Style: Growth / Value

Highlights In this week’s report we update our Chart Pack, updating familiar charts that underscore our strategic themes and cyclical/tactical views. Social unrest in Kazakhstan points to two of our strategic themes: great power struggle and populism/nationalism. A sneak preview of our Black Swan risks for the year: Iran crisis, Russian aggression, and a massive cyber attack. Recent market moves reinforce the BCA House View that investors will rotate out of US growth stocks and into global cyclicals and value plays.  We are sticking with our current tactical and cyclical views and trades. Feature Since releasing our key views for 2022, bond yields have surged, tech shares have sold off, and social unrest has erupted in Central Asia. These developments have both structural and cyclical drivers and are broadly supportive of our investment strategy. First, a brief word about Kazakhstan. The surge in unrest this week is a new and urgent example of one of our strategic themes: populism and nationalism. Long-accumulating Kazakh nationalism is blowing up and forcing the autocratic regime to complete an unfinished political leadership transition that began three years ago. Russia is now forced to intervene militarily to maintain stability in this important satellite state. If instability is prolonged, Russia will be weakened in its high-stakes standoff against the United States and the West over Ukraine. China’s interest in Kazakhstan is also threatened by the change in political orientation there. We will provide a full report on this topic soon but for now the investment implication is to stay short Russian equities. In the rest of this report we offer our newly revised chart book for investors to consider as they gird for a year that promises to be anything but dull. The purpose of the chart book is to update a succinct series of charts that underpin our key themes and views. Many of these charts will be familiar to regular readers but here they are updated with some notable points highlighted in the text. A Waning Pandemic And Global Growth Falling To Trend The Omicron variant of COVID-19 is causing a surge of new cases and hospitalizations around the world, which will weigh on economic activity in the first quarter. However, this variant does not appear to be a game changer. While it is highly contagious, not as many people who go to the hospital end up in the intensive care unit (Chart 1). Chart 1 China is in a difficult predicament that will continue to constrict the global supply side of the economy. Chinese authorities maintain a “zero COVID” policy that emphasizes draconian social restrictions to suppress COVID cases and deaths to minimal levels (Chart 2A). Chart 2 ​​​​​ Chart 2 But Chinese-made vaccines are not as effective as western alternatives, particularly against Omicron, as discussed in our flagship Bank Credit Analyst. Hence China cannot open its economy without risking a disastrous wave of infections. When China shuts down activity, as at the Yantian port last spring, the rest of the world suffers higher costs for goods (Chart 2B). Chart 3Global Growth Will Fall Back To Trend Global Growth Will Fall Back To Trend Global Growth Will Fall Back To Trend Global economic growth is decelerating from the peaks of the extreme rebound (Chart 3). The historic fiscal stimulus of 2020 (Chart 4A) is giving way to negative fiscal thrust, or a decline in budget deficits, that will take away from growth (Chart 4B). Chart 4 Chart 4 Chart 5Inflation Will Moderate But Remain A Long-Term Risk Inflation Will Moderate But Remain A Long-Term Risk Inflation Will Moderate But Remain A Long-Term Risk Yet a recession is not the likeliest scenario since growth is expected to stabilize given the resumption of activity across the world due to an improved ability to live with the virus. The Federal Reserve is considering hiking interest rates faster than the market had expected given that the unemployment rate is collapsing and core inflation is surging. The persistence of the pandemic’s supply disruptions adds to concerns. At the same time, a wage-price spiral is not yet taking shape, as our bond strategist Ryan Swift shows. Productivity is growing faster than real wages and long-term inflation expectations remain within reasonable ranges, at least for now (Chart 5). Three Strategic Themes In our annual outlook (“2022 Key Views: The Gathering Storm”)  we revised our long-term mega themes: 1. Great Power Struggle The US’s relative decline as a share of global geopolitical power, despite a brief respite last year, is indicated in Charts 6-8. Chart 6 Chart 7 ​​​​​ Chart 7 ​​​​​ Chart 8America's Global Role Persists (If Lessened) America's Global Role Persists (If Lessened) America's Global Role Persists (If Lessened) 2. Hypo-Globalization An ongoing globalization process, yet one that falls short of potential, is shown in Charts 9-10. A tentative improvement in our multi-century globalization chart is misleading – it is due to lack of data reporting by several countries, which artificially suppresses the denominator.  Chart 9Hypo-Globalization And Hegemonic Instability Hypo-Globalization And Hegemonic Instability Hypo-Globalization And Hegemonic Instability Chart 10AFrom 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization While trade sharply rebounded from the pandemic, the global policy setting is now averse to ever-deeper dependency on international trade. Chart 10BFrom 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization ​​​​​ 3. Populism and Nationalism The post-pandemic cycle will see these structural trends reaffirmed. Charts 11-12 shows a rising Misery Index, or sum of unemployment and inflation, a source of political turmoil that will both reflect and feed these trends. Chart 11Misery Indexes Signal More Unrest, Populism, And Nationalism Misery Indexes Signal More Unrest, Populism, And Nationalism Misery Indexes Signal More Unrest, Populism, And Nationalism ​​​​​​ Chart 12EM Populism/Nationalism Threatens Negative Surprises In 2022 EM Populism/Nationalism Threatens Negative Surprises In 2022 EM Populism/Nationalism Threatens Negative Surprises In 2022 ​​​​​ Chart 12 highlights major markets that have local or nationwide elections in 2022-23, where policy fluctuations are already occurring with various investment implications. We are tactically bullish on South Korea and Brazil, strategically but not tactically bullish on India, and bearish on Turkey. Russia’s domestic sociopolitical problems are not all that different from Kazakhstan’s and its response may be outwardly aggressive, so we are bearish. Three Key Views For 2022 Our annual outlook also outlined three key views for this year: 1. China’s Reversion To Autocracy The government will ease policy to secure the economic recovery so that President Xi Jinping can clinch his personal rule for at a critical Communist Party personnel reshuffle this fall (Chart 13). Chart 13China Will Easy Policy Ahead Of Political Reversion To Autocracy China Will Easy Policy Ahead Of Political Reversion To Autocracy China Will Easy Policy Ahead Of Political Reversion To Autocracy A stabilization of Chinese demand in 2022 will be positive for commodities, cyclical equity sectors, and emerging markets. Chart 14 ​​​​​​ Chart 14 Policy easing will not lead to a sustainable rally in Chinese equities, as internal and external political risks remain high (Charts 14A & 14B). A “fourth Taiwan Strait Crisis”  is likely in the short run while a military conflict is not unlikely over the long run. ​​​​​​​​​​​​​​2. America’s Policy Insularity The Biden administration is focused on domestic legislation and the midterm elections, due November 8, 2022. Biden’s approval rating has deteriorated further, putting the Democrats in line for a loss of around 40 seats in the House and four seats in the Senate, judging by historic patterns (Chart 15). But our sense is that the Senate is still in play – Democrats probably will not lose four Senate seats – but they are likely to lose control of both chambers as things stand. Chart 15 However, the Democrats still have a subjective 65% chance of passing a partisan budget reconciliation bill, which would be a badly needed victory. The “Build Back Better” plan would include a minimum corporate tax and various social programs. Another round of fiscal reflation would reinforce the Federal Reserve’s less dovish pivot. Chart 16US Still At Peak Polarization US Still At Peak Polarization US Still At Peak Polarization Polarization will remain at historic peaks leading up to the election, as the Democrats will need “wedge issues” to drive enthusiasm among their popular base in the face of Republican enthusiasm. For decades polarization has correlated with falling Treasury yields and US tech sector equity outperformance (Chart 16). Midterm election years tend to see flat equity performance and falling yields, albeit with yields higher when a single party controls government, as is the case this year. 3. Petro-State Leverage Globally, commodity markets continue to tighten on the supply side. Our Commodity & Energy Strategist Bob Ryan outlines the situation admirably: The supply side is tightening in oil markets, where OPEC 2.0 producers have been unable to restore output under their agreement to return 400,000 barrels per day each month since August 2021. It is true in base metals, where the energy crisis in Europe and Asia are constricting supplies, particularly in copper. And it is true in agricultural commodities, where high natural gas prices are driving fertilizer prices higher, which will push food prices up this year. Demand for these commodities will increase as Omicron becomes the dominant COVID-19 strain, keeping consumption above production, particularly in oil. These are long-term trends. Oil and natural gas markets will probably remain tight throughout the decade, as will base metal markets. This is going to put enormous stress on the global energy transition to renewable energy over the next 10 years. The ascendance of left-of-center political parties in critical base-metal exporting states, and rising ESG initiatives, will increase costs for energy and metals producers; and global climate activism in boardrooms and courtrooms will push costs higher as well. Higher prices will be necessary to recover these cost increases. In this context, energy producers gain geopolitical leverage. Their treasuries become flush with cash and they see an opportunity to pursue foreign policy objectives. Conflicts involving oil producers are more likely when oil prices are swinging up (Chart 17). Chart 17 This trend is on display in Russia’s dispute with the West, where Europe is struggling with a surge in natural gas prices due to Russian supply constraints that weaken its resolve in the showdown over Ukraine (Chart 18, top panel). Chart 18Energy Prices: Biden's And Europe's Problem Energy Prices: Biden's And Europe's Problem Energy Prices: Biden's And Europe's Problem ​​​​​ Yet even in the energy-independent US, the Biden administration is wary of pursuing policies against Russia or Iran that would ignite a bigger spike in prices at the pump during an election year (Chart 18, bottom panel). Biden will have to attend to foreign policy this year but will be defensive. Petro-states are not immune to domestic problems, including social unrest. Many of them are poor, unequal, misgoverned, and suffering from inflation. Iran is a prime example. Yet Iran has not collapsed under sanctions so far, the world is recovering, and Tehran has the advantage in its negotiations with the US because it can stage attacks across the Middle East, including the Persian Gulf and Strait of Hormuz. Military incidents could drive oil prices into politically punitive territory. Three Black Swans For 2022 This brings us to three “Black Swans” or low-probability, high-impact events for 2022. We will publish our regular annual report on this year’s black swans soon. For now we offer a sneak preview: 1. Iran Crisis In Middle East The fear of being abandoned by the US has kept Israel from acting unilaterally so far (Chart 19A). Chart 19 ​​​​​​ Chart 19 ​​​​ But an attack is not impossible if Iran reaches “breakout” levels of highly enriched uranium – and the global impact of an attack could be catastrophic (Chart 19B). The news media have been conspicuously quiet about Iran. Taken together, this scenario is pretty much the definition of a black swan. 2. Russian Aggression Abroad There is a 50% chance that Russia will stage a limited re-invasion of Ukraine to secure its control of territory in the east or along the Black Sea coast. Chart 20Black Swan #2: Russian Aggression Abroad Black Swan #2: Russian Aggression Abroad Black Swan #2: Russian Aggression Abroad Within this risk, there is a small chance (less than 5%) that Russia would invade all of Ukraine. We do not expect this and neither do other analysts. The total conquest of Ukraine is unlikely when Russia’s domestic conditions are weak and it faces so much unrest in other parts of its sphere of influence (including Belarus and Kazakhstan). As we go to press, Russia is staging a military intervention in Kazakhstan, which could expand. Kazakhstan could create a way for Russia to avoid its self-induced pressure to take military action against Ukraine. But most likely Russia and Kazakhstan will quell the unrest, enabling Russia to sustain the threat of a partial re-invasion of Ukraine. Putin’s low approval rating often triggers new foreign adventures and financial markets are pricing higher risks (Chart 20). 3. Massive Cyber Attack Amid the pandemic and inflation surge, investors have forgotten about the huge risks facing businesses and individuals from their extreme dependency on remote work and digital services. A cyber war is also raging behind the scenes. So far it has not spilled into the physical realm. Yet Russia-based ransomware attacks in 2021 showed that vital US infrastructure is vulnerable. Cyber stocks have topped out amid the recent tech selloff (Chart 21A). But the global average cost of data breaches is skyrocketing. Governments are devoting more resources to network security and cyber-security (Chart 21B), which should be positive for earnings. Chart 21ABlack Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack ​​​​​ Chart 21BBlack Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack ​​​​​ Investment Takeaways The revised Geopolitical Risk Index does not show as pronounced of an uptrend as the version published last year but it is still higher than in the late 1990s (Chart 22). Our reading of all available evidence points to rising geopolitical risk – at least until the current challenge to US global supremacy leads to a new equilibrium. Chart 22 Global policy uncertainty is also rising on a secular basis and maintaining its correlation with the trade-weighted dollar, which has rebounded despite the global growth recovery and rise in inflation (Chart 23). We remain neutral on the dollar. Chart 23A Secular Rise In Global Uncertainty A Secular Rise In Global Uncertainty A Secular Rise In Global Uncertainty Gold has fallen from its peaks during the onset of the pandemic and real rates suggest it will fall further. But we hold it as a hedge against geopolitical risk as well as inflation (Chart 24). Chart 24Stay Long Gold As Hedge Against Geopolitical Crisis As Well As Inflation Stay Long Gold As Hedge Against Geopolitical Crisis As Well As Inflation Stay Long Gold As Hedge Against Geopolitical Crisis As Well As Inflation The evidence is inconclusive about whether global investors will rotate away from US assets this year. The US share of global equity capitalization is stretched. Long-dated Treasuries will eventually reflect higher inflation expectations (Chart 25). Chart 25No Substitute For The USA Yet No Substitute For The USA Yet No Substitute For The USA Yet ​​​​​ Chart 26Waiting For Rotation Waiting For Rotation Waiting For Rotation ​​​​​ US equity outperformance continues unabated and emerging market equities are still underperforming their developed peers (Chart 26). Cyclically investors should take the opposite side of these trends but not tactically. The renminbi is tentatively peaking against both the dollar and euro. As expected, China’s policymakers are shifting toward preserving economic stability (Chart 27). Stabilization may require a weaker renminbi, though producer price inflation is also a factor for the People’s Bank to consider. Chart 27Strategically Short Renminbi And Taiwanese Dollar Strategically Short Renminbi And Taiwanese Dollar Strategically Short Renminbi And Taiwanese Dollar Taiwanese stocks continue to outperform Korean stocks (to our chagrin) but they have not broken above previous peaks relative to global equities. Nor has the Taiwanese dollar broken above previous peaks versus the greenback (Chart 28). So far Taiwan has avoided the fate of semiconductor stocks, which have sold off. This situation presents a buying opportunity for semi stocks but we remain short Taiwan as a bourse because it is central to US-China strategic conflict. Chart 28Strategically Short Taiwan Strategically Short Taiwan Strategically Short Taiwan ​​​​​​ Chart 29Strategically Short Russia And EM Europe Strategically Short Russia And EM Europe Strategically Short Russia And EM Europe ​​​​​​ Chart 30Safe Havens Look Attractive Safe Havens Look Attractive Safe Havens Look Attractive Russia and eastern European assets continue to underperform developed market peers as geopolitical risks mount across the former Soviet Union (Chart 29). Russia’s negotiations with the US, NATO, and the EU in January will help us to gauge whether tensions will break out to new highs. Assuming Russia succeeds in quashing Kazakh unrest, it will be necessary for the US to offer concessions to Russia to prevent the Ukraine showdown from worsening Europe’s energy crisis. Safe havens caught a bid in early 2021 and have not yet broken down. Our geopolitical views support building up safe-haven positions (Chart 30). Presumably one should favor global cyclical equities as the pandemic wanes and global growth stabilizes. But cyclicals are struggling to outperform defensives (Chart 31A). Chart 31AFavor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization ​​​​​ Chart 31BFavor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization ​​​​​ ​​​​​​​China’s policy easing is positive in this regard, although the new wave of fiscal-and-credit support is only just beginning and financial markets will remain skeptical until the dovish policy pivot is borne out in hard data (Chart 31B). Global value stocks have ticked up again versus growth stocks, suggesting that the choppy process of bottom formation continues (Charts 32A & 32B). Chart 32AValue’s Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks ​​​​​​ Chart 32BValue’s Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks ​​​​​     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Highlights Global equities are poised to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Non-US markets are likely to outperform. We examine the four pillars that have historically underpinned stock market performance. Pillar 1: Technically, the outlook for equities is modestly bullish, as investor sentiment is nowhere near as optimistic as it usually gets near market tops. Pillar 2: The outlook for economic growth and corporate earnings is modestly bullish as well. While global growth is slowing, it will remain solidly above trend in 2022. Pillar 3: Monetary and financial conditions are neutral. The Fed and a number of other central banks are set to raise rates and begin unwinding asset purchases this year. However, monetary policy will remain highly accommodative well into 2023. Pillar 4: Valuations are bearish in the US and neutral elsewhere. Investors should avoid tech stocks in 2022, focusing instead on banks and deep cyclicals, which are more attractively priced. The Bedrock For Equities In assessing the outlook for the stock market, our research has focused on four pillars: 1) Sentiment and other technical factors, which are most pertinent for stocks over short-term horizons of about three months; 2) cyclical fluctuations in economic growth and corporate earnings, which tend to dictate the path for stocks over medium-term horizons of about 12 months; 3) monetary and financial conditions, which are also most relevant over medium-term horizons; and finally 4) valuations, which tend to drive stocks over the long run. In this report, we examine all four pillars, concluding that global equities are likely to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Pillar 1: Sentiment And Other Technical Factors (Modestly Bullish)   Chart 1US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern Scaling The Wall Of Worry Stocks started the year on a high note, before tumbling on Wednesday following the release of the Fed minutes. Market breadth going into the year was quite poor. Even as the S&P 500 hit a record high on Tuesday, only 57% of NYSE stocks and 38% of NASDAQ stocks were trading above their 200-day moving averages compared to over 90% at the start of 2021 (Chart 1). The US stock market had become increasingly supported by a handful of mega-cap tech stocks, a potentially dangerous situation in an environment where bond yields are rising and stay-at-home restrictions are apt to ease (more on this later). That said, market tops often occur when sentiment reaches euphoric levels. That was not the case going into 2022 and it is certainly not the case after this week's sell-off. The number of bears exceeded the number of bulls in the AAII survey this week and in six of the past seven weeks (Chart 2). The share of financial advisors registering a bullish bias declined by 25 percentage points over the course of 2021 in the Investors Intelligence poll. Option pricing is far from complacent. The VIX stands at 19.6, above its post-GFC median of 16.7.  According to the Minneapolis Fed’s market-based probabilities model, the market was discounting a slightly negative 12-month return for the S&P 500 as of end-2021, with a 3.6 percentage-point larger chance of a 20% decline in the index than a 20% increase (Chart 3). Chart 3Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Chart 2Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Equities do best when sentiment is bearish but improving (Chart 4). With bulls in short supply, stocks can continue to climb the proverbial wall of worry.   Whither The January Effect? Historically, stocks have fared better between October and April than between May and September (Chart 5). One caveat is that the January effect, which often saw stocks rally at the start of the year, has disappeared. In fact, the S&P 500 has fallen in January by an average annualized rate of 5.2% since 2000 (Table 1). Other less well-known calendar effects – such as the tendency for stocks to underperform on Mondays but outperform on the first trading day of each month – have persisted, however. Chart 4 Chart 5 Table 1Calendar Effects The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Bottom Line: January trading may be choppy, but stocks should rise over the next few months as more bears join the bullish camp. Last year’s losers are likely to outperform last year’s winners. Pillar 2: Economic Growth And Corporate Earnings (Modestly Bullish)   Economic Growth And Earnings: Joined At The Hip The business cycle is the most important driver of stocks over medium-term horizons of about 12 months. The reason is evident in Chart 6: Corporate earnings tend to track key business cycle indicators such as the ISM manufacturing index, industrial production, business sales, and global trade. Chart 6The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons Chart 7PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth Global growth peaked in 2021 but should stay solidly above trend in 2022. Both the service and manufacturing PMIs remain in expansionary territory (Chart 7). The forward-looking new orders component of the ISM exceeded 60 for the second straight month in December. The Bloomberg consensus is for real GDP to rise by 3.9% in the G7 in 2022, well above the OECD’s estimate of trend G7 growth of 1.4% (Chart 8). Global earnings are expected to increase by 7.1%, rising 7.5% in the US and 6.7% abroad (Chart 9). Our sense is that both economic growth and earnings will surprise to the upside in 2022. Chart 9Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Chart 8 Plenty Of Pent-Up Demand For Both Consumer And Capital Goods US households are sitting on $2.3 trillion in excess savings (Chart 10). Around half of these savings will be spent over the next few years, helping to drive demand. Households in the other major advanced economies have also buttressed their balance sheets. Chart 10Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand After two decades of subdued corporate investment, capital goods orders have soared. This bodes well for capex in 2022. Inventories remain at rock-bottom levels, which implies that output will need to exceed spending for the foreseeable future (Chart 11). On the residential housing side, both the US homeowner vacancy rate and the inventory of homes for sale are near multi-decade lows. Building permits are 11% above pre-pandemic levels (Chart 12). Chart 11Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Chart 12Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Chart 13China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed Chinese Growth To Rebound, Europe To Benefit From Lower Natural Gas Prices Chinese credit growth decelerated last year. However, the 6-month credit impulse has bottomed, and the 12-month impulse is sure to follow (Chart 13). Chinese coal prices have collapsed following the government’s decision to instruct 170 mines to expand capacity (Chart 14). China generates 63% of its electricity from coal. Lower energy prices and increased stimulus should support Chinese industrial activity in 2022. Like China, Europe will benefit from lower energy costs. Natural gas prices have fallen by nearly 50% from their peak on December 21st. A shrinking energy bill will support the euro (Chart 15). Chart 14Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Chart 15A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro Chart 16 Omicron Or Omicold? While the Omicron wave has led to an unprecedented spike in new cases across many countries, the economic fallout will be limited. The new variant is more contagious but significantly less lethal than previous ones. In South Africa, it blew through the population without triggering a major increase in mortality (Chart 16). Preliminary data suggest that exposure to Omicron confers at least partial immunity against Delta. The general tendency is for viral strains to become less lethal over time. After all, a virus that kills its host also kills itself. Given that Omicron is crowding out more dangerous strains such as Delta, any future variant is likely to emanate from Omicron; and odds are this new variant will be even milder than Omicron. Meanwhile, new antiviral drugs are starting to hit the market. Pfizer claims that its new drug, Paxlovid, cuts the risk of hospitalization by almost 90% if taken within five days from the onset of symptoms. Bottom Line: While global growth has peaked and the pandemic remains a risk, growth should stay well above trend in the major economies in 2022, fueling further gains in corporate earnings and equity prices.   Pillar 3: Monetary And Financial Factors (Neutral)   Chart 17The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months Tighter But Not Tight Monetary and financial factors help govern the direction of equity prices both because they influence economic growth and also because they affect the earnings multiple at which stocks trade. There is little doubt that a number of central banks, including the Federal Reserve, are looking to dial back monetary stimulus. However, there is a big difference between tighter monetary policy and tight policy. Even if the FOMC were to raise rates three times in 2022, as the market is currently discounting, the fed funds rate would still be half of what it was on the eve of the pandemic (Chart 17). Likewise, even if the Fed were to allow maturing assets to run off in the middle of this year, as the minutes of the December FOMC meeting suggest is likely, the size of the Fed’s balance sheet will probably not return to pre-pandemic levels until the second half of this decade.   A Higher Neutral Rate We have argued in the past that the neutral rate of interest in the US is higher than widely believed. This implies that the overall stance of monetary policy remains exceptionally stimulative. Historically, stocks have shrugged off rising bond yields, as long as yields did not increase to prohibitively high levels (Table 2). Table 2As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market If the neutral rate ends up being higher than the Fed supposes, the danger is that monetary policy will stay too loose for too long. The question is one of timing. The good news is that inflation should recede in the US in 2022, as supply-chain bottlenecks ease and spending shifts back from goods to services. The bad news is that the respite from inflation will not last. As discussed in Section II of our recently-published 2022 Strategy Outlook, inflation will resume its upward trajectory in mid-2023 on the back of a tightening labor market and a budding price-wage spiral. This second inflationary wave could force the Fed to turn much more aggressive, spelling the end of the equity bull market. Bottom Line: While the Fed is gearing up to raise rates and trim the size of its balance sheet, monetary policy in the US and in other major economies will remain highly accommodative in 2022. US policy could turn more restrictive in 2023 as a second wave of inflation forces a more aggressive response from the Fed.   Pillar 4: Valuations (Bearish In The US; Neutral Elsewhere)   US Stocks Are Looking Pricey… While valuations are a poor timing tool in the short run, they are an excellent forecaster of stock prices in the long run. Chart 18 shows that the Shiller PE ratio has reliably predicted the 10-year return on equities. Today, the Shiller PE is consistent with total real returns of close to zero over the next decade. Chart 18 Investors’ allocation to stocks has also predicted the direction of equity prices (Chart 19). According to the Federal Reserve, US households held a record high 41% of their financial assets in equities as of the third quarter of 2021. If history is any guide, this would also correspond to near-zero long-term returns on stocks. Chart 19Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II)   … But There Is More Value Abroad Valuations outside the US are more reasonable. Whereas US stocks trade at a Shiller PE ratio of 37, non-US stocks trade at 20-times their 10-year average earnings. Other valuation measures such as price-to-book, price-to-sales, and dividend yield tell a similar story (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) Cyclicals And Banks Overrepresented Abroad Our preferred sector skew for 2022 favors non-US equities. Increased capital spending in developed economies and incremental Chinese stimulus should boost industrial stocks and other deep cyclicals, which are overrepresented outside the US (Table 3). Banks are also heavily weighted in overseas markets; they should also do well in response to faster-than-expected growth and rising bond yields (Chart 21). Table 3Deep Cyclicals And Financials Are Overrepresented Outside The US The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Chart 21Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Bottom Line: Valuations are more appealing outside the US, and with deep cyclicals and banks set to outperform tech over the coming months, overseas markets are the place to be in 2022. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Highlights Demand in the major economies remains well below its pre-pandemic trend. Meaning that relative to potential output, demand is lukewarm, at best. Inflation is hot, not because of strong overall demand, but because of the surging demand for goods. If the spending on goods cools, then inflation will also cool. We expect this ‘good’ resolution of inflation to unfold, because there are only so many goods that any person can buy. Underweight personal goods versus consumer services. Bond yields have the scope to rise by just 50-100 bps before pulling the bottom out of the $300 trillion global real estate market and the $100 trillion global equity market. Long-term investors should continue to own US T-bonds and focus their equity investments in long-duration (growth) stocks, sectors, and stock markets… …because the ultimate low in bond yields is yet to come. Feature Chart of the WeekWill Bond Yields Stay Chilled With Inflation So Hot? Will Bond Yields Stay Chilled With Inflation So Hot? Will Bond Yields Stay Chilled With Inflation So Hot? 2022 begins with an investment conundrum. Why have long bond yields been so chilled when inflation is running so hot? (Chart I-1) While US and UK inflation have ripped to 6.9 percent and 5.1 percent respectively, the 30-year T-bond yield and 30-year gilt yield remain a relative oasis of calm – standing at 2.1 percent and 1.2 percent respectively. 10-year yields have also stayed relatively calm. Moreover, as long-duration bonds set the valuations of long-duration stocks, a calm bond market has meant a calm stock market. What can explain this apparent conundrum of chilled yields in the face of the hottest inflation in a generation? Long Bond Yields Are Tracking Demand, Not Inflation Chart I-2 answers the conundrum. The long bond yield is taking its cue not from hot inflation, but from economic demand, which is far from overheating. Quite the contrary, US real GDP and consumption are struggling to reach their pre-pandemic trends. Meanwhile, UK real GDP languishes 5 percent below its pre-pandemic trend (Chart I-3), and other major economies tell similar stories. Chart I-2Long Bond Yields Are Tracking Demand Long Bond Yields Are Tracking Demand Long Bond Yields Are Tracking Demand Chart I-3Demand Is Lukewarm, At Best Demand Is Lukewarm, At Best Demand Is Lukewarm, At Best Some people mistake the strong economic growth in recent quarters for overheating demand. In fact, this robust growth is just the natural snap-back after the pandemic induced collapse in early-2020. Meaning that the strong growth is unsustainable, just as the bounce that a ball experiences after a big drop is unsustainable. Demand in the major economies remains well below its pre-pandemic trend. To repeat, demand in the major economies remains well below its pre-pandemic trend. As this pre-pandemic trend is a good gauge of potential output, economic demand is lukewarm, at best. And this explains why long bond yields have remained chilled. Inflation Is Tracking The Displacement Of Demand Yet solving the first conundrum simply raises a second conundrum. If overall demand is lukewarm, then why is inflation so hot? (Chart I-4). The answer is that inflation is being fuelled by the displacement of demand into goods from services (Chart I-5). Chart I-4Hot Inflation Is Not Reflecting Lukewarm Overall Demand Hot Inflation Is Not Reflecting Lukewarm Overall Demand Hot Inflation Is Not Reflecting Lukewarm Overall Demand Chart I-5Hot Inflation Is Reflecting The Hot Demand For Goods Hot Inflation Is Reflecting The Hot Demand For Goods Hot Inflation Is Reflecting The Hot Demand For Goods If a dollar spent on goods is displaced from a dollar spent on services, then overall demand will be unchanged. However, what happens to the overall price level depends on the relative price elasticities of demand for goods and services. If the price elasticities are the same, then overall prices will also be unchanged, because a higher price for goods will be exactly countered by a lower price for services. But if the price elasticities are very different, then overall prices can rise sharply because the higher price for goods will dominate overall inflation. All of which solves our second conundrum. Spending on services that require close contact with strangers – using public transport, going to the dentist, cinema, or recreational activities that involve crowds – are suffering severe shortfalls compared to pre-pandemic times. Some people say that this is due to supply shortages, yet the trains and buses are running empty and there is no shortage of dentists, cinema seats, or even (English) Premier League tickets. Indeed, the Premier League team that I support (which I will not name) has been sending me begging emails to attend matches! Surging inflation is no longer a reliable reflection of overall demand. If somebody doesn’t use public transport, or go to the cinema or crowded events because he is worried about the health risk, then lowering the price will not lure that person back. In fact, the person might interpret the lower price as a signal of greater risk, and might become more averse. In other words, the price elasticity of demand for certain services has flipped from its usual negative to zero, or even positive.   This creates a major problem for central banks, because if the price elasticity of services demand has changed, then surging inflation is no longer a reliable reflection of overall demand, which remains below its potential. Instead, surging inflation is largely reflecting the surging demand for goods. Two Ways That Inflation Can Resolve: One Good, One Bad It follows that if the spending on goods cools, then inflation will also cool. We expect this ‘good’ resolution of inflation to unfold, because there are only so many goods that any person can buy. Durables, by their very definition, last a long time. Even clothes and shoes, though classified as nondurables, are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can own before reaching saturation. We recommend that equity investors play this inevitable normalisation by underweighting personal goods versus consumer services. Still, the resolution of inflation could also take a ‘bad’ form. If inflation persisted, then bond yields could lose their chill as they flipped their focus from lukewarm demand to hot inflation. Given that long-duration bonds set the valuations of long-duration stocks, and given that stock valuations are already stretched versus bonds, this would quickly inflict pain on stock investors (Chart I-6). Chart I-6The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits More significantly, it would also quickly inflict pain on the all-important real estate market. Through the past ten years, world prime residential prices are up by 70 percent while rents are up by just 25 percent1 (Chart I-7). Meaning that the bulk of the increase in global real estate prices is due to skyrocketing valuations. The culprit is the structural collapse in global bond yields (Chart I-8). Chart I-7The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion… The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion... The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion... Chart I-8…And The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields ...And The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields ...And The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields This means that bond yields have the scope to rise by just 50-100 bps before pulling the bottom out of the $300 trillion global real estate market. Given that this dwarfs the $90 trillion global economy, the massive deflationary backlash would annihilate any lingering inflation. Some people counter that in an inflationary shock, stocks and property – as the ultimate real assets – ought to perform well even as bond yields rise. However, when valuations start off stretched as now, the initial intense headwind from deflating valuations would obliterate the tailwind from inflating incomes. The scope for higher bond yields is limited by the fragility of stock market and real estate valuations. With the scope for higher yields limited by the fragility of stock market and real estate valuations, and with the ultimate low in yields yet to come, long-term investors should continue to own US T-bonds. And they should focus their equity investments in long-duration (growth) stocks, sectors, and stock markets. Fractal Trading Update Owing to the holidays, we are waiting until next week to initiate new trades. We will also add a new feature – a ‘watch list’ of investments that are approaching potential turning points, but are not yet at peak fragility. We believe that this enhancement will help to prepare future trades. Stay tuned.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Based on Savills Prime Index: World Cities – Capital Values, and World Cities – Rents and Yields, June 2011 through June 2021. Fractal Trading System Fractal Trades Image 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations ​​​​

Dear Client, Thank you for your continued readership and support this year. This is the last European Investment Strategy report for 2021. In this piece, we review ten charts covering important aspects of the European economy and capital markets. We will resume our regular publishing schedule on January 10th, 2022. The European Investment Strategy team wishes you and your loved ones a wonderful holiday season, and a healthy, happy, and prosperous new year. Best regards, Mathieu Savary   Highlights European growth continues to face headwinds as it enters 2022. The ECB will be slow to remove more accommodation than what is implied by the end of the PEPP. Value stocks and Italian equities will enjoy a modest tailwind from rising Bund yields. The lower quality of European stocks creates a long-term headwind versus US benchmarks. The outperformance of European cyclicals relative to defensives will resume and financials will have greater upside. The relative performance of small-cap stocks will soon stabilize, but a weak euro will create a near-term risk. President Emmanuel Macron’s real contender is the center-right candidate Valerie Pécresse, not populists. Feature Chart 1: Wave Dynamics The current wave of COVID-19 infections continues to surge in Europe. As Chart 1 highlights, Austria and the Netherlands just witnessed intense waves that eclipsed those experienced earlier this year. However, these waves are already ebbing because of the containment measures implemented in recent weeks. In these two severely hit nations, hospitalization rates also increased significantly; however, they did not reach the degree experienced in France or the UK in the first half of 2021 (Chart 1, right panel). Chart 1Wave Dynamics Wave Dynamics I Wave Dynamics I Chart 1Wave Dynamics Wave Dynamics II Wave Dynamics II Europe will experience another test in the coming weeks as the highly contagious Omicron variant becomes the dominant COVID-19 strain. However, data from South Africa continues to suggest that this mutation is much less pathogenic than previous variants and will not place as much strain on the healthcare system as potential case counts would indicate. Nonetheless, it is too early to make this prognosis with great confidence. Importantly, even if a small proportion of infected people is hospitalized, a large enough a pool of infections could cause a rupture in the healthcare system. As a result, politicians will likely remain cautious until a larger share of the population receives its booster dose. Hence, Omicron still represents a near-term risk to economic activity, albeit one that will prove ephemeral. Chart 2: The Economy Is Not Out Of The Woods Yet European growth remains highly dependent on the fluctuations of the global economy because exports and capex account for a large share of the continent’s output. Consequently, global economic trends remain paramount when considering the European economic outlook. In the near-term, Europe continues to face headwinds beyond the uncertainty caused by the potential effects of the Omicron variant. Global economic activity, for instance, is likely to face some further near-term headwinds caused by the supply shock typified by elevated commodity prices and bottlenecks (Chart 2). Not only does this shock limit the ability of producers to procure important inputs, but it also increases the costs of production. Historically, this combination results in downward pressure on global manufacturing activity. Chart 2The Economy Is Not Out Of The Woods Yet The Economy Is Not Out Of The Woods Yet I The Economy Is Not Out Of The Woods Yet I Chart 2The Economy Is Not Out Of The Woods Yet The Economy Is Not Out Of The Woods Yet II The Economy Is Not Out Of The Woods Yet II The second problem remains the deceleration in the Chinese economy. Declining credit growth in China results in slower European exports, which also hurts the region’s PMI. The recent Central Economic Work Conference suggests that China is ready to inject more stimulus in its economy, which will help Europe. However, the beginning of 2022 will still witness the lagged impact of previous tightening in credit conditions on European economic indicators. Moreover, BCA’s China Investment Strategy team expects the stimulus to be modest at first and only grow in intensity later.  It is unlikely to be as credit-heavy as in the past, which also means it will be less beneficial to Europe. Chart 3: A Careful ECB Last week, the European Central Bank aggressively upgraded its inflation forecast for 2022 and announced the end of the PEPP for March, however, it will increase temporarily the APP program to EUR40bn. Moreover, President Christine Lagarde remains steadfast that the Governing Council will not raise rates in 2022. Our Central Bank Monitor points to the need for tighter policy, yet the ECB continues to adopt a cautious tone, even if the Eurozone HICP inflation has reached 4%—the highest reading in thirteen years. First, the ECB still runs the risk of dislocation in the periphery, where Italian and Spanish spreads may easily explode if monetary accommodation is removed too quickly. Second, European inflationary pressures remain significantly narrower than they are in the US (Chart 3, left panel). Our Eurozone trimmed-mean CPI continues to linger well below core CPI readings, while in the US both measures track each other closely. Third, the decline in energy prices and the ebbing transportation bottlenecks mean that odds are growing that sequential inflation will soon experience an interim peak (Chart 3, right panel). Chart 3A Careful ECB A Careful ECB I A Careful ECB I Chart 3A Careful ECB A Careful ECB II A Careful ECB II This view of the ECB implies that German yields will not rise as much as US yields next year, which BCA’s US Bond Strategy team expects to reach 2.25% by the end of 2022. Moreover, the more tepid pace of the removal of accommodation and the implicit targeting of peripheral bond markets also warrant an overweight position in Italian bonds. Spreads will be volatile, but any move upward will be self-limiting because of their role in the ECB’s reaction function. As a result, investors should continue to pocket the additional income over German paper. Chart 4: A Murky Outlook For The Euro The market continues to test EUR/USD. Any breakdown below 1.1175 is likely to prompt a pronounced down leg toward 1.07-1.08, near the pandemic lows. The euro suffers from three handicaps. First, Europe’s economic links with China are greater than those of the US with China. Consequently, the Chinese economic deceleration hurts European rates of returns more than it hurts those in the US. Second, the acceleration of US inflation is inviting investors to reprice the path of the Fed’s policy rate, which accentuates the upside pressure on the dollar. Finally, the energy crisis is ramping up anew following Germany’s suspension of the approval of the Nord Stream 2 pipeline and the buildup of Russian troops on Ukraine’s borders. Surging European natural gas prices act as a powerful headwind for EUR/USD because they accentuate stagflation risks in the Eurozone (Chart 4, left panel). While these create downside pressures on the euro, the picture is more complex. Our Intermediate-Term Timing Model shows that EUR/USD is one-sigma oversold (Chart 4, right panel). Over the past 20 years, it was more depressed only in 2010 and in early 2015. Such a reading indicates that most of the bad news is already embedded in EUR/USD and that sentiment has become massively negative. Thus, we are not chasing the euro lower, even though we will respect our stop-loss at 1.1175 if it were triggered. Instead, we will look to buy the euro at lower levels in the first quarter of 2021. Chart 4A Murky Outlook For The Euro A Murky Outlook For The Euro I A Murky Outlook For The Euro I Chart 4A Murky Outlook For The Euro A Murky Outlook For The Euro II A Murky Outlook For The Euro II Chart 5: German Yields Are Key To Value Stocks And Italian Equities The performance of European value stocks relative to that of growth stocks continues to exhibit a close relationship with the evolution of German Bund yields (Chart 5, left panel). Value stocks are less sensitive than growth stocks to higher yields because they derive a smaller proportion of their intrinsic value from long-term deferred cash flows; which suffer more from rising discount factors than near-term cash flows. Moreover, value stocks overweight financials, whose profitability increases when yields rise. The same relationship exists between the performance of Italian equities relative to the Eurozone benchmark (Chart 5, right panel). This correlation holds because of Italy’s significant value bias and its large exposure to financials. Chart 5German Yields Are Key To Value Stocks And Italian Equities German Yields Are Key To Value Stocks And Italian Equities I German Yields Are Key To Value Stocks And Italian Equities I Chart 5German Yields Are Key To Value Stocks And Italian Equities German Yields Are Key To Value Stocks And Italian Equities II German Yields Are Key To Value Stocks And Italian Equities II Based on these observations, BCA’s view that German Bund yields will rise toward 0.25% is consistent with a modest outperformance of value and Italian equities in 2022. For a more robust outperformance by value and Italian stocks, the Chinese economy will have to re-accelerate clearly and the dollar will have to fall significantly. However, these two outcomes could take more time to materialize than our bond view. Chart 6: Europe’s Quality Deficit The gyrations in the performance of European equities relative to US stocks continue to be influenced by China’s economic fluctuations. The deterioration in various measures of China’s credit impulse remains consistent with further near-term underperformance of European equities (Chart 6, left panel). Moreover, if Omicron has a significant impact on consumer behavior (via personal choices or government measures), it will once again hurt spending on services and boost the appeal of growth stocks, which Europe underrepresents. These headwinds will not be long lasting. Europe has an opportunity to outperform next year if global yields rise. However, European equity markets continue to suffer from a potent long-term disadvantage relative to those of the US. American benchmarks are composed of higher quality stocks than European ones. As a result of greater market concentration, more innovative applications of research, and the development of greater moats, US stocks generate wider profits margins than European companies and have a higher utilization of their asset base. Consequently, US shares sport significantly higher RoEs and earnings growth than European large-cap names (Chart 6, right panel). Historically, the quality factor has been one of the top performers and is an important contributor to the current strength of growth equities. Thus, even if Europe’s day in the sun arrives before the middle of 2022, it will again be a temporary phenomenon. Chart 6Europe’s Quality Deficit Europe's Quality Deficit I Europe's Quality Deficit I Chart 6Europe’s Quality Deficit Europe's Quality Deficit II Europe's Quality Deficit II Chart 7: Will the Cyclicals Outperformance Resume? For most of 2021, European cyclicals equities have not performed as well against defensive stocks as many investors hoped. In fact, the relative performance of cyclicals is broadly flat since March. Going forward, cyclicals will resume their uptrend against defensive equities and even break out of their range of the past twenty years. From a technical perspective, cyclicals have expunged many of their excesses. By the spring, European cyclicals had become prohibitively expensive compared to their defensive counterparts (Chart 7, left panel). However, their overvaluation has now passed and medium-term momentum measures are not overbought anymore, which creates a much better entry point for cyclical equities. From a fundamental perspective, cyclicals will also enjoy rising yields after being hamstrung by Treasury yields that have moved sideways for more than nine months (Chart 7, right panel). Moreover, the eventual stabilization of the Chinese economy will create an additional tailwind for these stocks. Chart 7Will The Cyclicals Outperformance Resume? Will the Cyclicals Outperformance Resume? I Will the Cyclicals Outperformance Resume? I Chart 7Will The Cyclicals Outperformance Resume? Will the Cyclicals Outperformance Resume? II Will the Cyclicals Outperformance Resume? II The biggest risk to cyclical stocks lies in inflation expectations. Ten-year CPI swaps have stopped increasing despite rising inflation. As the yield curve flattens and long-term segments of the OIS curve invert, markets register their fears that the Fed might tighten too much over the next two years. In other words, markets continue to agonize over the effect of a very low perceived terminal rate. These worries may cause the CPI swaps to decline significantly as the Fed hikes rates next year, creating a headwind for cyclicals. Chart 8: Favor Financials Financials in general and banks in particular have outperformed the European benchmark this year. This trend will persist in 2020. More than the positive impact of higher yields on the profitability of financials justifies this view. One of the key drivers supporting our optimism toward this sector is the continued improvement in the balance-sheet health of the European banking sector (Chart 8, left panel). Capital adequacy ratios remain in an uptrend and NPLs continue to be well-behaved. Meanwhile, both the governments’ liquidity support during the pandemic and the nonfinancial sector’s cash buildup over the past 18 months limit the risk that a brisk rise in insolvencies would threaten the viability of the banking system. European bank lending is also likely to remain superior to that of the post-GFC years. Consumer confidence is still sturdy, despite the recent increase in COVID cases and the tax hike created by rapidly climbing energy prices (Chart 8, right panel). Companies also benefit from an environment of low real rates and limited fiscal austerity. Unsurprisingly, capex intentions are elevated, which should support credit demand from businesses going forward. Chart 8Favor Financials Favor Financials I Favor Financials I Chart 8Favor Financials Favor Financials II Favor Financials II These factors imply that the current large discount embedded in European financials’ valuations remains excessive (even if a smaller discount is still warranted). As long as peripheral spreads do not blow out durably, financials will have scope to outperform further. Banks should also beat insurance companies. Chart 9: Small-Caps Are Nearly There Despite a sideways move followed by a 4% dip, the performance of European small-cap stocks remains in a pronounced uptrend relative to large-cap equities. The recent bout of underperformance is likely to end soon, unless a recession is around the corner. Small-cap stocks are becoming oversold (Chart 9, left panel) and will benefit from their pronounced procyclicality, especially if the recent improvement in global economic surprises continues next year. Moreover, above-trend European growth as well as an ECB that will maintain accommodative monetary conditions will combine to prevent a significant widening in European high-yield spreads, particularly once natural gas prices are turned down after the winter. This process will also help small-cap equities. The biggest risk for the European small-caps’ relative performance is the currency market. The relative performance of small-cap names is still closely correlated to the euro (Chart 9, right panel). As a result, if EUR/USD were to falter in the coming weeks, the underperformance of small-cap stocks could deepen. At the very least, small-cap stocks would languish before resuming their uptrend later in the year. Chart 9Small-Caps Are Nearly There Small-Caps Are Nearly There I Small-Caps Are Nearly There I Chart 9Small-Caps Are Nearly There Small-Caps Are Nearly There II Small-Caps Are Nearly There II Chart 10: A Risk to Macron’s Second Term The emergence of the new populist candidate Éric Zemmour has galvanized the media in recent weeks. However, he is very unlikely to pose a credible threat to French President Emmanuel Macron, unlike center-right candidate Valerie Pécresse, who just won the Les Républicains (LR) primary. In a Special Report published conjointly with our geopolitical strategists last summer, we identified the emergence of a single candidate able to unite the center-right as one of the biggest risks to Macron. As Chart 10 shows, Pécresse has made a comeback in the polls and is now expected to face Macron in the second round. According to an Elabe poll conducted after her victory in the primary, if the second round of the elections were held now, she would beat Macron. Chart 10 Chart 10 Will Pécresse manage to keep her momentum going until April 2022? First, she has to ensure the center-right remains united behind her. Up until the primaries, the center-right was divided. While she won the primary by a wide margin, her main opponent Éric Ciotti won the first round (25.6%), and Michel Barnier as well as Xavier Bertrand came close behind, with 23.9% and 22.7% respectively. Second, Pécresse must work hard to prevent voters from succumbing to the siren songs of Zemmour and Marine Le Pen, or to lean toward former Prime Minister Phillippe Edouard, a declared supporter of Macron. Investors should ignore Le Pen and Eric Zemmour. The real threat to Macron lies in Valerie Pécresse’s ability to keep the center-right united under her banner. Considering that the center-left does not represent an option and that the far-right is entangled in a tug-of-war, there is a high probability that Pécresse will reach the second round.   Footnotes Tactical Recommendations Europe In Charts Europe In Charts Cyclical Recommendations Europe In Charts Europe In Charts Structural Recommendations Europe In Charts Europe In Charts Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights 2022 will be a year of economic normalization. We hope that even if we can’t leave COVID behind, we will learn to live with it. Economic growth will remain strong, but it will be trending down towards its long-term average, while inflation will cool off somewhat on the back of the resolution of supply chain bottlenecks and waning pent-up demand. Monetary conditions will tighten, and 10-year rates will move up towards the 2-2.25% mark. Corporate profitability will return to trend. The likely deceleration in earnings growth and margin contraction will be driven by a combination of factors: A slowdown in top-line growth, a decline in corporate pricing power, and increases in labor and input costs. The US economy is firmly in the slowdown stage of the business cycle. However, growth is coming off high levels, and this phase is likely to be prolonged, and this is by no means a death knell for the bull market. Yet, during the slowdown, returns tend to be lower than during the recovery and expansion phases of the business cycle, and volatility is heightened. We expect an S&P 500 total return of just under 8% – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Point estimates are difficult in finance, so we will characterize this return expectation as in the middle single digits. Overweight Small vs. Large for the following reasons: First, Small is expected to outperform in an environment of rising rates - A BCA view for 2022. Second, Small is cheap. Third, the profitability of Small has improved dramatically which attests to the ability of smaller companies to efficiently manage their operations even under duress. Last, while Small is trading with a 25% discount to Large on a forward PE basis, its earnings growth over the next 12 months is expected to be double of Large, 20% vs. 10%. We are neutral in our Growth/Value allocation, but we find the argument of rates rising and Value outperforming highly compelling. Our neutral position will be a great launching pad towards overweighting value stocks at the first whiff of rising long rates. In the meantime, we choose a selective exposure to value sectors by the means of our hand-picked cyclical themes. Overweight Cyclicals vs. Defensives as the pandemic will recede in importance in 2022: Every time COVID fears subside, Cyclicals outperform Defensives. Pent-up demand has not yet waned, hindered by supply shortages and shipping delays. Further, rising rates is an environment favorable for Cyclicals at the expense of Defensives. Within Cyclicals, we prefer the following sectors and themes: Consumers are flush with cash and there is strong pent-up demand for services and selected consumer goods like services: Overweight Hotels, Restaurants, Cruises, Amusement Parks, and Casinos, along with Commercial and Professional Services. Also, overweight Healthcare Equipment and Services which benefits from the backlog in elective procedures. New Capex Cycle: Businesses bring their supply chains back to the US and excess consumer demand has driven the need for expanded capacity. Capex intentions are on the rise. Overweight Construction and Engineering, Building Materials, and Capital Goods. New Credit Cycle: Early signs that both consumer and business lending is picking up. Rising rates will also lend a helping hand to Banks – overweight Overweight Energy as demand for oil is robust on the back of global recovery and chronic underinvestment in Capex. Underweight resource stocks, which are exposed to a slowdown in China. The US housing market should post a solid performance next year on the back of the structural demand tailwinds: Since GFC, around five million houses were underbuilt. This supply shortage also coincides with millennials, a cohort that has 11 million more people compared to the previous generation, starting families. Overweight Real Estate and Homebuilders Multi-year structural themes are Millennials, Generation Z, EV revolution, and Cybersecurity. 2022 will be a big year for the new technology themes. We are reading about gene editing, the metaverse, 3D printing, and cleantech. We will be sure to share what we learn in a series of Special Reports. Feature House Views Last Week, BCA published its annual outlook, a transcript of our yearly discussion with the firm’s long-time clients, Mr. X and his daughter, Ms. X. In this document, we discussed the major themes for 2022. Below are some of the main conclusions: The COVID-19 pandemic is likely to recede in importance next year. The effect of the recently discovered Omicron variant remains unknown, but we expect any negative economic impact that occurs to be limited to the first half of the year. A receding pandemic will lay the groundwork for a more normal labor market, prices, and the supply of both goods and services. We expect actual inflation will come in lower next year than what short-maturity inflation expectations currently suggest. Economic growth in advanced economies will be above trend for the year on average, and we expect the US and euro area output gaps to close in 2022. Any economic activity disrupted by Omicron in the first half of 2022 will likely shift into the second half of the year. Above-trend growth will be supported by easy monetary policy, a shift in spending from goods to services, and a sizeable amount of excess savings that will support overall consumer spending. A reacceleration in Chinese economic activity is more likely in the latter half of next year rather than in the coming six months. Chart 0 Stocks will outperform bonds in 2022, but equity market returns will be in the single-digit territory – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Equity market volatility may increase in the lead-up to US monetary policy tightening at the end of the year, but we expect only a moderate rise in long-maturity bond yields—which will not threaten economic activity or cause a major decline in equity multiples. Equity investors should favor small-cap over large-cap stocks in 2022. Small-cap stocks tend to outperform when bond yields are rising, and relative valuation levels are attractive. We generally favor cyclical sectors next year but stretched relative performance versus defensives means that we expect to rotate away from cyclicals at some point over the coming year. A window exists for value outperformance versus growth in 2022, in response to higher long-maturity government bond yields. We do recommend the former over the latter. Brent oil prices will average around $80-81/bbl next year, essentially flat from pre-Omicron levels. The US dollar may remain strong over the coming few months, depending on the extent of the economic impact from the Omicron variant. Beyond that, the dollar’s countercyclical nature, above-trend global growth, and overbought conditions suggest that investors should bet on a lower dollar. In this report, we will explore the implications of the above views for US Equities. 2022 Is A Year Of Normalization If 2021 passed under the banner of recovery, 2022 will be a year of economic normalization. We hope that even if we can’t leave COVID behind, we will learn to live with it, variants and all, and it will become less disruptive to the economy and our personal lives. As such, economic growth will remain strong, but it will be trending down towards its long-term average, while inflation will cool off somewhat on the back of the resolution of supply chain bottlenecks and waning pent-up demand. Monetary conditions will tighten, and 10-year rates will move up towards the 2-2.25% mark. US Economic Growth And Corporate Profitability Will Return To Trend The economy is expected to grow at a robust pace next year (7.3% nominal GDP growth), albeit slower than this year (Chart 1). After a growth surge on the back of the post-COVID recovery, the economy has entered the slowdown phase of the business cycle. Economic growth is poised to shift closer to its long-term trend in 2022. Corporate profitability is also expected to trend lower next year (Chart 2). While corporate earnings in 2021 have been impressive, this performance is unlikely to be repeated, as the unique circumstances of the pandemic and the recovery are giving way to more ordinary business conditions. Amid the pandemic and during the early innings of recovery, companies have cut costs aggressively, improved productivity, while lower interest rates have reduced debt servicing burdens, and a weaker dollar has boosted overseas earnings. As the economy restarted, sales growth surged, and corporate pricing power was on the rise thanks to significant pent-up demand for goods and services and consumers being flush with cash. Chart 1Economic Growth Will Return To Trend Economic Growth Will Return To Trend Economic Growth Will Return To Trend Chart 2Sales Growth Is Poised To Slow Sales Growth Is Poised To Slow Sales Growth Is Poised To Slow   In 2022, earnings growth will return to trend (Chart 3). The likely deceleration in earnings growth and margin contraction (Chart 4) next year will be driven by a combination of factors: First and foremost, a slowdown in top-line growth, a decline in corporate pricing power, i.e., the ability of companies to raise prices, which has been diminished by consumers’ income increasing slower than inflation. Chart 3 Chart 4Profit Margins Are Set To Compress Profit Margins Are Set To Compress Profit Margins Are Set To Compress In the meantime, the tight labor market is putting upward pressure on wage growth (Chart 5). Labor costs are singlehandedly the largest expense, hovering around 50% of sales, dwarfing all the other expense items. Input costs are also on the rise with PPI soaring, cutting into corporate profitability (although we do expect PPI to decelerate) (Chart 6). Chart 5Wage Growth Is Accelerating Wage Growth Is Accelerating Wage Growth Is Accelerating Chart 6Corporate Pricing Power Has Been Waning Corporate Pricing Power Has Been Waning Corporate Pricing Power Has Been Waning In addition, there are a few minor expenses that are set to rise in 2022: Capex recovery will push up depreciation expense, interest expense is set to go up because of rising rates and corporate re-leveraging, and taxes are projected to increase, especially for the US multinationals exposed to the international minimum tax. And of course, there is also an appreciating dollar, diminishing the translated value of overseas profits. While each of these line items is minor, in concert they will have a noticeable adverse effect on corporate profitability. We provide analysis of the S&P 500 margins in Marginally Worse and Sector Margin Scorecard reports. 2022: Pedestrian Returns And Higher Volatility The US economy is firmly in the slowdown stage of the business cycle. However, growth is coming off high levels, and this phase is likely to be prolonged, and this is by no means a death knell for the bull market. Yet, during the slowdown, returns tend to be lower than during the recovery and expansion phases of the business cycle (Chart 7). Slowdowns are also usually accompanied by heightened volatility. Chart 7 The TINA trade is still on – there are few inexpensive asset classes, and yield is hard to come by. With rates expected to rise, equities are still a more attractive alternative to bonds (Chart 8). Equities are real assets that do a good job protecting investments from rising prices (that is until inflation triggers tighter monetary policy). With rate hikes still a few quarters away, the party is continuing. There is still a lot of liquidity sloshing around looking for attractive corners of the market. This is manifested in positive equity inflows and a “buy-on-dips” mentality, which, so far, has precluded any major market corrections. Buybacks are on the rise – many corporations have had bumper profits and are returning cash to shareholders (Chart 9). This trend is exacerbated by the current administration’s hostility to M&A activity. Chart 8 Chart 9Buybacks Are Reverting To The Pre-pandemic Level Buybacks Are Reverting To The Pre-pandemic Level Buybacks Are Reverting To The Pre-pandemic Level   Returns: Multiple Expansion Passes Baton To Earnings Growth Multiple expansion was a key driver of returns in 2020. In 2021, the baton was passed to earnings growth, which contributed 40% to realized returns this year (Chart 10). 2022 will be more like 2021 than 2020. Multiple expansion is highly unlikely as it tends to be a driver of returns during the recovery stage of the business cycle when the market anticipates economic rejuvenation. Furthermore, valuations are already elevated. When the S&P 500 is trading at over 21x forward earnings, the probability of negative returns over the next 12 months has historically been around 65% (Chart 11). While we believe that there are many factors supporting equities delivering positive returns next year, it is hard to be overly optimistic. Chart 10 Chart 11 Hence, it will be earnings growth again that will rule the day in 2022, with a little help from dividends and buybacks. However, while earnings growth is a key driver of returns, it is expected to slow from the current levels, returning to its historical trend (Chart 12). The blockbuster returns of 2021 will be in the rear-view mirror. Chart 12Earnings Growth Is Slowing Earnings Growth Is Slowing Earnings Growth Is Slowing Total Return Estimate: Mid-To-High Single Digits Above-trend economic growth and consumer price inflation point to revenue growth in the high single digits, and this would normally serve as a conservative estimate for earnings growth given that profit margins have been trending higher since the beginning of the 2009 economic recovery. However, margins are expected to compress in 2022, and earnings growth to decelerate. We proxy sales growth to nominal GDP growth of 7.6%. With margins expected to contract, the best scenario for the degree of operating leverage for the S&P 500 is a historical average of 0.96, translating sales growth into earnings growth of 7.3% (Table 1). For reference, sell-side analysts expect S&P 500 earnings to grow by 8% in 2022 (Chart 13). S&P 500 PE NTM stands at 20.5 which, historically, on average, is about three points below realized PE LTM in 12 months. We assume that PE LTM at the end of 2022 will be 25.6, or a 1.6% contraction from the 25.2 multiple today. Table 12022 S&P 500 Price Target And Total Return Estimate 2022 Key Views: US Equities 2022 Key Views: US Equities Chart 13 With an average historical dividend yield of 2.2%, we get: (1+7.3%)*(1-1.6%)*(1+2.2%) = 7.9% - Total Return Estimate 4,591*(1+7.3%)*(1-1.6%) =~ 4,850 - Price Target We expect an S&P 500 total return of just under 8% – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Point estimates are difficult in finance, so we will characterize this return expectation in the middle single digits. The rate of multiple contraction, earnings growth, and dividend yield in 2022 are just educated guesses. Sector And Styles Key Views Small Vs. Large Cap: It Is Finally A Small World 2021 was a tumultuous year for small caps. After a strong outperformance at the beginning of the year on the back of a recovery trade, this asset class has been languishing since March, with each new attempt for a prolonged rally failing (Chart 14). Over the year, small caps have become extremely cheap and unloved, trading at 16x forward earnings with a 25% discount to Large. The BCA Valuation Indicator for Small vs. Large is standing more than two standard deviations below its long-term average. So why was Small so unloved considering two blockbuster reporting seasons with earnings growth of more than 200%? Even on an annualized basis, since 2019 Small has delivered 47% annualized growth compared to 14% from Large (Chart 15). Moreover, smaller companies have been successful in repairing their balance sheets, which now look much healthier. Chart 14Small Had A Tumultuous Year Small Had A Tumultuous Year Small Had A Tumultuous Year Chart 15 Small was out of favor as investors fretted about an economic slowdown (Chart 16), the Delta variant (along with the other Greeks), razor-thin margins, and the ability of smaller companies to navigate the economy, plagued with supply bottlenecks and labor shortages. Yet, we went overweight Small vs. Large back in October and are still sticking to our guns. First, Small, which has higher allocations to Cyclicals, such as Financials and Industrials, is expected to outperform in the environment of rising rates (Chart 17) - A BCA view for 2022. Second, in a market where most asset classes are exuberantly expensive, Small is cheap. Third, the profitability of Small has improved dramatically, which attests to the ability of smaller companies to efficiently manage their operations even under duress, as well as to pass costs on to their customers. Last, while Small is trading with a 25% discount to Large on a forward PE basis, its earnings growth over the next 12 months is expected to be double that of Large, 20% vs. 10%. The froth in expectations for the earnings growth of Small has also come down from its peak at 88% and now appears to be a low bar to clear. Chart 16Small Earnings Growth Expectations Are Reasonable And Profitability Has Rebounded Small Earnings Growth Expectations Are Reasonable And Profitability Has Rebounded Small Earnings Growth Expectations Are Reasonable And Profitability Has Rebounded Chart 17Small Is Expected To Outperform In The Environment Of Rising Rates Small Is Expected To Outperform In The Environment Of Rising Rates Small Is Expected To Outperform In The Environment Of Rising Rates What are the risks to this call? If economic growth disappoints, and the yield curve continues its relentless flattening, signifying a Fed policy mistake or the onset of another COVID Greek, Small is bound to underperform. Margins are narrow and continued cost pressures, especially surging labor costs, have the potential to dent small caps’ profitability. Yet, on a balance of probabilities of such an outcome vs. attractive valuations and fundamentals, this is a risk we are willing to take. Growth Vs. Value: Be Nimble The story of Growth vs. Value is similar to that of Large vs. Small. Value had a fantastic run as the pandemic started to recede, but then as worries about the Delta variant emerged, Growth took over yet again. Over the past year, Growth outperformed Value by 11%, and by 18% over just the last 26 weeks. As a result of such a strong run, Growth has become very expensive, trading at 29x forward multiples, which is a 80% premium to Value (which is trading at 16x). The Growth/Value BCA Valuation indicator is nearly 3 standard deviations above average, and from a statistical perspective, is 99% likely to mean revert. What makes this valuation discrepancy absurd is that both asset classes are bound to deliver roughly the same earnings growth over the next year, i.e., 10%. What is the deal? Just like Small vs. Large, this year, Value vs. Growth has been strongly linked to the 30-year Treasury yield (Chart 18). This has not always been the case in the past, but since the onset of the pandemic, very long-maturity bond yields have done a good job at explaining the relative performance of these asset classes. Growth is overweight Technology, which has been a star of the “work from home” theme. Further, falling long rates inflate the present value of cash flows and earnings of the growth stocks. In the meantime, Value is highly exposed to Financials, which have a hard time maintaining their profitability during times of falling rates and flattening yield curves. Apart from sector composition, Growth as an asset class has also become synonymous with quality, which comes to the rescue at times of heightened risk aversion and uncertainty. This is usually accompanied by falling rates. Indeed, profit margins for Growth are 7% higher than for Value. Since 2019, the annualized earnings growth of Growth is 14.4% compared to 9.8% for Value. The difference is even more dramatic for Sales growth: 6.5% for Growth vs. -1.1% for Value (Chart 19). Chart 18US Value Versus Growth Is Strongly Correlated With Interest Rates US Value Versus Growth Is Strongly Correlated With Interest Rates (CHART 18) US Value Versus Growth Is Strongly Correlated With Interest Rates (CHART 18) Chart 19 However, while we observe that Growth is more reliable for churning out strong numbers, falling sales of Value indicate substantial pent-up demand for products and services. Value also thrives in the environment of robust economic growth and the steepening yield curve. We are currently neutral in our Growth/Value allocation, but we find the argument of rates rising and Value outperforming highly compelling. Our neutral position will be a great launching pad towards overweighting value stocks at the first whiff of rising long rates. In the meantime, we choose a selective exposure to value sectors by the means of our hand-picked cyclical themes. We have also retained some exposure to Growth by staying with our overweights to Technology and Pharma, as a means of protecting our portfolio from the kind of volatility we have experienced because of the Omicron scare and the Fed’s policy adjustments. Growth Is Robust And COVID Is Receding: Overweight Cyclicals Cyclical sectors have significantly outperformed Defensives this year (by 12%), benefiting from economic reopening and ubiquitous pent-up demand both from businesses and consumers. Despite a strong run and exceeding the pre-pandemic peak (Chart 20), Cyclicals have room to move higher when compared with the prevailing levels in 2010-2011, but that period reflected resource price levels that we are unlikely to see in the coming year. Yet, we expect further outperformance of Cyclicals in 2022. Chart 20Cyclicals/Defensives Performance Has Exceeded Pre-Pandemic Peak Cyclicals/Defensives Performance Has Exceeded Pre-Pandemic Peak Cyclicals/Defensives Performance Has Exceeded Pre-Pandemic Peak Chart 21Cyclicals Rally When COVID Fears Reced Cyclicals Rally When COVID Fears Reced Cyclicals Rally When COVID Fears Reced We do hope that the pandemic will recede in importance in 2022: Every time COVID fears subside, Cyclicals outperform Defensives (Chart 21). Pent-up demand has not yet waned, hindered by supply shortages and shipping delays. For many cyclical sectors, such as Consumer Discretionary, Financials, Real Estate, and Industrials, annualized sales growth from 2019 to 2021 is below historical levels, suggesting that there is room for catchup growth (Chart 22). Chart 22 One of the cornerstones of the BCA outlook is that rates will rise. This is an environment favorable for Cyclicals. Defensive sectors tend to underperform when bond yields are rising, as many of them are heavily indebted and have somewhat fixed cash flows because of regulations (Utilities, Telecoms) or strong competition from cheaper substitutes (Pharma amid challenges from generics and biosimilars). Cyclicals are not that much more expensive than Defensives (22x vs. 19x forward earnings) and are trading with a 13% premium. The Cyclical/Defensive Valuations Indicator has come down from three to two standard deviations (Chart 23). Despite a modest valuations premium, earnings of Cyclical sectors are expected to grow at 25% while Defensives will only grow at 6% over the next 12 months. In short, Cyclicals are more attractive than Defensives as a group, but we prefer a granular approach and handpick cyclical sectors that we expect to thrive in the current macroeconomic environment and have favorable sales and earnings growth prospects. Later in the report, we will discuss some of our cyclical sector picks. Chart 23Relative Valuations Of Cyclicals Have Come Down But Are Still Rich Relative Valuations Of Cyclicals Have Come Down But Are Still Rich Relative Valuations Of Cyclicals Have Come Down But Are Still Rich Despite Worries About Inflation, Consumers Still Have Money To Spend: Overweight Consumer Services The US government has supported consumers during the lockdowns with a series of helicopter cash drops to all Americans, enumerated in trillions of dollars. As a result, even nine months after the last cash disbursement, consumers are sitting on $2.3 trillion in excess savings (Chart 24). Extremely loose fiscal and monetary policy have lifted household net worth by 128% of GDP (Chart 25). And while consumers do indeed worry about inflation, expecting it to rise to 7.5% in 12 months, there is still plenty of dry powder sitting in their bank accounts. Chart 24Consumers And Businesses Have A Lot Of Dry Powder Consumers And Businesses Have A Lot Of Dry Powder Consumers And Businesses Have A Lot Of Dry Powder Chart 25Household Wealth Has Soared Household Wealth Has Soared Household Wealth Has Soared Consumer spending on goods has been above the pre-pandemic trend for months and has recently turned. In the meantime, spending on services is still below pre-pandemic levels, suggesting that there is plenty of pent-up demand (Chart 26). Specifically, spending on sports clubs, public transportation, personal care, medical services, and professional services are still below pre-pandemic levels. Pent-up demand will boost Consumer Services, and we recommend overweights to Hotels, Restaurants, Cruises, Amusement Parks, and Casinos, along with Commercial and Professional Services. Further, while pent-up demand for goods has generally been met, there are still pockets of demand out there due to shortages, such as for automobiles and selected consumer durables. We are also overweight Healthcare Equipment and Services which benefits from the backlog in elective procedures. Chart 26Spending On Services Is Still Below The Pre-pandemic Trend Spending On Services Is Still Below The Pre-pandemic Trend Spending On Services Is Still Below The Pre-pandemic Trend New Capex Cycle: Overweight Industrials Industrials is another cyclical sector that we favor. Supply chain disruptions have demonstrated for many businesses that they need to bring their supply chains back to the US, launching the US Manufacturing Renaissance. Also, excess consumer demand has driven the need for expanded capacity. For months now, manufacturers have been inundated with orders (Chart 27). The industrial sector is also exposed to the restocking of inventories and is poised to benefit from the Infrastructure Bill. Therefore, Industrials will continue to benefit from the surge in capital expenditures, as evidenced by the sharp increase in US core capital goods orders. Capex intentions have been on the rise as well (Chart 28). Chart 27Producers Inundated With Orders And Need More Capacity Producers Inundated With Orders And Need More Capacity Producers Inundated With Orders And Need More Capacity To profit from this emerging trend, we are overweight Construction and Engineering, Building Materials, and Capital Goods. Chart 28Surge In Capital Expenditure Will Benefit Industrials Surge In Capital Expenditure Will Benefit Industrials Surge In Capital Expenditure Will Benefit Industrials New Credit Cycle: Overweight Banks 2021 was a blockbuster year for banks on the back of the booming M&A and IPO activity. However, to achieve sustainable profitability, they need to jumpstart the loan growth process. Both businesses and consumers have repaired their balance sheets, and the re-leveraging cycle is set to commence to finance Capex and higher price tag purchases like autos. There are early signs that lending is likely to pick up next year (Chart 29). According to JPM: “The customers who typically contribute to credit card loan growth are starting to spend the savings built up from the pandemic at a faster clip, suggesting they could be getting closer to taking on debt again.” Credit card spending is recovering (Chart 30). Chart 29Early Innings Of A New Credit Cycle Early Innings Of A New Credit Cycle Early Innings Of A New Credit Cycle Chart 30Consumers Are Borrowing Again Consumers Are Borrowing Again Consumers Are Borrowing Again While sell-side analysts anticipate that margins will decline, we believe that they may surprise on the upside: High operating leverage, improving pricing power, and growing demand for loans will contribute to strong profitability. Further, the BCA house view is 10-year rates rising to 2.0 – 2.25% in 2022, which will support net interest margins. Energy Sector Vs. Materials Energy profit margins are linked to underlying commodity prices. The BCA Commodity and Energy strategists’ view is that the medium-term supply/demand backdrop is highly supportive of the current energy pricing dynamics and that the oil price is expected to stay high, at around its current level, for the next two years. They also note that upside price risk is increasing going forward, due to inadequate Capex. Although the price of oil has risen above the break-even level, energy companies are reluctant to invest in Capex due to pressure from shareholder activists and newly found financial discipline (Chart 31). As a result, prices are likely to remain high until “high prices cure high prices.” In the meantime, energy producers are returning cash to shareholders – a unique bonus in the current world starved for yields. Oil demand is expected to stay robust on the back of the global economic recovery, especially with an increase in consumption by airlines that are resuming international travel. Case in point: ExxonMobil (XOM) “anticipates demand improvement in its downstream segment with a continued economic recovery.” Chart 31Chronic Underinvestment Is Driving Up Price Of Oil Chronic Underinvestment Is Driving Up Price Of Oil Chronic Underinvestment Is Driving Up Price Of Oil Chart 32A Slowdown In China Is Hurting Demand For Raw Materials A Slowdown In China Is Hurting Demand For Raw Materials A Slowdown In China Is Hurting Demand For Raw Materials Resource stocks, on the other hand, may not meaningfully outperform in 2022, at least not consistently – our views on China imply that metals and mining stocks may at least passively underperform in the first half of the year (Chart 32). US Housing Rally Still Has Legs To Run On The US housing market should post a solid performance next year on the back of the structural demand tailwinds: Since the GFC, around five million houses were underbuilt. This supply shortage also coincides with millennials, a cohort that has 11 million more people compared to the previous generation, starting families. The data is also reflective of the supply/demand mismatch with inventories of new and existing homes for sale, and the homeowner vacancy rate at all-time lows, and housing prices exploding higher. At the same time, US building permits are still below the two million SAAR print that historically marked previous housing cycle peaks (Chart 33). The implication is that the current housing boom still has room to go further, benefiting US homebuilders as they monetize the supply/demand mismatch. Homebuilder sentiment rose to a six-month high in November. Tack on the 80bps sell-off in the 30-year US Treasury yield that translates into more affordable mortgage rates for consumers, and there is little that can undercut the US housing market throughout 2022. We are bullish on both the Real Estate and Homebuilders sectors. However, we would be remiss not to mention risks to this call: The performance of the real estate market is highly dependent on the direction of the rates. If long rates rise substantially, this sector will be in the crosscurrents of housing shortages and less affordable mortgages. However, the 2-2.25% 10-year yield that BCA anticipates by end -2022 should not put a significant dent into house ownership affordability. Chart 33Housing Shortages Will Drive Multi-Year Outperformance of Real Estate And Homebuilders Housing Shortages Will Drive Multi-Year Outperformance of Real Estate And Homebuilders Housing Shortages Will Drive Multi-Year Outperformance of Real Estate And Homebuilders Risks To The Outlook Rising rates are a key condition for our sector and style calls to pan out. However, if supply chain bottlenecks do not clear soon, inflation will not slow down meaningfully, and the US economy will enter a rising price-wage spiral. The Fed will realize that it is behind the curve and will start hiking rates aggressively, i.e., faster than the pace currently anticipated by the market. As a result, economic growth will disappoint, and the unemployment rate will rise. The yield curve will continue flattening with long rates staying range-bound or moving lower. In this scenario, Growth and Defensives will outperform, while Small, Value and Cyclicals will underperform. Multi-Year Structural Themes To finish, we want to remind clients of our long-term themes, which we expect to continue to pan out next year. Millennials Are Not Coming Of Age; They Are Already Here According to the US Census Bureau, millennials (born 1982 to 2000), are the US's largest living generation and represent more than one-quarter of the US population. This is a generation that is highly educated, and relatively unburdened by debt. While in the past, this generation was perceived as “forever young,” it is rapidly showing signs of maturing: Joining the labor force, starting families, and shopping for houses and cars, thereby pushing consumption up. However, millennials’ consumption basket is different, with an emphasis on new technology, homeownership, electric vehicles, and green energy. ETFs that capture the theme are MILN and GENY. Gen Z Is Coming Of Age And Has Money To Spend Generation Z in the US includes 62 million people born between 1997 and 2012. With $143B in buying power in the US alone, making up nearly 40% of all consumer sales, Gen Z wields increasing influence over consumer trends. This is the first generation of digital natives—they simply can’t remember the world without the internet. They are the early adopters of the new digital ways to bank, get medical treatments, and learn. Gen Z is joining the workforce and replacing retiring baby boomers. We have created a Gen Z basket with stocks representing fintech, investing and crypto, online gaming, quality-over-price, and some others. There are no ETFs just yet that capture this emerging theme. Cybersecurity Is A Must-Have Global digital transformation as well as rising geopolitical tensions create fertile ground for attacks by both cybercriminals and malicious state actors. The cyber defenses of most private and public companies are still ill-prepared, and the space is poised for robust growth since cybersecurity is a “must-have” for survival. This growing market has attracted a plethora of new cybersecurity players who 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. The following ETFs provide exposure to the theme: BUG, CIBR, and HACK. EV Revolution The auto industry is undergoing a major technological disruption. This process is expensive and perilous yet presents an enormous future earnings growth opportunity. And all the ingredients for success are in place: The proliferation of new technologies, government support, changing consumer preferences, and a surging US economy. This tide will lift all boats: Legacy and EV-only auto manufacturers and suppliers as well as EV ecosystem players. We are bullish on the sector on a 12-month investment horizon. ETFs are DRIV, IDRIV, KARS, BATT, and LIT. What We Are Researching For 2022 2022 will be a big year for the new technology themes. Some are brand new, while others have been around for a while. We are reading about gene editing, the metaverse, 3D printing, and cleantech. We will be sure to share what we learn in a series of Special Reports.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Highlights Our theme for the year, “No Return To Normalcy,” is largely vindicated. Inflation is back! The geopolitical method still points to three long-term strategic themes: multipolarity, hypo-globalization, and populism. All are inflationary in today’s context. Our three key views for 2021 produced two hits and one miss: China sold off, oil prices held up, but the euro fell hard. Our view on Iran is still in flux. COVID-19 proved more relevant for investors than we believed, though we took some risk off the table before the Delta and Omicron variants emerged. Our biggest miss was long Korea / short Taiwan equities. Our geopolitical forecast was spot on but our trade recommendation collapsed. Our biggest hit was long India / short China equities. China’s historic confluence of internal and external risk drove investors to India, the most promising strategic EM play. Feature Every year we conduct a review of the past year’s geopolitical forecasts and investment recommendations. The intention is to hold ourselves to account, prepare for our annual outlook, and improve our analytical framework. Our three key views for 2021 were: 1.  China’s historic confluence of political and geopolitical risk = bearish view of Chinese equities; 2.  The US pivot to Asia runs through Iran = neutral-to-bullish view of oil prices; 3.  Europe wins the US election = bullish view of the euro and European equities. The first view on China was a direct hit. The second view is in flux. The third view was initially right but then turned sour. A crude way of assessing these views would be to look at equity performance relative to long-term trends: China sold off, the UAE rallied, and Europe sold off (Chart 1). Chart 1Three Key Views For 2021: Two Hits, One Miss Three Key Views For 2021: Two Hits, One Miss Three Key Views For 2021: Two Hits, One Miss This is not the whole story. We modified our views over the course of the year as new information came to light. In March we turned neutral on the US dollar, with negative implications for the euro. In June we adjusted our position on Europe overall, arguing that European political risk had bottomed and would rise going forward. In August we adjusted our position on Iran, warning of an imminent crisis due to the Biden administration’s refusal to lift sanctions and Iran’s pursuit of “breakout” uranium enrichment capacity. We stayed bearish on China throughout the year. Going forward, given that a near-term crisis is necessary to determine whether Iran will stay on a diplomatic track, we would short UAE or Saudi equities. We would expect oil to remain volatile given upside risks from geopolitics but downside risks from the new Omicron variant and China’s slowdown. China’s slowdown was also a controlling factor for the Europe view. The energy crisis and showdown with Russia can also get worse before they get better. So we prefer US assets for now and will revisit this issue in our annual strategic outlook due in the coming weeks. Before we get to the worst (and best) calls of the year, we have a few words on our analytical framework in the context of this year’s signal developments. The Geopolitical Method: Lessons From 2021 As with any method rooted in practice, the geopolitical method has many flaws. But it has the advantage of being systematic, empirical, probabilistic, and non-partisan. How do we check ourselves on the thorny problem of partisanship? First, geopolitics requires practicing empathetic analysis, i.e. striving to understand and empathize with the interests of each nation and nation-state when analyzing their behavior. For example: China: China’s ruling party believes it is necessary to have an all-powerful leader to deal with the urgent systemic risks facing the country. We refrain from criticizing single-party rule or China’s human rights record. But we do see compelling evidence that the Communist Party’s shift from consensus rule to personal rule will have a negative impact on governance and relations with the West.1 China obviously rejects foreign diplomatic and military support for Taiwan, which Beijing sees as a renegade province, and hence the odds of a war in the Taiwan Strait are high over the long run. Russia: Russia is threatening its neighbors on multiple fronts not because it is an evil empire but because of its insecurity in the face of the US and NATO, and particularly its opposition to western defense cooperation with Ukraine. Its unproductive domestic economy and vulnerability to social unrest are additional reasons to expect aggression abroad. Second, we take very seriously any complaints of bias we receive from clients. Such complaints are rare, which is encouraging. But we treat all feedback as an opportunity to improve. At the same time, the need to draw clean-cut investment conclusions for all clients will always override the political sensitivities of any subset of clients. Geopolitics is based in the idea that politics is rooted in structural forces like geography and demography, i.e. forces that limit or constrain individual actors and only change at a glacial pace. Geopolitical analysts focus on measurable and material factors rather than ever-changing opinions and ideas. It is impossible for investors today to ignore the global political environment, so the important thing is to analyze it in a cold and clinical manner. To combine this method with global macroeconomic and investment research, one must assess whether and to what extent financial markets have already priced any given policy outcome. The result will be a geopolitically informed macro conclusion, which should yield better decisions about conserving and growing wealth. This is the ideal for which we aim, even though we often fall short. Over the years our method has produced three primary strategic themes: Great Power struggle (multipolarity); hypo-globalization; and domestic populism (Table 1). Table 1Our Major Themes Point To Persistent Inflation Risk Geopolitical Report Card: 2021 Geopolitical Report Card: 2021 The macro impact of these themes will vary with events but in general they point toward a reflationary and inflationary context. They involve a larger role of government in society, new constraints on supply, demand-side stimulus, and budget indiscipline. Bottom Line: Nation-states are mobilizing, which means they will run up against resource constraints. A Return To Normalcy? Or Not? As the year draws to a close, our annual theme is vindicated: “No Return To Normalcy.”  The term “normalcy” comes from President Warren G. Harding’s election campaign in 1920. It was an appeal to an American public that yearned to move on from World War I and the Spanish influenza pandemic. A hundred years later, in December 2020, the emergence of a vaccine for COVID-19 and the election of an orthodox American president (after the unorthodox President Trump) made it look as if 2021 would witness another such return to normalcy. We foresaw this narrative and rejected it. Primarily we rejected it on geopolitical grounds – global policy will not revert to the pre-Trump status quo. We also argued that the pandemic and the gargantuan fiscal relief designed to shield the economy would have lasting consequences. Specifically they would create a more inflationary context. Chart 2No Return To Normalcy In 2021 No Return To Normalcy In 2021 No Return To Normalcy In 2021 The most obvious sign that things have not returned to normal in 2021 is the “Misery Index,” the sum of unemployment and headline inflation. Misery Indexes skyrocketed during the crisis and today stand at 10.8% in the US and 11.4% in the EMU, up from 5.2% and 8.1% in 2019, respectively (Chart 2). Unemployment rates are falling but inflation has surged to the highest levels since the 1990s. For investors to be concerned about inflation at the beginning of a new business cycle is unusual and requires explanation. It suggests that inflation will be a persistent problem going forward, as the unemployment rate falls beneath NAIRU and participation rates rise. While we expected inflation, we did not expect the political blowback to come so quickly. President Biden’s approval rating collapsed to 42.2% this fall. Approval of his handling of the economy fell even lower, to 39.6%, below President Trump’s rating at this stage. Consumer confidence has fallen by 15.1% since its post-election peak in June 2021. Republicans are automatically favored to win the House of Representatives in the 2022 midterm elections – but if the economy does not improve they will also win the Senate. Despite Biden’s unpopularity, we argued that his $550 billion bipartisan infrastructure bill and his $1.75 trillion partisan social spending bill would pass Congress. So far this view is on track, with infrastructure signed into law and the Senate looking to vote on the social bill in December (or January). These bills illustrate the strategic themes listed above: the US is reviving public investments in civil and military sectors, reducing global dependencies, and expanding its social safety net. However, large new government spending when the output gap is virtually closed will tend to be inflationary. Russia and China also have high or rising misery indexes, which underscores that political and geopolitical risks will rise rather than fall over the coming 12 months. Unemployment rates are not always reliable in authoritarian states, so the Misery Index is if anything overly optimistic regarding social and economic conditions. China is not immune to social unrest but Russia is particularly at risk. Quality of life and public trust in government have both deteriorated. Inflation will make it worse. Russians remember inflation bitterly from the ruble crisis of 1998. President Putin is already ratcheting up tensions with the West to distract from domestic woes. While we were positioned for higher inflation in 2021, we were too dismissive of the global pandemic. We expected vaccination campaigns to move faster, especially in the US, and we underrated the Delta variant as a driver of financial markets, at least relative to politics. A close look at Treasury yields, oil prices, and airline stocks shows that the evolution of the pandemic marked the key inflection points in the market this year (Chart 3). Chart 3COVID-19 Stayed Relevant In 2021 ... Now Omicron Variant Emerging COVID-19 Stayed Relevant In 2021 ... Now Omicron Variant Emerging COVID-19 Stayed Relevant In 2021 ... Now Omicron Variant Emerging Bottom Line: Tactically the market impact of the newly discovered Omicron variant of the virus should not be underrated. It is critical to find out if it is more harmful to younger people than Delta and other variants. Cyclically inflation will remain a persistent risk even if it abates somewhat in 2022. Worst Calls Of 2021 We now proceed to our main feature. As always we begin with the worst calls of the year: Chart 4Taiwan Rolled Over ... But Not Against Korea Taiwan Rolled Over ... But Not Against Korea Taiwan Rolled Over ... But Not Against Korea 1.  Long Korea / Short Taiwan. Geopolitical view correct, market view incorrect. US-China conflict is a secular trend and contains elements of all our major themes: Great Power struggle, hypo-globalization, and populism. Taiwan is the epicenter of this conflict and a war is likely over the long run. For 2021 we predicted a 5% chance of war but a 60% chance of a “fourth Taiwan Strait crisis,” i.e. a diplomatic crisis, and our contrarian short of Taiwanese equities was premised on this expectation. Investors are starting to respond to these self-evident geopolitical risks, judging by the TWD-USD exchange rate and the relative performance of Taiwanese equities, which have peaked and are lagging expectations based on global semiconductor stocks. But our choice of South Korean equities as the long end of the pair trade was very unfortunate and the trade is down by 22% (Chart 4). Korea is suffering from a long de-rating process in the face of China’s industrial slowdown and a downgrade to Korean tech sector earnings, as our Emerging Markets Strategy has highlighted. 2.  Short CNY Versus USD And EUR. Geopolitical view correct, market view incorrect. This year we argued that President Biden would be just as hawkish on China as President Trump and would not remove tariffs or export controls. We also argued that the SEC would punish US-listed China stocks and that bilateral relations would not improve despite a likely Biden-Xi summit. These views proved correct. But our neutral view on the dollar and bullish view on the euro betrayed us and the trade has lost 4% so far. The euro collapsed amid its domestic energy crisis and China’s import slowdown (Chart 5). China’s exports boomed while the People’s Bank kept the currency strong to fend off inflation. Chart 5China Tensions Sure, But Don't Fight The People's Bank China Tensions Sure, But Don't Fight The People's Bank China Tensions Sure, But Don't Fight The People's Bank Chart 6Value Surged Then Fell Back Against Growth Stocks Value Surged Then Fell Back Against Growth Stocks Value Surged Then Fell Back Against Growth Stocks 3.  Long Value Versus Growth. Geopolitical view correct, market view incorrect. We have long favored value over growth stocks, expecting that our strategic themes would lead to more muscular fiscal spending, government intervention in the economy, and a return of inflation. In 2021 we bet that rising inflation expectations and higher bond yields would favor value over growth. This was only one aspect of our larger pro-cyclical view that tech-heavy US equities would underperform their global peers and emerging markets would outpace developed markets. These expectations came true during the first part of the year when exuberance over the “reflation trade” led to a big pop in value (Chart 6). By the second quarter we had pared back our pro-cyclical leanings but we maintained value over growth, ultimately at a loss of 3.75%. The reality nowadays is that value is a byword for low quality, as our colleagues Juan Correa-Ossa and Lucas Laskey have shown. Growth stocks continue to provide investors with innovation and robust earnings amid a lingering pandemic. 4.  Long Aerospace And Defense Stocks. Geopolitical view mixed, market view incorrect. We are perennially bullish on defense stocks given our strategic themes. We expected aerospace and defense stocks to recover as vaccines spread and travel revived. We successfully played the rebound in absolute terms. But the slow pace of vaccination and the emergence of the Delta variant dealt a blow to the sector relative to the broad market. And now comes Omicron. As for defense stocks specifically, investors are downplaying Great Power struggle and worried that government defense budgets will be flat or down. Significant saber-rattling is occurring as expected in the major hotspots – the Taiwan Strait, the Persian Gulf, and Russia’s periphery – but investors do not care about saber-rattling for the sake of saber-rattling. Geopolitical tensions went nowhere so far this year and hence defense stocks floundered relative to the broad market (Chart 7). Still we would be buyers at today’s cheap valuations as we see geopolitical risk rising on a secular basis and the odds of military action are non-negligible in all three of the hotspots just mentioned. 5.  Long Safe Havens. Geopolitical view mixed, market view incorrect. Measured geopolitical risk and policy uncertainty collapsed over the second half of 2020. By early 2021 we expected it to revive on US-China, US-Russia, and US-Iran tensions. As such we expected safe-haven assets to catch a bid, especially having fallen as the global economy reopened. We stayed long gold (up 22.6% since inception, down 5.2% YTD) and at various times bought the Japanese yen and Swiss franc. Some of these trades generated positive returns but in general safe havens remained out of favor (Chart 8). As with defense stocks, we are still constructive on the yen and franc. Chart 7Market Ignored Saber-Rattling Market Ignored Saber-Rattling Market Ignored Saber-Rattling 6.  Long Developed Europe / Short Emerging Europe. Geopolitical view correct, market view incorrect. Our pessimistic view of Russia’s relations with the West, and hence of Russian currency and equities, clashed with our positive outlook on oil and commodity prices this year. To play Russian risks we favored developed European equities over their emerging peers (mainly Russian stocks). But emerging Europe has outperformed by 5% since we initiated the trade and other variations on this theme had mixed results (Chart 9). Of course, geopolitical tensions are escalating in eastern Europe we go to press. Chart 8Safe Havens Fell After US Election, Insurrection Safe Havens Fell After US Election, Insurrection Safe Havens Fell After US Election, Insurrection ​​​​​​ Chart 9Refrain From The Russia Rally Refrain From The Russia Rally Refrain From The Russia Rally We do not think investors can afford to ignore the US-Russia conflict, which has escalated over two decades. President Putin has not changed his strategy of building a sphere of influence in the former Soviet Union. The US is internally divided and distracted by a range of challenges, while it continues to lack close coordination with its European allies. Western responses to Russian aggression have failed to change Russia’s cost-benefit analysis. Thus we continue to expect market-negative surprises from Russia, whether that means a seizure of littoral territory in Ukraine, a militarization of the Belarussian border, more disruptive cyber attacks, or some other big surprise. Bottom Line: While our geopolitical forecasts generally hit the mark this year, global financial markets ignored most geopolitical risks other than China. The global recovery, inflation, and the pandemic, vaccines, variants, and social distancing remained the key dynamics. This threw many of our trades off track. However, we are sticking with some of our worst calls this year given the underlying geopolitical and economic forces motivating them beyond a 12-month time frame. Best Calls Of 2021 1.  Long India / Short China. Geopolitical view correct, market view mixed. Our number one view for 2021 was that China would suffer a historic confluence of political and geopolitical risk that would be negative for equities. This view contrasted with our bullish view on India. Prime Minister Narendra Modi had won another single-party majority in the 2019 elections and stood to benefit from the attempts of the US and other democracies to diversify away from China. We favored Indian stocks and local currency bonds – both trades saw a sharp run-up (Chart 10). Unfortunately, we took profits too soon, only netting 12% on the long India / short China equity trade. Some of our other India trades did not go so well. Going forward we expect a tactical reset given India’s tremendous performance this year. 2.  Booking Gains At Peak Biden. Geopolitical view correct, market view correct. We closed several of our reflation trades in the first quarter, when exuberance over vaccines and the Democrat’s election sweep reached extreme levels (Chart 11). We captured a 24% gain on our materials trade and a 37% gain on energy stocks. We turned a 17% profit on our BCA Infrastructure Basket relative trade. We were prompted to close these trades by dangers over Taiwan and Ukraine that soon dissipated. But we also believed that markets were priced for perfection. By the second quarter we had taken some risk off the table, which served us well throughout the middle of the year when the Delta variant struck. While global energy and materials rose to new highs later in the year, the Fed and Omicron interrupted their run. Chart 10Call Of The Year: Long India, Short China Call Of The Year: Long India, Short China Call Of The Year: Long India, Short China 3.  Long Natural Gas On Russia Risks. Geopolitical view correct, market view correct. All year we held the contrarian view that the new Nord Stream II pipeline linking Russia and Germany would become a major geopolitical flashpoint and that it was much less likely to go into operation than consensus held. Chart 11Reflation Trade' Peaked Early, Peaked Again, Then Omicron Reflation Trade' Peaked Early, Peaked Again, Then Omicron Reflation Trade' Peaked Early, Peaked Again, Then Omicron ​​​​​​ We also fully expected Russia to act aggressive in its periphery. In March we argued that while Russia probably would not re-invade Ukraine, long-term risk was substantial (and accordingly a new military standoff began in the fall) We also noted that Russia had other tools to coerce its neighbors. As a result we went long natural gas futures, following our colleagues at Commodity & Energy Strategy. While the trade returned 20%, we took profits before the European energy crisis really took off (Chart 12). 4.  The “Back To War” Trade. Geopolitical view correct, market view correct. Cyber warfare is one of the ways that the Great Powers can compete without engaging in conventional war. We have long been bullish on cyber-security stocks. However, the pandemic created a unique tactical opportunity to initiate a pair trade of long traditional defense stocks / short cyber stocks that returned 10%. It was a geopolitical variation on the “back to work” trades that characterized the revival of economic activity after pandemic lockdowns. Cyber stocks will enjoy a tailwind as long as the pandemic persists and working from home remains a major trend. But over the cyclical time frame defense stocks should rebound relative to their cyber peers, just as physical geopolitical tensions should begin to take on renewed urgency with nations scrambling for territory and resources (Chart 13). Chart 12Hold Onto The Good Ones: Long Natural Gas Hold Onto The Good Ones: Long Natural Gas Hold Onto The Good Ones: Long Natural Gas Chart 13The 'Back To War' Trade The 'Back To War' Trade The 'Back To War' Trade Chart 14Rare Earths Revived On Commodity Surge Rare Earths Revived On Commodity Surge Rare Earths Revived On Commodity Surge 5.  Long Rare Earth Metals. Geopolitical view correct, market view mixed. We have long maintained that rare earth metals would catch a bid as US-China tensions rose. The pandemic stimulus galvanized a new capex cycle with a focus on strategic goals like supply chain resilience, military-industrial upgrades, and de-carbonization that will boost demand for rare earths. Our trade made a 9% gain, despite difficulties throughout the year arising from our homemade BCA Rare Earth Basket, which proved to be an idiosyncratic instrument. Going forward we will express our view via the benchmark MVIS Rare Earth Index (Chart 14). Bottom Line: Our successful trades hinged on broad geopolitical views: China’s confluence of internal and external risk, Biden’s reflationary agenda, persistent US-Russia conflict, and India’s attractiveness relative to other emerging markets. The change in 2022 is that Biden’s legislative agenda will be spent so the market will shift from American reflation to the Fed and global concerns. If China does not stabilize its economy, more bad news will hit China-related plays and global risk assets. Honorable Mentions: For Better And For Worse Short EM “Strongmen.” Geopolitical view correct, market view mixed. We shorted the currencies of Turkey, Brazil, and the Philippines relative to benchmark EM currencies. Though we closed the trade too early, earning a paltry sum, the political analysis proved correct and the market ultimately responded in a major way (Chart 15). Upcoming elections for these countries in 2022-23 will ensure that their dysfunctional politics remain negative for investors, while other emerging market currencies continue to outperform. Chart 15Short EM 'Strongman' Leaders Short EM 'Strongman' Leaders Short EM 'Strongman' Leaders ¡Viva México! Geopolitical view correct, market view mixed. Mexico benefited from US stimulus, the USMCA trade deal, the West’s economic divorce from China, and the resumption of tourism, immigration, and remittances. In general Latin America stands aloof from the Great Power struggles afflicting emerging markets in Europe and East Asia. But Latin America’s perennial problem with domestic populism and political instability undermines US dollar returns. Mexico looks to be a notable exception. Chart 16¡Viva México! ¡Viva México! ¡Viva México! Mexico suffered the biggest opportunity cost from the West’s love affair with China over the past 40 years. Now it stands to gain from the US drive to relocate supply chains, onshore to North America, and diversify from China. Two of our Mexico trades were ill-timed this year, but favoring Mexico over other emerging markets, particularly Brazil, was fundamentally the right call (Chart 16). Bottom Line: Cyclically Mexico is an emerging market with a compelling story based on fundamentals. Tactically disfavor emerging market “strongmen” regimes. Investment Takeaways Our batting average this year was 65%. 2021 will be remembered as a transitional year in which the world tried but did not quite return to normal amid a lingering pandemic. Inflation reemerged as a major concern of consumers, governments, and central banks. Developed markets adopted proactive fiscal policy but global cyclicals faced crosswinds as China resumed its monetary, fiscal, and regulatory tightening campaign. Our bearish call on China was a direct hit. China’s political risks will persist ahead of the twentieth national party congress in fall 2022. Cyclically stay short CNY-USD and TWD-USD. Our worst market call was long Korean / short Taiwanese equities. But the world awoke to Taiwan risk and Taiwanese stocks peaked relative to global equities. Over the long run we think war is likely in the Taiwan Strait. Re-initiate long JPY-KRW as a strategic trade. Our best market call was long Indian / short Chinese equities. Tactically this trade will probably reverse but strategically we maintain the general thesis. The US and Iran failed to rejoin their nuclear deal this year as we originally expected. In August we adjusted our view to expect a short-term Persian Gulf crisis, which in turn will lead either to diplomacy or a new war path. Oil shocks and volatility should be expected over the next 12 months. Tactically go short UAE equities relative to global. European equities and the euro disappointed this year, even though we were right that Scotland would not secede from the UK, that Italian politics would not matter, and that Germany’s election would be an upset but not negative for markets. In March we turned neutral on the US dollar and in June we argued that European political risk had bottomed and would escalate going forward. We remain tactically negative on the euro, though we are cyclically constructive. We still prefer DM Europe over EM Europe due to Russian geopolitical risks. Re-initiate long CAD-RUB and long GBP-CZK as strategic trades. We are waiting for a tactical re-entry point for the following trades: long CHF-USD, CHF-GBP, GBP-EUR, short EM ‘Strongman’ currencies versus EM currencies, long US infrastructure stocks, long European industrials, and long Italian versus Spanish stocks.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1   While autocracy is agreed to be negative for governance indicators, the connection between regime type and economic growth is debatable. Suffice it to say that the determinants of total factor productivity, such as human capital, trade openness, and effectiveness of the legislature, are often difficult to sustain under autocratic or authoritarian regimes. On this point see United Nations Industrial Development Organization, "Determinants of total factor productivity: a literature review," Staff Working Paper 2 (2007). For further discussion, see Carl Henrik Knutsen, "A business case for democracy: regime type, growth, and growth volatility," Democratization 28 (2021), pp 1505-24; Ryan H. Murphy, "Governance and the dimensions of autocracy," Constitutional Political Economy 30 (2019), pp 131-48. For a skeptical view of the relationship, see Adam Przeworski and Fernando Limongi, "Political Regimes and Economic Growth," Journal of Economic Perspectives 7:3 (1993), pp 51-69.   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Highlights Why have Value stocks underperformed so much during the past decade? The rise in intangible assets is likely the most important reason since traditional valuation metrics are no longer an accurate measure of intrinsic value. Value stocks today have a larger negative tilt to Quality than they did in the past. This has hurt Value due to Quality's outperformance. Value's underperformance is not just the result of the relative performance of a few sectors or industries, although this has played a role. Falling interest rates have not been the main driver of Value’s underperformance as they can only account for a small portion of returns. “Migration”, or mean-reversion in and out of value buckets, has declined since the Great Financial Crisis, possibly because of an increase in monopoly power. But even this cannot fully account for the underperformance since 2012. We propose that investors who wish to invest in Value screen for Quality. They should also express their Value tilts in sectors with few intangibles, such as Energy or Materials. More sophisticated stock pickers can adjust earnings and book values for intangibles. Asset allocators who invest only in indices should stay away from a structural allocation to Value. Feature Chart 1No Premium From Value Stocks Over The Last Four Decades No Premium From Value Stocks Over The Last Four Decades No Premium From Value Stocks Over The Last Four Decades Betting on cheap stocks has been a cornerstone of equity investing for decades. The rationale is simple: Stocks which are undervalued, according to some measure of intrinsic value, will eventually converge up to their fair value, on average, while stocks that are overvalued will converge down, on average. Historically, this bet on mean-reversion has proven successful – low price-to-book stocks have outperformed high price-to-book stocks by more than 3% per annum since 1927. However, the recent decades have put Value investing to the test. The Value factor, as defined by Fama and French, has not provided a structural premium in the US large cap space since the late 1970s (Chart 1, panel 1). Commercial Value indices haven’t been any more successful: Value aggregates by MSCI, Russell, and S&P have either underperformed or performed in line with the market benchmark over the same time frame (Chart 1, panel 2). The current situation presents a difficult dilemma. On the one hand, buying Value could be a tremendous opportunity. By several measures, Value stocks are the most undervalued they have been since the end of the tech bubble, right before they went on a historic run (Chart 2). Academic work has argued that these deep value spreads tend to be positively correlated with long-term outperformance of Value stocks.1 In a world of sky-high valuations and with equities and bonds projected to deliver very low returns over the next decade, a cheap return stream would be a fantastic addition to most portfolios. Chart 2Value Stocks Are Really Cheap Value Stocks Are Really Cheap Value Stocks Are Really Cheap Chart 3   And yet, Value has become so popular, that many investors are now worried that the Value premium may no longer exist. This worry is not without merit. Several studies have shown that factors lose a sizable portion of their premium once they appear in academic literature2  (Chart 3). Other issues, such as the inability of valuation metrics to properly account for intrinsic value in the modern economy, have also led some investors to seriously question whether buying Value indices will deliver excess returns in the future. So what is the right answer? Why has Value underperformed so much? Is the beaten down Value factor a generational buying opportunity? Or will it continue its decline going forward? In this report we try to answer these questions. Using a company-level dataset from our BCA Research Equity Analyzer (EA), as well as drawing on the latest academic research, we assess the evidence behind Five Theories On Value’s Underperformance. Once we determine which explanations have merit and which do not, we conclude by providing some guidelines on how investors should consider the Value factor going forward in our Investment Implications section. A word of caution: We have constructed our sample of companies to roughly resemble the sample used by MSCI World. Thus, the conclusions from our analysis based on the EA dataset should be relevant to Value indices in general. However, be advised that the methodology that EA uses is different from other commercial Value indices. Specifically, the EA methodology is more aggressive in its positioning and uses a wider array of metrics. For clarity, Table 1 shows the metrics used by EA compared to other Value indices. If you wish to know more on how the methodology works, please refer to the Appendix. Table 1Value Factor Methodologies Mythbusting The Value Factor Mythbusting The Value Factor Also, please note that our report will not deal with the cyclical outlook for Value. While it is entirely possible that a period of cyclical growth could help Value stocks outperform, the question we are trying to answer is whether buying cheap versus expensive stocks still provides a structural premium over the long term. While the Global Asset Allocation service does not use the Value versus Growth framework for equity allocation, our colleagues from our Global Investment Strategy service have written extensively on why they believe investors should pivot to Value on a cyclical basis.3 Five Theories On Value’s Underperformance Chart 4More To The Underperformance Of Value Than Sector Tilts More To The Underperformance Of Value Than Sector Tilts More To The Underperformance Of Value Than Sector Tilts Theory #1: The underperformance of Value indices is purely a result of their sector composition Some investors suggest that Value stocks’ large underweight of mega-cap tech, as well as their overweight in Financials and Energy, have been responsible for Value’s woes over the past decade. However, our research suggests that this theory is not entirely correct. A Value index with the same sector and industry weightings as the Developed Markets (DM) benchmark has still underperformed by more than 15% since 2010 (Chart 4, panel 1). Sector and industry composition have been responsible for about a third of the underperformance of the DM Value index. What about excluding the FAANGM stocks? Again, the story is similar. Even when omitting these stocks from our investment universe, Value stocks have still underperformed by almost the same amount as a regular Value composite (Chart 4, panel 2). Finally, we can also look at the performance of cheap versus expensive stocks within each industry. Chart 5A shows that cheap stocks have underperformed expensive stocks in 18 and 17 out the 24 GICS Level 2 industries in DM and in the US, respectively, since 2012 (roughly corresponding to the peak in relative performance in the EA Value index). Even on an equally-weighted basis, which eliminates the effects of large companies, cheap stocks have underperformed expensive stocks in both the average and median industry (Chart 5B). Chart 5 Chart 5 Verdict: Myth. The underperformance of cheap versus expensive stocks has been broad. While sector and industry dynamics have certainly been an important factor, Value's underperformance is not just the result of a few companies, sectors, or industries. Chart 6Value Likes Rising Yields... Value Likes Rising Yields... Value Likes Rising Yields... Theory #2: The decline in interest rates is to blame for the underperformance of Value Another reason used to explain the underperformance of Value is the secular decline in interest rates. The reasoning goes as follows: Cash flows from growth stocks are set to be received further into the future, while cash flows from Value stocks are closer to the present. Using a Discounted Cash Flow model, one can show that all else being equal, a decline in the discount rate should result in a relatively higher increase in the present value for Growth stocks versus Value stocks. There is some evidence in support of this theory. While prior to 2010, Value and interest rates had an inconsistent relationship, the beta of cheap stocks to the monthly change in the 10-year US Treasury yield has increased markedly over the past 10 years (Chart 6, panel 1). On the other hand, the beta of expensive stocks to yields has become increasingly more negative. A similar situation occurs when we use the yield curve. Cheap stocks tend to exhibit higher excess returns whenever it steepens, while expensive stocks do so when it flattens (Chart 6, panel 2). Importantly, these relationships are not purely a result of Value’s exposure to banks. Value stocks excluding financials also show a strong positive relationship to both the 10-year yield and yield curve slope versus their growth counterparts (Chart 7). But while this relationship is statistically significant, it fails to be economically significant. Our analysis shows that the betas to either interest rates or the slope of the yield curve only explain a small fraction of the performance of cheap or expensive stocks (Chart 8). This result is in line with the research from Maloney and Moskowitz, which showed that the vast majority of the decline in Value in recent years could not be explained by interest rates.4 Chart 7...Even When Excluding Financials... ...Even When Excluding Financials... ...Even When Excluding Financials... Chart 8...But Yields Don't Explain Much ...But Yields Don't Explain Much ...But Yields Don't Explain Much   Verdict: Myth. Cheap stocks have an increasingly positive beta to both the 10-year yield and the slope of the yield curve, whereas expensive stocks have an increasingly negative beta. However, while these betas are statistically significant, they can only account for a small portion of Value's underperformance. Theory #3: A decline in market mean-reversion is responsible for the underperformance of Value In a seminal paper, Fama and French describe the process of migration.5 Migration is when stocks move across different value buckets: For example, when stocks in the cheap bucket migrate to the neutral and expensive buckets, and when stocks in the expensive bucket migrate to the neutral or cheap buckets. Historically, this process of mean-reversion has provided a significant share of the Value premium. However, migration has declined significantly over the past decade (Chart 9, panel 1). The amount of market cap migrating each month as a percentage of total market cap has declined from over 12% before the GFC to less than 8% currently. Importantly, this decline in migration has been broad-based. Neither cheap, neutral, nor expensive stocks are moving to other valuation cohorts at the same rates that prevailed in the past (Chart 9, panel 2). The market has become much more ossified: Value stocks remain Value stocks, Neutral stocks remain Neutral stocks, and Growth stocks remain Growth stocks.5 Chart 9What Happens In Value Now Stays In Value What Happens In Value Now Stays In Value What Happens In Value Now Stays In Value Chart 10Market Concentration Could Be The Reason Why Migration Has Declined Market Concentration Could Be The Reason Why Migration Has Declined Market Concentration Could Be The Reason Why Migration Has Declined Why has migration declined? One theory is that industries have increasingly become more monopolistic, which means that it has become harder for new entrants to gain market share (Chart 10). Meanwhile market leaders are able to grow at an above-average pace thanks to their large network effects.6 What has been the role of this decreased migration in the performance of Value? A paper written by Arnott, Harvey, Kalesnik, and Linainmaa showed that while the returns attributable to migration have decreased over the past 15 years, this change is still not strong enough to explain the deep underperformance in Value.7 Our own research assigns it a relatively larger weight, with migration accounting for a little less than half of the underperformance of Value since 20128 (Table 2). Table 2Return Attribution Of Cheap And Expensive Stocks Mythbusting The Value Factor Mythbusting The Value Factor Verdict: Somewhat True. Migration has declined since the GFC, possibly because of an increase in monopoly power. While this decline has certainly played a role in the underperformance of Value, it explains, at most, less than half of the drawdown since 2012. Theory #4: Value has underperformed because it is increasingly a play on junk stocks Chart 11 It is a well-known empirical fact that cheap stocks tend to have lower Quality than expensive stocks. Conceptually this makes sense: Companies with higher profitability, more stability, and less leverage should trade at a valuation premium, whereas low income, high-debt companies should trade at a discount. However, this gap in Quality between cheap and expensive stocks is not always the same. Consider the composition of cheap and expensive stocks in 2000 – the eve of the tech bubble crash. About a third of expensive stocks were also junk (low quality), whereas 36% were quality stocks (Chart 11). Today, this composition is much different: Only about a fifth of the market capitalization of expensive stocks is junk, whereas quality stocks now make up 44% of the overall expensive cohort. On the other hand, the Quality of cheap stocks has deteriorated: Cheap junk stocks are now 37% of the cheap cohort versus 29% in 2000. Importantly, the difference in Quality between cheap and expensive stocks tends to be a good predictor for value returns (Chart 12). A big gap in the Quality factor often implies lower returns of cheap versus expensive stocks, whereas a small gap implies higher returns. These results are in line with similar research which has shown that Quality, or Quality proxies like profitability, can be used to enhance the Value factor.9 Chart 12Value Does Well When The Quality Gap Is Small Value Does Well When The Quality Gap Is Small Value Does Well When The Quality Gap Is Small Why is this the case? As we have discussed in the past, Quality has been one of the best performing factors over the past 30 years - likely driven by powerful behavioral biases as well as by the incentives in the money management industry.10 As a result, taking an overly negative position on this factor over a long enough period eventually eats away at the Value premium. Verdict: True. Value stocks today have a larger negative tilt to Quality than they did in the past. This negative tilt has hurt Value as excess returns of cheap stocks tend to be dependent on their Quality gap to expensive stocks. Theory #5: Value has underperformed because traditional valuation metrics are no longer a reliable indicator of intrinsic value How exactly to measure whether a company is cheap or expensive has been a matter of debate since the very beginnings of Value investing. Benjamin Graham famously cautioned against using book value as a measure of intrinsic value, preferring a more holistic approach. Today most index providers use a combination of traditional valuation metrics like price-to-book and price-to-earnings to build Value indices. It is fair to ask if these measures are still relevant for today’s companies. Intangible investment has become a much larger part of the economy, having surpassed tangible investment in the US in the late 1990s (Chart 13). However, both US GAAP and IFRS are very restrictive on the capitalization of R&D activities, which are known to originate valuable intangible assets.11 Other types of intangible capital such as unique production processes or customer lists are normally also expensed within SG&A expenses and are never capitalized unless there is an acquisition. This means that both the book value and earnings of intangible-heavy companies could be inadequate estimates of their true intrinsic value. Chart 13 Is there any evidence that this is the case? Using our EA dataset, we confirm that expensive companies generally have higher R&D expenditures as a percent of sales than cheap companies (Chart 14). Importantly, we see that the performance of Value within low R&D stocks is much better than the performance within high R&D stocks (Chart 15). This is line with the work of Dugar and Pozharny, who found that the value relevance for both earnings and book values has declined for high intangible companies, while it has stayed stable for low-intangible companies.12 This suggests that traditional valuation measures are losing their relevance as intangible-heavy companies become a larger part of the economy.13 Chart 14Growth Stocks Spend More On Intangibles Growth Stocks Spend More On Intangibles Growth Stocks Spend More On Intangibles Chart 15Are Traditional Metrics Underestimating Intrinsic Value In High-Intangible Companies? Are Traditional Metrics Underestimating Intrinsic Value In High-Intangible Companies? Are Traditional Metrics Underestimating Intrinsic Value In High-Intangible Companies? The effect of intangibles on traditional valuation metrics can also give us a clue as to why Value has performed well in some industries but not in others. Using a measure of intangible intensity derived by Dugar and Pozharny14 – which includes identifiable intangible assets, intellectual capital (as proxied by R&D spending), and organizational capital (as proxied by SG&A spending) – we can see that Value has done relatively better in industries with lower intangible intensity while it has performed relatively worse in industries with higher intangible intensity (Chart 16). Chart 16 Verdict: True. Value performs better when considering only companies with low R&D expenses or industries with low-intangible intensity. This suggests that the rise in intangible assets might be responsible for the underperformance of cheap stocks, as traditional valuation metrics may no longer be an accurate measure of intrinsic value in intangible-heavy companies or industries. Investment Implications Chart 17Investors Can Invest In Value Within Low-Intangible Sectors Investors Can Invest In Value Within Low-Intangible Sectors Investors Can Invest In Value Within Low-Intangible Sectors What does our analysis mean for investors? Aside from the most well-known practices to improve the performance of Value – for example, using a wide array of valuation metrics, exploiting value in small stocks, or using equal-weighted indices to avoid the effect of sector weightings or large companies15 – we would recommend investors first screen cheap stocks for quality to avoid Value traps. Investors should also account for the failure of traditional metrics to measure intangible assets. This can be done in two ways: The first is to take Value tilts only on intangible-light sectors such as Energy and Materials – for example, allocating only to the cheapest oil and materials stocks. For the last decade, the cheapest Energy and Materials companies have outperformed their respective sectors, even while overall Value has cratered (Chart 17). Alternatively, more sophisticated stock pickers can adjust valuation ratios to account for intangibles. There is some promise to this approach. Arnott, Harvey, Kalesnik, and Linainmaa showed that even a crude adjustment to the HML (High-Minus-Low) index consistently outperforms the regular value factor16 (Chart 18). What about asset allocators who invest only in broad indices? We would recommend that they stay away from structural allocations to commercial Value indices altogether. While it is true that sector rotations or interest-rate movements could benefit value on a short-term basis, in the long term, the negative Quality tilt of Value stocks should be a drag on returns. Additionally, it remains a big risk that indices based on traditional measures are underestimating intangible value. This underestimation will only get worse as the economy becomes more digitalized. Investors who wish to take advantage of trends like higher inflation or rising interest rates should just bet on cyclical sectors. So far this has been the right approach. Just this year, even though interest rates have increased by more than 60 basis points, and both Financials and Energy have outperformed IT by 13% and 30% respectively, Value stocks have underperformed Growth stocks (Chart 19). Chart 18Adjusting For Intangibles Improves Value Adjusting For Intangibles Improves Value Adjusting For Intangibles Improves Value Chart 19Rates Rose, Financials And Energy Outperformed IT, And Yet Value Underperformed Growth Rates Rose, Financials And Energy Outperformed IT, And Yet Value Underperformed Growth Rates Rose, Financials And Energy Outperformed IT, And Yet Value Underperformed Growth Appendix A Note On Methodology The Equity Analyzer service is a stock picking tool that applies a top-down approach to bottom-up stock picking. The crux of the platform is the BCA Score, which is a weighted composite of 30 cross sectionally percentile ranked factors. Within this report we focus on the value (price-to-earnings, price-to-book, price-to-cash, price-to-cash flow and price-to-sales) and quality (accruals, profitability, asset growth, and return on equity) factors used in the BCA Score model. Each of the factors are cross sectionally-percentile ranked, within the specified universe, where a score of 100% is best ranked stock according to that particular score. From here, we create the value and quality scores used in this report by equal-weighting and combining the scores from each value and quality factors. It is important to note that a high score does not mean the underlying value is high, but that it exhibits a better characteristic for forecasting future excess returns. For example, the stock with the highest value score would be considered the cheapest. The scores are re-calculated each period and applied on a one-period forward basis when calculating returns. To keep the analysis comparable the MSCI Data and relevant to our clients, we limit the universe of stocks to only those with a market capitalization greater than 1 billion USD. Also, unless otherwise specified, the scores are market-cap weighted when aggregated and all returns are in US dollars.   Juan Correa-Ossa, CFA Editor/Strategist juanc@bcaresearch.com Lucas Laskey Senior Quantitative Analyst lucasl@bcaresearch.com Footnotes 1  Please see Clifford Asness, John M. Liew, Lasse Heje Pedersen, and Ashwin K Thapar, “Deep Value,” The Journal of Portfolio Management, 47-64 (11-40), 2021.2   2  Please see Andrew Y. Chen and Mihail Velikov, “Zeroing in on the Expected Returns of Anomalies,” Finance and Economic Discussion Series 2020-039, Board of Governors of the Federal Reserve. 3 Please see Global Investment Strategy Report, “Pivot To Value,” dated September 18, 2020. 4 Please see Thomas Maloney and Tobias J. Moskowitz, “Value and Interest Rates: Are Rates to Blame for Value’s Torments?” The Journal of Portfolio Management, 47-6 (65-87), 2021. 5 Please see Eugene Fama and Kenneth French, “Migration,” Financial Analyst Journal, 63-3 (48-58), 2007. 6 Please see Robert D. Arnott, Campbell R. Harvey, Vitali Kalesnik and Juhani T. Linainmaa, “Reports of Value’s death May Be Greatly Exaggerated,” Financial Analyst Journal, 77-1 (44-67), 2021. 7  Please see Robert D. Arnott, Campbell R. Harvey, Vitali Kalesnik and Juhani T. Linainmaa (2021). 8  Much like us, Lev and Srivastava assign a relatively bigger role to the decline in migration. For more details, please see Baruch Lev and Anup Srivastava, “Explaining the Recent Failure of Value Investing,” NYU Stern School of Business (2019). 9  Please see Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz, “Fact, Fiction, and Value Investing,” The Journal of Portfolio Management, 42-1 (34-52), 2015. 10 Please see Global Asset Allocation Special Report, “Junk Disposal: The Quality Factor In Equity Markets,” dated September 8, 2020. 11 US GAAP requires both Research and Development costs to be expensed. IFRS prohibits capitalization of Research cost but allows it for Development costs provided that some conditions are met. For a further discussion on the accounting treatment of intangibles, please see Amitabh Dugar and Jacob Pozharny, “Equity Investing in the Age of Intangibles,” Financial Analyst Journal, 77-2 (21-42), 2021. 12 Please see Amitabh Dugar and Jacob Pozharny (2021). 13This also follows from research from Lev and Srivastava which showed that while capitalizing intangibles did not improve the value factor in the 1970s, it increased returns substantially after the 1990s. For more details, please see Baruch Lev and Anup Srivastava (2019). 14This measure excludes Banks, Diversified Financials, and Insurance. For more details, please see Amitabh Dugar and Jacob Pozharny (2021). 15Please see Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz (2015). 16Please see Robert D. Arnott, Campbell R. Harvey, Vitali Kalesnik and Juhani T. Linainmaa (2021).  

Highlights US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. If aggregate demand exceeds aggregate supply, the price level will rise. We argue that the US aggregate demand curve is currently quite steep. This implies that the price level may need to rise a lot to restore balance to the economy. In fact, if the aggregate demand curve is not just steep but upward-sloping, which is quite possible, there may be no price level that brings aggregate demand in line with supply; the US economy could go supernova. When supply is the binding constraint to growth, investors need to throw the old playbook for dealing with growth slowdowns out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. The Binding Constraint To Growth Is Now Supply After a post-Delta wave rebound in Q4, the US economy is expected to slow over the course of 2022. The Bloomberg consensus is for US growth to decelerate from 4.9% in 2021Q4 to 4.1% in 2022Q1, 3.9% in 2022Q2, 3.0% in 2022Q3, and 2.5% in 2022Q4. Growth in the first quarter of 2023 is expected to dip further to 2.3%. We agree that US growth will slow next year but think the market narrative around this slowdown is misguided. Chart 1Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand The standard market playbook for dealing with an economic slowdown is to position for lower bond yields, a stronger US dollar, and a decline in commodity prices. On the equity side, the playbook calls for shifting equity exposure from cyclicals to defensives, favoring large caps over small caps, and growth stocks over value stocks. There are two major problems with this narrative. First, growth is peaking at much higher levels than before and is unlikely to return to trend at least until the second half of 2023. Second, and more importantly, US growth will slow due to supply-side constraints rather than inadequate demand. US final demand will remain robust for the foreseeable future. Households are sitting on $2.3 trillion in excess savings, equivalent to 15% of annual consumption (Chart 1). The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 2). Banks are falling over themselves to make consumer loans (Chart 3). Chart 2Revolving Credit On The Rise Again Revolving Credit On The Rise Again Revolving Credit On The Rise Again Chart 3Banks Are Easing Credit Standards For Consumers Banks Are Easing Credit Standards For Consumers Banks Are Easing Credit Standards For Consumers Chart 4A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 4). As we discussed two weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Investment demand should remain strong. Business inventories are near record low levels (Chart 5). Core capital goods orders, a leading indicator for corporate capex, have soared (Chart 6). Chart 5Business Inventories Are Near Record Low Levels Business Inventories Are Near Record Low Levels Business Inventories Are Near Record Low Levels Chart 6Rise In Durable Goods Orders Bodes Well For Capex Rise In Durable Goods Orders Bodes Well For Capex Rise In Durable Goods Orders Bodes Well For Capex Chart 7The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Dodge Momentum Index, which tracks planned nonresidential construction, rose to a 13-year high in October. The home­owner vacancy rate is at multi-decade lows, signifying the need for more homebuilding (Chart 7). While increased investment will augment the nation’s capital stock down the road, the short-to-medium term effect will be to inflate demand. Policy Won’t Tighten Enough To Cool The Economy What is the mechanism that will push down aggregate demand growth towards potential GDP growth? It is unlikely to be policy. While budget deficits will narrow over the next few years, the IMF still expects the US cyclically-adjusted primary budget deficit to be nearly 3% of GDP larger between 2022 and 2026 than it was between 2014 and 2019 (Chart 8). Chart 8 Chart 9The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation   As Matt Gertken, BCA’s Chief Geopolitical Strategist, writes in this week’s US Political Strategy report, the passage of the $550 billion infrastructure bill has increased, not decreased, the odds of President Biden and the Democrats passing their social spending bill via the partisan budget reconciliation process. On the monetary side, the Federal Reserve will finish tapering asset purchases next June and begin raising rates shortly thereafter. However, the Fed has no intention of raising rates aggressively. Most FOMC members see the Fed funds rate rising to only 2.5% this cycle (Chart 9). The “dots” call for only one rate hike in 2022 and three rate hikes in both 2023 and 2024. Investors expect rates to rise even less by end-2024 than the Fed foresees (Chart 10).   Chart 10 The Inflation Outlook Hinges On The Slope Of The Aggregate Demand Curve If policy tightening will not suffice in cooling demand, the economy will overheat and inflation will rise. But by how much will inflation increase? The answer is of great importance to investors. It also hinges on a seemingly technical question: What is the slope of the aggregate demand curve? As Chart 11 illustrates, prices will rise more if the aggregate demand curve is steep than if it is flat. Chart 11 Chart 12Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s It is tempting to think of the aggregate demand curve in the same way one might think of the demand curve for, say, apples. When the price of apples rises, there is both a substitution and an income effect. An increase in the price of apples will cause shoppers to substitute away from apples towards oranges. In addition, if apples are so-called “normal goods,” shoppers will buy fewer apples in response to lower real incomes. This chain of reasoning breaks down at the aggregate level. When economists say the price level has risen, they are referring to all prices; hence, there is no substitution effect. Moreover, since one person’s spending is another’s income, rising prices do not necessarily translate into lower overall real incomes. Granted, if nominal wages are sticky, as they usually are in the short run, an unanticipated increase in prices will reduce real wage income. However, this will be offset by higher business income. Over time, wages tend to catch up with prices. In fact, wage growth usually outstrips price growth during inflationary periods. For example, real wages rose during the late-1960s and 70s but fell during the disinflationary 1980s (Chart 12). Textbook Reasons For A Downward-Sloping Aggregate Demand Curve According to standard economic theory, there are three main reasons why aggregate demand curves are downward-sloping: The Pigou Effect: Higher prices erode the purchasing power of money, resulting in a negative wealth effect. The Keynes Effect: Higher prices reduce the real money supply. This pushes up real interest rates, leading to lower investment spending. The Mundell-Fleming Effect: Higher real rates push up the value of the currency, causing net exports to decline. None of these three factors are particularly important for the US these days. Chart 13Base Money Has Swollen Since The Subprime Crisis Base Money Has Swollen Since The Subprime Crisis Base Money Has Swollen Since The Subprime Crisis Strictly speaking, the Pigou wealth effect applies only to “base money,” also known as “outside money.” Outside money includes cash notes, coins, and bank reserves. Inside money such as bank deposits are not included in the Pigou effect because while an increase in consumer prices decreases the real value of bank deposits, it also decreases the real value of commercial bank liabilities.1  In the US, the monetary base has swollen from 6% of GDP in 2008 to 28% of GDP as a result of the Fed’s QE programs (Chart 13). Nevertheless, even if one were to generously assume a wealth effect of 10% from changes in monetary holdings, this would still imply that a 1% increase in consumer prices would reduce spending by only 0.03% of GDP. Simply put, the Pigou effect is just not all that big. Chart 14 In contrast to the Pigou effect, the Keynes effect has historically had a significant impact on the business cycle. However, the importance of the Keynes effect faded following the Global Financial Crisis as the Fed found itself up against the zero lower bound on interest rates. When interest rates are very low, there is little to distinguish money from bonds. Rather than holding money as a medium of exchange (i.e., for financing transactions), households and businesses end up holding money mainly as a store of wealth. In the presence of the zero bound, the demand for money becomes perfectly elastic with respect to the interest rate (Chart 14). As a result, changes in the real money supply have no effect on interest rates, and by extension, interest-rate sensitive spending. And if a decline in the real money supply does not push up interest rates, this undermines the Mundell-Fleming effect as well. Could The Aggregate Demand Curve Be Upward-Sloping? The discussion above, though rather theoretical in nature, highlights an important practical point: The aggregate demand curve may be quite steep. This means that the price level might need to rise a lot to equalize aggregate demand with aggregate supply. Chart 15US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows In fact, one can easily envision a scenario where a rising price level boosts spending; that is, where the demand curve is not just steep but upward-sloping. One normally assumes that higher inflation will prompt central banks to raise rates by more than inflation has risen, leading to higher real rates. However, if the Fed drags its feet in hiking rates, as it is wont to do given its concerns about the zero bound, rising inflation will translate into a decline in real rates. Lower rates will boost demand, leading to higher inflation, and even lower real rates. In addition, lower real rates will benefit debtors, who tend to have a higher marginal propensity to spend than creditors. This, too, will also boost aggregate demand. It is striking in this regard that real bond yields hit a record low this week, with the 10-year TIPS yield falling to -1.17% and the 30-year yield drooping to -0.57% (Chart 15). Black Holes Vs. Supernovas Chart 16 In the case where the aggregate demand curve is upward-sloping, there is no stable equilibrium (Chart 16). If demand falls short of supply, demand will continue to shrink as the price level declines, leading to ever-rising unemployment. Unless policymakers intervene with stimulus, the economy will sink into a deflationary black hole. In contrast, if demand exceeds supply, demand will continue to rise as the price level increases exponentially. The economy will go supernova. Tick Tock Young stars fuse hydrogen into helium, releasing excess energy in the process. After the star has run out of hydrogen, if it is big enough, it will start fusing helium into heavier elements such as carbon and oxygen. The process of nucleosynthesis continues until it reaches iron. That is the end of the line. Fusing elements heavier than iron requires a net input of energy. Unable to generate enough external pressure through fusion, the star loses its battle to gravity. The core collapses, spewing material deep into interstellar space (a good thing since your body is mainly made from this stardust). Observing the star from afar, one would be hard-pressed to see anything abnormal until it explodes. The path to becoming a supernova is highly non-linear. The same is true for inflation. Just like a star with an ample supply of hydrogen, the Fed can burn through its credibility for a while longer. During the 1960s, it took four years for inflation to take off after the economy had reached full employment (Chart 17). By that time, the unemployment rate was two percentage points below NAIRU. Most of today’s inflation is confined to durable goods. This is not a sustainable source of inflation. The durable goods sector is the only part of the CPI where prices usually fall over time (Chart 18). Chart 17Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Chart 18Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time To get inflation to go up and stay up in modern service-based economies, wages need to rise briskly. While US wage growth has picked up, the bulk of the increase has been among low-wage workers, particularly in the services and hospitality sector (Chart 19). Chart 19Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution The most likely scenario for next year is that firms will simply ration output, fearful that raising prices too quickly will hurt brand loyalty and trigger accusations of price gouging. Shortages will persist, but this time they will be increasingly concentrated in the service sector. Such a state of affairs will not last, however. Competition for workers will cause wages to rise much more than they have so far. Keen to protect profit margins, firms will start jacking up prices. A wage-price spiral will develop. The US economy could go supernova. Investment Conclusions Chart 20Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. This means that the old playbook for dealing with growth slowdowns needs to be thrown out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. While inflation expectations have recovered from their pandemic lows, the 5-year/5-year forward TIPS breakeven inflation rate is still near the bottom end of the Fed’s comfort zone (Chart 20). Rising inflation expectations will lift long-term bond yields, justifying a short duration stance in fixed-income portfolios. Higher bond yields will benefit value stocks. Chart 21 shows that there has been a strong correlation between the relative performance of growth and value stocks and the 30-year bond yield this year. Rising input prices will make the US export sector less competitive, leading to a weaker dollar. Historically, non-US stocks have done well when the dollar has been weakening (Chart 22). Chart 21The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year Chart 22Non-US Stocks Tend To Do Best When The US Dollar Is Weakening Non-US Stocks Tend To Do Best When The US Dollar Is Weakening Non-US Stocks Tend To Do Best When The US Dollar Is Weakening As for the overall stock market, with the Fed still in the dovish camp, it is too early to turn negative on equities. An equity bear market is coming, but not until rising inflation forces the Fed to step up the pace of rate hikes. That will probably not happen until mid-2023. Short Gilt Trade Activated We noted last week that we would go short the 10-year UK Gilt if the yield broke below 0.85%. Our limit order was activated on November 5th and we are now short this security.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1  To distinguish between inside and outside money, one should ask where the liability resides. If the liability resides within the private sector, it is inside money. By convention, central bank reserves are classified as outside money. However, one could argue that since taxpayers ultimately own the central bank, an increase in the price level will benefit taxpayers by eroding the real value of the central bank’s liability. If one were to take this view, the Pigou effect would be even weaker. Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

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