Sectors

Highlights Rate Hikes Are Coming – O/W Banks And Small Caps: Rampant inflation is changing investor expectations on the timing and speed of rate hikes. At present, the market is pricing in three rate hikes in 2022. Overweight sectors that outperform in a rising rates environment. Shortages Of Goods – O/W Semis: Overweight industries which are upstream in the supply chain, such as semiconductor manufacturers. They enjoy strong pent-up demand and significant pricing power. Transportation Bottlenecks – O/W Airfreight, Road And Rail: While skyrocketing transportation costs are a boost for most, they are a boon for ocean shipping lines, and US transport companies, such as truck lines and railways. Pent-Up Demand For Services – O/W Travel Complex: The ISM PMI Non-Manufacturing composite reading indicates that demand for services still exceeds demand for goods. Stay overweight Hotels, Restaurants, Entertainment and Professional Business Services. Underweight Airlines for now. US Consumers Are Feeling Poorer – This Will Weight On Profits: Real wages are not keeping up with prices, erasing American consumer purchasing power, thus putting a lid on corporate pricing power. This will hurt profits in the Consumer Discretionary sector, in addition to causing broad-based margin compression. Fundamentals Are Strong For Now: Companies delivered blockbuster Q3 2021 earnings results and peak margins. However, an unusually high percentage of companies (52.6%) were guiding lower. Rising labor costs, reduced productivity, and loss of corporate pricing power will lead to margin compression as early as 2022. Strong Equity Inflows Into Year-End: Late-in-year catchup pension contributions translate into strong inflows into US equities after the early fall hiatus. Buying on dips still offers downward protection from a major market pullback. Buybacks vs Dividends: Share buybacks are on the rise, seemingly displacing dividends as a means of returning cash to shareholders. For cash yield, focus on sectors known for using buybacks to disburse cash to shareholders: Technology and Financials. Image Reiterating Investment Positioning Overarching Macroeconomic Themes Rate Hikes Are Coming Taper Tantrum 2.0 rotation is running its course: Sectors and styles most adversely affected by rising rates, such as Consumer Staples, Communications, Services and Health Care have underperformed in October (Chart 1), while cyclicals, geared to rising rates, have outperformed. Growth/Technology has benefited from recent rate stabilization. Chart 1 Chart 2Market Is Pricing In Three Rate Hikes in 2022 Market Is Pricing In Three Rate Hikes in 2022 Market Is Pricing In Three Rate Hikes in 2022 Market now expects three rate hikes by the end of 2022: Rampant inflation is changing investor expectations on the timing and the speed of rate hikes. A month ago, the probability of two rate hikes in 2022 stood at around 55%. Now, the probability of three rate hikes is roughly 64% (Chart 2). The BCA house view is that the Fed will raise rates once in December 2022 – an outlook much more temperate than the market’s. Investment Implication: Banks, Small Caps and Cyclicals outperform in a rising rates environment (Table 1). Table 1Recent Performance Of Sectors In A Rising Rates Regime US Equity Chart Pack US Equity Chart Pack Shortages Of Goods   Shortages are ubiquitous. How do we make money from this theme? We choose industries that are positioned upstream in the supply chain; for example, we prefer Semis to Durable Goods (Chart 3). Manufacturers of chips face strong demand and significant pricing power, while durable goods manufacturers face shortages and have to pass higher input costs on to their customers, which constrains demand and sales growth. Of course, there is also another aspect contributing to the underperformance of durables: Purchases of goods have exceeded the pre-pandemic trend and turned. Over the past three months, semis outperformed the S&P 500 by nearly 5%, while durables underperformed by 12%. Investment Implication: Stay overweight Semiconductors and Semiconductor Equipment, underweight Durable Goods (Table 2). Chart 3Demand for Chips Is Booming Demand for Chips Is Booming Demand for Chips Is Booming Table 2Sectors Affected By Shortage: Recent Performance US Equity Chart Pack US Equity Chart Pack Pent-Up Demand for Services The ISM Non-Manufacturing PMI for October has come in at a record 66.7 (62 expected) (Chart 4A), and new orders are soaring at 70. These readings exceed the ISM Manufacturing PMI (60.8), suggesting that demand for services still exceeds demand for goods. Furthermore, spending on services is still below pre-pandemic levels, and the rebound is running its course (Chart 4B). We conclude that our “pent-up demand for services” investment theme still has legs. Chart 4AISM Services Is Soaring ISM Services Is Soaring ISM Services Is Soaring Chart 4BStill Strong Pent-up Demand For Services Still Strong Pent-up Demand For Services Still Strong Pent-up Demand For Services Investment Implication: Stay overweight Hotels, Restaurants, Entertainment and Professional Business Services (Table 3). Stay away from Airlines for now. Table 3Travel Complex: Recent Performance US Equity Chart Pack US Equity Chart Pack Transportation Bottlenecks Shipping costs continue their ascent (Chart 5). Over 100 ships are currently anchored in LA/Long Beach ports compared to almost immediate unloading before the pandemic. While rising transportation costs are denting the profit margins of a wide range of companies, from retailers to manufacturers, they are a boon for ocean shipping lines, and US transport companies, such as truck lines and railways. Case in point: A.P. Moller-Maersk, the world’s largest boxship operator, delivered $5.44B in quarterly profits last week – doubling its entire 2020 income, on the heels of the unprofitable years of 2018 and 2019.1 Profits of other freight operators are also surging. Investors take notice: After a stretch of underperformance, the S&P 500 Transportation Index outperformed the S&P 500 by 6.55% in October. Chart 5Shipping Costs Still Exorbitant Shipping Costs Still Exorbitant Shipping Costs Still Exorbitant Investment Implication: Continue overweight of Transportation Services, specifically Air Freight and Logistics, and Road and Rail (Table 4). Table 4Transportation: Recent Performance US Equity Chart Pack US Equity Chart Pack US Consumers Are Feeling Poorer Consumers are right to worry about inflation: Nominal wages increased by 4.5% Year-on-Year in October, the highest reading over the past 40 years. However, real wage growth is negative, i.e. it is not keeping up with prices, erasing American consumers’ buying power (Chart 6). According to a Gallup survey, upticks in citations of the deficit and inflation are largely responsible for an increase in mentions of any economic issue – from 16% in September to 24% in October.2 According to the Conference Board survey, consumers expect prices to rise by 7% over the next 12 months. Loss of purchasing power is bound to dampen consumer demand, as we have seen with demand for Consumer Durables and Autos which has collapsed due to shortages and sky-high prices. Corporate pricing power is waning: As a result of pressures on consumer purchasing power, US producers are reporting that they find it harder to raise prices. Looking ahead, companies will have to absorb price increases (Chart 7). Chart 6Wage Increases Are Not Keeping Up With Inflation Wage Increases Are Not Keeping Up With Inflation Wage Increases Are Not Keeping Up With Inflation Chart 7Corporate Pricing Power Is Waning Corporate Pricing Power Is Waning Corporate Pricing Power Is Waning Investment Implication: Erosion of consumer pricing power will eventually harm the Consumer Discretionary sector and will lead to a broad-based margin compression. Fundamentals Peak margins are here: The confluence of rising wages, falling productivity, and reduced ability to raise prices translates into an impending margin squeeze. We forecast that the year-over-year margin change will be negative in 2022 (Chart 8). The Q3 2021 earnings season delivered blockbuster results so far with roughly two-thirds of the companies reporting, and results are striking. 83% of companies have beaten the street expectations with the average earnings surprise standing at 11% (Chart 9). Chart 8 Chart 9 Sales beats are only marginally worse: 77% of the companies have exceeded expectations with an average sales surprise of 3%. Quarter-on-quarter earnings growth is 0.25%, exceeding an expected 6% contraction. Compared to Q3 2019, EPS CAGR is 12%. These results indicate that street expectations were a low bar to clear. Forward guidance is concerning: Most companies commented that supply chain bottlenecks and soaring shipping costs are the major headwinds. Most companies have navigated a challenging economic environment swimmingly so far. However, looking ahead, waning pricing power, falling productivity, and rising costs will weigh on profitability. These factors are the ubiquitous reasons for negative guidance: 52.6% of companies are guiding lower for Q4 2021 (compare that to 32.7% in the previous quarter). Investment Implication: It is likely that the Q4 2021 earnings season disappoints. Sentiment Strong inflows into US equities after early fall hiatus. This can be explained by FOMO (fear of missing out), and lots of cash sitting on the sidelines, which many retail investors aim to park in US equities (Chart 10). Furthermore, historically, November and December have been characterized by robust equity inflows: Retail investors wait until the end of the year to reach clarity on their financial situation and to allocate funds to 401Ks, IRAs, and 529s. Investment Implication: Buying on dips still offers downward protection from a major market pullback. Chart 10Strong Inflows Into US Equities: Buying On Dip Is Still En Vogue Strong Inflows Into US Equities: Buying On Dip Is Still En Vogue Strong Inflows Into US Equities: Buying On Dip Is Still En Vogue Uses Of Cash Buybacks Replace Dividends: Share buybacks are on the rise again (Chart 11, Panel 1), seemingly displacing dividends as a means of returning cash to shareholders: The dividend payout ratio is flagging (Chart 11, Panel 2). From a corporate standpoint, dividends require a long-term commitment, while buybacks can be a “one-off,” lending more flexibility to corporate treasurers. Corporations also prefer buybacks as they reduce their share count and inflate earnings per share. Investment Implication: For cash yield, focus on sectors known for using buybacks to disburse cash to shareholders: Technology and Financials. Chart 11Buybacks Are Replacing Dividends Buybacks Are Replacing Dividends Buybacks Are Replacing Dividends   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   S&P 500 Chart 12Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 13Profitability Profitability Profitability Chart 14Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 15Uses Of Cash Uses Of Cash Uses Of Cash Cyclicals Vs Defensives Chart 16Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 17Profitability Profitability Profitability Chart 18Valuation And Technicals Valuation And Technicals Valuation And Technicals Chart 19Uses Of Cash Uses Of Cash Uses Of Cash Growth Vs Value Chart 20Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 21Profitability Profitability Profitability Chart 22Valuations And Technicals Valuations And Technicals Valuations And Technicals     Small Vs Large Chart 23Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 24Profitability Profitability Profitability   Chart 25Valuations and Technicals Valuations and Technicals Valuations and Technicals Chart 26Uses Of Cash Uses Of Cash Uses Of Cash       Footnotes 1     WSJ, Supply-Chain Pain Is Maersk’s Gain as $5.44 Billion Profit Dwarfs Amazon, UPS, November 2, 2021. 2     Job Market Ratings Set Record, but Economic Confidence Slides (gallup.com), October 27, 2021.   Recommended Allocation

Highlights We introduce our rotation graphs to assess the evolution of the relative trend and momentum of various assets. US equities remain on firm footing, but their weakening relative momentum suggests that investors may soon begin to rotate away from this market in favor of the Eurozone and EM. Cyclicals continue to dominate defensives, globally and in Europe. European value stocks are experiencing improving momentum, which suggests that a rotation out of growth equities is afoot. While European small-cap equities sport attractive fundamentals, rotational dynamics indicate it is still too early to overweight them aggressively. The energy crisis is a dominant driver of the relative sector performance in Europe and resulted in a massive shift in leadership from industrials to energy. As long as oil and natural gas act as a drag, industrials will lag. Financials are well supported. Swedish stocks have borne the brunt of the energy price spike, while Norwegian equities have been its main beneficiaries. The improvement in momentum of German stocks suggests that their relative underperformance will soon end. Spanish shares look attractive from a tactical perspective. Swiss industrials will need a recovery in EUR/CHF to outperform other European industrials. UK industrials will continue to outperform their continental competitors, while Spanish industrials have a window through which to shine. A rotation into UK financials may soon begin as their momentum improves. The darkest days for German financials are ending, while Spanish, Italian, and Swedish financials may soon witness a wave of underperformance. Spanish consumer discretionary equities are becoming more attractive compared to their European counterparts. While Dutch names continue to outperform other European tech equities, their softening momentum suggests investors are beginning to rotate out of this country. Spanish and German tech names offer an attractive diversification opportunity within the industry. Feature Methodology The combination of excess liquidity, large pools of fast money, elevated valuations across most securities, and the existence of the near-term momentum reversal effect encourage investors to rotate from one asset to the next in the hope of rapid profits. Measures to assess where each market stands in this rotational pattern can be useful for investors to catch these swings. In this optic, we introduce our rotation screener focused on equities. It is a simple tool that looks at whether a sector or a country is strengthening relative to its benchmark and whether this strength is happening at a faster or slower momentum. To measure each dimension, we use proprietary indicators of relative strength and momentum. Once each asset’s relative strength and relative momentum are established, we can position them in quadrants. We follow traditional terminology. The upper right quadrant denotes “Leading” assets, or securities that are outperforming their benchmark with strengthening momentum. The bottom right quadrant denotes “Weakening” assets, or securities that are outperforming their benchmark but with a deteriorating momentum. The bottom left quadrant denotes “Lagging” assets, or securities that are underperforming with decreasing momentum. Finally, the top left quadrant indicates “Improving” assets, or securities that are underperforming but with increasing momentum. Investors should move to overweight assets that are in the Improving quadrants and to underweight assets that are inching toward the “Lagging” from the “Weakening” quadrants. This method is very flexible and can be applied to sectors, countries, styles, and so on, as long as a benchmark is available to generate comparisons. In this report, we will analyze the following from a rotational perspective: global national markets, global cyclicals vs global defensive’s, European cyclicals vs European defensives, European sectors, European national markets, European financials, European consumer discretionaries, and European tech stocks. Global National Markets Chart 1 US equities have moved from the Leading quadrant to the Weakening one as they continue to outperform the global benchmark but with a decelerating momentum (Chart 1). This locates the US market in a risky position that could herald a period of underperformance, especially if global economic surprises accelerate. From a rotational perspective, US stocks could still experience another wave of outperformance over the coming weeks, as momentum has been firming over the past four weeks.   The Euro Area benchmark has fully moved from the Weakening quadrant in August to the Lagging one today. Investors should monitor Europe’s relative momentum closely, because a pick-up from here would push the Eurozone into Improving territory, a warning of an imminent trend change in European relative stock prices. Emerging markets have exited the Lagging zone and moved into the Improving quadrant. The move is far from decisive and remains at risk with Chinese credit growth still decelerating. The recent decline in steel prices in China suggests that construction activity in that economy continues to slow. Thus, as long as Chinese credit flows deteriorate, EM stocks will have trouble moving into the Leading quadrant. Cyclicals Vs Defensives Global defensive equities tried to move into the Leading quadrant at the end of the summer, but, ultimately, they plunged back into Lagging territory as global stocks recovered in October (Chart 2). Meanwhile, global cyclicals moved in the opposite trajectory, shifting from the Lagging quadrant to the Leading one over the past three months. Cyclicals continue to benefit from the general uptrend in the market. Even the recent decline in yields is doing little to boost the performance of defensive equities. The biggest risk to these stocks remains the Chinese economic slowdown. For now, this deterioration has not been large enough to compensate for the general vigour in profits and consumption in advanced economies. However, if inflation worries do not abate, then the Chinese slowdown will become more problematic for global cyclicals as it will raise the spectre of stagflation.  Chart 2 Chart 3 The rotational pattern for European cyclicals vs defensive stocks mimics that of global equities (Chart 3). However, European cyclicals are somewhat softer than their global equivalents, hurt by Europe’s greater exposure to the Chinese business cycle compared to the US’s exposure. European Investment Styles Chart 4 Over the past three months, European investment styles have begun a major shift. Value has moved from the Lagging quadrant to the Improving one, which suggests that flows could push value into the Leading quadrant (Chart 4). Moreover, growth has moved from the Leading quadrant to the weakening one, which created a similar dynamic as the decline in performance of the quality factor. This confirms that the rise in yields is beginning to favour a shift in style from growth to value. Meanwhile, small-cap stocks have tumbled into the Lagging quarter. We do expect attractive returns for European small-cap names over an 18- to 24-month investment horizon. However, we have not moved yet to overweight this sector of the market and rotational patterns confirm it is too early to do so safely. European Sectors Chart 5 Sectors have begun to make some important shifts in European markets (Chart 5). Tech has moved from the Leading quadrant to the weakening one. While the sector continues to outperform, it is doing so with a declining momentum, and it could soon move to the Lagging quadrant. This deteriorating price action must be monitored closely. Consumer discretionary names, which were strong performers that have become increasingly weak, have moved from the Weakening quadrant to the lagging one. However, their momentum is not deteriorating as much as it did nine weeks ago, which suggests a move to the Improving quadrant could soon be in the offing. Financials have greatly enjoyed the uptick in global yields. After a short passage through the Lagging quadrant, they have shifted into the Leading one. This suggests that the winds remain behind this sector, which we continue to overweight. Industrials and energy have become mirror images of one another, highlighting the negative impact on European economic activity and profitability of the recent surge in energy prices. The industrials have moved from the Leading quadrant to the lagging one, as the energy sector experienced the opposite direction of travel. This suggests that industrials will only recover their shine once the energy crisis abates, which will also hurt energy stocks. European National Markets Chart 6 The rotational pattern exhibited by European national markets bears their respective sectoral footprints (Chart 6). The tech-heavy Dutch market has moved from the Leading quadrant to the Weakening one, the industrials-focused Swedish market has fallen into the Lagging quadrant from the Weakening one and the Norwegian market has leapt out of Lagging into Leading territory. Hence, if the rotation out of tech deepens, The Netherlands will tumble directly into the Lagging zone, while an easing in energy prices will force Norway and Sweden to switch places on the back of a rotation out of energy into industrials. Germany is of particular interest. It is a well-diversified market that has become oversold. Moreover, as we wrote in September, its relative performance exhibits a significant discount to relative earnings. From a rotational perspective, Germany is moving to leave the Lagging quadrant; a durable shift into the Improving quadrant will sufficiently assuage traders into buying this market. This process will support our overweight position in German equities. Spain is another market we like on a tactical basis. Over the course of the past three months, it moved out of Lagging territory into the Improving zone. This price action supports our thesis that the large country-discount embedded across Spanish equity sectors is excessive and should soon dissipate. The main risk to this view would be another down leg in bond yields, which would hurt financials—a major weight in this market. Italy, too, is in the process of executing a full rotation, having exited the Weakening quadrant and moved into the Lagging one. Italian stocks have tried to punch their way into the Improving zone but have failed to do so. They will require higher yields to move out into the Improving zone durably because of the heavy financials weighting of Italian stocks. European Industrials Chart 7 Within European industrials, a rotational pattern is also evident (Chart 7). Swiss industrials have moved out of the Leading quadrant into the Lagging one as the Swiss franc continues to appreciate against the euro. The rising CHF imparts deflationary pressures into Switzerland and the SNB continues to build up its reserves. As a result, EUR/CHF will appreciate once EUR/USD finds a firmer footing. Thus, while it is too early to overweight Swiss industrials relative to those of the Eurozone, their oversold nature suggests that a rotation in favour of Swiss manufacturing businesses will soon take place. At the current juncture, Spanish industrials look appealing. They have moved out of the Lagging quadrant into the Improving one as the momentum of their relative performance improves. Additionally, they are close to moving into the leading territory. This picture is consistent with a narrowing of the discount embedded in all Spanish sectors since the pandemic broke out. Swedish industrials are also trying to exit the Lagging territory; their elevated RoE, and heavy sensitivity to the DM capex cycle indicate that they should move into the Leading quadrant in the coming weeks. UK industrials have remained in the Leading zone for the past three months, but their relative momentum is softening, which risks them being placed in the Weakening zone. The recent deterioration in GBP/EUR could provide a breath of fresh air, as it will improve the competitiveness of UK industrials compared to continental firms. Even then, for now, rotational dynamics do not flag an imminent problem for UK industrials. European Financials Chart 8 The clearest rotational pattern within European financials may be found in Sweden and the UK (Chart 8). Over the past three months, Swedish financials have fallen out of the Leading quadrant into the Weakening one, and they are inching closer toward the Lagging zone. This suggests that they could soon begin to underperform. Meanwhile, UK financials offer a mirror image as they exited the Lagging quadrant and moved into the improving one. They have yet to enter Leading territory, but seem close to doing so. The pessimism toward the UK is overdone right now. BCA’s Global Fixed-Income Strategy team expects the UK yield curve to steepen anew. UK financials would be prime beneficiaries of this dynamic. Italian and Spanish financials are also exhibiting some concerning moves lately. Both were in the Leading quadrant, but they have since shifted to the lagging one as peripheral spreads widened. Meanwhile, money seems to be moving into German financials, which have advanced from the Lagging quadrant to the Improving quadrant. While they are not as close to the Leading quadrant as their UK competitors, this shift warrants monitoring. European Consumer Discretionary Chart 9 Within the consumer discretionary space, most European countries have remained in their quadrant (Chart 9). Nonetheless, Spanish CD stocks have moved out of the Lagging zone into the Leading quadrant, while their Italian counterparts have recently entered the Weakening quadrant where they have joined French CDs. While both these countries’ consumer discretionary firms are witnessing weakening momentum, they remain in an upward trend against their European competitors. It is therefore too early to sell these countries within this industry. German Consumer discretionary equities are still in the Lagging quadrant, but they are trying to move into the Improving one, where UK CD names have remained for the past three months. European Tech Chart 10 The European tech sector is very much a story about The Netherlands versus the rest, due to the large size of the Dutch tech sector (Chart 10). For now, rotational patterns remain in favour of Dutch names; they have exited the Leading quadrant, but, while their momentum is weakening somewhat, they remain in a pronounced relative uptrend. A few small markets offer some promise. Over the past three months, both Spanish and German tech names have shifted from the Lagging quadrant into the Improving one. Their elevated momentum measures suggest that a shift into the Leading quadrant is imminent. As such, investors should consider switching some of their tech holdings into these two countries to diversify away from the Dutch behemoth.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com

Highlights Supply-side pressures should abate over the coming months as semiconductor availability improves, transportation bottlenecks ease, energy prices recede, and more workers enter the labor force. The respite from inflation will be temporary, however. The combination of easy fiscal and monetary policies will cause unemployment to fall below its equilibrium level in the US, and eventually, in most major economies. Unlike in the late 1990s, when rising wages were counterbalanced by robust productivity gains, most of the recent rebound in US productivity growth will prove to be illusory. US inflation will follow a “two steps up, one step down” trajectory. We are currently at the top of those two steps, but rising unit labor costs will eventually drive inflation higher. Rather than fretting that the Federal Reserve will keep rates too low for too long, investors are worried that the Fed will tighten too much. This is a key reason why the 20-year/30-year Treasury slope has inverted. Such an inversion does not make sense to us. Hence, we are initiating a trade going long the 20-year bond versus the 30-year bond. Go short the 10-year Gilt on any break below 0.85%. UK real bond yields are amongst the lowest in the world. The Bank of England will eventually have to turn more hawkish, which will support the beleaguered pound. Structurally higher bond yields will benefit value stocks. Banks stand to gain from rising bond yields while tech could suffer. The eventual re-emergence of supply-side pressures will catalyze more investment spending. This will bolster industrial stocks. The Supply Side Matters, Again Savings glut, secular stagnation; call it what you will, but for the better part of two decades, the global economy has faced a chronic shortfall of aggregate demand. Times are changing, however. The predominant problem these days is not a lack of spending; it is a lack of production. Unlike during the Global Financial Crisis – when worries about moral hazard complicated efforts to bail out homeowners and banks – the victims of the pandemic elicited sympathy. As a result, governments in developed economies rolled out a slew of measures to support workers and businesses. Thanks to bountiful fiscal transfers, households in the US have accrued $2.2 trillion in income since the start of the pandemic, about $1.2 trillion more than one would have expected based on the pre-pandemic trend (Chart 1). With many services unavailable, consumers diverted spending towards manufactured goods. At first, sellers were able to dip into their inventories to meet rising demand. By early this year, however, inventories had been depleted (Chart 2). Shortages began to pop up across much of the global supply chain. Chart 1Stimulus-Supported Income Growth Boosted Goods Consumption Stimulus-Supported Income Growth Boosted Goods Consumption Stimulus-Supported Income Growth Boosted Goods Consumption Chart 2The Pandemic Depleted Inventories The Pandemic Depleted Inventories The Pandemic Depleted Inventories While today’s empty warehouses can be largely attributed to surging demand for goods, supply-side disruptions have also played an important role. Four disruptions stand out: 1) semiconductor shortages; 2) transportation bottlenecks; 3) inadequate energy supplies; and 4) reduced labor force participation. Let us examine all four in turn. Semiconductor Shortages Chart 3Car Prices Have Jumped Car Prices Have Jumped Car Prices Have Jumped The global supply chain was not equipped to handle the dislocations caused by the pandemic. The combination of just-in-time inventory systems and far-flung supplier networks ensured that bottlenecks in one part of the global economy quickly filtered down to other parts of the economy. Few industries are as important as semiconductors. The auto sector has felt the brunt of the chip shortage. Both new and used vehicle prices have soared as dealer lots have emptied out (Chart 3). The drop in vehicle spending alone shaved 2.4 percentage points off US real GDP growth in the third quarter. Semiconductor makers have ramped up production to meet growing demand. The US Census Bureau’s Quarterly Survey of Plant Capacity Utilization showed that semiconductor plants operated an average of 73 hours per week in the first half of this year, up from around 45-to-50 hours prior to the pandemic (Chart 4). Chip production in Northeast Asia has rebounded (Chart 5). Southeast Asian production dropped in August due to Covid lockdowns, with semiconductor exports falling by over a third in Malaysia and Vietnam. Fortunately, since then, a decline in Covid cases and rising vaccination rates have spurred a recovery throughout the region. Chart 4Chipmakers Are Working Overtime Chipmakers Are Working Overtime Chipmakers Are Working Overtime Chart 5Semiconductor Production Has Accelerated In Northeast Asia Semiconductor Production Has Accelerated In Northeast Asia Semiconductor Production Has Accelerated In Northeast Asia Chart 6Memory Chip Prices Are Declining Memory Chip Prices Are Declining Memory Chip Prices Are Declining Commentary from semiconductor companies and automakers suggest that the chip shortage will ease over the coming months. In an auspicious sign, US auto sales jumped to 13.1 million in October from 12.3 million in September. Memory chip prices are also falling (Chart 6). Nevertheless, the overall chip market is unlikely to return to balance until 2023. Transportation Bottlenecks Unlike semiconductors and high-end electronics, which usually arrive by air, bulkier items such as furniture, sporting goods, and housing appliances typically arrive by sea. Port congestion, insufficient warehouse capacity, and a lack of truck chassis on which to place containers have all contributed to transportation bottlenecks. Chart 7Transportation Bottlenecks: Past The Worst? Transportation Bottlenecks: Past The Worst? Transportation Bottlenecks: Past The Worst? As with the semiconductor shortage, we are probably past the worst point in the shipping crisis. Drewry’s composite World Container Index has edged down 11% from its highs, although it is still up more than three-fold from mid-2020 levels (Chart 7). The easing in container shipping costs follows a dramatic 47% decline in the Baltic Dry Index since early October. The number of ships waiting to unload cargo off the coast of Los Angeles and Long Beach remains near record highs (Chart 8). Port congestion should ease over the next few months. US port throughput usually falls starting in the late fall and remains weak during the winter months, bottoming shortly after the Chinese New Year. If throughput remains elevated near current levels this year, this should be enough to clear much of the backlog. Looking further out, shipping costs could face additional downward pressure. Chart 9 shows that the number of container ships on order has risen to a 10-year high; these new ships will be delivered over the next two years. Chart 8Port Congestion Should Ease Over The Coming Months Port Congestion Should Ease Over The Coming Months Port Congestion Should Ease Over The Coming Months Chart 9Shipbuilders Are Busy Shipbuilders Are Busy Shipbuilders Are Busy Inadequate Energy Supplies After a torrid rally since the start of the year, energy prices have come off their highs. The price of Brent oil has dipped 6% from its October peak. US natural gas prices have retreated 11%. Natural gas prices in Europe have fallen 37%. Chart 10 The biggest move has been in coal prices, which have dropped 36% over the past two weeks alone. Futures curves are pricing in further declines in key energy prices (Chart 10). BCA’s Commodity and Energy Strategy service expects energy prices to soften over the next 12 months, but not as much as markets are discounting. Their latest forecast calls for the price of Brent crude to average $81/bbl in 2021Q4, $80/bbl in 2022 (versus market expectations of $77/bbl), and $81/bbl in 2023 (versus market expectations of $71/bbl). As we discussed a few weeks ago, years of underinvestment have led to tight supply conditions across the entire energy complex (Chart 11). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade. Gas reserves followed a similar trajectory, increasing by only 5% between 2010 and 2020 compared to 30% over the prior ten years (Chart 12). Chart 11 Chart 12   With little spare capacity, energy markets have become increasingly vulnerable to shocks. A cold snap across the Northern Hemisphere this spring depleted natural gas supplies, while a lack of wind reduced energy production by European wind farms. Increased gas imports from Russia could have mitigated the problem, but the dispute over the Nord Stream 2 pipeline prevented that from happening. The pipeline is popular with German voters (Chart 13). BCA’s geopolitical team expects it to be approved, a welcome development given that La Niña is highly likely to lead to colder-than-normal temperatures across northern Europe this winter. Chart 13 China has also restarted 170 coal mines and will probably begin re-importing Australian coal. Beijing is also allowing utilities to charge higher prices, which should help stave off bankruptcies across the sector. These measures should help mitigate China’s energy crisis. Chart 14US Rig Count Has Risen From Low Levels US Rig Count Has Risen From Low Levels US Rig Count Has Risen From Low Levels A bit more oil production will also help. The US rig count, while still far below its 2014 highs, has doubled since last year (Chart 14). BCA’s commodity strategists expect output in the Lower 48 states to average 9.5mm b/d in 2022 and 10mm b/d in 2023, versus 2021 production levels of 9.0mm b/d. Nevertheless, shale producers are a lot more disciplined these days. Debt reduction and cash flow generation are now the top priorities. This implies that fairly high oil prices may be necessary to catalyze additional investment in the industry.  Reduced Labor Force Participation Despite the rapid economic recovery, US employment remains 5 million below its pre-pandemic peak. One would not know this from the survey data, however. A record 51% of small businesses expressed difficulty finding qualified workers in the October NFIB survey. The share of households reporting that jobs are plentiful versus hard-to-get has returned to its 2000 highs. Both the quits rate and the job openings rate are well above their pre-pandemic levels (Chart 15). A wave of early retirement accounts for some of the apparent labor market tightness. About 1.3 million more workers have retired since the pandemic began than one would have expected based on demographic trends. Yet, there is more to the story than that. The labor force participation rate for workers aged 25-to-54 has not fully recovered; the employment-to-population ratio for that age cohort is still 2.5 percentage points below pre-pandemic levels (Chart 16). Chart 15 Chart 16Labor Force Participation Has Room To Rise Labor Force Participation Has Room To Rise Labor Force Participation Has Room To Rise   There is considerable uncertainty about how many workers will re-enter the labor force over the coming months. On the one hand, the expiration of enhanced unemployment benefits could prod more workers into the job market. Diminished anxiety about the virus should help. While the number has fallen by half, there are still 2.5 million people not working due to concerns about getting or spreading Covid-19 (Chart 17). According to Boston College’s Center for Retirement Research, the retirement rate rose more for older lower-income workers than higher-income workers (Chart 18). Some of these retirees may decide to re-enter the labor force. Chart 17Less Anxiety About The Coronavirus Should Increase Labor Supply Poorer Older Workers Were More Likely To Retire Last Year Poorer Older Workers Were More Likely To Retire Last Year Chart 18   On the other hand, the imposition of vaccine mandates could reduce labor supply. About 100 million US workers are currently subject to the mandates. According to the Census Household Pulse Survey, about 8 million of them are unvaccinated and attest that “they will definitely not get the vaccine.” Perhaps the biggest question mark is over whether the pandemic will lead to permanent changes in peoples’ perspectives on the optimal work/life balance. High burnout rates (especially in the health care sector), a reluctance to restart the daily commute to the office, and the desire to spend more time with family have all contributed to what some commentators have dubbed The Great Resignation. Ultimately, the deciding factor may be wages. Wage growth accelerated during the late 1990s as the labor market tightened (Chart 19). This drew a lot of people – especially less-skilled workers – into the labor force. Recently, wage growth has exploded at the bottom end of the income distribution, and our guess is that this will entice more people to seek employment (Chart 20). Chart 19Wage Growth Accelerated During The Late 1990s As The Labor Market Tightened Wage Growth Accelerated During The Late 1990s As The Labor Market Tightened Wage Growth Accelerated During The Late 1990s As The Labor Market Tightened Chart 20Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly     Will Higher Productivity Growth Mitigate Supply-Side Pressures? The late 1990s saw a resurgence in productivity growth. This helped restrain unit labor costs in the face of rising wages. Chart 21 While US productivity did jump during the pandemic, we are sceptical of claims that this can be attributed to efficiency gains from digitalization and work-from-home practices. A recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. It is telling that productivity outside of the US generally declined during the pandemic (Chart 21). This suggests that last year’s productivity gains stemmed mainly from increased operating leverage, a common feature of post-recession US recoveries (Chart 22). Supporting this view is the fact that productivity growth slowed from 4.3% in Q1 to 2.4% in Q2 on a quarter-over-quarter annualized basis. Productivity declined by 5% in Q3, leading to an 8.3% increase in unit labor costs. Chart 22US Productivity Tends To Jump After Recessions US Productivity Tends To Jump After Recessions US Productivity Tends To Jump After Recessions Chart 23Capital Goods Orders Have Soared Capital Goods Orders Have Soared Capital Goods Orders Have Soared The only saving grace is that core capital goods orders have soared (Chart 23). This should translate into increased business capital spending next year and higher productivity down the road. Investment Implications Supply-side pressures should abate over the coming months as semiconductor availability improves, transportation bottlenecks ease, energy prices recede, and more workers enter the labor force. The respite from inflation will be temporary, however. The combination of easy fiscal and monetary policies will cause unemployment to fall below its equilibrium level in the US, and eventually, in most major economies. This is consistent with our “two steps up, one step down” projection for US inflation. We are probably near the top of those two steps at present. This implies that the next move for inflation is to the downside, even if the longer-term trend is still to the upside. The US 10-year Treasury yield should stabilize at around 1.8% in the first half of 2022, before moving higher later in the year. As we discussed last week, markets are understating the true level of the neutral rate of interest. Rather than fretting that the Federal Reserve will keep rates too low for too long, investors are worried that the Fed will tighten too much. This is a key reason why the 20-year/30-year Treasury slope has inverted (Chart 24). Such an inversion does not make sense to us. Hence, as of this week, we are initiating a trade going long the 20-year bond versus the 30-year bond. We would also go short the 10-year Gilt on any break below 0.85%. The Bank of England’s “surprising hold” knocked the yield down 14 basis points to 0.93%. UK real bond yields are amongst the lowest in the world (Chart 25). Growth is strong and will remain buoyant as Brexit headwinds fade. The BoE will eventually have to turn more hawkish, which will support the beleaguered pound. Chart 24Go Long US 20-Year Bonds Versus 30-Year Bonds Go Long US 20-Year Bonds Versus 30-Year Bonds Go Long US 20-Year Bonds Versus 30-Year Bonds Chart 25UK Real Bond Yields Are Amongst The Lowest In The World UK Real Bond Yields Are Amongst The Lowest In The World UK Real Bond Yields Are Amongst The Lowest In The World   Structurally higher bond yields will benefit value stocks. Chart 26 shows that there has been a close correlation between the US 30-year Treasury yield and the relative performance of global value versus growth stocks. Banks stand to gain from rising bond yields while tech could suffer (Chart 27). Chart 26Higher Bonds Yields Favor Value Stocks Higher Bonds Yields Favor Value Stocks Higher Bonds Yields Favor Value Stocks Chart 27     The re-emergence of supply-side pressures could affect companies in a variety of unexpected ways. For example, Facebook and Google both rely heavily on revenue from advertising. But what is the point of trying to boost demand for your product if you already cannot produce enough of it? Companies such as Hershey and Kimberly-Clark are already cutting ad spending in response to supply-chain bottlenecks. Finally, tight supply conditions will catalyze more investment spending. This will benefit industrial stocks. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Chart 28 Special Trade Recommendations The Supply Side Strikes Back The Supply Side Strikes Back Current MacroQuant Model Scores Chart 29

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

Image The markets were deluged by a lot of information in late October. Several central banks made surprise moves towards tightening (the Bank of Canada, for example, ended asset purchases, and the Reserve Bank of Australia effectively abandoned its yield-curve control). Inflation continued to surprise on the upside (headline CPI in the US is now 5.4% year-on-year). But, at the same time, there were signs of faltering growth with, for example, US real GDP growth in Q3 coming in at only 2.0% quarter-on-quarter annualized, compared to 6.7% in Q2. This caused a flattening of the yield curve in many countries, as markets priced in faster monetary tightening but lower long-term growth (Chart 1). Nonetheless, equities shrugged off the barrage of news, with the S&P500 ending the month at a new high. All this highlights what we discussed in our latest Quarterly: That the second year of a bull market is often tricky, resulting in lower (but still positive) returns from equities and higher volatility. For risk assets to continue to outperform, our view of a Goldilocks environment needs to be “just right”: The economy must not be too hot or too cold. We think it will be – and so stay overweight equities versus bonds. But investors should be aware of the risks on either side. How too hot? Inflation is broadening out (at least in the US, UK, Australia and Canada, though not in the euro zone and Japan) and is no longer limited to items which saw unusually strong demand during the pandemic but where supply is constrained (Chart 2). Chart 1What Is The Message Of Flattening Yield Curves? What Is The Message Of Flattening Yield Curves? What Is The Message Of Flattening Yield Curves? Chart 2Inflation Is Broadening Out In The US Inflation Is Broadening Out In The US Inflation Is Broadening Out In The US There is a risk that this turns into a wage-price spiral as employees, amid a tight labor market, push for higher wages to offset rising prices. We find that wages tend to follow prices with a lag of 6-12 months (Chart 3). The Atlanta Fed Wage Tracker (good for gauging underlying wage pressures since it looks only at employees who have been in a job for 12 months or more) is already at 3.5% and looks set to rise further. On the back of these inflationary moves, the market has significantly pulled forward the date of central bank tightening. Futures now imply that the Fed will raise rates in both July and December next year (Chart 4) and that other major developed central banks will also raise multiple times over the next 14 months (Table 1). Breakeven inflation rates have also risen substantially (Chart 5). Chart 3Wages Tend To Rise After Prices Rise Wages Tend To Rise After Prices Rise Wages Tend To Rise After Prices Rise Chart 4Will The Fed Really Hike This Soon? Will The Fed Really Hike This Soon? Will The Fed Really Hike This Soon?   Table 1Futures Implied Path Of Rate Hikes Monthly Portfolio Update: The Risks To Goldilocks Monthly Portfolio Update: The Risks To Goldilocks Chart 5Breakevens Suggest Higher Inflation Breakevens Suggest Higher Inflation Breakevens Suggest Higher Inflation     We think these moves are a little excessive. There are several reasons why inflation might cool next year. Companies are rushing to increase capacity to unblock supply bottlenecks. For example, semiconductor production has already begun to increase, bringing down DRAM prices over the past few months (Chart 6). Another big contributor to broad-based inflation has been a 126% increase in container shipping costs since the start of the year (Chart 7). But currently the number of container ships on order is at a 10-year high; these new ships will be delivered over the next two years. Such deflationary forces should pull down core inflation next year (though we stick to our longstanding view that for multiple structural reasons – demographics, the end of globalization, central bank dovishness, the transition away from fossil fuels – inflation will trend up over the next five years). Chart 6DRAM Prices Falling As Production Ramps Up DRAM Prices Falling As Production Ramps Up DRAM Prices Falling As Production Ramps Up Chart 7All Those Ships On Order Should Bring Down Shipping Costs All Those Ships On Order Should Bring Down Shipping Costs All Those Ships On Order Should Bring Down Shipping Costs The Fed, therefore, will not be in a rush to raise rates. It does not see the labor market as anywhere close to “maximum employment” – it has not defined what it means by this, but we would see it as a 3.8% unemployment rate (the median FOMC dot for the equilibrium unemployment rate) and the prime-age participation rate back to its 2019 level (Chart 8). We continue to expect the first rate hike only in December next year. The Fed will feel the need to override its employment criterion only if long-term inflation expectations become unanchored – but the 5-year 5-year forward breakeven rate is only at 2.3%, within the Fed’s effective CPI target range of 2.3-2.5% (Chart 5). We remain comfortable with our view of only a moderate rise in long-term rates, with the US 10-year Treasury yield at 1.7% by end-2021, and reaching 2-2.25% at the time of the first Fed rate hike. It is also worth emphasizing that even a fairly sharp rise in long-term rates has historically almost always coincided with strong equity performance (Chart 9 and Table 2). This has again been evident in the past 12 months: When rates rose between August 2020 and March 2021, and then from July 2021, equities performed strongly. Chart 8We Are Not Back To "Maximum Employment" We Are Not Back To "Maximum Employment" We Are Not Back To "Maximum Employment" Chart 9Rising Rates Are Usually Accompanied By A Rising Stock Market Rising Rates Are Usually Accompanied By A Rising Stock Market Rising Rates Are Usually Accompanied By A Rising Stock Market   Table 2Episodes Of Rising Long-Term Rates Since 1990 Monthly Portfolio Update: The Risks To Goldilocks Monthly Portfolio Update: The Risks To Goldilocks But could the economy get too cold? We would discount the weak US GDP reading: It was mostly due to production shortages, especially in autos, which pushed down consumption on durable goods by 26% QoQ annualized, and by some softness in spending on services due to the delta Covid variant, the impact of which is now fading. US growth should continue to be supported by a combination of the $2.5 trillion of excess household savings, strong capex as companies boost their production capacity, and a further 5% of GDP in fiscal stimulus that should be passed by Congress by year-end. Similar conditions apply in other developed economies. Chart 10Real Estate Is A Big Part Of Chinese GDP Real Estate Is A Big Part Of Chinese GDP Real Estate Is A Big Part Of Chinese GDP We see three principal risks to this positive outlook: A new strain of Covid-19 that proves resistant to current vaccines – unlikely but not impossible. Our geopolitical strategists worry about Iran, which may have a nuclear bomb ready by December, prompting Israel to bomb the country. Iran would likely react by hampering oil supplies, even blocking the Strait of Hormuz, through which 25% of global oil flows. Chinese growth has been slowing and the impact from the problems at Evergrande is still unclear. Real estate is a major part of the Chinese economy, with residential investment comprising 10% of GDP (Chart 10) and, broadly defined to include construction and building materials, real estate overall perhaps as much as one-third. Our China strategists don’t expect the government to launch a major stimulus which would bail out the industry, since it is happy with the way that property-related lending has been shrinking in recent years (Chart 11). We expect the slowdown in Chinese credit growth to bottom out over the coming few months, but economic activity may have further to slow (Chart 12), and there is a risk that the authorities are unable to control the fallout from the property market. Chart 11Chinese Authorities Are Happy To See Slowing Property Lending Chinese Authorities Are Happy To See Slowing Property Lending Chinese Authorities Are Happy To See Slowing Property Lending Chart 12When Will Credit Growth Bottom? When Will Credit Growth Bottom? When Will Credit Growth Bottom?       Fixed Income: Given the macro environment described above, we remain underweight bonds and short duration. If we assume 1) a Fed liftoff in December 2022, 2) 100 basis points of rate hikes over the following year, and 3) a terminal Fed Funds Rate of 2.08% (the median forecast from the New York Fed’s Survey of Market Participants), 10-year US Treasurys will return -0.2% over the next 12 months, and 2-year Treasurys +0.3%.1 TIPs have overshot fair value and, although we remain neutral since they a tail-risk hedge against high inflation over the next five years, we would especially avoid 2-year TIPS which look very overvalued. We see some pockets of selective value in lower-quality high-yield bonds, specifically US Ba- and Caa-rated issues, which are still trading at breakeven spreads around the 35th historical percentile, whereas higher-rated bonds look very expensive (Chart 13). For US tax-paying investors, municipal bonds look particularly attractive at the moment, with general-obligation (GO) munis trading at a duration-matched yield higher than Treasurys even before tax considerations (Chart 14). Our US bond strategists have recently gone maximum overweight. Chart 13 Chart 14Muni Bonds Are A Steal Muni Bonds Are A Steal Muni Bonds Are A Steal     Equities: We retain our longstanding preference for US equities over other Developed Markets. US equities have outperformed this year, irrespective of whether rates were rising or falling, or how US growth was surprising relative to the rest of the world, emphasizing the much stronger fundamentals of the US market (Chart 15).  Analysts’ forecasts for the next few quarters look quite cautious, and so earnings surprises can push US stock prices up further (Chart 16). We reiterate the neutral on China but underweight on Emerging Markets ex-China that we initiated in our latest Quarterly. Our sector overweights are a mixture of cyclicals (Industrials), rising-interest-rate plays (Financials), and defensives (Heath Care). Chart 15US Equites Outperformed This Year Whatever Happened US Equites Outperformed This Year Whatever Happened US Equites Outperformed This Year Whatever Happened Chart 16Analysts Are Pessimistic About The Next Couple Of Quarters Analysts Are Pessimistic About The Next Couple Of Quarters Analysts Are Pessimistic About The Next Couple Of Quarters   Currencies: We continue to expect the US dollar to be stuck in its trading range and so stay neutral. Recent moves in prospective relative monetary policy bring us to change two of our currency recommendations. We close our underweight on the Australian dollar. The recent rise in Australian inflation (with both trimmed mean and 10-year breakevens now above 2% – Chart 17) has brought forward the timing of the first rate hike and should push up relative real rates (Chart 18). We lower our recommendation on the Japanese yen from overweight to neutral. The Bank of Japan will not raise rates any time soon, even when other central banks are tightening. This will push real-rate differentials against the yen (Chart 18, panel 2). Chart 17Australian Inflation Is Picking Up Australian Inflation Is Picking Up Australian Inflation Is Picking Up Chart 18Real Rates Moving In Favor Of The AUD And Against The JPY Real Rates Moving In Favor Of The AUD And Against The JPY Real Rates Moving In Favor Of The AUD And Against The JPY Chart 19Chinese-Related Metals' Prices Are Falling Chinese-Related Metals' Prices Are Falling Chinese-Related Metals' Prices Are Falling Commodities: We remain cautious on those industrial metals which are most sensitive to slowing Chinese growth and its weakening property market. The fall in iron ore prices since July is now being followed by aluminum. However, metals which are increasingly driven by investment in alternative energy, notably copper, are likely to hold up better (Chart 19). We are underweight the equity Materials sector and neutral on the commodities asset class. The Brent crude oil price has broadly reached our energy strategists’ forecasts of $80/bbl on average in 2022 and $81 in 2023 (Chart 20). Although the forward curve is lower than this, with December-22 Brent at only $75/bbl, it is a misapprehension to characterize this as the market forecasting that the oil price will fall. Backwardation (where futures prices are lower than spot) is the usual state of affairs for structural reasons (for example, producers hedging production forward). The market typically moves to contango only when the oil price has fallen sharply and reserves are high (Chart 21). We remain neutral on the equities Energy sector.   Chart 20Brent Has Reached Our 2022 And 2023 Forecast Level Brent Has Reached Our 2022 And 2023 Forecast Level Brent Has Reached Our 2022 And 2023 Forecast Level Chart 21Lower Oil Futures Don't Mean Oil Price Is Forecast To Fall Lower Oil Futures Don't Mean Oil Price Is Forecast To Fall Lower Oil Futures Don't Mean Oil Price Is Forecast To Fall Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com GAA Asset Allocation  

This week we continue our series of thematic Special Reports. Over the past few months, we have covered the EV Revolution and Generation Z. In this report, we conduct a “deep dive” analysis of Cybersecurity as an investment theme for equity investors. Spoiler Alert: We recommend Cybersecurity as a structural and tactical overweight. For a shorter investment horizon, the recent pullback and deflated valuation premium present a good entry-point. A Primer On Cybersecurity What Is Cybersecurity? Cybersecurity focuses on protecting computers, networks, programs, and data from unauthorized and/or unintended access. A wide range of malicious activities fall under the umbrella of cybercrime: Theft and damage of personal and financial data, theft of money, embezzlement, demands for ransom, theft of intellectual property, and illicit and illegal use of computers' processing power or cloud storage. The methods the hackers use are breaches, phishing, privileged-access credential abuse, and endpoint security attacks. Cybersecurity Index ISE Cyber Security Index (HXR) is a NASDAQ index launched in 2010, that encapsulates publicly traded companies that operate in the Cybersecurity space, whether by providing infrastructure or services. Cybersecurity is a theme that spans several different industries: It is dominated by Software (57%) and Computer Services (29%). The remaining 14% are split between Telecommunications Equipment and Defense (Chart 1). The space includes both legacy providers and aggressive cloud-only newcomers. Cybersecurity Vs Software Services The S&P 500 Software and Services Industry Group Index (Software and Services) is HXR’s best proxy – the correlation of monthly returns is 65%. Compared to Software and Services, HXR index performance has been volatile and more recently underwhelming. Cybersecurity was underperforming for the past six months (Chart 2). There are several reasons for Cybersecurity lagging Software and Services. Chart 1 Chart 2Cybersecurity Has Underperformed Software And Services Cybersecurity Has Underperformed Software And Services Cybersecurity Has Underperformed Software And Services First, companies in the former are much younger and smaller than in the latter (Chart 3), and the size effect has been at play. Second, the industry composition of the two indexes is different, with HXR's allocations to Telecom and Defense sectors being slightly more defensive in nature. Last, and most important, Cybersecurity stocks surged early in the pandemic on the back of lockdowns and a ubiquitous shift to remote work, and hence some of the performance and profits growth were “borrowed” from the future. Chart 3Cybersecurity Theme Is Exposed To The Size Effect Cybersecurity Theme Is Exposed To The Size Effect Cybersecurity Theme Is Exposed To The Size Effect Cybercrime Statistics Cybercrime statistics are sobering, with the number of occurrences increasing fast, and financial damage reaching catastrophic amounts. Cybercrime will cost the world $6 trillion in 2021, and $10.5 trillion annually by 2025,1 representing one of the greatest transfers of wealth in history. The average total cost of a data breach is $4.24 million in 2021, which is up from $3.86 million in 2020.2 US ransomware attacks cost an estimated $915 million in 2020.3 93% of companies deal with rogue cloud apps usage.4 86.2% of surveyed organizations were affected by a successful cyberattack.5 The cost and damage of cyberattacks underpins why Cybersecurity has risen from being an accessory to becoming a “must-have” for companies’ survival (Charts 4 and 5). Chart 4 Chart 5Cybercrime Losses Spur Demand For Cybersecurity Cybercrime Losses Spur Demand For Cybersecurity Cybercrime Losses Spur Demand For Cybersecurity   Key Cybersecurity Verticals And Companies Cybersecurity has evolved over time. Legacy non-cloud incumbents that used to offer on-premises anti-virus software, such as NortonLifeLock, are morphing into or giving way to cloud-based solutions and software-as-a-service (SaaS) providers. These cutting-edge security players leverage Artificial Intelligence (AI) and Machine Learning (ML) to preempt threats, as opposed to reacting to them. In addition, the advantage of the cloud-based solutions is that there is no hardware to buy or manage. The Cybersecurity universe can be split into three major categories: Physical Network Infrastructure, Digital Network Infrastructure, and Cloud And Data Security. Physical Network Infrastructure Companies in this segment provide a mix of digital and physical solutions including supplying communication appliances such as routers and other network hardware. This segment has two incumbents: Cisco Systems (CSCO) and Juniper Networks (JNPR). Digital Network Infrastructure Companies focus on providing broad server and network security against a wide range of attacks. Product offerings may also include firewalls and AI threat detection. A10 Networks (ATEN) and Akamai Technologies (AKAM) operate in this segment. Cloud And Data Security The key verticals of Cloud And Data Security are Endpoint Protection, Secure Web Gateways, Identity Access Management, and Detection and Blocking of malicious emails. Most companies in this space offer cloud-based solutions and SaaS and have products in each of the four data security categories. Companies that roll up a variety of security software functions into a cloud- based service comprise a broad segment called Secure Access Service Edge, or SASE. Fortinet (FTNT), Check Point Software (CHKP), Palo Alto Networks (PANW), and Zscaler (ZS) are all SASE. These companies replace existing gateways, virtual private networks (VPN), edge routers, and firewalls. SASE is expected to have 57% growth in spending in 2021, with 40% compounded growth through 2024.6 Endpoint Protection Platforms help customers secure end-user devices such as mobile devices, laptops, and servers. To be one step ahead of cyber adversaries, these cloud-based companies offer SaaS that deploys AI and ML algorithms to detect and predict threats based on the analysis of the vast data collected across the entire platform. Crowdstrike, Check Point, and SentinelOne are the segment leaders. Secure Web Gateways prevent unsecured traffic from entering an internal network through external web applications. This is executed by the providers acting as a middleman so that users can bypass their internal networks to connect to the applications by leveraging providers data-cloud. These cloud-only companies’ SaaS and Firewall-as-a-Service secure customer access to internally and externally managed applications, such as email or customer relationship management. Fortinet, Zscaler, Palo Alto Networks (PANW), AvePoint (AVE), and Cloudflare (NET) are the best-of-breed players in this space. Identity Access Management (IAM) focuses on enabling access to networks only to authorized users. Multi-factor authentication, application programming interface (API) access management, and single sign-on (SSO) are a few identity solutions that fall under this vertical. Okta (OCTA) and Ping Identity (PING) are the leading players in this space. Their cloud native solutions offer access to all applications within a single portal using the same authentication. Detection And Blocking Of Malicious Emails – Companies in this segment detect and block emails that include known or unknown malware, malicious URLs, and impersonation of legitimate contacts. Mass and spear phishing is becoming a preferred gateway for cyber criminals and is becoming epidemic – 95% of cyberattacks use email. These providers complement traditional detection techniques with AI to identify fake logos and detect anomalous email patterns and high-risk links. Mimecast (MIME) and Check Point (CHKP) are active in this segment. Key Industry Drivers Digitization, Remote Work, And Shift To Cloud Increase Demand For Cybersecurity The pandemic-driven shift to remote work, broad-based migration to cloud computing, development of the Internet-of-Things – every new digital process and asset create new potential targets for hackers. The sophistication of the attacks is also on the rise, deploying AI, ML, and 5G. There appears also to be cooperation among different hacker groups. This year alone, high-profile data breaches, such as Kaseya, Accellion, Pulse Secure, and Solar Winds, affected universities, defense firms, S&P 500 companies, and government agencies. These developments, as troubling as they are, are a boon for Cybersecurity companies. Cybersecurity is becoming business-critical. Despite its celebrity status, this is an industry that is still in the early innings, and ubiquitous digitization requires increasingly more complex cyber defenses. Cyber-Space: A New Realm Of (Geo)Political Conflict Generally the risk of a major exogenous shock affecting global markets from a cyber incident is underrated (Table 1). The world is inherently an anarchic place because nations are sovereign and there is not a single world government to enforce international law. However, nations periodically work out codes of conduct and norms of behavior to impose limitations on conflict and chaos. The post-WWII and post-Cold War global order is an example. A tolerably functional international order is beneficial for global trade and investment flows. Increasingly international rules and norms are being challenged. The decline of the US and Europe in economic, technological, and military weight – relative to the rest of the world – has given rise to a “multipolar” distribution of power in which the rules of the road are contested. Disputes over sovereignty, territory, maritime rights, and air space have been escalating for over a decade in the areas around Russia, China, and the Mediterranean region. Table 1Cyber Event Underrated In Consensus View Of Global Risks Cybersecurity: A Must-Have For Survival Cybersecurity: A Must-Have For Survival Cyber-space is a new realm or domain of human activity. Because it is international, it is inherently ungovernable, and because it is new, nations have not had decades in which to establish basic rules or norms. It is very close to pure anarchy. Given that overall geopolitical competition is rising in the context of multipolarity, cyber-space is an attractive arena for nations to pursue their objectives because it presents fewer constraints – nations can act more independently and aggressively with limited accountability. Cyber gives nation-states (and their proxy groups) greater anonymity and plausible deniability. Russia can directly intervene in American social and political life through state-backed cyber agents, or it can condone the actions of criminal groups that conduct ransomware attacks. Nations can also use cyber tools to pursue state economic goals that align with broader strategic goals. For example, China can pursue technological upgrades for state-backed industry through cyber-theft. The trend for the foreseeable future is for governments to invest in Cybersecurity and cyber-capabilities in order to fortify this new and lawless realm of competition. Russia and China have attempted to seal off their cyber-space to prevent interference from foreign powers. They have also used cyber capabilities to take advantage of the relatively unregulated cyberspace of the liberal democracies. The democracies are now attempting to increase control over their own cyber domains. They need to protect critical infrastructure but also are increasingly focused on patrolling the ideological space. Finally, while nations are often deterred from aggression by conventional militaries, cyber-space creates an avenue to pursue interests aggressively with minimal risk of physical conflict. The US and Israel will continue to sabotage Iran’s nuclear program. Russia will continue to use cyber tools to try to reclaim dominance in the former Soviet Union. And China could resort to cyber-attacks against Taiwan if it is not yet willing to pursue an extremely difficult and risky amphibious invasion. Governments and corporations will deal with extreme uncertainty in this environment. They will have to invest in Cybersecurity. But they will also run the risk that at some point cyber-meddling will go too far and provoke real-world retaliation. President Biden reflected the sentiment of the US political establishment during a speech in July at the Office of the Director of National Intelligence: “I think it’s more likely we’re going to end up, if we end up in a war – a real shooting war with a major power – it’s going to be as a consequence of a cyber breach of great consequence and it’s increasing exponentially, the capabilities.”7 This risk will reinforce the need for more robust cyber defenses to prevent physical harm to a nation’s people and wealth. Hence what governments will not be able to do is penalize or break up their Cybersecurity corporations. Cyber firms will see strong public and private demand without the regulatory pressure that other tech companies (especially social media) will face. Corporate Spending On Cybersecurity Services Is Soaring According to IDC, the global Cybersecurity market is expected to grow from $125 billion in 2020 to $175 billion by 20248 at an 8.8% CAGR. After all, companies that purchased or implemented automated security features in their businesses can reduce potential cyber-attack losses by more than 50%, making it a worthwhile investment. Both large and small businesses are yet to fully implement Cybersecurity defenses. According to an IDG cybersecurity survey,9 91% of organizations are increasing their Cybersecurity budgets in 2021 (compared to 96% in 2020). Companies invest to prevent malicious attacks, and protect an increasingly distributed IT environment, and securely connect their remote workforce (Chart 6). According to an IBM security survey, only 25% of responders stated that they had fully implemented automated security. Clearly, demand for cyber defenses is poised for strong growth. Chart 6 Public Spending Commitments Will Fortify Cyber Defenses In response to the numerous breaches, the current US administration is placing a high priority on defensive cyber programs. Within the broader $6 trillion Biden budget request to Congress, $10 billion will be allocated to civilian government Cybersecurity in 2022 (Chart 7), bringing the total federal IT spending to just over $58 billion. Since 2017, US government departments have seen the Cybersecurity share of their basic discretionary funding rise steadily from 1.38% to 1.73%. The Biden administration’s broader legislative agenda includes expanding broadband Internet, building infrastructure, and regearing the US energy grid. New cyber vulnerabilities will emerge and both public and private entities will need to invest in security. Chart 8 further reveals the importance of Federal software spending to Cybersecurity equity performance. Our bet is that increases in Federal software spending outlays will lead to outperformance of HXR relative to the Software and Services index. Chart 7 Chart 8Stepped Up Government Spending Will Lift Cybersecurity Stocks Stepped Up Government Spending Will Lift Cybersecurity Stocks Stepped Up Government Spending Will Lift Cybersecurity Stocks Key Drivers Of Profitability Sales Growth Cybersecurity sales year-over-year growth is soaring at 40% this year and dwarfs the rate of sales growth of Software and Services (Chart 9). This is consistent with a joint survey by IDC and Bloomberg Intelligence Services, which found that worldwide Cybersecurity spending will outpace general software spending by almost 4.9% annualized from 2020 to 2024 (Chart 10).10 Chart 9Cybersecurity Sales Are Soaring Cybersecurity Sales Are Soaring Cybersecurity Sales Are Soaring Chart 10 R&D Investing Has Slowed Cybersecurity companies have been investing in R&D aggressively prior to the pandemic. Intellectual property is a competitive advantage in this space, and R&D has likely been ramped up in “arms races”, with different industry players building their competitive moats. Recently, spending on R&D has eased. We believe that this slowdown is temporary as companies need to stay competitive and fend off threats from cybercriminals (Chart 11). Earnings Growth Despite robust revenue growth, year-over-year earnings growth has recently slowed (Chart 12). Shift to remote work in 2020 resulted in a demand surge that has pulled profits forward. However, despite economic normalization and a return to the pre-pandemic trends, the structural shifts towards cloud and remote work are here to stay, while cybercriminals are getting increasingly more creative and aggressive. As a result, earnings growth is bound to pick up going forward. Chart 11R&D Investment Has Slowed Down R&D Investment Has Slowed Down R&D Investment Has Slowed Down Chart 12After Lockdown Surge, Earnings Growth Is Normalizing After Lockdown Surge, Earnings Growth Is Normalizing After Lockdown Surge, Earnings Growth Is Normalizing Valuations Currently, HXR is trading at 37x forward earnings, and 104x trailing, which translates into an 13% premium to Software and Services. While this valuation premium appears high, it is low compared to historical values (Charts 13 & 14). The former hefty premium has been deflated by recent underperformance (18%). There is also a meaningful discount to Software and Services when it comes to the Price-To-Sales metric, which is, arguably, the best gauge of value for growing companies. Chart 13Relative Valuation Premium Is Low Compared To Pre-Pandemic Highs Relative Valuation Premium Is Low Compared To Pre-Pandemic Highs Relative Valuation Premium Is Low Compared To Pre-Pandemic Highs Chart 14Cybersecurity Is Cheap By Price-To-Sales Metric Cybersecurity Is Cheap By Price-To-Sales Metric Cybersecurity Is Cheap By Price-To-Sales Metric From a valuation standpoint, Cybersecurity stocks are exorbitantly expensive, yet we can make a case that they are attractive compared to their own history, and these levels signify an opportunity to build a new position in this theme. How To Invest In Cybersecurity ETFs There are a number of highly liquid ETFs, such as CIBR, BUG, and HACK, powered by the Cybersecurity theme, cutting across several industry groups (Table 2 & Appendix). These passively managed funds have relatively high expense ratios. Direct indexing may be preferable as a basket of the Cybersecurity stocks is relatively easy to assemble. Given that the CIBR ETF has predominantly US companies, is most liquid, and has the highest AUM, it is our vehicle of choice for capturing the Cybersecurity theme. Table 2Cybersecurity ETFs Cybersecurity: A Must-Have For Survival Cybersecurity: A Must-Have For Survival S&P 500 Investors with an S&P500-only mandate may create a Cybersecurity basket from five major players spread across several sectors to gain direct exposure to the large-cap Cybersecurity universe: Cisco (CSCO), Juniper (JNPR), Fortinet (FTNT), NortonLifeLock (NLOK), and Akamai (AKAM). These companies represent the entire network security market, with CSCO and JNPR providing exposure to physical network infrastructure, AKAM representing the Digital Network Infrastructure vertical, FTNT covering Digital Data Security, and finally NLOK a legacy player focused on End Point Protection. It is important to note that some of the fastest growing and innovative players, such as Crowdstrike, Okta, and Zscaler, are outside of the S&P 500 as their market capitalizations are too small. Investment Implications Cybersecurity is increasingly important for businesses in the US and abroad, with demand for solutions surging. As a result, Cybersecurity is a structural investment theme, which warrants a long-term position in most equity portfolios. As with any investment into an emerging technology or theme, it is likely to be volatile, but the long-term upside should justify day-to-day jitters. Also, our analysis demonstrates that now is a good time to build a tactical overweight in Cybersecurity stocks. These stocks have been languishing for a few months, losing some of the valuation froth generated by the work-from-home hype. As a result, most of the cybersecurity stocks are attractively valued compared to history and are poised for a rebound on the back of robust demand for their services. Bottom Line Global digital transformation as well as rising geopolitical tensions create fertile ground for attacks by both cyber criminals and malicious state actors. The cyber defenses of most private and public companies are still ill-prepared, and the space is poised for a robust growth since Cybersecurity is a “must have” for survival. This growing market has attracted a plethora of new cybersecurity players which provide cloud-based SaaS solutions, and are well-versed in deploying AI and ML to counter cyber threats. While many of these companies are still young with relatively small capitalization, their potential is enormous. We recommend tactical and structural overweights to the theme.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Arseniy Urazov Senior Analyst ArseniyU@bcaresearch.com Appendix Image Image     Footnotes 1     Special Report: Cyberwarfare In The C-Suite, Cybercrime Magazine, Nov 13, 2020.  2     IBM and Ponemon Institute Research 3    Emsisoft 4    Imperva 2019 Cyberthreat Defense Report 5    CyberEdge Group 2021 Cyberthreat Defense Report 6    Barron’s, Security Software Stocks Should Have Strong Q2 Results. Here’s Why, July 12, 2021. 7     Nandita Bose, “Biden: If U.S. has ‘real shooting war’ it could be result of cyber attacks,” Reuters, July 28, 2021, reuters.com. 8    IDC, “Ongoing Demand Will Drive Solid Growth for Security Products and Services, According to New IDC Spending Guide,” Aug 13, 2020. 9    Cybersecurity at a Crossroads: The Insight 2021 Report", IDG Research Services, 2021. Respondents included more than 200 C-level IT and IT security executives in organizations with an average of 21,300 employees across a wide range of industries. 10   Source: Bloomberg Intelligence (Mandeep Singh - Senior Industry Analyst), August 25, 2021 & IDC.

Overweight BCA house view is for the US yields moving higher, with Treasury 10-year yields reaching 1.7-1.9% by the year-end.   Ever since the GFC, Financials and Banks equities relative performance has been tied to US yields, and these two sectors remain the most direct way to express a bearish bond bias within the US equity universe.  Consistent with that, our S&P Financials and S&P Banks overweight calls are currently up 4% and 8% in relative to SPX terms, respectively, since the position inception.  Two factors support further above benchmark allocation to the S&P Financials and the S&P Banks indexes. First, imminent tapering will propel yields higher.  Second, the broader economic revival and the accompanying easing in lending conditions will ensure a healthy demand pipeline for the US banks’ loans. Bank of America’s CEO, Brian Moynihan confirmed our view in his most recent earnings call citing that: “Deposit growth was strong and loan balances increased for the second consecutive quarter, leading to an improvement in net interest income even as interest rates remained low.” Bottom Line: We continue to recommend an above benchmark allocation in the S&P financials and the S&P banks indexes. An Update On Financials An Update On Financials

Highlights Increasing consumption should be a lot easier than increasing savings. After all, most people like to spend! It is getting them to work that should be challenging. Yet, the conventional wisdom is that deflation is a much tougher problem to overcome than inflation. It is true that the zero-bound constraint on interest rates makes it more difficult for central banks to react to deflationary forces. However, monetary policy is not the only game in town; fiscal policy becomes more effective as interest rates fall because governments can stimulate the economy without incurring onerous financing costs. When the borrowing rate is below the growth rate of the economy, the more profligate a government has been in the past, the more profligate it can be in the future, while still maintaining a stable debt-to-GDP ratio. The pandemic banished the bond vigilantes. Governments ran massive budget deficits, but bond yields still dropped. While budget deficits will decline from their highs, fiscal policy will remain structurally more accommodative in the post-pandemic period. The combination of easier fiscal policy, increased household net worth, and other factors has raised the neutral rate of interest in the US and most other economies. This means that monetary policy is currently much more stimulative than widely believed. This is good news for equities and other risk assets in the near term, even if it does produce a major hangover down the road. New trade: Short US consumer discretionary stocks relative to other cyclicals. Consumer durable goods spending will slow as services spending and capex continue to recover. A Paradoxical Problem Economic pundits like to say that deflation is a tougher problem to overcome than inflation. We hear this statement so often that we do not think twice about it. In many respects, it is a rather strange perspective. Inflation results from too much spending relative to output, whereas deflation results from too little spending. Yet, people like to spend! One would think it would be much easier to get people to consume than to get them to work. The claim that deflation is a bigger problem than inflation is really just a statement about the limits of monetary policy. If the economy is overheating, central banks can theoretically raise rates as high as they want. In contrast, if the economy is in a deflationary funk, the zero-bound constraint limits how far interest rates can fall. Fortunately, there are other ways of stimulating the economy when interest rates cannot be cut any further. Most notably, governments can utilize fiscal policy by cutting taxes, spending more on goods and services, or increasing transfer payments. Getting Paid To Eat Lunch When interest rates are very low, not only is fiscal stimulus a free lunch, but you actually get paid for eating more. If the borrowing rate is below the growth rate of the economy, the more profligate a government has been in the past, the more profligate it can be in the future, while still maintaining a stable debt-to-GDP ratio. This sounds so counterintuitive that it is worth thinking through a simple example. Suppose you currently earn $100,000 per year and expect your income to rise by 8% per year. You have $100,000 in debt, which incurs an interest rate of 3%, and want to keep your debt-to-income ratio constant at 100% over time. Next year, your income will be $108,000, so you should target a debt level of $108,000. Thus, this year, you can spend $105,000 on goods and services, make $3,000 in interest payments, and take on $8,000 in additional debt. Now, suppose you have been spendthrift in the past and have accumulated $200,000 in debt. You still want to keep your debt-to-income ratio constant, but this time at 200%. How much can you spend this year? The answer is $110,000. If you spend $110,000 and pay an additional $6,000 in interest, your cash outflows will exceed your income by $16,000, taking your debt to $216,000 — exactly twice next year’s income. Notice that by maintaining a higher debt balance, you can actually spend $5,000 more while still keeping your debt-to-income ratio constant. Appendix A proves this point mathematically. One might protest that the interest rate you face would be higher if you had more debt. Fair enough, although in our example, the interest rate would need to rise above 5.5% for spending to decline. The more important point is that unlike people, governments which issue debt in their own currencies get to choose whatever interest rate they want. Granted, if central banks set interest rates too low, the economy will overheat, leading to higher inflation. But this just reinforces the point we made at the outset, which is that inflation and not deflation is the real constraint to macroeconomic policy. A Blissful Outcome For Stocks We would not have waded through this theoretical discussion if it did not serve a practical purpose. In April of last year, we wrote a controversial report asking if, paradoxically, the pandemic could turn out to be good for stocks. Chart 1 We noted that by combining monetary easing with fiscal stimulus, policymakers could steer equity markets towards a “blissful outcome” where the economy was operating at full capacity, yet interest rates were lower than they were before (Chart 1). If such a blissful state were reached, earnings would return to their pre-pandemic level, but the discount rate would remain below its pre-pandemic level, thus allowing stock prices to rise above their pre-pandemic peak. In the months following our report, the stock market played out this narrative.   From Blissful To Blissless? Chart 2Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate More recently, bond yields have risen, stoking fears that we are moving towards less auspicious conditions for equities. There is no doubt that many central banks are looking to normalize monetary policy. That said, what central banks regard as normal today is very different from what they thought was normal in the past. Back in 2012, when the Fed began publishing its “dot plot,” the FOMC thought the neutral rate of interest was around 4.25%. Today, it thinks the neutral rate is only 2.5%. And based on the New York Fed’s survey of market participants and primary dealers, investors believe the neutral rate is even lower than the Fed’s estimate (Chart 2). Even if the Fed did not face political pressure to keep interest rates low, it probably would not want to raise them all that much anyway. The same applies to most other central banks. Why The Neutral Rate Is Higher Than The Fed Believes There are at least four reasons to think that the neutral rate of interest is higher than what the Fed believes:   Reason #1: The drag on growth from the household deleveraging cycle is ending As a share of disposable income, US household debt has declined by nearly 40 percentage points since 2008. Debt-servicing costs are now at record low levels (Chart 3). The Fed’s Senior Loan Officer Survey points to an increasing willingness to lend (Chart 4). The Conference Board’s Leading Credit Index also remains in easing territory (Chart 5). Chart 3The Deleveraging Cycle Has Run Its Course The Deleveraging Cycle Has Run Its Course The Deleveraging Cycle Has Run Its Course Real personal consumption increased by only 1.6% in Q3. However, this was largely driven by a 54% drop in auto spending on the back of the semiconductor shortage. While vehicle purchases normally account for only 4% of consumer spending, the sector still managed to shave 2.4 percentage points off GDP growth in Q3. Chart 4Banks Are Easing Credit Standards Banks Are Easing Credit Standards Banks Are Easing Credit Standards Chart 5A Positive Signal For Credit Growth A Positive Signal For Credit Growth A Positive Signal For Credit Growth Spending on services rose by 7.9%, an impressive feat considering the quarter saw the peak in the Delta variant wave.   Reason #2: Fiscal policy is likely to remain accommodative in the post-pandemic period The combination of lower real rates and higher debt levels has increased the budget deficit consistent with a stable debt-to-GDP ratio in the US and most developed markets (Chart 6). This point has not been lost on governments. While the flow of red ink will abate, the IMF estimates that the US cyclically-adjusted primary budget deficit will be 3% of GDP larger in 2022-26 than it was in 2014-19. The IMF also expects most other advanced economies to run larger budget deficits (Chart 7). Chart 6 Chart 7 Chart 8A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth Reason #3: Higher asset prices will bolster spending According to the Federal Reserve, US household net worth rose by over 113% of GDP between 2019Q4 and 2021Q2, the largest six-quarter increase on record (Chart 8). Empirical estimates of the wealth effect suggest that households spend about 5-to-8 cents on goods and services for every additional dollar of housing wealth, and 2-to-4 cents for every additional dollar of equity wealth. Based on the latest available data, we estimate that US homeowner equity has increased by $5 trillion since the start of 2020, while household equity holdings have increased by $15.8 trillion. Together, this would translate into 2.5%-to-4% of GDP in additional annual consumption. And this does not even include any spending arising from the $2.4 trillion in incremental bank deposits that households have amassed since the start of the pandemic.    Chart 9Most Of The Deceleration In US Potential Real GDP Growth Has Already Occurred Most Of The Deceleration In US Potential Real GDP Growth Has Already Occurred Most Of The Deceleration In US Potential Real GDP Growth Has Already Occurred Reason #4: Population aging will drain savings Aging populations can affect the neutral rate either by dragging down investment demand or reducing savings. The former would lead to a lower neutral rate, while the latter would lead to a higher rate. As Chart 9 shows, most of the decline in US potential GDP growth has already occurred. According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.8% today, mainly due to slower labor force growth. The CBO expects potential growth to edge down to 1.5% over the next few decades. The average age of the US capital stock is now the highest on record (Chart 10). Whereas real business fixed investment is 6% below its pre-pandemic trend, core capital goods orders – a leading indicator for capex – are 17% above trend. Capex intentions remain near multi-year highs (Chart 11). All this suggests that investment spending is unlikely to fall much in the future. Chart 10The Average Age Of The US Capital Stock Is Now The Highest On Record The Average Age Of The US Capital Stock Is Now The Highest On Record The Average Age Of The US Capital Stock Is Now The Highest On Record Chart 11Capex Intentions Remain At Lofty Levels Capex Intentions Remain At Lofty Levels Capex Intentions Remain At Lofty Levels Chart 12 In contrast, the depletion of national savings from an aging population is just beginning. Baby boomers are leaving the labor force en masse. They hold over half of US household wealth, considerably more than younger generations (Chart 12). As baby boomers transition from net savers to net dissavers, national savings will fall. UnTaylored  Monetary Policy The Taylor Rule prescribes the Fed to hike rates by between 50-to-100 bps for each percentage point that output rises relative to its potential. Over the past decade, the Fed has favored the higher output gap coefficient, meaning that a permanent one percentage-point increase in aggregate demand should translate, all things equal, into a one percentage-point increase in the neutral rate of interest. Taken at face value, the combination of increased household wealth and looser fiscal policy may have raised the neutral rate in the US by more than five percentage points since the pandemic. This estimate, however, does not consider feedback loops: A higher term structure for interest rates would depress asset prices, thus obviating some of the wealth effect. Higher rates would also reduce the incentive for governments to run large budget deficits. Taking these feedback loops into account, a reasonable estimate is that the neutral rate in the US is about 2% in real terms, or slightly over 4% in nominal terms based on current long-term inflation expectations. This is close to the historic average for real rates, although well above current market pricing. The implication for investors is that US monetary policy is currently more stimulative than widely believed. This is the good news. The bad news is that in the absence of fiscal tightening, the Fed will eventually be forced to raise rates by more than investors are discounting. Higher Inflation Won’t Force The Fed’s Hand… Just Yet When will the Fed be forced to move away from its baby-step approach to monetary policy normalization and adopt a more aggressive stance? Our guess is not for another two years. Last week, we argued that inflation in the US and many other countries is likely to follow a “two steps up, one step down” trajectory of higher highs and higher lows over the remainder of the decade. We are currently near the top of those two steps: Most of the recent increase in inflation has been driven by surging durable goods prices (Chart 13). Considering that durable goods prices usually fall over time, this is not a sustainable source of inflation. Chart 13ADurable Goods Spending Has Further To Fall (I) Durable Goods Spending Has Further To Fall (I) Durable Goods Spending Has Further To Fall (I) Chart 13BDurable Goods Spending Has Further To Fall (II) Durable Goods Spending Has Further To Fall (II) Durable Goods Spending Has Further To Fall (II) In modern service-based economies, structurally high inflation requires rapid wage growth. While US wage growth has picked up recently, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 14). The Fed welcomes this development, given its expanded mandate to pursue “inclusive growth.” At some point in the future, long-term inflation expectations could become unmoored. However, that has not happened yet, whether one looks at market-based or survey-based expectations (Chart 15). Thus, for now, investors should remain constructive on stocks. Chart 14Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly Chart 15   New Trade: Short Consumer Discretionary Stocks Relative To Other Cyclicals We continue to favor cyclical stocks over defensives. Within the cyclical category, however, we are cautious on consumer discretionary names. Spending on consumer durable goods still has further to fall in order to return to trend. Durable goods prices will also come down, potentially squeezing profit margins. Go short the Consumer Discretionary Select Sector SPDR Fund (XLY) versus an S&P 500 sector-weighted basket of the Industrial Select Sector SPDR Fund (XLI), the Energy Select Sector SPDR Fund (XLE), and the Materials Select Sector SPDR Fund (XLB). Appendix A Image Peter Berezin Chief Global Strategist pberezin@bcaresearch.com View Matrix Image Special Trade Recommendations This table provides trade recommendations that may not be adequately represented in the matrix on the preceding page. Image Current MacroQuant Model Scores Image

Highlights Faced with large excesses in the housing market, we contend that Beijing’s goal is to achieve flat property prices in the coming years. Stable property prices would allow for improved housing affordability over the coming years while precluding debt deflation. However, when authorities fix/control prices, they lose control of volumes/activity. The housing market will not clear. Property sales and construction activity will hit an air pocket. Shrinking construction activity will weigh on China’s economy and China-plays around the world. Feature The recent struggles of several Chinese property developers to service their debt have put the mainland’s real estate market on the radar of global investors. What is the outlook for the Chinese property market and what will be its impact on the mainland and global economies? What does it mean for global financial markets? In contrast to the US housing debacle in 2008, the central pressure point in China’s property market adjustment will not be home prices and mortgage defaults but retrenchment by property developers and a downsizing in construction activity. That is why we are maintaining our negative view on Chinese demand for raw materials and machinery. This will have implications for emerging Asia, developing countries that produce raw materials and machinery stocks worldwide. How Important Is The Property Market? Chart 1Land Sales Revenue And Property Developers Funding Are Sizable Land Sales Revenue And Property Developers Funding Are Sizable Land Sales Revenue And Property Developers Funding Are Sizable In a 2020 paper,1 Kenneth Rogoff and Yuanchen Yang estimate that real estate investment accounted for 12-15% of GDP in China between 2011 and 2018. This compares with a 7% share of GDP in the US at the peak of the housing boom in 2005. Hence, the sheer size of real estate construction in China – which does not include infrastructure investment – implies that real estate investment is very important for the mainland economy. The above numbers do not capture secondary effects from fluctuations in real estate investment. Thereby, the impact of property construction is greater than what is implied by its share of GDP. Further, local governments derive more than 40% of their aggregate revenues – budgetary and off budgetary (managed funds) – from land sales (Chart 1, top panel). As land sales dry up, local government revenues will plummet, undermining their ability to finance infrastructure spending – which is also a major part of the economy. Property developers’ annual funding makes up a very large 20% of GDP, which attests to their importance to the economy and the financial system (Chart 1, bottom panel).  Critically, construction activity drives demand for raw materials and machinery. Granted, Chinese imports of raw materials and machinery used in real estate construction and infrastructure building are non-trivial, the shockwaves from the downturn will spill over to the rest of the world in general and to developing economies in particular. Excesses  The Chinese property market’s vulnerability stems from its excesses. These excesses are apparent on multiple fronts. Table 1Chinese Housing Is Expensive / Unaffordable China: Is The Property Carry Trade Over? China: Is The Property Carry Trade Over? 1. Extreme Overvaluation: Compared to most countries around the world, housing in China is very expensive. The house price-to-household income ratio is 19 in tier-1 cities, 10 in tier-2 and 7 in tier-3 cities (Table 1). For comparison, even after the recent surge in property prices, the house price-to-income ratio is 4 in the US nationwide. Importantly, the mortgage rate in China – currently at 5.4% – is considerably higher than mortgage rates in the US or in other developed economies. The high house price-to-income ratio and relatively high mortgage rate entail that mortgage interest payments account for a larger share of household income in China than in any advanced economy. For new buyers, assuming a 30% down-payment, mortgage interest payments alone make up 28% of household income on average nationwide (Table 1). Chart 2Chinese Households Are As Leveraged As Their US Peers Chinese Households Are As Leveraged As Their US Peers Chinese Households Are As Leveraged As Their US Peers Finally, Chinese household indebtedness is much higher than is often presumed by the global investment community – the household disposable income-to-debt ratio is close to 100%, as high as it is in the US (Chart 2). All this does not mean that China will experience a US-style 2008 credit crisis with households defaulting on their mortgages. As we discuss below, the adjustment process will be different in China than it was in the US. 2. Capital misallocation: Property developers have been building the wrong type of housing at the wrong prices and for the wrong type of buyers. They have been building high-end houses and selling them at very high prices to high-income households who have been buying multiple properties as investments. This represents capital misallocation. Widespread home vacancies confirm this thesis. As of 2017, 21.5% of the housing stock was vacant according to the Survey and Research Center for China Household Finance.  As per the same source, only 11.5% of homebuyers in 2018 were first timers. That compares with 70% of first-time buyers in 2008-2010. In 2018, 22.5% of homebuyers already owned two or more dwellings while 66% owned one. Clearly, housing in China has become an object of speculation which has made it unattainable for first-time homebuyers. Chart 3Property Developers Have Accumulated Massive Assets Property Developers Have Accumulated Massive Assets Property Developers Have Accumulated Massive Assets 3. Speculation and the carry trade: There is nothing wrong with individuals investing in real estate. This practice is widespread all around the world. However, contrary to many other countries, multiple home owners in China do not rent out their properties, but instead keep their houses vacant. For those few owners who rent their houses, the current rental yield on properties rarely exceeds 2%. Given that the mortgage rate is currently 5.4%, the carry costs for individual investors is negative. Therefore, property investors in China can only expect to profit from ever rising prices. This strategy has paid off enormously over the last 20 years. Yet, past performance does not guarantee future gains. A stampede into real estate since 2009 has made housing extremely expensive and has instigated socio-political problems that have made Beijing wary. Critically, property speculation has been prevalent not only among households but also among property developers. The latter have been participating in the largest carry trade of the past 12 years. Facing borrowing costs that were lower than the pace of house price appreciation, property developers in China have done what any business would do: they borrowed as much as they could and accumulated real estate assets in the form of land, incomplete construction as well as completed but unsold properties. Chart 4Property Developers Are Very Leveraged Property Developers Are Very Leveraged Property Developers Are Very Leveraged As long as the rate of annual asset price appreciation exceeds the borrowing costs (the carry), carrying these assets on a balance sheet produces lofty profits. The top panel of Chart 3 demonstrates that housing starts have chronically exceeded completions, i.e., developers have been starting but not completing/delivering properties. The gap between starts and completions – unfinished construction – has ballooned (Chart 3, bottom panel). In short, property developers have been holding on to a lot of land and unfinished construction and have been financing it via debt. The asset-to-equity ratio for property developers trading on the A-share market has surged to 9 (Chart 4).  Overall, the primary reason for real estate asset accumulation in China by individuals and companies has been expectations of continuous price appreciation. When an investor purchases an asset that generates little or no recurrent cash flow and the only rationale for holding onto it is expectations for continuous price appreciation, it qualifies as speculation – not investment. This speculation can continue only as long as there is demand from new buyers. Bottom Line: The property market is suffering from numerous excesses such as extreme overvaluation, capital misallocation and widespread speculative activities. Clouds Are Forming Over Real Estate Odds are that the speculative fever that has held the Chinese housing market in its grip is waning. Chart 5Less Funding = Less Completions = Less Commodity Demand Less Funding = Less Completions = Less Commodity Demand Less Funding = Less Completions = Less Commodity Demand First, the three red lines introduced by authorities a year ago limit property developers’ ability to take on more debt. In fact, many property developers are being forced to reduce their indebtedness to meet these regulatory requirements. These rules mean that property developers will have to reduce new construction at best or sell their assets at worst. When many developers try to offload their assets simultaneously, asset prices will deflate, producing a vicious debt deflation cycle. Second, the reluctance of authorities to bail out large property developers – which are struggling to service their debt – is sending a clear message to both onshore and offshore creditors not to lend to property developers. This is especially true for small and medium banks, trust companies, wealth management products and onshore and offshore bondholders. These lenders along with pre-sales account for the lion’s share of financing options for property developers. Chart 5 illustrates that diminishing funding for property developers weighs down on completion, i.e., less construction work and less demand for raw materials and machinery (Chart 5, bottom panel). Third, the property carry trade does not make sense when the rate of real estate asset price appreciation drops below property developers’ borrowing costs. A negative carry means incurring losses, necessitating the sale of assets, including land and completed properties. A rush to offload assets amid a buyer strike could prompt classic debt deflation. Chart 6Households’ House Buying Intentions Have Plummeted Households' House Buying Intentions Have Plummeted Households' House Buying Intentions Have Plummeted Finally, the upcoming pilot program for a real estate tax and a broader public campaign by Beijing against buying houses as an investment has discouraged individuals from purchasing properties. The proportion of households planning to buy a house has dropped to only 7.7% in Q3 2021 from 11.6% in Q4 2020 (Chart 6). House sales contracted by 16% in September from a year ago and initial reports point to further deterioration in October.     Bottom Line: Central authorities in China are attempting to tackle the property market because they reckon that an expensive and speculative property market could either create socio-political problems down the road or get out of control and crumble of its own accord. Beijing’s objective is to achieve a soft landing by acting preemptively and managing it.  The Role Of Policy Why is Beijing obsessed with taming the property market? We suspect the current hawkish stance is due to the following: Chart 7Housing Prices Correlate With Starts Housing Prices Correlate With Starts Housing Prices Correlate With Starts Housing is becoming unaffordable for low- and some middle-income residents in China. This may give rise to a sense of injustice/inequality and goes against president Xi’s common prosperity goals. This is also negatively affecting family formation and demographics and, ultimately, the nation’s potential growth rate. Beijing believes that the 2019 protests in Hong Kong were to a certain extent due to housing unaffordability. The latter fanned young people’s rage toward authorities and the political system. The Communist party leadership wants to avoid a similar uprising in the mainland. Anytime policymakers have stimulated in the past 12 years, property prices have surged widening the gap between the poor and the rich and making housing even more unaffordable. Presently, they are reluctant to do the same. Also, authorities are clamping down on property developers because historically there was a strong positive correlation between property starts and house prices (Chart 7). The basis for this positive correlation is that whenever property developers start new projects, they raise expectations of higher future prices via aggressive marketing. As a result, people become more inclined to buy houses. In fact, over the years more supply has not precluded property prices from surging and vice versa, as shown in Chart 7. Finally, the central government has learned from its own experience in 2015 and from the US case in 2008 that when a bubble bursts, it is difficult to stop it. Chinese economic policymakers prefer to be proactive than reactive. All of the above does not mean that authorities are planning to instigate a property market crash and will stand by and not stimulate. If and when broad economic conditions deteriorate to the point that income growth and employment are jeopardized, authorities will rachet up their stimulus. Presently, the unemployment rate for the 25-59 age group is very low and the urban labor market is tight (Chart 8). In addition, the nation’s exports are booming, so it is a good time to undertake some deleveraging. In brief, there is now no urgency to stimulate aggressively. Bottom Line: Considering the size of the real estate market and how dire its fundamentals are, we expect economic conditions to get much worse in China. That will ultimately force policymakers to stimulate more aggressively. The End Of The Property Carry Trade Conditions have fallen into place for the property carry trade by developers to unravel: Faced with limited access to funding, a diminished willingness on the part of creditors to rollover their debt as well as plummeting home sales, property developers have already dramatically cut back on land purchases (Chart 9, top panel). Chart 8China's Labor Market Is Strong China's Labor Market Is Strong China's Labor Market Is Strong Chart 9China's Construction Cycle In Perspective China's Construction Cycle In Perspective China's Construction Cycle In Perspective   However, they have so far been completing and delivering pre-sold homes to buyers who had paid in advance. In the last couple of years 90% of homes have been pre-sold. Hence, these completions do not generate new cash inflows for real estate developers. Yet, this completion work has supported construction activity and demand for materials over the past 12 months (Chart 9, bottom panel). Looking forward, reduced funding entails shrinking completions with negative ramifications for the economy (Chart 5 above). Real estate deflation, lack of new sales and restricted financing could turn property developers’ liquidity troubles into a solvency issue. This is how typical financial/credit crises develop – they start with liquidity strains and then turn into solvency problems as the value of collaterals drop, becoming insufficient to cover debt obligation. Defaults ensue. Property development is an extremely fragmented industry in China. There are officially around 100 000 property developers in China. Even the largest ones like Evergrande have a very small share of the market. Therefore, authorities cannot ensure that the sector will function properly by ring fencing or bailing out several large developers. In sum, authorities have very little control over real estate construction because it is quite spread out across the country and involves many private small- and medium-sized developers. We think that Beijing’s goal is to achieve flat property prices in the coming years. Authorities realize that property deflation could be devastating but are also less tolerant of growing excesses and imbalances in this area. Flat home prices and rising incomes will lead to a lower house price-to-income ratio, i.e., will make home ownership more affordable. In short, policymakers are attempting to fix property prices to achive a soft landing. Yet, there is a caveat: when authorities fix/control prices, they lose control of volumes/activity. This will likely be the case in China. Without meaningful drop in house prices, low-and middle-income first-time homebuyers will not become buyers right away and healthy property developers will be unwilling to snap up the assets of their troubled competitors. Hence, the market will not clear and the property sales and construction activity will hit an air pocket. Bottom Line: After more than a decade of speculative excesses, policymakers have embarked on the very difficult task of controlling house prices. They can control house prices via administrative measures. Yet, as expectations of rapidly rising property prices vanish, land sales, home purchases and property construction will likely shrink substantially for a period of time. Investment Recommendations A few market-relevant observations: Chinese non-TMT stocks and China-related plays globally are at risk from shrinking construction activity on the mainland. Critically, EM non-TMT stocks have not priced in the slowdown. Chart 10 illustrates that China’s credit and fiscal spending impulse is back to its previous low, but EM non-TMT stocks have not corrected much. In the past, Chinese onshore property stocks correlated with global material stocks (Chart 11). The basis is that China’s construction accounts for a considerable share of global raw materials consumption. Hence, the bear market in Chinese property stocks is raising a red flag for global material stocks. Chart 10EM Ex-TMT Stocks Are Not Pricing China's Slowdown EM Ex-TMT Stocks Are Not Pricing China's Slowdown EM Ex-TMT Stocks Are Not Pricing China's Slowdown Chart 11A Red Flag For Global Materials A Red Flag For Global Materials A Red Flag For Global Materials   EMs are most vulnerable, and the US is the least exposed to China’s construction and infrastructure investment segments. The basis is that the US is a closed economy and trades very little with China. That is why we believe that the US dollar has more upside and US equities will continue outperforming the global stock index as China’s slowdown persists. Putting it all together, we recommend the following strategies: Avoid EM stocks and underweight EM versus DM in a global equity portfolio. Continue shorting select EM currencies versus the US dollar. Avoid local currency bonds and favor US credit over EM credit markets. Avoid bottom fishing in Chinese offshore corporate bonds, including high-yield ones. As for Chinese equities, investors should stay with the long onshore A shares / short investable index strategy. We also reiterate a strategy we have been recommending for both onshore and offshore stocks since May 9, 2019: short property stocks relative to the benchmark. This has been a very profitable trade. Today, we recommend closing the long position in Chinese insurance stocks given that credit woes will worsen before they improve. One way for global investors to bet on China’s slowdown while hedging the risk of stronger growth in DM is via the following trade: short global materials / long global industrials. Our report from July 30 elaborated the bullish case for global industrials beyond China’s slowdown. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Footnotes 1 See Kenneth S. Rogoff and Yuanchen Yang, "Peak China Housing," National Bureau of Economic Research, August 2020. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

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