical pattern in a recession. Accelerating real wage rates are entirely consistent with a contracting economy as we witnessed in both 2008 and 2020.  As Two Huge Imbalances Correct, Demand Will Be Pegged Back All of this assumes that real demand will remain under pressure, so the question is what is pegging back real demand? The answer is: corrections in two huge imbalances in the global economy. A breakdown of the -1.3 percent contraction in the US economy reveals these two corrections:3   Spending on goods, which contributed -1.2 percent Housing investment, which contributed -0.7 percent. These corrections are not over. As we presciently explained back in February in A Massive Economic Imbalance, Staring Us In The Face: “The pandemic overspend on goods constitutes one of the greatest imbalances in economic history. An overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend. The pandemic overspend on goods constitutes one of the greatest imbalances in economic history. This unfortunate asymmetry means that the recent overspend on goods at the expense of services makes the economy vulnerable to a recession. And the risk is exacerbated by central banks’ intentions to hike rates in response to inflation” (Chart I-6). Chart I-6The Pandemic Overspend On Goods Constitutes One Of The Greatest Imbalances In Economic History The Pandemic Overspend On Goods Constitutes One Of The Greatest Imbalances In Economic History The Pandemic Overspend On Goods Constitutes One Of The Greatest Imbalances In Economic History Then, in The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting, we identified a second major imbalance that is starting to correct. Specifically, the global housing boom of the past decade, which has doubled the worth of global real estate to $370 trillion, was predicated on ultra-low mortgage rates that made buying a home more attractive than renting. But in many parts of the world now, buying a home has become more expensive than renting (Chart I-7). Disappearing US and European homebuyers combined with a flood of home-sellers will weigh on home prices and housing investment – at least until policymakers are forced to bring down mortgage rates (Chart I-8 and Chart I-9). Chart I-7Buying A Home Has Become More Expensive Than Renting! Buying A Home Has Become More Expensive Than Renting! Buying A Home Has Become More Expensive Than Renting! Chart I-8Homebuyers Have Disappeared... Homebuyers Have Disappeared... Homebuyers Have Disappeared... Chart I-9...While Home-Sellers Are Flooding The Market ...While Home-Sellers Are Flooding The Market ...While Home-Sellers Are Flooding The Market Meanwhile, as Chinese policymakers try and gently let the air out of the $100 trillion Chinese real estate market, a collapse in Chinese property development and construction activity will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. More Investment Conclusions In addition to the long-term investment conclusions just described, we can draw some shorter-term conclusions: If inflation comes down slowly, then the current ‘cost of living crisis’, which is pummelling everyone’s real incomes, will persist. But if inflation comes down quickly while wage inflation remains sticky, firms will be forced to lay off workers to protect their profits, turning the ‘cost of living crisis’ into a ‘jobs crisis’. Either way, this will keep a choke on consumer spending, and particularly the spending on goods, which is likely to remain in recession. Meanwhile, until mortgage rates move meaningfully lower, housing investment will also remain in recession.  Equityinvestors should stick with ‘defensive growth’, specifically healthcare and biotech. This double choke on growth is likely to keep a lid on ultra-long bond yields, even if central banks need to hike short-term rates more than expected to slay inflation. Our proprietary fractal analysis confirms that the sell-off in the 30-year T-bond is likely over (Chart I-10). Chart I-10The Bear Market In The 30-Year T-Bond Is Likely Over The Bear Market In The 30-Year T-Bond Is Likely Over The Bear Market In The 30-Year T-Bond Is Likely Over For the stock market, this suggests that the valuation bear market is now over, but that ‘cyclical value’ sectors are now vulnerable to profit downgrades. Hence, equity investors should stick with ‘defensive growth’, specifically healthcare and biotech. Fractal Trading Watchlist This week we noticed that the sudden 20 percent collapse of Hungarian versus Polish 10-year bonds, has reached the point of short-term fractal fragility that suggests an imminent rebound. Hence, we are adding this to our watchlist. Go long GBP/USD. But our trade is GBP/USD. UK political risk is diminishing, the BoE is likely to be as, or more, hawkish than the Fed, and the 260-day fractal structure of GBP/USD is at the point of fragility that has signalled major turning points in 2014, 15, 16, 18 and 21 (Chart I-11). Accordingly the recommendation is long GBP/USD, setting the profit target and symmetrical stop-loss at 5 percent.   Chart I-11Go Long GBP/USD Go Long GBP/USD Go Long GBP/USD Go Long GBP/USD Go Long GBP/USD Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Chart 1CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point   Chart 2Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Chart 3Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Chart 4US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 5CAD/SEK Is Reversing CAD/SEK Is Reversing CAD/SEK Is Reversing Chart 6Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Chart 7The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended Chart 8The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended Chart 9FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 10Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 11The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 12The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 13Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 14German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse Chart 15Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 16ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 18The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 19A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 21Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 22Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 23Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 24USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 25The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 26A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 27US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 28The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The best measure of wage rates is the employment cost index (ECI) because it includes all forms of compensation including benefits and bonuses. 2  In fact, stock market profits are even more cyclical because, as well as wages, there are other sticky deductions from revenues such as interest and taxes. 3 All expressed as annualised rates. Fractal Trading System Fractal Trades Welcome To The Topsy-Turvy Recession Of 2022! Welcome To The Topsy-Turvy Recession Of 2022! Welcome To The Topsy-Turvy Recession Of 2022! Welcome To The Topsy-Turvy Recession Of 2022! 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Biden Taps China-Bashing Consensus Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake House Speaker Nancy Pelosi’s visit to Taiwan reflects one of our emerging views in 2022: the Biden administration’s willingness to take foreign policy risks ahead of the midterm elections. Biden’s foreign policy will continue to be reactive and focused on domestic politics through the midterms. Hence global policy uncertainty and geopolitical risk will remain elevated at least until November 8.  Biden is seeing progress on his legislative agenda. Congress is passing a bill to compete with China while the Democrats are increasingly likely to pass a second reconciliation bill, both as predicted. These developments support our view that President Biden’s approval rating will stabilize and election races will tighten, keeping domestic US policy uncertainty elevated through November. These trends pose a risk to our view that Republicans will take the Senate, but the prevailing macroeconomic and geopolitical environment is still negative for the ruling Democratic Party. We expect legislative gridlock and frozen US fiscal policy in 2023-24. Close Recommendation (Tactical) Initiation Date  Return Long Refinitiv Renewables Vs. S&P 500 Mar 30, 2022 25.4% Long Biotech Vs. Pharmaceuticals Jul 8,  2022 -3.3% Bottom Line: While US and global uncertainty remain high, we will stay long US dollar, long large caps over small caps, and long US Treasuries versus TIPS. But these are tactical trades and are watching closely to see if macroeconomic and geopolitical factors improve later this year. Feature President Biden’s average monthly job approval rating hit its lowest point, 38.5%, in July 2022. However, Biden’s anti-inflation campaign and midterm election tactics are starting to bear fruit: gasoline prices have fallen from a peak of $5 per gallon to $4.2 today, the Democratic Congress is securing some last-minute legislative wins, and women voters are mobilizing to preserve abortion access.  These developments mean that the Democratic Party’s electoral prospects will improve marginally between now and the midterm election, causing Senate and congressional races to tighten – as we have expected. US policy uncertainty will increase. Investors will see a rising risk that Democrats will keep control of the Senate – and conceivably even the House – and hence retain unified control of the executive and legislative branches. This “Blue Sweep” risk will challenge the market consensus, which overwhelmingly (and still correctly) expects congressional gridlock in 2023-24. A continued blue sweep would mean larger tax hikes and social spending, while gridlock would neutralize fiscal policy for the next two years. Investors should fade this inflationary blue sweep risk and continue to plan for disinflationary gridlock. First, our quantitative election models still predict that Democrats will lose control of both House and Senate (Appendix). Second, Biden’s midterm tactics face very significant limitations, particularly emanating from geopolitics – the snake in this report’s title. Pelosi’s Trip To Taiwan Raises Near-Term Market Risks One of Biden’s election tactics is our third key view for 2022: reactive foreign policy. Initially we viewed this reactiveness as “risk-averse” but in May we began to argue that Biden could take risky bets given his collapsing approval ratings. Either way, Biden is using foreign policy as a means of improving his party’s domestic political fortunes. In particular, he is willing to take big risks with China, Russia, Iran, and terrorist groups like Al Qaeda. The template is the 1962 congressional election, when President John F. Kennedy largely defied the midterm election curse by taking a tough stance against Russia in the Cuban Missile Crisis (Chart 1). If Biden achieves a foreign policy victory, then Democrats will benefit. If he instigates a crisis, voters will rally around his administration out of patriotism. Nancy Pelosi’s visit to Taipei is the prominent example of this key view. The trip required full support from the US executive branch and military and was not only the swan song of a single politician. It was one element of the Biden administration’s decision to maintain the Trump administration’s hawkish China policy. Thus while Congress passes the $52 billion Chips and Science Act to enhance US competitiveness in technology and semiconductor manufacturing, Biden is also contemplating tightening export controls on computer chip equipment that China needs to upgrade its industry.1 Biden is reacting to a bipartisan and popular consensus holding that the US needs to take concrete measures to challenge China and protect American industry (Chart 2). This is different from the old norm of rhetorical China-bashing during midterms. Chart 1Biden Provokes Foreign Rivals Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart 2Biden Taps China-Bashing Consensus Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Reactive US foreign policy will continue through November and possibly beyond – including but not limited to China. The US chose to sell long-range weapons to Ukraine and provide intelligence targeting Russian forces, prompting Russia to declare that the US is now “directly” involved in the Ukraine conflict. The US decision to eradicate Al Qaeda leader Ayman Al-Zawahiri also reflects this foreign policy trend. Reactive foreign policy will increase the near-term risk of new negative geopolitical surprises for markets. Note that the 1962 Cuban Missile Crisis analogy is inverted when it comes to the Taiwan Strait. China is willing to take much greater risks than the US in its sphere of influence. The same goes for Russia in Ukraine. If US policy backfires then it may assist the Democrats in the election – but not if Biden suffers a humiliation or if the US economy suffers as a result. Chart 3US Import Prices Will Stay High From Greater China US Import Prices Will Stay High From Greater China US Import Prices Will Stay High From Greater China US import prices will continue to rise from Greater China (Chart 3), undermining Biden’s anti-inflation agenda. Supply kinks in the semiconductor industry will become relevant again whenever demand rebounds  (Chart 4). Global energy prices will also remain high as a result of the EU’s oil embargo and Russia’s continued tightening of European natural gas supplies. Chart 4New Semiconductor Kinks Will Appear When Demand Recovers New Semiconductor Kinks Will Appear When Demand Recovers New Semiconductor Kinks Will Appear When Demand Recovers OPEC has decided only to increase oil production by 100,000 barrels per day, despite Biden’s visit to Saudi Arabia cap in hand. We argued that the Saudis would give a token but would largely focus on weakening global demand rather than pumping substantially more oil to help Biden and the Democrats in the election. The Saudis know that Biden is still attempting to negotiate a nuclear deal with Iran that would free up Iranian exports. So the Saudis are not giving much relief, and if Biden fails on Iran, oil supply disruptions will increase. Bottom Line: Price pressures will intensify as a result of the US-China and US-Russia standoffs – and probably also the US-Iran standoff. Hawkish foreign policy is not conducive to reducing inflationary ills. Global policy uncertainty and geopolitical risk will remain high throughout the midterm election season, causing continued volatility for US equities. Abortion Boosts Democratic Election Odds Earlier this year we highlighted that the Supreme Court’s overturning of the 1972 Roe v. Wade decision would lead to a significant mobilization of women voters in favor of the Democratic Party ahead of the midterm election. The first major electoral test since the court’s ruling, a popular referendum in the state of Kansas, produced a surprising result on August 2 that confirms and strengthens this thesis. Kansas is a deeply religious and conservative state where President Trump defeated President Biden by a 15% margin in 2020. The referendum was held during the primary election season, when electoral turnout skews heavily toward conservatives and the elderly. Yet Kansans voted by an 18% margin (59% versus 41%) not to amend the constitution, i.e. not to empower the legislature to tighten regulations on abortion. Voter turnout is not yet reported but likely far higher than in recent non-presidential primary elections. Kansans voted in the direction of  nationwide opinion polling on whether abortion should be accessible in cases where the mother’s health is endangered. They did not vote in accordance with more expansive defenses of abortion, which are less popular (Chart 5). If the red state of Kansas votes this way then other states will see an even more substantial effect, at least when abortion is on the ballot. Chart 5Abortion Will Mitigate Democrats’ Losses Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake The question is how much of this Roe v. Wade effect will carry over to the general congressional elections. The referendum focused exclusively on abortion. Voters did not vote on party lines. Voters never like it when governments try to take away rights or privileges that have previously been granted. But in November the election will center on other topics, including inflation and the economy. And midterm elections almost always penalize the incumbent party. Our quantitative election models imply that Democrats will lose 22 seats in the House and two seats in the Senate, yielding Congress to the Republicans next year (Appendix). Still, women’s turnout presents a risk to our models. Women’s support for the Democratic Party has not improved markedly since the Supreme Court ruling, as we have shown in recent reports (Chart 6). But the polling could pick up again. Women’s turnout could be a significant tailwind in a year of headwinds for the Democrats. Bottom Line: Democrats’ electoral prospects have improved, as we anticipated earlier this year (Chart 7). This trend will continue as a result of the mobilization of women. Republicans are still highly likely to take Congress but our conviction on the Senate is much lower than it is on the House. Chart 6Biden’s And Democrats’ Approval Among Women Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart 7Democrats’ Odds Will Improve On Margin Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Reconciliation Bill: Still 65% Chance Of Passing Ultimately Democrats’ electoral performance will depend on inflation, the economy, and cyclical dynamics. If inflation falls over the course of the next three months, then Democrats will have a much better chance of stemming midterm losses. That is why President Biden rebranded his slimmed down “Build Back Better” reconciliation bill as the “Inflation Reduction Act.” We maintain our 65% odds that the bill will pass, as we have done all year. There is still at least a 35% chance that Senator Kyrsten Sinema of Arizona could defect from the Democrats, given that she opposed any new tax hikes and the reconciliation bill will impose a 15% minimum tax on corporations. A single absence or defection would topple the budget reconciliation process, which enables Democrats to pass the bill on a simple majority vote. We have always argued that Sinema would ultimately fall in line rather than betraying her party at the last minute before the election. This is even more likely given that moderate-in-chief, Senator Joe Manchin of West Virginia, negotiated and now champions the bill. But some other surprise could still erase the Democrats’ single-seat majority, so we stick with 65% odds. Most notably the bill will succeed because it actually reduces the budget deficit – by an estimated $300 billion over a decade (Table 1). Deficit reduction was the original purpose of lowering the number of votes required to pass a bill under the budget reconciliation process. Now Democrats are using savings generated from new government caps on pharmaceuticals (a popular measure) to fund health and climate subsidies. Given deficit reduction, it is conceivable that a moderate Republican could even vote for the bill. Table 1Democrats’ Inflation Reduction Act (Budget Reconciliation) Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Bottom Line: Democrats are more likely than ever to pass their fiscal 2022 reconciliation bill by the September 30 deadline. The bill will cap some drug prices and reduce the deficit marginally, so it can be packaged as an anti-inflation bill, giving Democrats a legislative win ahead of the midterm. However, its anti-inflationary impact will ultimately be negligible as $300 billion in savings hardly effects the long-term rising trajectory of US budget deficits relative to output. The bill will add to voters’ discretionary income and spur the renewable energy industry. And if it helps the Democrats retain power, then it enables further spending and tax hikes down the road, which would prove inflationary. The reconciliation bill, annual appropriations, and the China competition bill were the remaining bills that we argued would narrowly pass before the US Congress became gridlocked again. So far this view is on track.   Investment Takeaways Companies that paid a high effective corporate tax rate before President Trump’s tax cuts have benefited relative to those that paid a low effective rate. They stood to suffer most if Trump’s tax cuts were repealed. But Democrats were forced to discard their attempt to raise the overall corporate tax rate last year. Instead the minimum corporate rate will rise to 15%, hitting those that paid the lowest effective rate, such as Big Tech companies, relative to high-tax rate sectors such as energy (Chart 8, top panel). Tactically energy may still underperform tech but cyclically energy could outperform and the reconciliation bill would feed into that trend. Similarly, companies that faced high foreign tax risk, because they made good income abroad but paid low foreign tax rates, stand to suffer most from the imposition of a minimum corporate tax rate (Chart 8, bottom panel). Again, Big Tech stands to suffer, although it has already priced a lot of bad news and may not perform poorly in the near term. Chart 8Market Responds To Minimum Corporate Tax Market Responds To Minimum Corporate Tax Market Responds To Minimum Corporate Tax Chart 9Market Responds To New Climate Subsidies Market Responds To New Climate Subsidies Market Responds To New Climate Subsidies Renewable energy stocks have rallied sharply on the news of the Democrats’ reconciliation bill getting back on track (Chart 9). We are booking a 25.4% gain on this tactical trade and will move to the sidelines for now, although renewable energy remains a secular investment theme. Health stocks, particularly pharmaceuticals, have taken a hit from the new legislation as we expected. However, biotech has not outperformed pharmaceuticals as we expected, so we will close this tactical trade for a loss of 3.3%. The reconciliation bill will cap drug prices for only the most popular generic drugs and does not pose as much of a threat to biotech companies (Chart 10). Biotech should perform well tactically as long bond yields decline – they are also historically undervalued, as noted by Dhaval Joshi of our Counterpoint strategy service. So we will stick to long Biotech versus the broad market. US semiconductors remain in a long bull market and will be in heavy demand once global and US economic activity stabilize. They are also likely to outperform competitors in Greater China that face a high and persistent geopolitical risk premium (Chart 11).  Chart 10Market Responds To Drug Price Caps Market Responds To Drug Price Caps Market Responds To Drug Price Caps Chart 11Market Responds To China Competition Bill Market Responds To China Competition Bill Market Responds To China Competition Bill Tactically we prefer bonds to stocks, US equities to global equities, defensive sectors to cyclicals, large caps to small caps, and growth stocks to value stocks (Chart 12). The US is entering a technical recession, Europe is entering recession, China’s economy is weak, and geopolitical tensions are at extreme highs over Ukraine, Taiwan, and Iran. The US is facing an increasingly uncertain midterm election. These trends prevent us from adding risk in our portfolio in the short term. However, much bad news is priced and we are on the lookout for positive economic surprises and successful diplomatic initiatives to change the investment outlook for 2023. If the US and China recommit to the status quo in the Taiwan Strait, if Russia moves toward ceasefire talks in Ukraine, if the US and Iran rejoin the 2015 nuclear deal, then we will take a much more optimistic attitude. Some political and geopolitical risks could begin to recede in the fourth quarter – although that remains to be seen. And even then, geopolitical risk is rising on a secular basis. Chart 12Tactically Recession And Geopolitics Will Weigh On Risk Assets Tactically Recession And Geopolitics Will Weigh On Risk Assets Tactically Recession And Geopolitics Will Weigh On Risk Assets Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com       Footnotes 1     Alexandra Alper and Karen Freifeld, “U.S. considers crackdown on memory chip makers in China,” Reuters, August 1, 2022, reuters.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A3US Political Capital Index Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart A1Presidential Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Chart A2Senate Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort  Table A4House Election Model Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5APolitical Capital: White House And Congress Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5BPolitical Capital: Household And Business Sentiment Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5CPolitical Capital: The Economy And Markets Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake

Executive Summary Government bond yields worldwide are falling due to fears of a global recession that will lead to monetary easing in 2023. This pricing is too optimistic with inflation likely to remain well above central bank targets next year. Even though US real GDP contracted modestly in the first half of 2022, the broader flow of US economic data is more consistent with an economy that is slowing substantially but not yet in recession. The Fed welcomes sharply slower growth to deal with high inflation, but will not unwind the 2022 rate hikes as quickly as markets expect given sticky core/wage inflation. The Fed rate cuts now discounted for 2023 will likely not be delivered. No Major Recessionary Signal From Global Yield Curves … Yet No Major Recessionary Signal From Global Yield Curves . . . Yet No Major Recessionary Signal From Global Yield Curves . . . Yet Bottom Line: Falling global bond yields have helped stabilize risk assets – a path that will eventually lead to a rebound in yields if easier financial conditions help avoid a deep recession. Stay neutral overall duration exposure in global bond portfolios. The Great Recession Debate Begins Global bond yields have seen substantial declines over the past few weeks, as the market narrative has quickly changed from surging inflation and rate hikes to imminent recession and eventual rate cuts (Chart 1). The truth is somewhere in the middle, with global inflation in the process of peaking and global growth slowing rapidly but not yet in full-blown recession. Related Report  Global Fixed Income StrategyMixed Messages & Range-Bound Bond Yields Bond markets are expecting central banks, most importantly the Fed, to quickly abandon the fight against high inflation for a new battle to tackle decelerating economic growth. The problem for investors is that weaker growth is needed – and, indeed, welcomed by policymakers - to create economic slack to help bring down elevated inflation. There is little evidence of such a disinflationary slack being created, with unemployment rates still near cyclical lows in the US, Europe and most of the developed world. The link between longer-term bond yields and shorter-term interest rate expectations remains strong in an environment of very flat government yield curves. For example, in the US, the 10-year Treasury yield has fallen from a peak of 3.47% in mid-June to 2.67% at the end of July. Over the same period, the 1-month interest rate, two-years ahead priced into the US overnight index swap (OIS) curve fell from a peak of 3.1% to 2.1% (Chart 2). Chart 1A Downward Adjustment Of Interest Rate Expectations A Downward Adjustment Of Interest Rate Expectations A Downward Adjustment Of Interest Rate Expectations ​​​​​​ Chart 2A Lower Trajectory For Rates Priced In As Growth Slows A Lower Trajectory For Rates Priced In As Growth Slows A Lower Trajectory For Rates Priced In As Growth Slows ​​​​​​ An even more dramatic decline in yields has been seen in Europe. The 10-year German Bund yield has fallen from a mid-June peak of 1.75% to 0.83% at the end of July, while the 1-month/2-year forward European OIS rate fell from 2.5% to 1.1%. The 2-year German yield, most sensitive to ECB rate hike expectations, also fell dramatically from 1.15% to 0.24%. There have also been substantial declines in bond yields and rate expectations in the UK, Canada and Australia over the past six weeks. As central banks continue to raise policy rates towards levels perceived to be at least neutral, if not mildly restrictive, there should a stronger correlation between future rate hike expectations and longer-term bond yields. Put another way, yield curves tend to flatten and eventually invert as policymakers move rates to levels that should slow growth and, eventually, reduce inflation. Currently, the “global” 2-year/10-year government bond yield curve, using Bloomberg Global Treasury index data, is slightly inverted at -13bps (Chart 3). More deeper curve inversions typically precede major contractions in global growth and equity prices. Chart 3No Major Recessionary Signal From Global Yield Curves . . . Yet No Major Recessionary Signal From Global Yield Curves . . . Yet No Major Recessionary Signal From Global Yield Curves . . . Yet At the moment, global equities have performed in line with deeper curve inversions and contracting growth, with the MSCI World equity index down -7% on a year-over-year basis (bottom panel). Yet actual global growth is not yet in contraction. Global industrial production, while slowing, is still growing at a +3% year-over-year rate. The global manufacturing PMI remains above 50, indicative of a still-expanding manufacturing sector. Euro area, which is widely believed to already be in recession, saw real GDP growth (non-annualized) of +0.5% and +0.7%, respectively, in Q1 and Q2 of this year. Meanwhile, US real GDP shrank modestly over the first half of 2022, down only -0.6% (non-annualized) over Q1 and Q2, but with no corroborating evidence of recession from the labor market with the headline unemployment rate falling from 4.0% to 3.6% over that same period. Further adding to the confusing mix of signals between yield curves and growth is that the curve inversion at the global level is not yet evident across all countries. For example, the 2-year/10-year curve is inverted in the US and Canada, countries where central banks have been more aggressive on hiking rates in 2022 (Chart 4A) Yet in both countries, there have only been moderate declines in leading economic indicators and composite PMIs (combining manufacturing and services). In contrast, the 2-year/10-year curve in Germany and the UK – where the ECB and Bank of England have delivered fewer rates than the Fed and Bank of Canada – remains positively sloped but with similar moderate declines in leading economic indicators and composite PMIs to those seen in the US and Canada (Chart 4B). Chart 4AA Policy-Driven Slowdown In North America A Policy-Driven Slowdown In North America A Policy-Driven Slowdown In North America ​​​​​​ Chart 4BAn Energy-Driven Slowdown In Europe An Energy-Driven Slowdown In Europe An Energy-Driven Slowdown In Europe ​​​​​​ Chart 5Central Banks Cannot Pivot Dovishly Against This Backdrop Central Banks Cannot Pivot Dovishly Against This Backdrop Central Banks Cannot Pivot Dovishly Against This Backdrop The deceleration of growth seen so far in this countries is nowhere near enough for central banks to begin contemplating a pivot away from hawkish rate hikes in 2022 to dovish rate cuts in 2023/24, as markets are now discounting. Inflation rates remain far too elevated, and labor markets remain far too tight, for policymakers to switch from the brake pedal to the gas pedal (Chart 5). This exposes global bond yields to a rebound from recent lows as central banks disappoint the market’s growing belief that policymakers’ focus will turn to growth from inflation. The language from recent central bank policy decisions, from the ECB’s 50bp hike on July 21 to the Fed’s 75bp hike last week to yesterday’s 50bp hike by the Reserve Bank of Australia, has been consistent, calling for a continued need to tighten policy. All three central banks essentially abandoned forward guidance, but described future rate moves as being “data dependent”, particularly inflation data. There is likely to be some relief from elevated inflation rates over the next few months. There have already been substantial declines in the growth of commodity prices, with the CRB Raw Industrials index now contracting in year-over-year terms (Chart 6). Global shipping costs and supplier delivery times have also declined, as evidence of some easing of supply chain disruptions that is helping bring down goods inflation. Yet given the starting point of such high headline inflation rates – at or above 9% in the US, UK and euro area – it is unlikely that there will be enough disinflation from the commodity/goods space to quickly bring inflation down by enough for central banks to breathe easier. This is especially true given that stickier domestically generated inflation stemming from wages and services will remain well above central bank targets over at least the next year, or at least until there is a substantial increase in slack-producing unemployment (i.e. a recession). What does all this mean for our view on the direction of global bond yields? We still see the current environment as more consistent with broad trading ranges for yields, rather than the start of a new major downtrend or uptrend. Europe was the one exception to this view, given how markets were pricing in a rise in ECB policy rates that was too aggressive, but even that has now corrected after the dramatic collapse in core European yields from the mid-June peak. Our Global Duration Indicator has been calling for a loss of cyclical upward momentum of bond yields in the latter half of 2022, which is now starting to play out (Chart 7). That indicator is focused on growth indicators like our global leading economic indicator and the ZEW expectations index for the US and Europe, all of which have been declining for the past several months. Chart 6Global Inflation Is Peaking Global Inflation Is Peaking Global Inflation Is Peaking ​​​​​ Chart 7Stay Neutral On Global Duration Exposure Stay Neutral On Global Duration Exposure Stay Neutral On Global Duration Exposure ​​​​​​ However, there is a potential note of economic optimism from another key component of the Global Duration Indicator - the diffusion index of our global leading economic indicator, which measures the number of countries with rising leading indicators versus those with falling ones. That diffusion index has hooked up as the leading economic indicators of some important countries that are typically leveraged to global growth – China, Japan, Brazil, Korea and Malaysia – have started to move higher. If this trend continues in the months ahead, our Duration Indicator may signal a reacceleration of global bond yield momentum in the first half of 2023 as the global growth outlook improves. Bottom Line: Bond markets are overreacting to slowing global growth momentum by pricing in a quick reversal of 2022 rate hikes in 2023 across the developed world. Do not chase bond yields lower. The Fed Will Respond To Inflation Before Recession The Q2/2022 US GDP report showed an annualized decline of -0.9%, following on the annualized -1.6% fall in Q1 real GDP (Chart 8). This fulfills the so-called “technical definition” of a recession widely cited by the financial media. However, the official arbiters of recession dating – the National Bureau of Economic Research, or NBER – use a broader list of data to identify recessions that focus on income growth, employment and industrial production. None of those indicators contracted in the first half of the year, when the GDP-defined recession allegedly took place. We are sympathetic to the view that the US has not yet entered recession. However, recession odds are increasing, with many reliable cyclical data series slowing to a pace that has preceded past recessions. In Chart 9, we show a “cycle-on-cycle” comparison of the latest readings on some highly cyclical US economic data with readings from past recessions dating back to the late 1970s. In the chart, the data series are lined up such that the vertical line represents the NBER-designated start date of each recession, starting with the 1979/80 recession up to the 2008 recession. We show both the average path for each series across all of those recessions (the dotted line) and the range of outcomes from each recession (the shaded zone). Given the unique nature of the 2020 COVID recession, which was limited to just one quarter of collapsing activity due to pandemic lockdowns rather than typical business cycle forces, we did not include that episode in this chart. Chart 8No US Growth In H1/2022 No US Growth In H1/2022 No US Growth In H1/2022 The selected variables in this cycle-on-cycle analysis are: The year-over-year growth of the Conference Board leading economic indicator The ISM manufacturing index The University Of Michigan consumer expectations index The year-over-year growth of housing starts The year-over-year growth rate of non-financial (top-down) corporate profits. Chart 9The US Is Definitely Flirting With Recession The US Is Definitely Flirting With Recession The US Is Definitely Flirting With Recession ​​​​​ All five series selected have slowed over past several months, consistent with the run-up to previous recessions. However, in terms of timing, not all of the indicators shown are at levels that would be consistent with the US already being in a recession, as the real GDP contractions in Q1 and Q2 would suggest. Typically, the ISM index falls below 50 at the start of the recession, while the growth in the leading indicator turns negative about six months before the start of the recession. The current readings on both are still modestly above levels seen at the start of those past recessions. Corporate profit growth typically contracts for a full year ahead of recessions, and the latest complete reading available from Q1 was still showing positive, albeit slowing, growth. Chart 10The Fed Is OK With This Outcome, Given High Inflation The Fed Is OK With This Outcome, Given High Inflation The Fed Is OK With This Outcome, Given High Inflation Some of the indicators shown are looking recessionary. The current contraction in the growth of housing starts is in line with the timing from the average of past recessions. The same can be said for falling consumer expectations, although the latest decline is particularly severe compared to past recessions. From the point of view of investors, the semantics over the “official” declaration of a recession are irrelevant. There has already been a major pullback in US equity markets and widening of US corporate credit spreads as investors have priced in substantially slower growth – and the Fed tightening that is helping engineer that economic outcome. The pullback in risk assets has tightened US financial conditions, exacerbating the hit to business and consumer confidence from high inflation and declining real incomes (Chart 10). Equity and credit markets did stage healthy recoveries in the month of June as markets began to price out Fed rate hikes in response to the US potentially entering recession. However, Fed rate hikes have already flattened the US Treasury curve, which has raised the odds of a US recession NEXT year. According to the New York Fed’s recession probability model, the current spread between the 10-year US Treasury yield and the 3-month US Treasury bill rate of 23bps translates to a 26% probability of a US recession occurring one year from now (Chart 11). That model uses data going back to the 1960s, which includes the Volcker-era Fed tightenings in the 1970s that resulted in dramatic increases in real US interest rates and steep inversions of the US Treasury curve. Using the post-1980 range of recession probabilities, ranging from 0-50%, the latest 26% probability is more like a 50/50 bet on a 2023 US recession. Chart 11A US Recession Is More Likely In 2023, Says The UST Curve A US Recession Is More Likely In 2023, Says The UST Curve A US Recession Is More Likely In 2023, Says The UST Curve The Fed will need to continue delivering rate hikes until there is evidence that core inflation has peaked and will begin the path of falling back to the Fed’s 2% target. That is certainly not a story for 2022, or even for 2023, given the rapid acceleration of US wage growth (Chart 12). If the Fed were to begin pivoting away from rate hikes now, with the Atlanta Fed Wage Tracker and the Employment Cost Index accelerating at a 5-7% pace, the result would be an unwanted increase in inflation expectations. Chart 12The Fed Must Stay Hawkish With Labor Costs Still Accelerating The Fed Must Stay Hawkish With Labor Costs Still Accelerating The Fed Must Stay Hawkish With Labor Costs Still Accelerating The Fed is fighting hard to regain the inflation-fighting credibility lost in 2022 when “Team Transitory” ruled the FOMC and policy did not respond to rapidly rising inflation. The Fed’s aggressive rate hikes in 2022 have helped restore some of that credibility with bond markets, judging by the pullback in longer-term CPI-based TIPS breakevens seen in recent months, which are now back in line with the 2.3-2.5% range we have deemed consistent with the Fed’s 2% PCE inflation target (Chart 13). The evidence from survey-based measures of inflation expectations is a bit mixed, but still consistent with improved Fed credibility. The New York Fed’s Consumer Survey shows 1-year-ahead inflation expectations still elevated at 6.8%, but the 3-year-ahead expectation has drifted back below 4% (bottom panel). The University of Michigan 5-10 year consumer inflation expectation is even lower, falling to 2.8% in July from 3.1% in June. The Fed will not risk those hard-earned declines in longer-term inflation expectations by turning dovish too quickly – especially as it is not year clear if the US is even in a recession. Investors betting on a dovish pivot by the Fed before year end, leading to substantial rate cuts in 2023, are likely to be disappointed. In our view, this is setting up a potential opportunity to reduce US duration exposure to position for a rebound in Treasury yields. However, a meaningful increase in yields will be difficult to achieve, as yields are still adjusting to downside data surprises and duration positioning among investors is still below benchmark, according to the JPMorgan client duration survey (Chart 14). We suggest staying neutral on US duration exposure, for now, until the technical backdrop becomes more conducive to higher yields. Chart 13Mixed Messages On US Inflation Expectations Mixed Messages On US Inflation Expectations Mixed Messages On US Inflation Expectations ​​​​​ Chart 14Stay Neutral On US Duration - For Now Stay Neutral On US Duration - For Now Stay Neutral On US Duration - For Now ​​​​​ Bottom Line: US recession odds have increased, but the economy is not yet in recession. The Fed welcomes sharply slower growth to deal with high inflation, but will not unwind the 2022 rate hikes as quickly as markets expect given sticky core/wage inflation. The Fed rate cuts now discounted for 2023 will likely not be delivered. Treasury yields are more likely to stay rangebound over the next 3-6 months than move lower.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Dovish Central Bank Pivots Will Come Later Than You Think Dovish Central Bank Pivots Will Come Later Than You Think The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Dovish Central Bank Pivots Will Come Later Than You Think Dovish Central Bank Pivots Will Come Later Than You Think

Listen to a short summary of this report.     Executive Summary Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Following last week’s sharp post-FOMC rally, we shifted our 12-month equity recommendation from overweight to neutral. We expect stock prices to rise further during the remainder of the year as US recession risks abate, but then to give up most of their gains early next year as it becomes clear that the Fed has no intention of cutting rates and may even need to raise rates. We have more conviction that US growth will hold up over the next 12 months than we do that inflation will fall as fast as the Fed expects or the breakevens imply. These varying degrees of conviction stem from the same reason: The neutral rate of interest in the US is higher than widely believed. A high neutral rate implies that it may take significant monetary tightening to slow the economy. That reduces the risk of a recession in the near term, but it raises the risk that inflation will remain elevated. A recession is now our base case for the euro area. However, we expect the European economy to bounce back early next year, as gas supplies increase and fiscal policy turns more stimulative. The euro has significant upside over the long haul. Bottom Line: Stocks will continue to recover over the coming months before facing renewed pressure early next year. We are retaining our tactical (3-month) overweight on global equities but are shifting our 12-month recommendation to neutral. Taking Some Chips Off the Table Following last week’s sharp post-FOMC rally, we shifted our cyclical 12-month equity recommendation from overweight to neutral. This note lays out the key considerations in a Q&A format.   Q: Have any of your underlying views about the economy changed recently or has the market simply moved towards pricing in your benign outlook? A: Mainly the latter. While we continue to see a higher-than-normal risk of a US recession over the next 12 months, our baseline (60% odds) remains no recession.   Q: Many would say that we are in a recession already. A: While two consecutive quarters of negative growth does not officially constitute a recession, it is correct to say that every time real GDP has contracted for two quarters in a row, the NBER has ultimately deemed that episode a recession (Chart 1). Chart 1In The Past, Two Consecutive Quarters Of Negative Growth Have Always Coincided With A Recession In The Past, Two Consecutive Quarters Of Negative Growth Have Always Coincided With A Recession In The Past, Two Consecutive Quarters Of Negative Growth Have Always Coincided With A Recession That said, one should keep two things in mind. First, preliminary GDP estimates are subject to significant revisions. According to our calculations, there is a 35% chance that real GDP growth in Q2 will ultimately be revised into positive territory (Chart 2). Even Q1 may eventually show positive growth. Real Gross Domestic Income (GDI), which conceptually should equal GDP, rose by 1.8% in Q1. Chart 2After Further Revisions, It Is Possible That GDP Growth Ends Up Being Positive In Q2 2022 Shifting Into Neutral: A Q&A Shifting Into Neutral: A Q&A Second, every single US recession has seen an increase in the unemployment rate (Chart 3). So far, that has not happened, and there is good reason to think it will not happen for some time: There are 1.8 job openings per unemployed worker (Chart 4). For the foreseeable future, most people who lose their jobs will be able to walk across the street to find a new one. Chart 3Recessions And Spikes In The Unemployment Rate Go Hand-In-Hand Recessions And Spikes In The Unemployment Rate Go Hand-In-Hand Recessions And Spikes In The Unemployment Rate Go Hand-In-Hand Chart 4A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market   Chart 5Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Q: Aren’t other measures of economic activity such as the ISM, consumer confidence, and homebuilder sentiment all signaling that a major slowdown is in progress? A: They are but we should take them with a grain of salt. The composition of consumer spending is shifting from goods to services. This is weighing on manufacturing output. As Chart 5 shows, goods spending has already retraced two-thirds of its pandemic surge, with no ill effects on the labor market. Consumer confidence tends to closely track real wages (Chart 6). Despite an extraordinarily tight labor market, real wages have been shrinking all year. As supply-chain bottlenecks abate, inflation will fall, allowing real wages to rise. This will bolster consumer confidence and spending. Falling gasoline prices will also boost disposable incomes. Prices at the pump have fallen for seven straight weeks and the futures market is pointing to further declines in the months ahead (Chart 7). Chart 6Falling Inflation Will Boost Real Wages And Consumer Confidence Falling Inflation Will Boost Real Wages And Consumer Confidence Falling Inflation Will Boost Real Wages And Consumer Confidence Chart 7The Futures Market Points To Further Declines In Gasoline Prices The Futures Market Points To Further Declines In Gasoline Prices The Futures Market Points To Further Declines In Gasoline Prices It is also critical to remember that the Fed is trying to slow the economy by tightening monetary policy. At the start of the year, investors expected the Fed funds rate to be 0.9% in early 2023. Today, they expect it to be 3.4% (Chart 8). Chart 8Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Chart 9Housing Activity Should Recover Now That Mortgage Rates Have Stabilized Housing Activity Should Recover Now That Mortgage Rates Have Stabilized Housing Activity Should Recover Now That Mortgage Rates Have Stabilized   Rising rate expectations curb aggregate demand. This temporarily leads to lower growth. However, once rate expectations stabilize – and demand resets to a lower level – growth will tend to return to trend. The 6-month mortgage yield impulse has already turned up. This suggests that housing and other interest-rate sensitive parts of the economy will begin to recover by the end of the year (Chart 9). Admittedly, if the unemployment rate rises in response to lower aggregate demand, this could set off a vicious circle where higher unemployment leads to less spending, leading to even higher unemployment. However, as noted above, given that the current starting point is one where labor demand already exceeds labor supply by a wide margin, the odds of a such a labor market doom loop are much lower than during past downturns.   Q: Does the question of whether we officially enter a recession or not really matter that much? A: It is a matter of degree. As Chart 10 shows, macroeconomic factors are by far the most important determinant of equity returns over medium-term horizons of about 12 months. As a rule of thumb, bear markets almost always coincide with recessions (Chart 11). Chart 10Macro Forces Are An Important Driver Of Equity Returns On Cyclical Horizons Macro Forces Are An Important Driver Of Equity Returns On Cyclical Horizons (I) Macro Forces Are An Important Driver Of Equity Returns On Cyclical Horizons (I) Chart 11Equity Bear Markets And Recessions Go Hand-In-Hand Equity Bear Markets And Recessions Go Hand-In-Hand Equity Bear Markets And Recessions Go Hand-In-Hand   Chart 12Soaring Energy Prices Have Boosted Earnings Estimates This Year Soaring Energy Prices Have Boosted Earnings Estimates This Year Soaring Energy Prices Have Boosted Earnings Estimates This Year Q: Are you surprised that earnings estimates have not come down faster this year as economic risks have intensified? A: Most analysts have not baked in a recession in their forecasts, so from that perspective, if our baseline scenario of no recession does not pan out, earnings estimates will almost certainly come down (Chart 12). That said, the bar for major downward earnings revisions is quite high. This is partly because we think that if a recession does occur, it is likely to be a mild one. It is also because earnings are reported in nominal terms. In contrast to real GDP, nominal GDP grew by 6.6% in Q1 and 7.8% in Q2.   Q: Let’s turn to interest rates. Why do you think the Fed will not cut rates next year as markets are discounting? A: It all boils down to the neutral rate of interest. In past reports, we made the case that the neutral rate in the US is higher than widely believed. The fact that job vacancies are so plentiful provides strong evidence in favor of our thesis. If the neutral rate were low, the labor market would not have overheated. But it did, implying that monetary policy must have been exceptionally accommodative. The good news for investors is that a high neutral rate implies that the Fed is unlikely to induce a recession by raising rates in accordance with its dot plot. That reduces the risk of a recession in the near term. The bad news is that a high neutral rate will essentially preclude the Fed from cutting rates next year. The economy will simply be too strong for that. Worse still, if the Fed is too slow in bringing rates to neutral, inflation – which is likely to fall over the coming months as supply-chain pressures ease – could reaccelerate at some point next year. That could force the Fed to start hiking rates again.   Chart 13Real Yields Have Scope To Rise Further Real Yields Have Scope To Rise Further Real Yields Have Scope To Rise Further Q: What is your estimate for the neutral rate in the US? A: In the past, we have written that the neutral rate in the US is around 3.5%-to-4%. However, I must admit, I’m not a big fan of this formulation. Real rates matter more for economic growth than nominal rates, and long-term rates matter more than short-term rates. Thus, a better question is what level of real long-term bond yields is consistent with stable inflation and full employment. Based on research we have published in the past, my best bet is that the neutral long-term real bond yield is between 1.5%-and-2%. That is substantially above the 10-year TIPS yield (0.27%) and the 30-year TIPS yield (0.79%) (Chart 13). Given that the yield curve is inverted, the Fed may have to raise policy rates well above 4% in order to drag up the long end of the curve. It is a bit like how oil traders say you need to lift spot crude prices in order to push up long-term futures prices when the oil curve is backwardated.   Chart 14Investors Expect Inflation To Fall Rapidly Over The Next Few Years Shifting Into Neutral: A Q&A Shifting Into Neutral: A Q&A Q: So presumably then, you would favor a short duration position in fixed-income portfolios? A: Yes, if the whole yield curve shifts higher, you will lose a lot less money in short-term bonds than in long-term bonds. Relatedly, we would overweight TIPS versus nominal bonds. The TIPS market is pricing in a very rapid decline in inflation over the next few years (Chart 14). The widely followed 5-year, 5-year forward TIPS inflation breakeven rate is trading at 2.28%, toward the bottom end of the Fed’s comfort zone of 2.3%-to-2.5%.1   Q: What about credit? A: US high-yield bonds are pricing in a default rate of 6.1% over the next 12 months. This is up from an expected default rate of 3.8% at the start of the year and is significantly higher than the trailing 12-month default rate of 1.4%. In a typical recession, high-yield default rates rise above 8% (Chart 15). Thus, spreads would probably increase if the US entered a recession. That said, it is important to keep in mind that many corporate borrowers took advantage of very low long-term yields over the past few years to extend the maturity of their debt. Only 7% of US high-yield debt, and less than 1% of investment-grade debt, held in corporate credit ETFs matures in less than two years. This suggests that the default cycle, if it were to occur, would be less intense and more elongated than previous ones. Chart 15High-Yield Bonds Are Pricing In Higher Default Rates High-Yield Bonds Are Pricing In Higher Default Rates High-Yield Bonds Are Pricing In Higher Default Rates On balance, we recommend a modest overweight to high-yield bonds within fixed-income portfolios.   Chart 16High Energy Prices Are Weighing On The European Economy High Energy Prices Are Weighing On The European Economy High Energy Prices Are Weighing On The European Economy Q: Let’s turn to non-US markets. The dollar has strengthened a lot against the euro this year as the economic climate in Europe has soured. Can Europe avoid a recession? A: Probably not. European natural gas prices are back near record highs and business surveys increasingly point to recession (Chart 16). That said, the nature of Europe’s recession could turn out to be quite different from what many expect. There are a few useful parallels between the predicament Europe finds itself in now and what the global economy experienced early on during the pandemic. Just like the Novel coronavirus, as it was called back then, represented an external shock to the global economy, the partial cut-off in Russian energy flows represents an external shock to the European economy. Policymakers in advanced economies responded to the pandemic by showering their economies with various income-support measures. European governments will react similarly to the energy crunch. In fact, the political incentive to respond generously is even greater this time around because the last thing European leaders want is for Putin to succeed in his efforts to destabilize the region. For its part, the ECB will set an extremely low bar for buying Italian bonds and the debt of other vulnerable economies. Just like the world eventually deployed vaccines, Europe is taking steps to inoculate itself from its dangerous addiction to Russian energy. The official REPowerEU plan seeks to displace two-thirds of Russian natural gas imports by the end of the year. While some aspects of the plan are probably too optimistic, others may not be optimistic enough. For example, the plan does not envision increased energy production from coal-fired plants, which is something that even the German Green Party has now signed on to. The euro is trading near parity to the dollar because investors expect growth in the common-currency bloc to remain depressed for an extended period of time. If investors start to price in a more forceful recovery, the euro will rally.   Q: China’s economy remains in the doldrums. Could that undermine your sanguine view on the global economy? A: China’s PMI data disappointed in July, as anxiety over the zero-Covid policy and a sagging property market continued to weigh on activity (Chart 17). We do not expect any change to the zero-Covid policy until the conclusion of the Twentieth Party Congress later this year. After that, the government is likely to ease restrictions, which will help to reignite growth. Chart 17The Zero-Covid Policy And Slumping Property Market Are Weighing On Chinese Economic Activity The Zero-Covid Policy And Slumping Property Market Are Weighing On Chinese Economic Activity The Zero-Covid Policy And Slumping Property Market Are Weighing On Chinese Economic Activity Chart 18China Faces A Structural Decline In The Demand For Housing China Faces A Structural Decline In The Demand For Housing China Faces A Structural Decline In The Demand For Housing The property market has probably entered a secular downturn (Chart 18). If a weakening property market were to cause a banking crisis, similar to what happened in the US and parts of Europe in 2008, this would destabilize the global economy. However, we doubt that this will happen given the control the government has over the banking system. In contrast, a soft landing for the Chinese real estate market might turn out to be a welcome development for the global economy, as less Chinese property investment would keep a lid on commodity prices, thus helping to ease inflationary pressures. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn & Twitter   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 2.3%-to-2.5%. View Matrix Image Special Trade Recommendations Current MacroQuant Model Scores Shifting Into Neutral: A Q&A Shifting Into Neutral: A Q&A

Executive Summary Reporters at last week’s post-FOMC press conference were consumed by the prospect of a recession. Their questions about the economy echoed the analysts’ on bank earnings calls and Chair Powell’s answers echoed the CEOs’ and the CFOs’: while it has clearly slowed, it remains stronger than it would be in a recession. Although the Econ 101 definition of a recession – two or more quarters of contracting real GDP – is embedded in the public’s mind, the NBER’s recession criteria are more involved and do not appear as if they have yet been met. With a little over half of index constituents (~70% of market cap) having reported, S&P 500 earnings have surprised to the upside. Despite a rampaging dollar and a sharp backup in corporate bond yields, margins are down less than 60 basis points from 2Q21 and are unchanged from 1Q22. We are constructive on equities and credit over a three-to-twelve-month timeframe because we believe markets have priced in the impact of the next recession too soon. We expect the Fed will eventually induce a recession, but not for at least another year. Earnings Haven't Stumbled Yet Earnings Have Not Stumbled Yet Earnings Have Not Stumbled Yet Bottom Line: Continue to overweight equities in multi-asset portfolios with a twelve-month timeframe because markets have gotten ahead of themselves by selling off so sharply. A recession will not arrive before underweight investors judged on their relative quarterly performance are forced back into stocks. Feature And we thought investors were preoccupied with recession. The questions sell-side analysts asked on big bank earnings calls in mid-July revealed that the shadow of a recession loomed large in their institutional investor clients’ minds. The questions markets and economics reporters asked Chair Powell at his post-FOMC meeting press conference last week demonstrated that the media is positively obsessed with it. If it bleeds, it leads is no longer just the local TV newscast’s mantra. We have been trying to steer the discussion away from are-we-or-aren’t-we toward questions that we think are more productive for investors. How bad will the next downturn be? What is its current estimated time of arrival? Have markets under or overreacted to our best guess about severity and ETA, assuming the marginal price setter has a timeframe of twelve months or less? Are-we-or-aren’t-we is manifestly Topic A in the financial and general media, however, so the body of this week’s report is given over to why we think we are neither in a recession nor on the cusp of one. We will turn to financial markets and investment strategy in the concluding section. What Is A Recession? In Econ 101 three-plus decades ago, I learned that a recession was defined as back-to-back quarters of economic contraction as measured by real GDP. For all the time that has passed since, I remember that definition clearly. Apparently other graduates do, too, and the definition taught in central Virginia was the standard in Economics departments across the nation. Alas, life is more complicated than it seemed in those halcyon student days. Business cycle inflections are not always apparent to the naked eye and the NBER’s Business Cycle Dating Committee has been tasked with assessing when downturns are sufficiently deep, diffuse and persistent to constitute a recession. The committee monitors a broad range of indicators and moves deliberately, announcing its determinations only after enough subsequent data have arrived to support its assessment of peaks and troughs. For the six recessions since 1980, the committee has announced cycle peaks with an average lag of seven months and cycle troughs with an average lag of fifteen months (Table 1). Table 1Long And Variable Lags Recession Obsession Recession Obsession Equity and credit portfolio managers and analysts spend a lot more time on corporate earnings than GDP, so the recession debate would seem to be of interest mainly within the ivory towers of academia, think tanks and the bureaucracy. The topic is relevant for investors, however, because equity bear markets tend to coincide with recessions. As bear markets (Chart 1, light red shading) typically begin before NBER-designated recessions (gray shading) and always end before them, it is worth investors’ time to try to anticipate their onset. Since a significant portion of bear market drawdowns occur after the recession is deemed to have started, there is also value in the humbler (and more attainable) aim of recognizing a recession once it’s begun. Chart 1Bear Markets And Recessions Tend To Travel Together Bear Markets And Recessions Tend To Travel Together Bear Markets And Recessions Tend To Travel Together So Has It Begun? At the risk of sounding like Jay Powell before a skeptical pool of reporters, we do not think the economy is in a recession, primarily because the labor market is so strong. Recessions always follow one-third percentage-point increases in the three-month moving average of the unemployment rate, but it has yet to begin moving upward (Chart 2). Leading indicators like small business hiring intentions (Chart 3, second panel), temporary employment (Chart 3, third panel) and initial jobless claims (Chart 3, bottom panel) point to continued payroll expansion (Chart 3, top panel). The economy is unquestionably slowing, and labor demand will slow with it, but the record backlog of job openings (Chart 4, top panel) and unabated stream of job quits (Chart 4, bottom panel) suggest that the labor market has a sizable cushion that will allow it to endure a few blows. Chart 2Unemployment Has Not Turned Yet Unemployment Has Not Turned Yet Unemployment Has Not Turned Yet Chart 3The Employment Outlook Is Still Good ... The Employment Outlook Is Still Good ... The Employment Outlook Is Still Good ... ​​​​​ Chart 4... As There Is Still A Shortage Of Workers ... As There Is Still A Shortage Of Workers ... As There Is Still A Shortage Of Workers Like Chair Powell, we would venture that the labor market’s cushion extends to the overall economy. We believe that households’ excess pandemic savings will buffer the largest component of aggregate demand from inflation pressures, though the eventual fate of those savings is hotly debated within BCA. Related Report  US Investment StrategyA Difference Of Opinion We expect that a meaningful share of the $2 trillion-plus that households have amassed will eventually be spent; our Counterpoint team does not. The matter is not yet settled, but we are encouraged that the savings rate dipped below its February 2020 level of 8.3% in the fourth quarter and has been less than 6% every month this year, reaching a low of 5.1% in June. If the savings rate is mean-reverting, and if households don’t circle the wagons en masse as they might if recession prophecies become self-fulfilling, households have quite a bit of catching up to do (Chart 5). If consumption continues to lead business investment in line with the empirical record, fixed investment should be able to keep its head above water. Even a downshift in consumption and investment ought to be enough to offset the modest fiscal drag that may ensue if gridlock becomes even more constraining after November’s elections, as our US Political Strategy colleagues expect, and keep the expansion going for a few more quarters. Chart 5These Squirrels Have Stored Up A Lot Of Nuts For The Winter These Squirrels Have Stored Up A Lot Of Nuts For The Winter These Squirrels Have Stored Up A Lot Of Nuts For The Winter Okay, But What About Earnings? S&P 500 earnings are where the rubber meets the road for investors. Befitting the one-step-forward, one-step-back course the macro data releases have followed, second quarter earnings have been mixed.1 In the aggregate, however, they’ve been solid, with the 56% of index constituents (~70% of market cap) that have reported so far beating earnings expectations by 5.2%. That’s in line with the typical underpromise-and-overdeliver earnings season theater but feels like a reprieve for investors who’ve been subjected to a steady drumbeat of recession talk. Profit margins have narrowed – earnings per share have grown 7.7% year over year, well shy of revenue per share’s 12.1% growth – but by less than expected, as the 5.2% earnings surprise has swamped the 1.6% revenue surprise. S&P 500 operating profit margins observed a tight range after the crisis before jumping by more than a percentage point when the top marginal corporate tax rate was lowered beginning in 2018 (Chart 6). They then made another percentage-point leap in 2021, as companies seemed to find another efficiency gear as they adjusted to the pandemic. The reasons for the pandemic leap aren’t clear – shrinking office footprints, lower utility bills and reduced travel and entertainment don’t seem like candidates to move the needle so far on their own – but according to Refinitiv, the owner of I/B/E/S, the definitive source for earnings estimates, it has persisted through the first two quarters of 2022.2 The contraction in real compensation since 2021 (Chart 7, second panel) has likely been the primary driver, but the backup in corporate bond yields (Chart 7, third panel) and the surging dollar (Chart 7, bottom panel) have been margin headwinds so far this year. Chart 6Profit Margins Remain Elevated Profit Margins Remain Elevated Profit Margins Remain Elevated Chart 7Falling Real Wages Have Been Great For Margins Falling Real Wages Have Been Great For Margins Falling Real Wages Have Been Great For Margins We expect that the interest expense and currency translation headwinds will largely disappear in the second half, leaving real wages as the critical swing factor. Our benign take on wages (from employers’ perspective) is not unanimously held within BCA and could be a crucial determinant of our more bullish recommendations’ outcome. Our view is predicated on an analysis of US labor relations history positing that employers have achieved formidable structural advantages over employees that cannot be unwound by a few years of a cyclical boost and one term of the determinedly labor-friendly Biden administration. Our interpretation runs counter to the prevailing view but we believe it is well supported and can provide a lengthy source bibliography for those inclined to check our work. Investment Implications There are no absolutes in financial markets. No asset is good or bad in itself; its merit is solely a function of its relative probability-adjusted risk-reward profile. The recession debate doesn’t matter much in itself; the key is whether this year’s market declines have gone too far in pricing in the severity, breadth, duration and proximity of the next downturn. We add proximity to the list of the NBER’s criteria because it is a critically important factor when most professional money managers, who exert outsize influence in setting prices, are judged on their relative quarterly and annual performance. We are not perma-bulls or attention-seekers. We are more bullish than our colleagues and the investor consensus purely because we think the equity market has gone too far in discounting the impact of a recession that we estimate will not begin before the second half of 2023 and may not be particularly deep in the absence of imbalances that make the real economy vulnerable to a metastasizing downturn. Inflation pressures have not been building unopposed across four presidencies (LBJ through Carter) while corporate management teams nearly indifferent to shareholder interests rolled over at the feet of the UAW and other formerly potent labor unions, entrenching the wage-price spiral. The Powell Fed has begun to hike the funds rate aggressively, but it will not have to smother the economy like the Volcker Fed to round up a fugitive inflation genie and force it back into the bottle. Chart 8It Is Not A Spiral When Prices Rout Wages It Is Not A Spiral When Prices Rout Wages It Is Not A Spiral When Prices Rout Wages Levered capital has not been cascading into commercial real estate for better than a decade to exploit tax loopholes which were closed by the 1986 Tax Act, leaving savings and loans holding the bag and imperiling a sizable swath of the banking system. Stocks are expensive and there are plenty of pockets of silliness, but financial markets have not replayed the dot-com mania, no matter how promiscuously the term "bubble" is applied or how thoroughly the post-crisis rise in asset values has driven Austrian School devotees up the wall. Malinvestment has not occurred on anything close to the scale of the subprime crisis, when lenders, ratings agencies, regulators, banks and investors collectively failed at their duties, spawning a global crisis. American households have modest debt loads and a mountain of savings. Nonfinancial corporations are well heeled after a frenzy of pandemic debt issuance at laughably favorable terms. The banking system is doubly and triply reinforced with the biggest banks hemmed in by excessive capital requirements and stifling risk limits. The economy is likely to be on a better footing at the start of the next recession than it has been in any of the recessions of the previous 40 years (ex-the flash COVID recession). Although he wouldn’t answer the question directly, we thought Chair Powell made it abundantly clear that the Fed is willing to induce a recession if that’s what it takes to bring inflation to heel. We ultimately think the Fed will have to squash the economy to get inflation back down to its 2% target, but we don’t think it will happen over the timeframe that matters to the institutional investor constituencies that have a huge say in setting marginal prices. That view is at risk if inflation does not show signs of peaking soon or if longer-run inflation expectations rise to uncomfortable levels. For now, neither has happened and the latest run of data did not break one way or the other. Final July long-run inflation expectations of 2.9% from the University of Michigan consumer sentiment survey were down from June’s final 3.1% reading and meaningfully below the 3.3% preliminary June false alarm that jarred the FOMC. The second quarter employment cost index grew by more than 1% for the fourth straight quarter, extending its nominal rise (Chart 8, top panel) even while it continues to contract in real terms (Chart 8, bottom panel). A growth shortfall is a threat as well, though it failed to materialize in second quarter earnings, forcing the S&P 500 to unwind some of the weak growth expectations it had already discounted. If our base-case scenario holds, more such unwinding is in store. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      As we worked on this report after Thursday’s market close, Amazon delighted investors, Apple pleased them and Intel, as per a barrons.com headline, “missed by a mile.” 2     Per Standard & Poor’s, the index’s operating margin fell by a percentage point in the first quarter. Though S&P has tended to define operating earnings less favorably than Refinitiv/I/B/E/S, the two series moved together directionally until 1Q22 and only Refinitiv’s data facilitates comparisons between past results and future expectations.

Listen to a short summary of this report.     Executive Summary The Dollar Rises During Recessions How Deep A Recession Is The Dollar Pricing In? How Deep A Recession Is The Dollar Pricing In? At 106.5, the dollar DXY index is certainly pricing in a recession deeper than during the Covid-19 crisis. The dollar tends to rise during recessions and only peaks when a global economic recovery is in sight (Feature Chart). One caveat: contrary to conventional wisdom, US economic data is deteriorating relative to the rest of the world. Historically, that has been a negative for the greenback. The key question facing investors is if markets are entering a riot point. That is a high probability. Historically, high volatility supports the dollar. As such, our recommended stance on the dollar is neutral over the next few months. Our highest conviction bets are short EUR/JPY and long Swiss franc trades. Valuations tend to matter when most investors least expect them to. On this basis, we are negative the dollar on a 12-to-18 month time horizon. Place a limit sell on CHF/SEK at 10.76.   TRADES* INITIATION DATE PERCENT RETURNS Short EUR/JPY 2022-07-21 2.73% Bottom Line: Stand aside on the dollar for now. Continue to opportunistically play trades at the crosses. Short EUR/JPY bets make sense as a volatility hedge.   Chart 1Any Dollar Bears Left? Any Dollar Bears Left? Any Dollar Bears Left? In our conversations with clients, it is rare to find a dollar bear these days. One barometer is price action – the dollar DXY index is up 18% from its 2021 lows. More instructively, net long speculative positions are near a multi-decade high (Chart 1). In our meetings, we sense a specter of capitulation among fundamental dollar bears, as the macroeconomic environment becomes more uncertain. For chart enthusiasts, the DXY index staged a classic breakout, and the next technical level is closer to the 2002 highs near 120. We doubt the DXY index will hit this level, as significant headwinds are building. It is true that as markets increasingly price in the probability of a recession, especially in Europe, the dollar will be bought. But as we argue below, the dollar has already priced in a recession, deeper than was the case in 2020 (or admittedly, at any time since the end of the Bretton Woods system). This suggests that investors with a relatively benign economic backdrop should be fading any strength in the dollar. In other words, if your bet on a recession is low odds, fade dollar strength relatively to your colleagues. As such, our recommended stance on the dollar is neutral over the next few months, but bearish for investors with a longer-term horizon. For today, our highest conviction bets are short EUR/JPY and long Swiss franc trades. The US Dollar And Global Growth Chart 2The Dollar Tracks Global Growth The Dollar Tracks Global Growth The Dollar Tracks Global Growth There are many important drivers of the US dollar. One is the path for global growth. If global activity is going to slow meaningfully, then as a countercyclical currency, the dollar tends to rise in that environment. The dollar has been closely correlated (inversely) to the trend in global PMIs, industrial production, and other measures of global growth (Chart 2). Across the world, global growth is slowing (Chart 3). Most manufacturing PMIs in the developed world peaked in the middle of last year. In the developing world, China’s zero Covid-19 policy has nudged many PMIs close to the 50 boom/bust level. As a rule of thumb, you do not want to be short the greenback when global industrial activity is slowing. That is the bull case. Chart 3AGlobal Growth Is Slowing In Developed Markets Global Growth Is Slowing In Developed Markets Global Growth Is Slowing In Developed Markets Chart 3BGrowth Is Also Soft In Emerging Markets Growth Is Also Soft In Emerging Markets Growth Is Also Soft In Emerging Markets The good news for dollar bears is that most of this information is already priced in. Looking back at recessions since the 1970s, the dollar is pricing in one of the most anticipated slowdowns in history (Chart 4). This alone is not a reason to turn bearish on the greenback, but it is a red flag towards the consensus view. In general, currencies are a relative game. The dollar tends to rise 10%-to-15% during recessions. We are already there, with the DXY index up 18% since the 2021 lows. It is also important to gauge how the US is faring relative to the rest of the world. Quite simply, US economy economic activity is deteriorating vis-à-vis its trading partners. This is visible in the Citigroup economic surprise indices, but also via a simple chart of relative PMIs (Chart 5). Historically, that has been a negative for the greenback outside of recessions. Chart 4The Dollar Overshoots During Recessions How Deep A Recession Is The Dollar Pricing In? How Deep A Recession Is The Dollar Pricing In? Chart 5US Economic Momentum Is Deteriorating US Economic Momentum Is Deteriorating US Economic Momentum Is Deteriorating The US Dollar And Interest Rates The Fed hiked interest rates by 75bps this week. This was as expected but given what the Bank of Canada delivered on July 13th, a 100bps hike was a whisper number in our books. More importantly, interest rate differentials (real and nominal) are increasingly moving against the US. As we go to press, 10-year bond yields are 2.67% in the US, but 2.62% in Canada, 3.41% in New Zealand, and even 3.1% in Australia. Chart 6The Euro And Relative Interest Rates The Euro And Relative Interest Rates The Euro And Relative Interest Rates The key point is that the market consensus is centered around the Fed being the most hawkish central bank. That will face a critical test in the next few months, if the world enters a recession. This is especially true in the euro area. The market is pricing that interest rates in the eurozone will be 200bps lower next year, relative to the US (Chart 6). The historical spread between US and German 2-year yields has been 83 bps. If Europe indeed enters a deep recession, then that is already priced in the euro. If we get any green shoots in economic growth, then the euro is poised for a coiled-spring rebound. The market is also pricing in that US interest rates will peak next year, relative to other G10 economies (Chart 7). This could happen in one of two ways: The Fed turns more dovish and/or non-US growth loses steam, leading to lower interest rates outside the US. It is difficult to forecast how the economic scenario will evolve, but from an investor’s standpoint, the dollar has already overshot the level implied by relative interest rates (Chart 8). Chart 7US Short Real Yields Are Attractive How Deep A Recession Is The Dollar Pricing In? How Deep A Recession Is The Dollar Pricing In? Chart 8The Dollar Has Overshot Rate Fundamentals The Dollar Has Overshot Rate Fundamentals The Dollar Has Overshot Rate Fundamentals A Short Note On USD Valuations Valuations usually get little respect, especially over the last few years. The bull market in the dollar from 2011 to 2022 coincided with higher real interest rates in the US relative to the rest of the developed world. That said, a rising trade deficit (imports > exports) requires a lower exchange rate to boost competitiveness in the manufacturing sector, or less spending to reduce the trade deficit. Therefore, the natural adjustment mechanism for countries running wide trade deficits will have to be the exchange rate. Quite simply, rising deficits are a symptom of an overvalued exchange rate. Within a broad spectrum of developed and emerging market currencies, the US dollar is overvalued on a real effective exchange rate basis (Chart 9 and 10). While valuations tend to matter less until they trigger a tipping point, such inflections usually occur with a shift in animal spirits, especially when investors start to worry about huge external imbalances. Chart 9The Dollar Is Overvalued The Dollar Is Overvalued The Dollar Is Overvalued Chart 10The Dollar Is One Of The Most Expensive Currencies How Deep A Recession Is The Dollar Pricing In? How Deep A Recession Is The Dollar Pricing In? In the US, these imbalances are already starting to spark a shift. The US trade deficit has deteriorated. The basic balance in the US (the sum of the current account and foreign direct investment) is deteriorating. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts deteriorating. It is remarkable that at a time when real rates are quite negative in the US, the dollar is the most overvalued in decades on a simple PPP model basis. This is a perfect mirror image of the dollar configuration at the start of the bull market in 2010, where the dollar was cheap and real rates were more supportive. According to economic theory, a currency should adjust to equalize returns across countries. In the early 80s, an expensive dollar was supported by very positive real rates. The subsequent dollar declines thereafter also coincided with falling real interest rates. If global growth shifts from relative strength in the US to overseas, interest rate differentials will tilt in favor of non-US markets. That will be solace for dollar bears. Conclusions In financial markets, it pays to be humble but also to be bold. Our recommended stance on the DXY (and by association, the euro and cable) is to stay on the sidelines. Our highest conviction trade is to short EUR/JPY. With the drop in commodity prices, resource-related currencies are becoming interesting, a topic we will discuss in upcoming bulletins. But momentum is your friend for now, which suggests prudence.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

The Global Investment Strategy service tactically downgraded equities in February but then upgraded them in May. The decision to upgrade equities to overweight in May was clearly premature, as stocks fell significantly in June. However, the rally in July has brought stocks back above the level where we upgraded them. Hence, we are using this opportunity to shift our recommended equity allocation back to neutral. While our base case forecast still foresees no recession in the US over the next 12 months, the risks to this view have increased. In Europe, we see a recession as more likely than not. China’s economy will remain under pressure due to Covid lockdowns, a shift in global spending away from manufactured goods, and a weakening property market. Even if the US avoids a recession, this could prove to be a bittersweet outcome for stocks: While earnings will hold up, the Fed is unlikely to cut rates next year, as markets are currently discounting. Real bond yields, which have already risen steeply this year, will rise further, weighing on equity valuations.  Time to Take Some Chips Off the Table The consensus view among investors these days seems to be that the US is heading into a recession (or may already be in one), which will cause stocks to fall during the remainder of the year as earnings estimates are slashed. Looking out to 2023, most investors expect stocks to recover as the Fed begins to cut rates. I have the opposite view. While the risks to growth have increased, the US will probably avoid a recession over the next 12 months. This will allow stocks to rise modestly from current levels into year-end. However, as we enter 2023, it will become obvious that the Fed has no reason to cut rates. This could cause stocks to give up some of their gains, thus producing a fairly flat profile for equities over a 12-month horizon. In past reports, we have argued that the neutral rate of interest – the interest rate consistent with full employment and stable inflation – is higher than widely believed in the US. The nice thing about a high neutral rate is that it insulates the economy from tighter monetary policy: Even if the Fed raises rates to 3.8% next year, as the dots are currently forecasting, that will only put rates in the middle of our fair value range of 3.5%-to-4% for the US neutral rate. The downside of a high neutral rate is that eventually, investors will need to value stocks using a higher discount rate. The 10-year TIPS yield has already increased from -0.97% at the start of the year to +0.36% today. It will rise to 1%-to-1.5% by the middle of 2023. A higher-than-expected neutral rate also raises inflation risks because it could cause the Fed to inadvertently keep monetary policy too loose. Inflation is likely to fall significantly over the coming months as supply-chain bottlenecks ease. However, this decline in inflation could sow the seeds of its own demise: As inflation falls, real wage growth – which is now negative – will turn positive. Rising real wages will booster consumer confidence and spending. A reacceleration in inflation in the second half of next year could prompt the Fed to start hiking rates again in late 2023, thus producing a recession not in 2022 but in 2024. Outside the US, the outlook is more challenging. In Europe, a recession is more likely than not in the second half of the year. We expect the recession to be fairly short-lived, with European governments moving aggressively to mitigate the fallout from gas shortages through various income support schemes for the private sector. Chinese growth should rebound in the second half of the year. However, the specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening property sector will continue to weigh on activity. We will have much more to say about this view change early next week. In the meantime, please review our report from last week entitled “The Downside Of A Soft Landing” for further color on some of the points made in this short bulletin. Tomorrow, my colleague Ritika Mankar will be sending you a Special Report making the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter.

Executive Summary Peak Fed Funds? Peak Fed Funds? Peak Fed Funds? The bond market is priced for a fed funds rate that will peak in February 2023 at 3.44% before trending down. We survey several interest rate cycle indicators and conclude that the market’s expected peak is too low and occurs too early. These indicators include: the unemployment rate, financial conditions, PMIs, the yield curve and housing starts. We also update our default rate forecast and are now looking for the default rate to rise to between 4.7% and 5.9% during the next 12 months. While our default rate forecasts imply a reasonably attractive 12-month junk bond valuation, we hesitate to turn too bullish on high-yield given that the next peak in the default rate is still not in sight. Bottom Line: We recommend keeping portfolio duration close to benchmark for the time being, though we will be looking for opportunities to reduce duration in the second half of this year. Similarly, we recommend a neutral (3 out of 5) allocation to junk bonds but will recommend reducing exposure if spreads rally back to average 2017-19 levels. Feature Last week’s report presented three conjectures about the US economy.1 One of those was that a recession will be required to get inflation back to 2%. But when will that recession occur? The question of timing is a vital one for bond investors. Are we on the cusp of recession right now? If so, then bond investors should extend portfolio duration in anticipation of Fed rate cuts and a return to 2% inflation. Conversely, if the recession is delayed, interest rates probably move higher before the cycle ends and investors should consider reducing portfolio duration. This week’s report addresses the topic of timing the next recession and discusses the implications for bond portfolio construction. Timing The Interest Rate Cycle From a bond market perspective, the question of whether the economy is in recession is less important than whether the Fed is hiking or cutting rates. Therefore, for the purposes of this report we will define a “recession” as an economic slowdown that is significant enough for the Fed to start cutting interest rates. Chart 1Peak Fed Funds? Peak Fed Funds? Peak Fed Funds? Now, let’s start by looking at what sort of interest rate cycle is priced in the market. The overnight index swap curve is currently discounting a peak fed funds rate of 3.44% (Chart 1). It is also priced for that peak to occur in 7 months, or by February 2023 (Chart 1, bottom panel). As bond investors, the question we must ask is whether this pricing seems reasonable. To do so, we will perform a survey of different indicators that have strong track records of sending signals near the peaks of interest rate cycles. Unemployment The first indicator we’ll look at is the unemployment rate. Economist Claudia Sahm has shown that a recession always occurs when the 3-month moving average of the unemployment rate rises to 0.5% above its trailing 12-month minimum.2 Table 1 dispenses with the moving average and simply shows the deviation of the unemployment rate from its trailing 12-month minimum on the dates of first Fed rate cuts since 1990. We see that the Fed has typically started to cut rates once the unemployment rate is 0.3-0.4 percentage points off its low. The exception is 2019 when the unemployment rate was only 0.1% off its low, but when inflation was below the Fed’s 2% target. Table 1Unemployment And Inflation When The Fed Starts Easing Recession Now Or Recession Later? Recession Now Or Recession Later? At 3.6%, the unemployment rate is currently at its cycle low. Based on the numbers shown in Table 1, this means that we should only expect the Fed to cut interest rates if the unemployment rises to at least 3.9% or 4.0%. We say “at least” because it’s also important to note that the inflation picture is a lot different today than it was during the periods shown in Table 1. With inflation so much higher, it is reasonable to think that the Fed will tolerate a greater increase in the unemployment rate before pivoting to rate cuts. Looking ahead, initial unemployment claims appear to have bottomed for the cycle and changes in initial claims are highly correlated with changes in the unemployment rate (Chart 2). That said, the trend in claims is currently consistent with a leveling-off of the unemployment rate, not a large increase. Financial Conditions Second, we turn to financial conditions. Fed officials often assert that monetary policy works through its impact on broad financial conditions. Therefore, it’s not too surprising that rate cuts tend to occur only after the Goldman Sachs Financial Conditions Index has moved into restrictive territory. Currently, despite the Fed’s dramatic hawkish shift, the index still shows financial conditions to be accommodative (Chart 3). Chart 2Jobless Claims Moving Higher Jobless Claims Moving Higher Jobless Claims Moving Higher Chart 3Financial Conditions Financial Conditions Financial Conditions   The same caveat we applied to the unemployment rate applies to financial conditions. As long as inflation is above the Fed’s target, it’s highly likely that the Fed will be comfortable with financial conditions that are somewhat restrictive. Therefore, the Fed may not pivot as soon as the Goldman Sachs index moves above 100, as has been the pattern in the recent past. Yield Curve Third, we note that an inverted Treasury curve almost always precedes the start of a Fed rate cut cycle, and the Treasury curve is certainly inverted today (Chart 4). The logic behind this indicator is somewhat circular in the sense that an inverted Treasury curve simply tells us that the market anticipates Fed rate cuts. If data emerge to suggest that Fed rate cuts will be postponed, then the Treasury curve could re-steepen. It’s for this reason that the Treasury curve often inverts well in advance of an economic recession and Fed rate cuts. We explored the relationship in more detail in a recent Special Report.3 Chart 4Interest Rate Cycle Indicators Interest Rate Cycle Indicators Interest Rate Cycle Indicators Chart 5Manufacturing PMIs Manufacturing PMIs Manufacturing PMIs PMIs Typically, the ISM Manufacturing PMI is below 50 by the time of the first Fed rate cut (Chart 4, panel 3). Currently, the ISM Manufacturing PMI is a healthy 53.0, but it has been falling quickly and trends in regional PMI surveys suggest that it will dip below 50 within the next few months (Chart 5). Interestingly, both the ISM and regional PMI surveys show that manufacturing supplier delivery times have come down a lot (Chart 5, panel 2). This gives some hope that goods inflation will trend lower during the next few months, as is our expectation. Recently, there’s also been an unusual divergence between the employment components of the ISM and regional Fed surveys. The New York and Philadelphia Fed surveys are showing strength in their employment components. Meanwhile, the ISM employment figure is below 50 (Chart 5, bottom panel). This divergence likely boils down to labor shortages that complicate how firms are responding to the employment question in the surveys. For example, despite the sub-50 employment figure, the latest ISM release noted that “an overwhelming majority of panelists […] indicate that their companies are hiring.”4 Housing In a recent report, we developed a rule of thumb that says that Fed rate cuts typically don’t occur until after the 12-month moving average of housing starts falls below the 24-month moving average.5 That indicator is coming down, but it still has a lot of breathing room before it dips into negative territory (Chart 4, bottom panel). That same report also outlined that we see the housing market slowdown proceeding in three stages. First, higher mortgage rates will suppress housing demand. This is already happening at a rapid pace as indicated by trends in mortgage purchase applications and existing home sales (Chart 6A). Second, lower housing demand will push up inventories and send prices lower. This has not yet shown up in the data (Chart 6B). Finally, once lower prices and higher inventories sufficiently disincentivize construction, we will see a marked deterioration in housing starts. Currently we see that housing starts have dipped, and homebuilder confidence has plummeted, but starts still haven’t decisively broken their uptrend (Chart 6C). Chart 6AHousing Demand Housing Demand Housing Demand Chart 6BPrices & Inventories Prices & Inventories Prices & Inventories Chart 6CBuilding Activity Building Activity Building Activity Putting It All Together To make sense of all the different indicators that could signal a Fed pivot toward rate cuts, we turn to our Fed Monitor. The Fed Monitor is a composite indicator that includes many of the individual indicators we have already examined in this report, as well as some others. The Fed Monitor is constructed so that a positive reading suggests that the Fed should be hiking rates and a negative reading suggests the Fed should be cutting rates. As can be seen in Chart 7, the Monitor is currently deep in positive territory. Chart 7Fed Monitor Calls For Tighter Money Fed Monitor Calls For Tighter Money Fed Monitor Calls For Tighter Money The Fed Monitor consists of three main sub-components, an economic growth component, an inflation component and a financial conditions component (Chart 7, bottom 3 panels). We see that the economic growth component of the Monitor is consistent with a neutral Fed policy stance – neither hikes nor cuts - and financial conditions point to a mildly restrictive stance. However, unsurprisingly, the inflation component is the highest it has been since the early-1980s and this is applying a ton of upward pressure to the Monitor. While our Fed Monitor is not a perfect indicator, it does speak to the tradeoff between inflation and economic growth that we have already hinted at in this report. Specifically, the Monitor illustrates that as long as inflation remains elevated it will take a significant deterioration in economic growth and financial conditions before the overall Monitor recommends a dovish Fed pivot. To us, this argues for a higher and later peak in the fed funds rate than is currently priced in the curve. Bottom Line: The peak fed funds rate that is currently priced in the market for 2023 is too low, and the funds rate will also likely peak later than what is priced in the curve. That said, falling inflation and economic growth concerns will probably keep a lid on bond yields during the next few months. We advise investors to keep portfolio duration close to benchmark for the time being, but to look for opportunities to reduce exposure. We will consider reducing our recommended portfolio duration stance to ‘below-benchmark’ if the 10-year Treasury yield falls to 2.5% or if core inflation reverts to our estimate of its 4%-5% underlying trend. Timing The Default Rate Cycle The interest rate cycle is not the only important one for bond investors. The default rate cycle is also crucial for spread product allocations because default trends are responsible for a significant amount of the volatility in corporate bond spreads. In this section we consider the outlook for corporate defaults and high-yield bond performance. We model the trailing 12-month speculative grade default rate using gross leverage (total debt over pre-tax profits) and C&I lending standards (Chart 8). Conservatively, if we assume 5% corporate debt growth for the next 12 months and corporate profit growth of between -10% and -20%, our model projects that the default rate will rise to between 4.7% and 5.9% (Chart 8, top panel). It’s notable that, like us, banks are also preparing for an increase in corporate defaults by raising their loan loss provisions (Chart 8, panel 2). Meanwhile, job cut announcements – another reliable indicator of corporate defaults – still don’t point to a higher default rate (Chart 8, bottom panel). Chart 8The Default Rate Has Troughed The Default Rate Has Troughed The Default Rate Has Troughed Interestingly, our model’s conservative projections suggest that in 12 months the default rate will be lower than its typical recession peak. Given today’s cheap junk valuations, this sort of analysis is encouraging a lot of people to turn bullish on high-yield bonds. Chart 9Default-Adjusted Spread Default-Adjusted Spread Default-Adjusted Spread This line of reasoning is not totally unfounded. Using the same forecasted default rate scenarios from Chart 8 along with an assumed 40% recovery rate on defaulted debt, we calculate that the excess spread available in the junk index after subtracting 12-month default losses is between 136 bps and 208 bps. This is below the historical average (Chart 9), but still above the 100 bps threshold that often delineates between junk bond outperformance and underperformance versus duration-matched Treasuries.6 More specifically, Chart 10 shows the relationship between our default-adjusted spread and high-yield excess returns versus Treasuries for each calendar year going back to 1995. We see that, in general, there is a positive relationship between spread and returns and that excess returns are more often positive than negative whenever the default-adjusted spread is above 100 bps. However, Chart 10 also shows periods when a pure analysis of junk bond performance based on the 12-month default-adjusted spread didn’t pan out. The year 2008 is a prime example. The default-adjusted spread came in at 249 bps for 2008, above the historical average. However, junk spreads widened dramatically in 2008 and excess returns were dismal. Chart 10The Default-Adjusted Spread And High-Yield Returns Recession Now Or Recession Later? Recession Now Or Recession Later? The reason the default-adjusted spread valuation framework failed in 2008 is that while the default rate only moved up to 4.9% in 2008, it wasn’t done increasing for the cycle. In fact, the rise in the default rate accelerated in 2009 until it hit 14.6% in November of that year. So, while default losses were low compared to the starting index spread in 2008, junk index spreads widened sharply in 2008 as the market prepared for worse default losses in 2009. The lesson we draw from the 2008 example is that even if the junk bond market is attractively priced relative to expected default losses on a 12-month horizon, unless we can forecast a peak in the default rate it is unwise to be overly bullish on high-yield bonds. Even if a recession doesn’t occur within the next 6-12 months, it will likely occur within the next 12-24 months. In that environment, investors are unlikely to realize the full potential of today’s attractive 12-month junk bond valuations. Chart 11Junk Spreads Junk Spreads Junk Spreads The bottom line is that we maintain a neutral (3 out of 5) allocation to high-yield within US fixed income portfolios for now. Junk spreads are elevated compared to past rate hike cycles and could tighten during the next few months as inflation converges to its underlying 4%-5% trend. That said, we will not turn outright bullish on junk bonds until we can reasonably forecast a peak in the default rate. In the meantime, a sell on strength strategy is more appropriate. We will reduce our recommended allocation to high-yield bonds if the average index spread tightens to its average 2017-19 level (Chart 11) or once inflation converges with its underlying 4%-5% trend. Ryan Swift US Bond Strategist rswift@bcaresearch.com   Footnotes 1     Please see US Bond Strategy Weekly Report, “Three Conjectures About The US Economy”, dated July 19, 2022. 2     https://www.hamiltonproject.org/assets/files/Sahm_web_20190506.pdf 3    Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. 4    https://www.ismworld.org/supply-management-news-and-reports/reports/ism… 5    Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 6    For a more complete analysis of the link between the default-adjusted spread and excess high-yield returns please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds,” dated April 12, 2022.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns