Technical

Listen to a short summary of this report.       Executive Summary Gold Has Established A Double-Top Formation Gold Has Established A Double-Top Formation Gold Has Established A Double-Top Formation Gold has done quite well amidst the turmoil in global financial markets. BCA is neutral global equities, which bodes well for gold as a hedge. The shiny metal is a great inflation hedge. Investors betting on non-transitory inflation should be overweight gold in their portfolios. Historically, gold has held up relatively well during equity market downturns. Most of our fair-value models are pinning gold at neutral valuations. This suggests that positioning should be tactical rather than strategic.   Bottom Line: Gold can be expected to trade higher over the next few months, as global central banks fall behind the curve in fighting inflation. Once it becomes clear that inflation has peaked, either via a soft landing in major economies or an outright recession, gold will lag other commodity prices. According to our models, the near-term target for gold is 1848 USD/oz, suggesting a modest overweight stance. Feature Gold has held up remarkably well, amidst very poor returns for traditional asset classes. The bellwether S&P 500 index is down 20% year to date. US 10-year treasury prices are down 14%. Even copper, a barometer for commodity prices is off 20% from its peak, despite a supply-driven bull market in many resources from grains to energy. Investors who decided to park their wealth in gold are flat year-to-date, not a desirable result, but a much better outcome compared to a 60/40 equity-bond portfolio, which is down 18% year-to-date. What is remarkable about gold’s resilience is that traditional tailwinds for the yellow metal are now opposing forces. For example, gold trends with falling real rates, but the 10-year TIPS yield has rebounded violently as the Federal Reserve has turned more hawkish. Gold also moves inversely to the dollar, but the DXY dollar index hit fresh cycle highs this year. In fact, we are witnessing the rare occurrence where both gold and the dollar are up this year (Chart 1). Gold’s resilience comes at an important time since, from a technical standpoint, a classic double-top formation has been established. For chartists, this means either a major downturn is in the cards, or some consolidation is due before new highs are established (Chart 2). In this report, we try to gauge the outlook for gold from the lens of the current macroeconomic paradigm, valuations, and shifts in investors’ perception of what defines a safe-haven asset. Chart 1Gold Has Held Up Remarkably Well Gold Has Held Up Remarkably Well Gold Has Held Up Remarkably Well Chart 2Gold Has Established A Double-Top Formation Gold Has Established A Double-Top Formation Gold Has Established A Double-Top Formation Gold As An Inflation Hedge Chart 3Gold Prices Track US Inflation Gold Prices Track US Inflation Gold Prices Track US Inflation Gold prices have historically been a good inflation hedge. Chart 3 shows that gold has done an excellent job at tracking consumer prices in the US. According to this chart, gold has lagged the overshoot in inflation. This suggests that bullion prices could be poised for a coiled spring rebound. Gold’s link to inflation dates back many centuries, given that it has historically been a monetary standard. The pre-war period in the early 1900s saw tremendously undervaluation in gold, as an economic boom was met with a rigid money supply. It was not until the 1929 stock market crash, and the ensuing Great Depression, that Western governments had to debase fiat money vis-à-vis gold to stop price deflation. Under the post-WW2 Bretton Woods system, the widespread implementation of social welfare schemes in the late 1960s, excessive government spending, and the Vietnam war all created a huge fiscal burden for the US government. This caused the current-account deficit to widen, leading to a sharp fall in confidence in the dollar. Inflationary pressures began to fester. As a result, the Nixon administration was forced to shut the gold window in 1971 and delink the US dollar from gold. The dollar collapsed and gold soared as a result. Today, most currencies are freely floating, adjusting to price differentials in a timely manner, but rising inflation once again is a global problem. This is an environment where gold usually does well. Proponents of the gold standard generally point out that since 2020, the US monetary base has expanded by 71%, but gold output has risen only by 4%. Ergo, monetary policy would have been extremely tight under a gold-exchange standard, helping curtail inflation. The bottom line is that inflation risks are here to stay, as outlined in various Commodity & Energy Strategy reports. This will be a tailwind for bullion. Gold And The Dollar It has become clear in recent weeks that the Fed (and most other central banks) are behind the curve on inflation. As an anti-fiat currency, gold typically does well in this environment. Chart 4 highlights that the real Fed fund’s rate is below a variety of reasonable estimates of neutral. Gold typically moves inversely to the dollar so the question becomes how fast the Fed can tighten financial conditions, while engineering a soft landing in the US. In our view, it is possible but not probable. The Fed’s hawkish shift has triggered a tremendous outflow from long-duration US equities (Chart 5). Bonds remain the overarching driver of US portfolio flows, but rising inflation volatility is keeping big buyers such as Japan on the sidelines. This raises the likelihood that the Fed will pivot in a dovish fashion, as financial conditions tighten. Chart 4Real Rates In The US Are Very Low Real Rates In The US Are Very Low Real Rates In The US Are Very Low Chart 5Higher Rates Are A Threat To US Equity Inflows Higher Rates Are A Threat To US Equity Inflows Higher Rates Are A Threat To US Equity Inflows Even if the US avoids a recession, it is likely that countries that were starved of growth during the pandemic will increasingly benefit, including China. It is noteworthy that currency strength has been bifurcated. Commodity-producing currencies have done relatively well (BRL, CAD, AUD), while commodity importers’ currencies have been hammered (EUR, JPY, SEK). Excluding the supply side of the commodity picture, the dollar would be marginally weaker. Gold And Commodities Most of gold’s demand comes from investment, but there is some industrial and jewelry use as well. As such, gold remains very highly correlated to overall commodity prices. The prices of many commodities are in a supply-side bull market. This has helped keep gold prices elevated. Gold’s industrial demand is likely to be a bane in the near term, even if it would support prices longer term. Most industrial powers are seeing a slowdown in their economies, notably China. This puts a lot of industrial commodities, including gold, at risk of a price reversal. Looking ahead, commodity demand is expected to remain firm especially in the face of supply-side bottlenecks. This will put a floor on how low gold prices can fall. Consumer demand could become a key source of support for gold prices. Chinese and Indian gold imports have surged this year, amidst soft prices. Gold coin and bar investment demand is also above its 5-year average. There is high seasonality to India’s demand for gold, so upcoming festival and wedding seasons, many of which were postponed due to Covid-19 restrictions, will provide a boost to gold purchases. In the US, gold coin sales in May were at the highest level in over a decade. Even Russia, which recently removed the VAT tax on gold purchases, saw a 54% year-on-year rise in gold coin sales. Gold And Central Banks The one profound change in the gold market has been the behavior of global central banks. Global allocations of foreign-exchange reserves have drifted away from the dollar and towards gold and other currencies (Chart 6). This helps underpin the gold bull market. This diversification away from the USD has been particularly acute among countries with a geopolitical incentive to increase non-dollar holdings. China has seen its gold reserves rise from 1.9% to 3.6% since 2016. Russia, which presently is at war with the West, has little Treasury holdings with 21% of its reserves in gold. With every country having an implicit geopolitical imperative to diversify its reserve holdings, gold sits as a neutral monetary standard. As such, the allocation of global FX reserves towards gold will continue to rise (Chart 7). Chart 6A Stealth Diversification From US Dollars A Stealth Diversification From US Dollars A Stealth Diversification From US Dollars Chart 7Central Banks Have Become Gold Buyers Central Banks Have Become Gold Buyers Central Banks Have Become Gold Buyers Gold And Financial Markets The biggest demand for gold is likely to come from hedging against equity volatility. Historically, gold has done relatively well during equity market drawdowns (Chart 8). This has been the case so far this year. As outlined above, if inflation continues to surprise to the upside, then gold should be a core holding in investor portfolios. That said, TIPS yields are rising; as such, should global central banks contain the risk of a wage-inflation spiral, gold will underperform other asset classes. Chart 8Gold Does Well During Crises What Should Investors Do About Gold? What Should Investors Do About Gold? The gold/commodity ratio has an eery correlation with the VIX (Chart 9). This cements gold’s role as a safe-haven asset. Given rising political and economic uncertainty, a gold hedge is practical. Chart 9Higher Volatility Will Benefit Gold Higher Volatility Will Benefit Gold Higher Volatility Will Benefit Gold How To Value Gold Valuing gold is an extremely difficult exercise. As an inflation hedge, gold is trading at a 210% premium relative to its purchasingpower (Chart 10). However, shorter-term models are more sanguine. Our in-house models using a combination of monetary and financial variables suggest gold is much closer to fair value at current levels (Chart 11). From a holistic sense, gold is a hedge against geopolitical uncertainty, overly abundant liquidity, and inflation risk, as well as a source of capital preservation. Putting all these together, the gold price is fair. Chart 10Gold Is Expensive In Real Terms Gold Is Expensive In Real Terms Gold Is Expensive In Real Terms Chart 11Gold At Fair Value According To Our Models Gold At Fair Value According To Our Models Gold At Fair Value According To Our Models From a commodity standpoint, gold is trading at a hefty premium to cash costs (Chart 12). This has always been the case during gold bull markets. Should the current paradigm shift to one of low inflation and little geopolitical risk, investors need to be cognizant of the safety premium currently embedded in gold prices. Chart 12Gold Is Trading Well Above Cash Costs Gold Is Trading Well Above Cash Costs Gold Is Trading Well Above Cash Costs From a technical standpoint, our indicators suggest gold is oversold but not yet at a nadir (Chart 13). This implies some consolidation is due before the next leg of the gold trend is established. Chart 13Sentiment On Gold Is Not Yet At A Nadir Sentiment On Gold Is Not Yet At A Nadir Sentiment On Gold Is Not Yet At A Nadir From a valuation standpoint, we will be buyers of gold today, but will not hold it for the long term. Investment Conclusions Gold can be expected to trade higher over the next few months, as global central banks fall behind the curve in fighting inflation. Once it becomes clear that inflation has peaked, either via a soft landing in major economies or an outright recession, gold will lag other commodity prices. According to our models, the near-term target for gold is 1848 USD/oz, suggesting a modest overweight stance is appropriate.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary  

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (May 17 at 9:00 AM EDT, 14:00 PM BST, 15:00 PM CEST and May 18 at 9:00 HKT, 11:00 AEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist

Highlights All four of our US Equity indicators are currently pointing in a bearish direction. Our Monetary Indicator has fallen to a three decade low, our Technical Indicator has broken into negative territory, our Valuation Indicator still signals extreme equity pricing, and our Speculation Indicator does not yet support a contrarian buy signal. Still, we do not expect a US recession over the coming year, which implies that S&P 500 revenue growth will stay positive. Nonrecessionary earnings contractions are rare, and are almost always associated with a significant contraction in profit margins. Our new profit margin warning indicator currently suggests the odds of falling margins are low, although the risks may rise later this year. Stocks are extremely expensive, but rich valuations are being driven by extremely low real bond yields, rather than investor exuberance. Valuation is unlikely to impact US stock market performance significantly over the coming year unless long-maturity bond yields rise substantially further. Technical analysis of stock prices has a long and successful history at boosting investment performance, which ostensibly suggests that investors should be paying more attention to technical conditions in the current environment. However, technical trading rules have been less helpful in expansionary environments when inflation is above average and when stock prices and bond yields are less likely to be positively correlated (as is currently the case). As such, the recent technical breakdown of the US equity market may simply reflect a reduced signal-to-noise ratio associated with these economic and financial market regimes. For now, we see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio over the coming 6 to 12 months. Rising odds of a recession, declining profit margins, and a large increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market, the risks of which should be monitored closely by investors. Feature In Section 1 of our report, we reviewed why a recession in the US is unlikely over the coming 6 to 12 months. However, we also highlighted that the risks to the economic outlook are meaningful and that an aggressively overweight stance toward risky assets is currently unwarranted. During times of significant uncertainty, investors should pay relatively more attention to long-term economic and financial market indicators with a reliable track record. In this report we begin by briefly reviewing the message from our US Equity Indicators, and then turn to a deeper examination of the top-down outlook for earnings, the determinants of rich valuation in the US stock market, and whether investors should rely on technical indicators in the current environment. We conclude that, while an indicator-based approach is providing mixed signals about the US equity market, we generally see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. Aside from tracking the risk of a recession, investors should be closely attuned to signs of a contraction in profit margins or shifting neutral rate expectations as a basis to reduce equity exposure to below-benchmark levels. A Brief Review Of Our US Equity Indicators Chart II-1Our Equity Indicators Are Pointing In A Bearish Direction Our Equity Indicators Are Pointing In A Bearish Direction Our Equity Indicators Are Pointing In A Bearish Direction Chart II-1 presents our US Equity Indicators, which we update each month in Section 3 of our report. We highlight our observations below: Chart II-1 shows that our Monetary Indicator has fallen to its lowest level since 1995, when the Fed surprised investors and shifted rapidly in a hawkish direction. The indicator is most acutely impacted by the speed of the rise in 10-year Treasury yields and a massive surge in the BCA Short Rate Indicator to levels that have not prevailed since the late 1970s (Chart II-2). Our Technical Indicator has recently broken into negative territory, which we have traditionally interpreted as a sign to sell stocks. The indicator has been dragged lower by a deterioration in stock market breadth across several tracked measures and by weak sentiment (Chart II-3). The momentum component of the indicator is fractionally positive but is exhibiting clear weakness. Our Valuation Indicator continues to highlight that US equities are extremely overvalued relative to their history, despite the recent sell-off in stock prices. Our Speculation Indicator arguably provides the least negative signal of our four indicators, at least from a contrarian perspective. In Q1 2021, the indicator nearly reached the all-time high set in March 2000, but it has since retreated significantly and has exited extremely speculative territory. While this may eventually provide a positive signal for stocks, equity returns have historically been below average during months when the indicator declines. Thus, the downtrend in the Speculation Indicator still points to weakness in stock prices, at least over the nearer term. Chart II-2Our Monetary Indicator Is Falling In Part Because Of Surging Interest Rate Expectations Our Monetary Indicator Is Falling In Part Because Of Surging Interest Rate Expectations Our Monetary Indicator Is Falling In Part Because Of Surging Interest Rate Expectations Chart II-3All Three Components Of Our Technical Indicator Are Falling All Three Components Of Our Technical Indicator Are Falling All Three Components Of Our Technical Indicator Are Falling In summary, all four of our US Equity indicators are currently pointing in a bearish direction, which clearly argues against an aggressively overweight stance favoring equities within a multi-asset portfolio. At the same time, we reviewed the odds of a US recession over the coming year in Section 1 of our report and argued that a recession is not likely over the coming 12 months. Thus, one key question for investors is whether a nonrecessionary contraction in earnings is likely over the coming year. We address this question in the next section of our report, before turning to a deeper examination of the relative importance of equity valuation and technical indicators. Gauging The Risk Of A Nonrecessionary Earnings Contraction Chart II-4Nonrecessionary Earnings Declines Usually Occur Due To Falling Margins Nonrecessionary Earnings Declines Usually Occur Due To Falling Margins Nonrecessionary Earnings Declines Usually Occur Due To Falling Margins Based on S&P data, there have been five cases since 1960 when 12-month trailing earnings per share fell year-over-year, while the economy continued to expand (Chart II-4). Sales per share growth remained positive in four of these cases (panel 2), underscoring that falling profit margins have been mostly responsible for these nonrecessionary earnings declines. We have noted our concern about how elevated US profit margins have become and have argued that a significant further expansion is not likely to occur over the coming 12-24 months.1 To gauge the risk of a sizeable decline in margins over the coming year, we construct a new indicator based on the seven instances when S&P 500 margins fell outside the context of a recession. This includes two cases when margins fell but earnings did not (because of buoyant revenue growth). We based the indicator on these five factors: Changes in unit labor cost growth to measure the impact of wage costs on firm profitability; Lagging changes in commodity prices as a proxy for material costs; The level of real short-term interest rates as a proxy for borrowing costs; Changes in a sales growth proxy to measure the impact of operating leverage on margins; And changes in the ISM manufacturing index to capture any residual impact on margins from the business cycle. Chart II-5The Odds Of A Nonrecessionary Profit Margin Contraction Are Currently Low The Odds Of A Nonrecessionary Profit Margin Contraction Are Currently Low The Odds Of A Nonrecessionary Profit Margin Contraction Are Currently Low Chart II-5 presents the indicator, which is shaded both for recessionary periods and the seven nonrecessionary margin contraction episodes we identified. While the indicator does not perfectly predict margin contractions outside of recessions, it did signal 50% or greater odds of a margin contraction in four of the seven episodes we examined, and signals high odds of a contraction in margins during recessions. Among the three cases in which the indicator failed to indicate falling margins during an expansion, two of those failures were episodes when earnings growth did not ultimately contract. The inability to explain the 1997-1998 margin contraction is the most relevant failure of the indicator, in addition to two false signals in 1963 and 1988. Still, the approach provides a useful framework to gauge the risk of falling profit margins, and the results provide an interesting and somewhat surprising message about the relative importance of the factors we included. We would have expected that accelerating wages would have been the most significant factor explaining nonrecessionary profit margin declines. Wages were highly significant, but they were the second most important factor behind our sales growth proxy. Lagged commodity prices were the third most significant factor, followed by real short-term interest rates. Changes in the ISM manufacturing index were least significant, underscoring that our sales growth proxy already captures most of the effect of the business cycle on profit margins. This suggests that operating leverage is an important determinant of margins during economic expansions, and that investors should be most concerned about declining profit margins when both revenue growth is slowing significantly and wage growth is accelerating. The indicator currently points to low odds of a nonrecessionary margin contraction, but this is likely to change over the coming year. We expect that all five of the factors will evolve in a fashion that is negative for margins over the coming twelve months: While the pace of its increase is slowing, median wage growth continues to accelerate, even when adjusting for the fact that 1st quartile wage growth is growing at an above-average rate (Chart II-6). Combining the latter with higher odds of at or below-trend growth this year implies that unit labor costs may rise further over the coming twelve months. Analysts expect S&P 500 revenue growth to slow nontrivially over the coming year (Chart II-7). Current expectations point to growth slowing to a level that would still be quite strong relative to what has prevailed over the past decade; however, accelerating wage costs in lockstep with decelerating revenue growth is exactly the type of combination that has historically been associated with falling margins during economic expansions. Chart II-6Wage Growth Is Accelerating... Wage Growth Is Accelerating... Wage Growth Is Accelerating... Chart II-7...And Revenue Growth Is Set To Slow ...And Revenue Growth Is Set To Slow ...And Revenue Growth Is Set To Slow ​​​​​​ Although these are less impactful factors, the lagged effect of the recent surge in commodity prices will also weigh on margins over the coming year, as will rising real interest rates and a likely slowdown in manufacturing activity in response to slower goods spending. In addition to our new indicator, we have two other tools at our disposal to track the odds of a decline in profit margins over the coming year. First, Chart II-8 illustrates that an industry operating margin diffusion index does a decent job at leading turning points in S&P 500 profit margins, despite its volatility. And second, Chart II-9 highlights that changes in the sales and profit margin diffusion indexes sourced from the Atlanta Fed’s Business Inflation Expectations Survey have predicted turning points in operating sales per share and margins over the past decade. Chart II-9 does suggest that profit margins may not rise further, but flat margins are not likely to be a threat to earnings growth over the coming year if a recession is avoided (as we expect). Chart II-8Sector Diffusion Indexes Are Not Signaling A Major Warning Sign For Margins... Sector Diffusion Indexes Are Not Signaling A Major Warning Sign For Margins... Sector Diffusion Indexes Are Not Signaling A Major Warning Sign For Margins... Chart II-9...Neither Are The Atlanta Fed Business Sales And Margin Diffusion Indexes ...Neither Are The Atlanta Fed Business Sales And Margin Diffusion Indexes ...Neither Are The Atlanta Fed Business Sales And Margin Diffusion Indexes     The conclusion for investors is that the odds of a decline in profit margins over the coming year are elevated and should be monitored, but are seemingly not yet imminent. In combination with expectations for slowing revenue growth, this implies, for now, that earnings growth over the coming year will be low but positive. Valuation, Interest Rates, And The Equity Risk Premium As noted above, our Valuation Indicator continues to highlight that US Equities are extremely overvalued relative to their history. Our Valuation Indicator is a composite of different valuation measures, and we sometimes receive questions from investors asking about the seemingly different messages provided by these different metrics. For example, Chart II-10 highlights that equity valuation has almost, but not fully, returned to late-1990 conditions based on the Price/Earnings (P/E) ratio, but is seemingly more expensive based on the Price/Book (P/B) and especially Price/Sales (P/S) ratios. In our view, this apparent discrepancy is easily resolved. Relative to the P/E ratio, both the P/B and especially P/S ratios are impacted by changes in aggregate profit margins, which have risen structurally over the past two decades because of the rising share of broadly-defined technology companies in the US equity index (Chart II-11). Barring a major shift in the profitability of US tech companies over the coming year, we do not see discrepancies between the P/E, P/B, or P/S ratios as being particularly informative for investors. As an additional point, we also do not see the Shiller P/E or other cyclically-adjusted P/E measures as providing any extra information about the richness or cheapness of US equities today, as these measures tend to move in line with the 12-month forward P/E ratio (Chart II-12). Chart II-10US Equities Are Extremely Overvalued, Based On Several Valuation Metrics US Equities Are Extremely Overvalued, Based On Several Valuation Metrics US Equities Are Extremely Overvalued, Based On Several Valuation Metrics Chart II-11Tech Margins Have Caused Stocks To Look Especially Expensive On A Price/Sales Basis Tech Margins Have Caused Stocks To Look Especially Expensive On A Price/Sales Basis Tech Margins Have Caused Stocks To Look Especially Expensive On A Price/Sales Basis In our view, rather than focusing on different measures of valuation, it is important for investors to understand the root cause of extreme US equity prices, as well as what factors are likely to drive equity multiples over the coming year. As we have noted in previous reports, the reason that US stocks are extremely overvalued today is very different from the reason for similar overvaluation in the late 1990s. Charts II-13 and II-14 present two different versions of the equity risk premium (ERP), one based on trailing as reported earnings (dating back to 1872), and one based on twelve-month forward earnings (dating back to 1979). Chart II-12The Shiller P/E Ratio Does Not Convey Any 'New' Information About Valuation The Shiller P/E Ratio Does Not Convey Any 'New' Information About Valuation The Shiller P/E Ratio Does Not Convey Any 'New' Information About Valuation Chart II-13The Equity Risk Premium Is In Line With Its Historical Average… The Equity Risk Premium Is In Line With Its Historical Average The Equity Risk Premium Is In Line With Its Historical Average The ERP accounts for the portion of equity market valuation that is unexplained by real interest rates, and the charts highlight that the US ERP is essentially in line with its historical average based on both measures, in sharp contrast to the stock market bubble of the late 1990s. This underscores that historically low interest rates well below the prevailing rate of economic growth are the root cause of extreme equity overvaluation in the US (Chart II-15), meaning that very rich pricing can be thought of as “rational exuberance.” Chart II-14…In Sharp Contrast To The Late 1990s ...In Sharp Contrast To The Late 1990s ...In Sharp Contrast To The Late 1990s Chart II-15US Equities Are Extremely Expensive Because Bond Yields Are Extremely Low US Equities Are Extremely Expensive Because Bond Yields Are Extremely Low US Equities Are Extremely Expensive Because Bond Yields Are Extremely Low     Chart II-16The Equity Risk Premium Is Fairly Well Explained By The Misery Index The Equity Risk Premium Is Fairly Well Explained By The Misery Index The Equity Risk Premium Is Fairly Well Explained By The Misery Index Over the longer term, the risks to US equity valuation are clearly to the downside, as we detailed in our October 2021 report.2 But over the coming 6 to 12 months, US equity multiples are likely to be flat or modestly up in the US. As we noted in Section 1 of our report, a significant further rise in long-maturity bond yields will likely necessitate a major shift in neutral rate expectations on the part of investors and the Fed, which we think is more likely a story for next year than this year. And Chart II-16 highlights that the ERP has historically been well explained by the sum of unemployment and inflation (the Misery Index), which should come down over the coming several months as inflation moderates and the unemployment rate remains low. To conclude, it is absolutely the case that US equities are extremely expensive, but this fact is unlikely to impact US stock market performance significantly unless long-maturity bond yields rise substantially further. Technical Analysis Amid A Shifting Economic Regime Technical analysis of financial markets, and especially stocks, has a long history. It has also provided disciplined investors with significant excess returns over time. A simple stock / bond switching rule based on whether stock prices were above their nine-month moving average at the end of the previous month has significantly outperformed since the 1960s, earning an average excess annual return of 1.3% relative to a 60/40 stock/bond benchmark portfolio (Chart II-17). This outsized performance has come at the cost of only a minor increase in portfolio volatility. Ostensibly, then, investors should be paying more attention to equity technical conditions in the current environment, which we noted above are not positive. Our Technical Indicator has recently broken into negative territory, and the S&P 500 has clearly fallen back below its 200-day moving average. However, Chart II-17 presented generalized results over long periods of time. Over the past two decades, investors have been able to rely on a durably negative correlation between stock prices and bond yields to help boost portfolio returns from technically-driven switching rule strategies. Chart II-18 highlights that this correlation has been much lower over the past two years than has been the case since the early 2000s, raising the question of whether similar switching strategies are viable today. In addition, there is the added question of whether technical analysis is helpful to investors during certain types of economic and financial market regimes, such as high inflation environments. Chart II-17Technically-Driven Trading Rules Have Historically Provided Investors With A Lot Of Alpha Technically-Driven Trading Rules Have Historically Provided Investors With A Lot Of Alpha Technically-Driven Trading Rules Have Historically Provided Investors With A Lot Of Alpha Chart II-18Switching-Rule Strategies May Not Work As Well When Stock Prices And Bond Yields Are Not Positively Correlated Switching-Rule Strategies May Not Work As Well When Stock Prices And Bond Yields Are Not Positively Correlated Switching-Rule Strategies May Not Work As Well When Stock Prices And Bond Yields Are Not Positively Correlated To test whether the message from technical indicators may be relied upon today, we examine the historical returns from a technically-driven portfolio switching strategy during nonrecessionary months under four conditions that reflect the economic and political realities currently facing investors: months when both stock and bond returns are negative; months of above-average inflation; months of above-average geopolitical risk; and the 1970s, when the Misery Index was very elevated. In all the cases we consider, the switching rule is simple: whether the S&P 500 index was above its nine-month moving average at the end of the previous month. If so, the rule overweights equities for the subsequent months; if not, the rule overweights a comparatively risk-free asset. We consider portfolios with either 10-year Treasurys or 3-month Treasury bills as the risk-free asset, as well as a counterfactual scenario in which cash always earns a 1% annual rate of return (to mimic the cash returns currently available to investors). Table II-1 presents the success and whipsaw rate of the trading rule. Table II-2 presents the annualized cumulative returns from the strategy. The tables provide three key observations: As reflected in Chart II-17, both Tables II-1 and II-2 highlight that simple technical trading rules have historically performed well, and that outperformance has occurred in both recessionary and nonrecessionary periods. Relative to nonrecessionary periods overall, technical trading rules have underperformed during the particular nonrecessionary regimes that we examined. It is the case not only that these strategies have performed in inferior ways during these regimes, but also that they were less consistent signals in that they generated significantly more “whipsaws” for investors. Among the four nonrecessionary regimes that we tested, technical indicators underperformed the least during periods of above-average geopolitical risk, and performed abysmally during nonrecessionary (but generally stagflationary) months in the 1970s. Table II-1During Expansions, Technically-Driven Switching Rules Underperform… May 2022 May 2022 Table II-2…When Inflation Is High And When Stocks And Bonds Lose Money May 2022 May 2022 The key takeaway for investors is that technical analysis is likely to be helpful for investors to improve portfolio performance as we approach a recession but may be less helpful in an expansionary environment in which inflation is above average and when stock prices and bond yields are less likely to be positively correlated. Investment Conclusions Echoing the murky economic outlook that we detailed in Section 1 of our report, our analysis highlights that an indicator-based approach is providing mixed signals about the US equity market. On the one hand, all four of our main equity indicators are currently providing a bearish signal, and the risk of a nonrecessionary contraction in S&P 500 profit margins over the coming year is elevated – albeit seemingly not imminent. On the other hand, our expectation that the US will not slip into recession over the coming year implies that revenue growth will stay positive, which has historically been associated with expanding earnings. In addition, US equity multiples are likely to be flat or modestly up, and the recent technical breakdown in the S&P 500 may simply reflect a reduced signal-to-noise ratio that appears to exist in expansionary environments in which inflation is high and the stock price / bond yield correlation is near-zero or negative. Netting these signals out, we see our equity indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. The emergence of a recession, declining profit margins, and a significant increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market. We will continue to monitor these risks and adjust our investment recommendations as needed over the coming several months. Stay tuned! Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate   Footnotes 1     Please see The Bank Credit Analyst “OUTLOOK 2022: Peak Inflation – Or Just Getting Started?” dated December 1, 2021, available at bca.bcaresearch.com 2 Please see The Bank Credit Analyst “The “Invincible” US Equity Market: The Longer-Term Outlook For US Stocks In Relative And Absolute Terms,” dated September 30, 2021, available at bca.bcaresearch.com

Executive Summary A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market The global government bond selloff looks stretched from a technical perspective, and a consolidation phase is likely over the next few months as global growth and inflation momentum both roll over. Central banks are starting to turn more aggressive on the pace of rate hikes in the face of elevated inflation expectations, as evidenced by the 50bp rate hikes in Canada and New Zealand last week (and the likely similar move the Fed next month). However, forward pricing of policy rates over the next 12-18 months is already at or above policymaker estimates of neutral in most developed countries. Global bond yields will be capped until central banks and markets revise higher their estimates of neutral policy rates. This is more a 2023/24 story than a 2022 story. Interest rate expectations are too high in Canada. High household debt will limit the ability for the Bank of Canada to match the Fed’s rate hikes during the current tightening cycle without bursting the Canadian housing bubble. Bottom Line: Maintain a neutral stance on overall global duration exposure. Upgrade Canadian government bonds to neutral (3 out of 5) in global bond portfolios, ideally funded out of US Treasury allocations. How To Interpret Rising Real Bond Yields Chart 1Bonds Under Pressure From Both Inflation & Real Yields Bonds Under Pressure From Both Inflation & Real Yields Bonds Under Pressure From Both Inflation & Real Yields The sharp rise in global government bond yields seen so far in 2022 has been driven by both rising inflation expectations and higher real yields (Chart 1). The former is a function of the war-fueled surge in oil prices at a time of high realized inflation, while the latter is a consequence of expectations for tighter monetary policy to fight that inflation. The magnitude of the yield increases seen year-to-date is surprising given the downgrades to global growth expectations. Just this week, the IMF downgraded its growth forecasts for the second time this year. It now expects global growth to reach 3.6% in both 2022 and 2023, shaving 0.8 and 0.2 percentage points, respectively, from the last set of yearly forecasts made back in January. The World Bank similarly chopped its growth forecast for 2022 to 3.2% from 4.1%. Spillovers from the Russia/Ukraine war were the main factor behind the downgrades, including more aggressive monetary tightening by global central banks in response to commodity-fueled inflation. We’re already seeing a faster pace of rate hikes from developed market central banks. The Bank of Canada (BoC) and Reserve Bank of New Zealand (RBNZ) lifted policy rates by 50bps last week and the Fed is signaling a similar move in May. Not all policymakers are sending hawkish signals, however. The ECB last week opted to not commit to the timing and pace of any future moves on rates, while the Bank of Japan has pledged to maintain monetary stimulus measures even in the face of a collapsing yen. Related Report  Global Fixed Income StrategyPolicymakers Face The No-Win Scenario While government bond yields have risen across the developed world so far in 2022, the drivers of the yield increase have not been the same in all countries when looking at moves in benchmark 10-year nominal and inflation-linked bonds (Chart 2). About three-quarters of the nominal yield moves seen year-to-date in the US (+134bps), Canada (+136bps) and Australia (+130bps) have come from higher real yields, while the increase in the Gilt yield (+92bps) was more of an equal split between real yields and inflation breakevens. In Germany (+102bps) and Japan (+17bps), the upward move in 10-year yields this year has all been from higher breakevens, as real yields have fallen in both countries. Chart 2Real Yields (ex-Europe/Japan) Driving Nominal Yields Higher In 2022 Global Bond Yields Take A Breather Global Bond Yields Take A Breather In the US, Canada and UK – three countries where central banks have delivered rate hikes this year and are promising to do more – real yields have been highly correlated to rising interest rate expectations for the next two years taken from overnight index swap (OIS) curves (Chart 3). Meanwhile, in Germany, Japan and Australia - where central banks have kept rates steady and not sending strong messages on when that will change – the correlation between real yields and OIS-derived interest rate expectations has not been as strong (Chart 4). Chart 3Rising Real Yields Where Central Banks Have Been Hiking Rising Real Yields Where Central Banks Have Been Hiking Rising Real Yields Where Central Banks Have Been Hiking ​​​​​ Chart 4More Stable Real Yields Where CBs Are More Dovish More Stable Real Yields Where CBs Are More Dovish More Stable Real Yields Where CBs Are More Dovish ​​​​​ Chart 5Real Rate Expectations Have Risen Much Faster In The US Global Bond Yields Take A Breather Global Bond Yields Take A Breather The link between interest rate expectations and real yields is intuitive after factoring in inflation expectations. In Chart 5, we show actual real interest rates (policy rates minus headline CPI inflation) in the US, euro area and UK, as well as a “market-based” measure of real interest rate expectations derived as the difference between forward rates from the nominal OIS and CPI swap curves (the dotted lines). The current path for real rates is the black dotted line, while the path as of the start of 2022 is the green dotted line. In all three countries, the market-derived path for real rates over the next decade has shifted upward since the start of the year, which is consistent with a rising path for real bond yields. Yet the largest move has been in the US where real rates are expected to average around zero over the next ten years. This lines up logically with the more hawkish messaging on rates from the Fed, leading to a repricing of the 10-year TIPS yield from -1% at the start of the year to a mere -0.04% today. By contrast, real rate expectations and real yields remain negative in the euro area and UK, as both the ECB and Bank of England have been much less hawkish compared to the Fed in terms of signaling the timing and magnitude of future rate hikes. We have long flagged deeply negative real bond yields, especially in the US, as the greatest source of vulnerability for global bond markets. Such yield levels can only be sustained in a rising inflation environment if central banks deliberately keep policy rates below inflation for a long time. The Fed was not going to allow that to happen with inflation reaching levels not seen since the early 1980s, leaving US Treasuries vulnerable to a sharp repricing of fed funds rate expectations that would drive real bond yields higher. Looking ahead, we do not expect to see much additional bearish repricing of global rate expectations and real yields over the rest of 2022, for the following reasons: Global growth momentum is slowing The combined shock of geopolitical uncertainty from the Ukraine war, high oil prices and tightening global monetary policy – in addition to the expected slump in Chinese growth due to the latest wave of COVID lockdowns – has damaged economic confidence. The April reading from global ZEW survey of professional forecasters and investors showed another modest decline in US and euro area growth expectations after the huge drop in March (Chart 6). Interestingly, the ZEW survey also showed a big decline in the net number of respondents expecting higher inflation and a small dip in the number of respondents expecting higher bond yields – both potential signals that the increase in global bond yields is ready to pause. Medium-term US inflation expectations have remained relatively contained The sharp run-up in US inflation has boosted survey-based measures of inflation expectations, although the increase has been much higher for shorter-term expectations (Chart 7). One-year-ahead inflation expectations from the University of Michigan and New York Fed consumer surveys have doubled over the past year and now sit at 6.6% and 5.4%, respectively. Yet the 5-10 year ahead inflation expectation from the Michigan survey has seen a much smaller increase and is holding stable around 3%. The 5-year/5-year forward TIPS breakeven is at even less worrisome levels and now sits at a trendline resistance level of 2.4% (bottom panel). Chart 6ZEW Survey Shows Weaker Growth & Inflation Expectations ZEW Survey Shows Weaker Growth & Inflation Expectations ZEW Survey Shows Weaker Growth & Inflation Expectations ​​​​​ Chart 7Medium-Term US Inflation Expectations Have Not Broken Out Medium-Term US Inflation Expectations Have Not Broken Out Medium-Term US Inflation Expectations Have Not Broken Out ​​​​​ US inflation is showing early signs of peaking Year-over-year headline US CPI inflation reached another cyclical high of 8.6% in March. However, core CPI inflation rose by a less-than-expected +0.3% on the month and the year-over-year rate of 6.5% was essentially unchanged versus the February level (Chart 8). Used car prices, a huge driver of the surge in US goods inflation in 2021, fell by a sizeable -3.8% in March, the second consecutive monthly decrease. Chart 8A Peak In US Core Inflation? A Peak In US Core Inflation? A Peak In US Core Inflation? ​​​​​ Chart 9Housing Cost Inflation Is A Global Problem Housing Cost Inflation Is A Global Problem Housing Cost Inflation Is A Global Problem We expect US consumer spending to shift more towards services from goods over the next 6-12 months, which should lead to overall US inflation rates converging more towards lower services inflation. Services inflation is still well above the Fed’s inflation target, however, particularly with shelter inflation – one-third of the overall US CPI index – now at 5.0% and showing no signs of slowing. Chart 10A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market Rising housing costs are not only a problem in the US, and house prices and valuations have soared across the developed world (Chart 9). This suggests that housing and rental costs will remain an important driver of underlying inflation in many countries, not just the US. Summing it all up, we continue to see conditions conducive to a period of relative global bond market stability, with government bond yields remaining rangebound over the next several months. The stimulus for higher yields – from even more hawkish repricing of central bank expectations, even higher real bond yields or additional increases in inflation expectations – is not evident. Bond yields look stretched from a technical perspective, and our Global Duration Indicator continues to signal that global yield momentum should soon peak (Chart 10). Bottom Line: Maintain a neutral stance on overall global bond portfolio duration. Upgrade Canadian Government Bonds To Neutral The Bank of Canada (BoC) hiked its policy interest rate by 50bps last week to 1%, the first rate increase of that size since 2000. The BoC also announced that it will begin quantitative tightening of its balance sheet at the end of April when it stops buying Canadian government bonds to replace maturing debt it currently owns. In the press conference explaining the move, BoC Governor Tiff Macklem noted that the central bank now saw the Canadian economy in a state of “excess demand” with inflation that was “expected to be elevated for longer than we previously thought” and that “the economy could handle higher interest rates, and they are needed.” Chart 11Canadian Growth Momentum Peaking? Canadian Growth Momentum Peaking? Canadian Growth Momentum Peaking? This is a very clear hawkish message from Macklem, who hinted that the BoC may have to lift rates above neutral for a period to bring Canadian inflation back down to the central bank’s target. We have our doubts that the BoC will be able to raise rates that far, and keep them there for long, before inflation pressures ease. The BoC Business Outlook Survey plays an important role in the central bank’s policy decisions. The survey for Q1/2022 showed dips in the overall survey, and the individual components related to sales growth expectations, investment intentions and hiring plans (Chart 11). There were even small drops in the net number of survey respondents seeing intense labor shortages and expecting faster wage growth (bottom panel). The moves in these survey components were modest, but they are important coming after the relentless upward rise since the trough in mid-2020. Importantly, this survey was conducted before the Russian invasion of Ukraine, which likely provided an additional drag on business confidence. The components of the Business Outlook Survey related to prices and costs continued to show that Canadian firms are facing lingering capacity constraints and intense cost pressures from both labor and supply chain disruption. A net 80% of respondents – a survey record – report they would have some or significant difficulty meeting an unexpected increase in demand. A net 35% of respondents in the Q1/2022 survey cited “labor cost pass through” as a source of upward pressure on their output prices, a huge jump from the Q4/2022 reading of 19% (Chart 12). Also, a net 33% of respondents noted “non labor cost pass through”, i.e. higher prices due to supply chain disruption, as a source of pressure on output prices. Only a net 12% of respondents cited strong demand as a source of pressure on prices, and the net balance of respondents noting that the competitive environment was inflationary was effectively zero. Chart 12Canadian Businesses See More Cost-Push Inflation Pressures Global Bond Yields Take A Breather Global Bond Yields Take A Breather The two main messages from the Business Outlook Survey are: a) Canadian growth momentum likely cooled in Q1, and b) Canadian inflation pressures remain significant, but are more supply driven than demand driven. Overall Canadian inflation is still accelerating rapidly, with headline CPI hitting an 31-year high of 5.7% in February. Underlying measures of inflation are more subdued, but still elevated: the BoC’s CPI-trim and CPI-median measures are at 4.3% and 3.5%, respectively, both above the BoC’s 1-3% target band (Chart 13). Chart 13Mixed Messages On Canadian Inflation Expectations Mixed Messages On Canadian Inflation Expectations Mixed Messages On Canadian Inflation Expectations There are more mixed messages coming out of Canadian inflation surveys. The 1-year-ahead inflation expectation from the BoC’s Survey of Consumer Expectations climbed to 5.1% in Q1/2022 from 4.9% in Q4, while the 5-year-ahead expectation dropped to 3.2% from 3.5%. The 10-year breakeven inflation rate on Canadian inflation linked bonds is even lower, now sitting near at 2.2%. There are also very mixed signals on wage expectations, even with the Canadian unemployment rate dropping to a record low of 5.3% in March. Canadian consumers expect wage growth to reach 2.2% over the next year, below the latest reading on actual wage growth of 2.5% and far below the 5.2% growth expected by Canadian businesses (bottom panel). If medium-term consumer inflation expectations are not rising in the current high inflation environment, and consumer wage expectations are not increasing with a record-low unemployment rate, then the BoC can potentially move slower than markets expect on rate hikes over the next year if realized inflation peaks. On that front there are tentative signs of optimism. When breaking down Canadian inflation into goods and services components, both are still accelerating rapidly (Chart 14). Goods inflation reached 7.6% in February, while services inflation hit 3.8%. However, the pace of year-over-year inflation for some key durable goods components like new cars, household appliances and furniture – items that saw demand and prices increase during the worst of the pandemic – appears to have peaked (middle panel). This may be a sign that overall goods inflation is set to roll over, similarly to what we expect in the US in the coming months. Also like the US, services inflation is less likely to decelerate, as rent inflation is accelerating and the housing cost component of Canadian inflation (home replacement costs) is still expanding at a 13.2% annual rate. On that note, housing remains the key component to watch to determine the BoC’s next move, given highly levered household balance sheets exposed to house prices and higher mortgage rates. The robust strength of the Canadian housing market has driven house prices to some of the most overvalued levels among the developed economies. There is a speculative aspect to the housing boom, with Canadian households expecting house prices to appreciate by 7.1% over the next year according to the BoC consumer survey (Chart 15). Canadian housing demand has also become more sensitive to rate increases by the choice of mortgages. 30% of outstanding mortgages are now variable rate, up from 18% at the start of the pandemic in 2020 after the BoC cut rates to near-0%. Chart 14The Goods-Driven Canadian Inflation Surge May Be Peaking The Goods-Driven Canadian Inflation Surge May Be Peaking The Goods-Driven Canadian Inflation Surge May Be Peaking ​​​​​​ Chart 15BoC Rate Hikes Will Cool Off Canadian Housing BoC Rate Hikes Will Cool Off Canadian Housing BoC Rate Hikes Will Cool Off Canadian Housing ​​​​​​ During the BoC’s last rate hiking cycle in 2017-19, national house price inflation slowed from 15% to 0%. Policy rates had to only reach 1.75% to engineer that outcome. With household balance sheets even more levered today, and with greater exposure to variable rate mortgages, it is unlikely that a policy rate higher than the previous cycle peak will be needed to cool off house price growth – an outcome that should also dampen Canadian services inflation with its large housing related component. In addition to the rate hike at last week’s policy meeting, the BoC also announced the results of its annual revision to its estimated range for the neutral policy rate. The range is now 2-3%, up slightly from 1.75%-2.75%. The current pricing of interest rate expectations from the Canadian OIS curve has the BoC lifting rates to the high-end of that new neutral range by the first quarter of 2023, then keeping rates near those levels over at least the next five years (Chart 16). Chart 16Markets Expect The BoC To Keep Rates Elevated For Longer Global Bond Yields Take A Breather Global Bond Yields Take A Breather Chart 17Upgrade Canadian Government Bonds To Neutral Upgrade Canadian Government Bonds To Neutral Upgrade Canadian Government Bonds To Neutral We doubt the BoC will be able to raise rates all the way to 3% without inducing instability in the housing market. More importantly, the current surge in inflation is not becoming embedded in medium-term inflation and wage expectations – outcomes that would require the BoC to keep policy rates at the high end of its neutral range or even move them into restrictive territory. Turning to bond strategy, we have had Canada on “upgrade watch” in recent weeks, with rate hike expectations looking a bit too aggressive. We now see it as a good time to pull the trigger on that upgrade. Thus, this week, we are moving our recommended exposure to Canadian government bonds to neutral (3 out of 5) from underweight (Chart 17). We are “funding” that move in our model bond portfolio by reducing exposure to US Treasuries (see the tables on pages 15-16), as we see the Fed as being more likely than the BoC to deliver on the rate hike expectations discounted in OIS curves. A move to an outright overweight stance, versus all countries and not just the US, will be appropriate once Canadian inflation clearly peaks and interest rate expectations begin to decline. It is too soon to make that move now, but we will revisit that call later this year. Bottom Line: Interest rate expectations are too high in Canada with medium-term inflation expectations relatively subdued. High household debt in Canada will limit the ability for the Bank of Canada to match the Fed’s rate hikes during the current tightening cycle without bursting the Canadian housing bubble. Upgrade Canadian government bonds to neutral (3 out of 5) in global bond portfolios, ideally funded out of US Treasury allocations. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Global Bond Yields Take A Breather Global Bond Yields Take A Breather The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Global Bond Yields Take A Breather Global Bond Yields Take A Breather Tactical Overlay Trades

Executive Summary Table 1Equity Capitulation Scorecard Have US Equities Hit Rock Bottom? Have US Equities Hit Rock Bottom? We have put together a framework to capture the extent to which recent economic and political developments have been priced in by the equity market.  It has seven criteria: Rate stabilization has not materialized yet, monetary conditions will continue to tighten Economic growth expectations do not yet reflect the deteriorating economic backdrop.  US GDP forecasts will be downgraded which will be a drag on equity performance Earnings growth expectations need to come down to reflect supply disruptions, raging input prices, and the stronger dollar Oil prices have stabilized which provides support for US equities Valuations have retraced, signaling that the market is reasonably priced Technicals signal that the market is oversold “Black swans”: The effects of the war in Ukraine will be a drag on US equities and are not yet fully priced in.  However, China’s pledge to be more investor-friendly is a positive. On balance, risks for US equities slightly outweigh the upside opportunity. Bottom Line: Although many ingredients for a sustainable rally are already in place, our analysis concludes that US equities have not hit rock bottom yet, and time is needed to resolve remaining headwinds. Feature The S&P 500 and NASDAQ are in correction territory, having pulled back 13% and 22%, respectively from their peak. Over the past few months, investors had to process a witches’ brew of staggering inflation, impending monetary tightening, and a war in the heart of Europe. Too much! Related Report  US Equity StrategyAre We There Yet? However, over the past couple of days, US equities have staged an aggressive rally: The S&P rebounded 5.5% and the NASDAQ 8%. While we are long-term investors and don’t focus on short-term market moves, we find a recent market turn a good excuse to take a close look at US equities and gauge whether this recent rally is a “dead-cat bounce” or the market has truly bottomed and is in the early stages of a recovery rally. To do so, we have put together a framework to capture the extent to which recent economic and political developments have been priced in by the equity market. “Equity Capitulation” Framework Historically, equities bottomed when bad news had been reflected in expectations, valuations had come down to reflect the new economic reality, and investors had capitulated. Here are our criteria for an equity rebound this economic cycle: Monetary tightening has been priced in and rates have stabilized Economic growth expectations have been downgraded Energy prices have normalized Earnings growth expectations have come down and earnings are unlikely to surprise on the downside Investors have capitulated and sentiment is rock-bottom Valuations have lost their “good times” froth and are attractive There are resolutions of the geopolitical factors that have contributed to market turmoil In this report, we will go through each of the criteria and do our best to gauge whether “we are there yet.” Pricing In Tighter Monetary Policy – Rate Stabilization Is Still Elusive The recent correction of US equities reflects a repricing due to tighter monetary policy. The million-dollar question is how much monetary tightening is priced in and when will rates stabilize? To our minds, this is one of the key conditions for a sustainable bull market. Last week, the Fed raised rates for the first time since 2018. This first rate hike is 0.25 - 0.50, which did not come as a surprise and was broadcast well in advance. The latest dot plot also signals that the Fed expects the target rate to reach 1.75% by the end of 2022, i.e., six more hikes are expected this year. However, a day after the announcement, the market is pricing eight to nine rate hikes (Chart 1), with the Fed rate ending the year at 2.25-2.5%. Thus, the market expects aggressive Fed action and is likely to be positively surprised when the Fed takes a more measured approach than anticipated. This is certainly positive for equities.   Chart 1The Market Is Pricing More Hikes In 2022 Then The Fed The Market Is Pricing More Hikes In 2022 Then The Fed The Market Is Pricing More Hikes In 2022 Then The Fed Chart 2Monetary Conditions Will Continue To Tighten Monetary Conditions Will Continue To Tighten Monetary Conditions Will Continue To Tighten However, despite the market coming to terms with an aggressive hiking schedule, monetary conditions are still easy (Chart 2), and real rates are negative. With the Fed’s emphasis on combating inflation, it is reasonable to expect that monetary conditions will continue to tighten, and real rates will rise. Also, nominal rates don’t yet show any signs of stabilization either (Chart 3). What does this mean for equities? Empirical analysis demonstrates that it takes around three months after the first hike for equities to adjust to a new monetary regime and deliver positive returns (Chart 4). Chart 3Rates Have Not Stabilized Yet Rates Have Not Stabilized Yet Rates Have Not Stabilized Yet Chart 4Adjusting to A Tighter Monetary Regime Takes Time Have US Equities Hit Rock Bottom? Have US Equities Hit Rock Bottom? Monetary conditions are likely to tighten further. Rate stabilization, which we are looking for, has not materialized just yet. On a positive note, we don’t expect any negative surprises from the Fed. Forecasts Need To Reflect Slowing Economic Growth According to the Bloomberg consensus, economic growth expectations for 2022 are still robust and have not been substantially downgraded (Chart 5). The market still expects the US economy to grow at 3.55%, compared to 3.8% in January, despite monetary tightening, falling ISM PMI readings (Chart 6), and soaring energy costs. The Fed is more realistic about the effects of its policy on economic growth, changing expectations from 4% to 2.8%. The logical conclusion is that more GDP growth downgrades are on the way. The latest reading of the Atlanta Fed stands at only 1.3%. Chart 5Economic Forecasts Do Not Yet Reflect Deteriorating Macro Backdrop Economic Forecasts Do Not Yet Reflect Deteriorating Macro Backdrop Economic Forecasts Do Not Yet Reflect Deteriorating Macro Backdrop Chart 6Surveys Signal Growth A Slow Down Surveys Signal Growth A Slow Down Surveys Signal Growth A Slow Down It is also important to note that both the direct and indirect effects of the war in Ukraine are yet to be reflected in US growth forecasts: Since the beginning of the war, the GSCI Commodities index has increased by 11%. One might argue that soaring commodity prices are a temporary phenomenon and forward curves signal eventual reversion to long-term averages. However, this may take months and even years, and by then, most of the stockpiles and hedges are likely to run out. Growth expectations are likely to fall, or worse yet, economic growth may surprise on the downside. Earnings Expectations Need To Come Down Similar to economic growth forecasts, bottom-up earnings growth expectations have barely budged (Chart 7): The market is still expecting about 9% earnings growth over the next 12 months. However, global supply disruptions and raging input prices are bound to cut into corporate profitability and slow earnings growth. Chart 7Earnings Expectations Have Not Budged Earnings Expectations Have Not Budged Earnings Expectations Have Not Budged To make things worse, the US dollar has appreciated by nearly 10% since the beginning of 2021 (Chart 8). Since companies in the S&P 500 derive 40% from abroad, the strong greenback is bound to translate into softer overseas profits, cutting into the profitability of US multinationals. The effect of a stronger currency will be further exacerbated by the withdrawal of US companies from Russia to protest the war in Ukraine. While most US companies have limited exposure to Russia, there are some that will take a hit: For example, Philip Morris derives 8% of sales from that market. McDonald’s announced that closing its restaurants in Russia will cost $50 million a month or 9% of annual sales. While it is hard to accurately gauge the effect of the war and self-sanctions on US corporate profits, on the margin it is definitely a negative. Chart 8Dollar Has Strengthened Significantly Dollar Has Strengthened Significantly Dollar Has Strengthened Significantly Earnings growth expectations have barely budged, and do not reflect a surge in commodity prices, a war, and slowing economic growth. We posit that downgrades are highly likely, and will be a drag on US equity performance. Oil Prices Have Stabilized The key channel for the war in Ukraine to affect the rest of the world is through the supply of energy. High energy prices present an economic danger because they touch every facet of the economy. Goldman Sachs estimates that spiraling electricity prices have already taken down 900,000 tonnes of aluminum capacity and 700,000 tonnes of zinc capacity in Europe. Certainly, in the past, a jump in the oil price has often been associated with recessions and negative equity returns (Chart 9). Therefore, we consider it a major shot in the arm that the WTI has come down from $130 to $105 on the back of lockdowns in China. This hiatus gives policymakers and oil producers time to negotiate deals and restart production – the onus is on US shale producers and Gulf nations. However, the long-term resolution is yet to be seen. Chart 9Oil Price Increases Have Been Associated With Negative Equity Returns Oil Price Increases Have Been Associated With Negative Equity Returns Oil Price Increases Have Been Associated With Negative Equity Returns Oil price stabilization provides solid support for US equity performance. Valuations – No Longer An Excuse Not To Buy The correction in US equity markets has taken the froth off valuations: The S&P 500 forward multiple has come down from roughly 23x to 19x earnings (Chart 10), with all of the change attributable to multiple contraction. The BCA S&P 500 Valuation Indicator shows that the index is no longer “overvalued” (Chart 11). Outright cheap? No. But valuations can no longer be an excuse not to buy. Also, there are multiple corners of the market that are outright cheap – lots of bottom fishing is already taking place. Chart 10Valuations Have Moderated Valuations Have Moderated Valuations Have Moderated Chart 11The S&P 500 Is No Longer Overvalued... The S&P 500 Is No Longer Overvalued... The S&P 500 Is No Longer Overvalued...   Valuations have moderated and the market is reasonably priced. Technicals – The Market Is Oversold While valuation multiples may contract further, most technical and sentiment indicators are flashing capitulation. The AAII Investor Bull/Bear Sentiment Indicator is below its March 2020 reading while the BCA Technical Indicator has shifted towards the oversold zone (Chart 12). It is important to note that this indicator is driven primarily by momentum components – its reading is oblivious to the top-heavy index composition and reflects prospects for large caps. A useful way to look under the index’s hood is to consider the number of stocks that retraced from their highs, currently over 95% of NASDAQ stocks have retraced  (Chart 13). This high a reading flashes that the market is oversold, and there are lots of bargains to be had. Chart 12...Or Overbought ...Or Overbought ...Or Overbought Chart 13Majority Of Stocks Are Oversold Majority Of Stocks Are Oversold Majority Of Stocks Are Oversold   Technicals indicate an oversold market. Black Swans Have Landed The war in Ukraine: Optimism about a potential peace deal between Russia and Ukraine seems premature – the conflict is just getting started and neither side will be backing off until it has to surrender unconditionally. However, while the war is contained in Ukraine, and Russian gas is flowing to Europe, any crisis in the equity market would be averted. The war in Ukraine will remain a headwind to global equities for a while. And while the US equity market is insulated from the direct consequences of the crisis, indirect effects will continue to reverberate through its economy for now. The direct and indirect effects of the war in Ukraine will be a drag on US equities and are not yet fully priced in. China pledged to keep capital markets stable and vowed to support overseas stock listings, indicating that regulation of Big Tech will end soon. In addition, it promised to offer support for property developers to minimize their risks. And China’s pledge to be more investor-friendly is believable as in its current stage of economy and with the onset of COVID, the government is in dire need of propping up both the economy and the stock market. Of course, China still presents great uncertainty associated with lockdowns. This is a positive for the US market as there are a number of Chinese companies listed on the US stock exchanges. Putting It All Together Our Equity Capitulation scorecard has seven different criteria, as discussed above. According to our assessment of the economic and market environments, there are two factors that signal near-term equity rebound: Investor capitulation or Technicals, and Energy prices. However, there are still headwinds: Monetary conditions will continue to tighten, economic and earnings growth expectations will be downgraded, and the war in Ukraine is unlikely to end soon. On balance, risks for US equities slightly outweigh the opportunity. The final score is -1, which indicates a mildly negative stance on US equities (Table 1). However, most of the outstanding negatives are likely to be resolved soon (i.e., downward revisions of expectations). Table 1Equity Capitulation Scorecard Have US Equities Hit Rock Bottom? Have US Equities Hit Rock Bottom? Investment Implications Our equity capitulation indicator signals that cautious investors should continue to be underweight equities on the back of monetary tightening, slowing growth, and upcoming downward revision cycles. While Technicals and valuations make equities tempting, volatility in equities is likely to continue, and rallies will probably be short-lived. As always, long-term investors have more latitude in investment decision-making, and we believe that the long-term outlook for equities is positive. Bottom Line Our analysis concludes that US equities have not hit rock bottom yet, although many ingredients are already in place: Valuations are attractive, and equities are outright oversold. While buying equities at these levels is tempting, we recommend patience: Economic growth expectations are still elevated, and bottom-up earnings growth forecasts need to come down to reflect slowing growth and the direct and indirect effects of the war in Ukraine.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Executive Summary Ebbing Stagflation Fear Will Prompt Rerating Ebbing Stagflation Fear Will Prompt Rerating Ebbing Stagflation Fear Will Prompt Rerating European inflation will rise further before peaking this summer. Core CPI will reach between 2.8% and 3.2% by year-end before receding. The combination of stabilizing growth and the eventual peak in inflation will cause stagflation fears to recede. European assets have greater upside. Cyclicals, small-caps, and financials will be major beneficiaries of declining stagflation fears. The underperformance of UK small-cap stocks is nearing its end. UK large-cap equities are a tactical sell against Eurozone and Swedish shares. TACTICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Buy European & Swedish Equities / Sell UK Large Caps Stocks 03/21/2022     Bottom Line: Stagflation fears are near an apex as commodity inflation recedes. A peak in these fears will allow European asset prices to perform strongly over the coming quarters.     Despite a glimmer of hope that Ukraine and Russia may find a diplomatic end to the war, the reality on the ground is that the conflict has intensified. Although the hostilities are worsening and the European Central Bank (ECB) surprised the markets with its hawkish tone, European assets have begun to catch a bid. The crucial question for investors is whether this rebound constitutes a new trend or a counter-trend move? Our view about Europe is optimistic right now. The path is not a direct line upward. The recent optimism about the outcome of the Russia-Ukraine talks is premature; however, we are getting to the point when markets are becoming desensitized to the war and energy prices are losing steam. Moreover, the increasing number of statements by Chinese economic authorities pointing toward greater stimulus and support to alleviate the pain created by China’s stringent zero-COVID policy are another positive omen. Higher Inflation For Some Time European headline inflation is set to exceed 7% this summer and core CPI will increase between 2.8% and 3.2% by the end of 2022. Related Report  European Investment StrategySpring Stagflation The main force that will push inflation higher in Europe remains commodity prices. Energy inflation is extremely strong at already 32% per annum (Chart 1). It will increase further because of both the recent jump in Brent prices to EUR122/bbl on March 8 and the upsurge in natural gas prices, which were as high as EUR212/MWh on the same day before settling to EUR106/MWh last Friday. The impact of energy prices will not be limited to headline inflation and will filter through to core CPI (Chart 1, bottom panel). The average monthly percentage change in the Eurozone core CPI inflation stands at 0.25% for the past six months (compared to an average of 0.09% over the past ten years), or the period when energy-prices inflation has been the strongest. Assuming monthly inflation remains at such an elevated level, annual core CPI will hit 3.3% in the Eurozone by the end of 2022 (Chart 2). Chart 2Core CPI to Rise Further Core CPI to Rise Further Core CPI to Rise Further Chart 1Energy Inflation: Alive And Well Energy Inflation: Alive And Well Energy Inflation: Alive And Well The picture is not entirely bleak. Many forces suggest that these inflationary forces will recede before year-end in Europe. Energy prices are peaking, which is consistent with a diminishing inflationary impulse from that space. We showed two weeks ago that the massive backwardation of oil curves, the heavy bullish sentiment, and the high level of risk-reversals were consistent with a severe but transitory adjustment in the energy market. Oil markets will experience further volatility, as uncertainty around peace/ceasefire negotiations continues to evolve in Ukraine. Nonetheless, the peak in energy prices has most likely been reached. BCA’s energy strategists expect Brent to average $93/bbl in 2022 and in 2023. The potential for a decline in headline CPI after the summer is not limited to energy prices. Dramatic moves in the commodity market, from metals to agricultural resources, have made headlines. Yet, the rate of change of commodity prices is decelerating, hence, the commodity impulse to inflation is slowing sharply. As Chart 3 shows, this is a harbinger of a slowdown in European headline CPI. Related Report  European Investment StrategyFallout From Ukraine Looking beyond commodity markets, the recent deceleration in European economic activity also suggests weaker inflation in the latter half of 2022. Germany will likely suffer a recession because it already registered a negative GDP growth in Q4 2021. Q1 2022 growth will be even worse because of the country’s high exposure to both China and fossil fuel prices. More broadly, the recent deceleration in the rate of change of both the manufacturing and services PMIs is consistent with an imminent peak in the second derivative of goods and services CPI (Chart 4). Chart 3Commodity Impulse Is Peaking Commodity Impulse Is Peaking Commodity Impulse Is Peaking Chart 4Inflation's Maximum Momentum Is Now Inflation's Maximum Momentum Is Now Inflation's Maximum Momentum Is Now Underlying drivers of inflation also remain tame in Europe. European negotiated wages are only expanding at a 1.5% annual rate, which translates into unit labor costs growth of 1% (Chart 5). This contrast with the US, where wages are expanding at a 4.3% annual rate. A peak in inflation, however, does not mean that CPI readings will fall below the ECB’s 2% threshold anytime soon. The European economy continues to face supply shortages that the Ukrainian conflict exacerbates (Chart 6). Moreover, the recent wave of COVID-19 in China increases the risk of disruptions in supply chains, as highlighted by the closure of Foxconn factories in Shenzhen. Finally, inflation has yet to peak; mathematically, it will take a long time before it falls back below levels targeted by Frankfurt. Chart 5The European Labor Market Is Not Inflationary The European Labor Market Is Not Inflationary The European Labor Market Is Not Inflationary Chart 6Not Blemish-Free Not Blemish-Free Not Blemish-Free Bottom Line: European headline inflation will peak this summer, probably above 7%. Additionally, core CPI is likely to reach between 2.8% and 3.2% in the second half of 2022. As a result of a decline in the commodity impulse, inflation will decelerate afterward, but it will remain above the ECB’s 2% target for most of 2023. Hopes For Growth Two weeks ago, we wrote that Europe was facing a stagflation episode in the coming one to two quarters, but that, ultimately, economic activity will recover well. Recent evidence confirms that assessment. Chart 7A Coming Chinese Tailwind? A Coming Chinese Tailwind? A Coming Chinese Tailwind? The tone of Chinese policymakers is becoming more aggressive, in favor of supporting the economy. On March 16, Vice-Premier Liu He highlighted that Beijing was readying to support property and tech shares and that it will do more to stimulate the economy. True, this response was made in part to address the need to close cities affected by the sudden spike of Omicron cases around China. Nonetheless, the global experience with Omicron demonstrates that, as spectacular and violent the surge in cases may be, it is short-lived. Meanwhile, the impact of stimulus filters through the economy over many months. As a result, Europe will experience the impact of China’s Omicron-induced slowdown, while it also suffers from the growth-sapping effects of the Ukrainian conflict; however, it will also enjoy the positive effect on growth of a rising credit impulse over several subsequent quarters (Chart 7). Beyond China, the other themes we have discussed in recent weeks remain valid. First, European fiscal policy will become looser, as governments prepare to fight the slowdown caused by the war, while also increasing infrastructure spending to wean Europe off Russian energy. Moreover, European military spending is well below NATO’s 2% objective. This will not remain the case, as military expenditure may leap from less than EUR100bn per year to nearly EUR400bn per year over the coming decade. Second, European spending on consumer durable goods still lags well behind the trajectory of the US. With the energy drag at its apex today, consumer spending on durable goods will be able to catch up in the latter half of the year, especially with the household savings rate standing at 15% or 2.5 percentage points above its pre-COVID level. Bottom Line: European growth will be very low in the coming quarters. Germany is likely to face a technical recession as Q1 2022 data filters in. Nonetheless, Chinese stimulus, European fiscal support, pent-up demand, and a declining energy drag will allow growth to recover in the latter half of the year. As a result, we agree with the European Commission estimates that European growth will slow markedly this year. Market Implications In the context of a transitory shock to European economic activity and a coming peak in inflation, European stock prices have likely bottomed. Chart 8Depressed Sentiment To Help Beta Depressed Sentiment To Help Beta Depressed Sentiment To Help Beta Sentiment has reached levels normally linked with a durable market floor. The NAAIM Exposure Index has fallen to a point from which global markets often recover. Europe’s high beta nature increases the odds that European equities will greatly benefit in that context (Chart 8). Valuations confirm that sentiment toward European assets has reached a capitulation stage. The annual rate of change of the earnings yields in the earnings yields has hit 73%, which is consistent with a market bottom (Chart 9). More importantly, the change in European forward P/E tracks closely our European Stagflation Sentiment Proxy (ESSP), based on the difference between the Growth and Inflation Expectations’ components of the ZEW survey (Chart 10). For now, our ESSP indicates that stagflation fears in Europe have never been so widespread, but these fears will likely dissipate as energy inflation declines. This process will lift European earnings multiples. Chart 9Bad News Discounted? Bad News Discounted? Bad News Discounted? Chart 10Ebbing Stagflation Fear Will Prompt Rerating Ebbing Stagflation Fear Will Prompt Rerating Ebbing Stagflation Fear Will Prompt Rerating Earnings revisions will likely bottom soon as well. The ESSP is currently consistent with a dramatic decline in European net earnings revisions (Chart 10, bottom panel). It will take a few more weeks for lower earnings revisions to be fully reflected. However, they follow market moves and, as such, the 17% decline in the MSCI Europe Index that took place earlier this year already anticipates their fall. Consequently, as stagflation fears recede, earnings revisions will rise in tandem with equity prices. Chart 11Maximum Pressure On Corporate Spreads Maximum Pressure On Corporate Spreads Maximum Pressure On Corporate Spreads A decline in stagflation fears is also consistent with a decrease in European credit spreads in the coming months (Chart 11). This observation corroborates the analysis from the Special Report we published jointly with BCA’s Global Fixed-Income Strategy team last week.  In terms of sectoral implications, a decline in stagflation fears is often associated with a rebound in the performance of small-cap equities relative to large-cap ones (Chart 12, top panel). This reflects the greater sensitivity of small-cap equities to domestic economic conditions compared to large-cap stocks. Moreover, small-cap equities had been oversold relative to their large-cap counterparts but now, momentum is improving (Chart 12). As a result, it is time to buy these equities. Similarly, financials have suffered greatly from the recent events associated with the Ukrainian conflict. European financial institutions have not only been penalized for their modest exposure to Russia, they have also historically declined when stagflation fears are prevalent (Chart 13). This relationship reflects poor lending activity when the economy weakens, and the risk of a policy-induced recession caused by high inflation. Financials will continue their sharp rebound as stagflation fears dissipate. Chart 13Financials Have Suffered Enough Financials Have Suffered Enough Financials Have Suffered Enough Chart 12Small-Caps Time To Shine Small-Caps Time To Shine Small-Caps Time To Shine The dynamics in inflation alone are very important. As Table 1 highlights, in periods of elevated inflation over the past 20 years, financials underperform the broad market by 11.3% on average. It is also a period of pain for small-cap equities and cyclicals. Logically, exiting the current environment will offer opportunities in European cyclical equities and for financials in particular. Table 1Who Suffers From High Inflation? Is Europe Turning The Corner? Is Europe Turning The Corner? Chart 14Long Industrials & Materials / Short Energy Long Industrials & Materials / Short Energy Long Industrials & Materials / Short Energy Finally, a pair trade buying industrials and materials at the expense of energy makes sense today. Materials and industrials suffer relative to energy equities when stagflation rises, especially in periods when these fears reflect rising energy pressures (Chart 14). A reversal in relative earnings revisions in favor of materials and industrials will propel this position higher. Bottom Line: Sentiment toward European assets reached a selling climax in recent weeks. Stagflation fears in Europe have reached an apex, and their reversal will lift both multiples and earnings revisions in the subsequent quarters. Diminishing stagflation fears will also boost the appeal of European corporate credit, contributing to an easing in financial conditions. Small-cap stocks, cyclicals, and financials will reap the greatest benefits from this adjustment. Going long materials and industrials at the expense of energy stocks is an attractive pair trade. Key Risk: A Policy Mistake The view above is not without risks. The number one threat to European growth and assets is a policy mistake from the ECB. On March 10, 2022, the ECB’s policy statement and President Christine Lagarde’s press conference showed that the Governing Council (GC) will decrease asset purchases faster than anticipated. Chart 15Will The ECB Repeat It Past Mistakes? Will The ECB Repeat It Past Mistakes? Will The ECB Repeat It Past Mistakes? It is important to keep in mind the dynamics of 2011. Back then, the ECB opted to increase interest rates as European headline CPI was drifting toward 2.6% on the back of rising energy prices. According to our ESSP, the April 2011 interest rates hike took place at the greatest level of stagflation fears recorded until the current moment (Chart 15). Lured by rising inflation, the ECB ignored underlying weaknesses in European economic activity, which wreaked havoc on European financial markets and growth. If the ECB were to increase rates as growth remains soft, a similar outcome would take place. For now, the ECB’s communications continue to de-emphasize the need for rate hikes in the near term, which suggests that the GC is cognizant of the risk created by weak growth over the coming months. Waiting until next year, when activity will be stronger and the output gap will be closed, will offer the ECB a better avenue to lift rates durably. This risk warrants close monitoring of the ECB’s communication over the coming months. If headline inflation does not peak by the summer, the ECB is likely to repeat its past error, which will substantially hurt European assets. Our optimism is tempered by this threat. UK Outperformance Long In The Tooth? Last week, the Bank of England (BoE) increased the Bank Rate by 25bps to 0.75%, in a move that was widely expected. Yet, the pound fell 0.7% against the euro and gilt yields fell 6 bps. This market reaction reflected the BoE’s choice to temper its forward guidance. The central bank is now expected to increase interest rates to 2.2% next year, before they decline in 2024. The dovish projection of the BoE shows the MPC’s concerns over the impact of higher energy costs and rising National Insurance contributions on household spending. In the BoE’s opinion, the economy is very inflationary right now, but it will slow, which will mitigate the inflationary impact down the road. We share the BoE’s worries about the UK’s near-term economic outlook. The combination of higher taxes, higher interest rates, and rising energy costs will have an impact on growth. However, the rapid decline in small-cap stocks, which have massively underperformed their large cap-counterparts, already discounts considerable bad news (Chart 16). Additionally, small-cap equities relative to EPS have begun to stabilize, while relative P/E and price-to-book ratios have also corrected their overvaluations. In this context, UK small-cap equities are becoming attractive. Chart 17UK vs Eurozone: A Stagflation Bet UK vs Eurozone: A Stagflation Bet UK vs Eurozone: A Stagflation Bet Chart 16UK Small-Cap Stocks Have Purged Their Excesses UK Small-Cap Stocks Have Purged Their Excesses UK Small-Cap Stocks Have Purged Their Excesses In contrast to small-cap stocks, UK large-cap equities have greatly benefited from the global stagflation scare. The UK large-cap benchmark had the right sector mix for the current environment, overweighting defensive names as well as energy and resources. It is likely that when stagflation fears recede, UK equities will undo their outperformance (Chart 17). Technically, UK equities are massively overbought against Euro Area and Swedish stocks, both of which have been greatly impacted by stagflation fears and their pro-cyclical biases (Chart 18 & 19). An attractive tactical bet will be to sell UK large-cap stocks while buying Eurozone and Swedish equities, as energy inflation declines and as China’s stimulus boosts global industrial activity in the latter half of 2022 Bottom Line: Move to overweight UK small-cap stocks within UK equity portfolios. Go long Euro Area and Swedish equities relative to UK large-cap stocks as a tactical bet. Chart 18UK Overbought Relative To Euro Area... UK Overbought Relative To Euro Area... UK Overbought Relative To Euro Area... Chart 19… And Sweden ... And Sweden ... And Sweden   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Executive Summary US Treasury yields have surged in response to high US inflation and Fed tightening expectations. However, the move looks overdone in the near-term. Too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short. These factors will act to stabilize Treasury yields over the next few months, even with the cyclical backdrop remaining bond bearish. Markets Think The Fed Will Hike More Sooner And Less Later – The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Recommendation Inception Level Inception Date Long Dec 2022/Short Dec 2024 3-Month SOFR Future 0.25 Feb 22/22 New Trade: Go long the December 2022 US SOFR interest rate futures contract versus shorting the December 2024 SOFR contract. The former discounts too many Fed hikes for this year and the latter discounts too few hikes over the next three years. Bottom Line: US Treasury yields now discount the maximum likely hawkish scenario for Fed rate hikes in 2022, with risks all pointing in the direction of the Fed delivering less than expected. Upgrade US duration exposure to neutral from below-benchmark on a tactical basis. Feature Chart 1A Near-Term Overshoot For UST Yields Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now During the BCA Research US Bond Strategy quarterly webcast last week, we announced a shift in our recommended US duration stance, moving from below-benchmark to neutral. This move was more tactical (i.e. shorter-term) in nature, as we still strongly believe that bond markets are underestimating the eventual peak for US bond yields over the next couple of years. In the near term, however, we see several good reasons to expect the recent big run-up in US bond yields to pause, warranting a more neutral tactical duration exposure (Chart 1). We discuss those reasons – and the implications for both US duration strategy - in this report published jointly by BCA Research’s US Bond Strategy and Global Fixed Income Strategy services. Reason #1: Too Many Fed Rate Hikes Are Now Discounted For 2022 The US overnight index swap (OIS) curve currently discounts 146bps of Fed rate hikes by the end of 2022. This is a big change from the start of the year when only 77bps of hikes were priced (Chart 2). The OIS curve repricing now puts the path of the funds rate for this year well above the last set of FOMC interest rate projections published at the December 2021 Fed meeting. In other words, the market has already moved to discount a big upward shift in the FOMC “dots” for 2022, and even for 2023, at next month’s FOMC meeting. Chart 2Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely We think a more likely outcome for 2022 is that the Fed lifts rates four or five times, not six or even seven times as some Wall Street investment banks are forecasting. We set out the reasons why we think the Fed will go less than expected in the rest of this report. At a minimum, there is virtually no chance that the Fed will provide guidance to markets that is more hawkish than current market pricing, which would push bond yields even higher in the near term. Reason #2: US Inflation Will Soon Peak The relentless string of upside surprises on US inflation has been the main reason the bond market has moved so rapidly on pricing in more Fed rate hikes. The story is about to change, however, as US inflation should peak sometime in the next few months and begin to rapidly decelerate toward levels much closer to, but still well above, the Fed’s 2% inflation target. Already, the intense global inflation pressures from commodities and traded goods prices over the past year has started to lose potency. The annual growth rate of the CRB Raw Industrials index has eased from a peak of 45% in June to 18%, in line with slowing growth momentum of global manufacturing activity (Chart 3, top panel). The softening of input price pressures is evident in business survey measures like the ISM Manufacturing Prices Paid index, which typically leads US headline CPI inflation by six months and has fallen by 16 points since the peak in June (middle panel). Chart 3Global Inflation Pressures Easing Global Inflation Pressures Easing Global Inflation Pressures Easing The global supply chain disruptions that have caused inventory shortages in products ranging from new cars to semiconductors also appear to be easing. Supplier delivery times are shortening according to the ISM Manufacturing and Non-Manufacturing surveys (bottom panel). Combined with other indications of the loosening of supply chain logjams, like lower shipping costs, the influence of supply disruptions on inflation should diminish, on the margin. Energy prices should also soon contribute to disinflationary momentum (Chart 4). BCA Research’s Commodity & Energy Strategy service is forecasting the Brent oil price to reach $76/bbl at the end of 2022 and $80/bbl at the end of the 2023. That represents a significant decline from the current $95/bbl price that reflects a large risk premium for the potential oil market supply disruptions in response to a Russian invasion of Ukraine. A war-driven spike in oil prices does risk extending the current period of high US (and global) inflation. However, it should be noted that the annual growth in oil prices has been decelerating even as oil prices have been rising recently, showing the power of base effect comparisons that should lead to a lower contribution to overall inflation from energy prices over the next 6-12 months. ​​​​​​Chart 4Oil Prices Will Soon Turn Disinflationary Oil Prices Will Soon Turn Disinflationary Oil Prices Will Soon Turn Disinflationary Chart 5A Changing Mix Of US Consumer Spending Will Lower Overall Inflation A Changing Mix Of US Consumer Spending Will Lower Overall Inflation A Changing Mix Of US Consumer Spending Will Lower Overall Inflation   Looking beyond the commodity space, a shifting mix of US consumer spending should also help push overall US inflation lower. US core CPI inflation hit a 34-year high of 6.0% in January, fueled by 11.7% growth in core goods inflation (Chart 5). We anticipate that overall core inflation will slow to levels more consistent with the trends seen in more domestically focused sectors like core services and shelter, where inflation is running around 4%. US consumers have started to shift their spending patterns away from goods, which was running well above its pre-pandemic trend, back toward services, which was running below its pre-pandemic trend (Chart 6). This will help narrow the gap between goods and services inflation, particularly as easing supply chain disruptions help dampen goods inflation. Chart 6Goods Inflation Should Soon Peak Goods Inflation Should Soon Peak Goods Inflation Should Soon Peak ​​​​​ Chart 7There Are Still Pockets Of Available US Labor Market Supply There Are Still Pockets Of Available US Labor Market Supply There Are Still Pockets Of Available US Labor Market Supply ​​​​​​ Chart 8US Wage Growth Should Soon Begin To Moderate US Wage Growth Should Soon Begin To Moderate US Wage Growth Should Soon Begin To Moderate There is also the potential for some of the pressures stemming from the tight US labor market to become a bit less inflationary in the coming months. While the overall US unemployment rate of 4% is well within the range of full employment NAIRU estimates produced by the FOMC, there are notable differences across employment categories suggesting that there are still sizeable pockets of labor supply. For example, the unemployment rate for managerial and professional workers is a tiny 2.3%, while the unemployment rate for services workers was a more elevated 6.7% (Chart 7, top panel). There are also noteworthy differences in US labor market trends when sorted by wage growth. Employment in industries with lower wages – predominantly in services – has not returned to the pre-pandemic peak, unlike employment in higher wage cohorts (middle panel).1 As the US economy puts the Omicron variant in the rearview mirror, service industries most impacted by pandemic restrictions should see an increase in labor supply as workers return to the labor force. This will help close the one percentage point gap between the labor force participation rate for prime-aged workers (aged 25-54) and its pre-pandemic peak (bottom panel). This will also help to mitigate the current upturn in service sector wage growth, which reached 5.2% at the end of 2021 according to the US Employment Cost Index (Chart 8). When US inflation finally peaks in the next few months – most notably for goods prices and service sector wages – the Fed will be under less pressure to hike rates as aggressively as discounted in current bond market pricing. Reason #3: US Inflation Expectations Have Stabilized Chart 9TIPS Breakevens Are Not Telling The Fed To Be More Aggressive TIPS Breakevens Are Not Telling The Fed To Be More Aggressive TIPS Breakevens Are Not Telling The Fed To Be More Aggressive The Fed always pays a lot of attention to inflation expectations, particularly market-based measures like TIPS breakevens, to assess if its monetary policy stance is appropriate. The current message from breakevens is that the Fed does not have to turn even more hawkish than expected to bring inflation back down to levels consistent with the Fed’s 2% target. The 10-year TIPS breakeven is currently 2.4%, down from a peak of 2.8% and within the 2.3-2.5% range that we deem consistent with the Fed’s inflation target. Inflation expectations are even more subdued on a forward basis, with the 5-year TIPS breakeven, 5-years forward now down to 1.95% (Chart 9). Shorter term TIPS breakevens remain elevated, with the 2-year breakeven at 3.7%. We continue to favor positioning for a narrower 2-year TIPS breakeven spread – realized inflation will soon peak and the New York Fed’s Consumer Expectations survey shows that household inflation expectations for the next three years have already fallen significantly (bottom panel). Lower inflation expectations, both market-based and survey-based, suggest that the Fed can be cautious on the pace of rate hikes after liftoff next month. Reason #4: US Financial Conditions Are Tightening Alongside Cooling US Growth Momentum We have long described the link between financial markets and the Fed’s policy stance as “The Fed Policy Loop.” In this framework, the markets act as a regulator on Fed hawkishness (Chart 10). If the Fed comes across as overly hawkish, risk assets will sell off (lower equity prices, wider corporate credit spreads), the US dollar will appreciate, the US Treasury curve will flatten and market volatility measures like the VIX index will increase. All of those trends act to tighten US financial conditions, threatening a growth slowdown that will force the Fed to back off from its previous hawkish bias. Chart 10The Fed Policy Loop Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now Financial conditions have indeed tightened as markets have priced in more Fed rate hikes in 2022 (Chart 11). Since the start of the year, the S&P 500 is down 9% year-to-date, US investment grade corporate spreads have widened 26bps, the 2-year/10-year US Treasury curve has flattened by 34bps and the VIX index has increased 11 pts. In absolute terms, US financial conditions remain highly stimulative and the risk asset selloff so far poses little threat to US economic growth. However, if the Fed were to deliver all of the rate hikes in 2022 that are currently discounted in the US OIS curve, the market selloff would deepen as investors began to worry about a Fed-engineered economic slowdown. This would lead to a more significant tightening of financial conditions, representing an even bigger risk to US growth. The Fed cannot risk appearing too hawkish too soon, with US growth momentum already showing signs of slowing (Chart 12). The Conference Board US leading economic indicator has stopped accelerating and may be peaking, US business confidence is softening and consumer confidence is very depressed according to the University of Michigan survey. Importantly, high inflation is cited as the main reason for weak consumer confidence, as wage increases have not matched price increases. If realized inflation falls, as we expect, this could actually provide a boost to consumer confidence as households would feel an improvement in real incomes and spending power – a development that could eventually lead to more Fed rate hikes in 2023 if consumer spending improves, especially if inflation stays above the Fed’s 2% target. Chart 11Fed Hawkishness Has Already Tightened Financial Conditions Fed Hawkishness Has Already Tightened Financial Conditions Fed Hawkishness Has Already Tightened Financial Conditions ​​​​​​ Chart 12Not The Best Time For The Fed To Be More Aggressive Not The Best Time For The Fed To Be More Aggressive Not The Best Time For The Fed To Be More Aggressive ​​​​​ For now, however, the risk of a preemptive tightening of financial conditions will ensure that the Fed delivers fewer rate hikes than the market expects this year. Reason #5: Treasury Market Positioning Is Now Very Short Chart 13Reliable Bond Indicators Calling For A Pause In The UST Selloff Reliable Bond Indicators Calling For A Pause In The UST Selloff Reliable Bond Indicators Calling For A Pause In The UST Selloff The final reason to increase US duration exposure now is that Treasury market positioning has become quite short and has become a headwind to higher bond yields and lower bond prices. The JP Morgan fixed income client duration survey shows that bond investors are running duration exposures well below benchmark (Chart 13). Speculators are also running significant short positions in longer-maturity US Treasury futures. This suggests limited selling power in the event of more bond bearish news and increased scope for short-covering in the event of risk-off event – like a shooting war in Ukraine – or surprisingly negative US economic data. On that front, the Citigroup US data surprise index, which is typically highly correlated to the momentum of US Treasury yields, has dipped a bit recently but remains at neutral levels (top panel). A similar measure of neutrality is sent by some of our preferred cyclical bond indicators like the ratio of the CRB raw industrials index to the price of gold – the 10-year yield is now in line with that ratio, which appears to be peaking (middle panel). Investment Conclusions Given the five reasons outlined in this report – too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short – we decided last week to upgrade our recommended US portfolio duration to neutral from below-benchmark. However, this move is only for a tactical investment horizon. We still see the cyclical backdrop as bond bearish, as Treasury yields do not yet reflect how high US interest rates will rise in the upcoming tightening cycle. The 5-year Treasury yield, 5-years forward is currently at 2.0%. This lies at the low end of the range of estimates of the longer-run neutral fed funds rate (Chart 14) from the New York Fed’s survey of bond market participants (2%) and the median FOMC longer-run interest rate projection from the Fed dots (2.5%). We see the Fed having to lift rates faster than markets expect in 2023 and 2024. US inflation this year is expected to settle at a level above the Fed’s 2% target before picking up again next year alongside renewed tightening of labor market conditions once the remaining supply of excess labor is fully absorbed. Chart 14The Cyclical UST Bear Market Is Not Over Yet The Cyclical UST Bear Market Is Not Over Yet The Cyclical UST Bear Market Is Not Over Yet Chart 15Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract As a way to position for the Fed doing fewer rate hikes than expected in 2022, but more hikes than expected in 2023/24, we are entering a new trade this week – going long the December 2022 3-month SOFR US interest rate futures contract versus a short position in the December 2024 3-month SOFR contract.  The implied interest rate spread on those two contracts has tightened to 25bps (Chart 15). We expect that trend to reverse, however, with the spread increasing as markets eventually move to price out rate hikes in 2022 and price in much more Fed tightening in 2023 and 2024. We will discuss the implications of the shift in our US duration stance for our views on non-US bond markets in next week’s Global Fixed Income Strategy report. Our initial conclusion is that our country allocation recommendations for government bonds will remain unchanged – underweighting the US, UK, and Canada; overweighting core Europe, peripheral Europe, Japan and Australia – but we will also increase duration exposure within most (if not all) countries. As in the US, we also see markets pricing in too many rate hikes in the UK and Canada for 2022 but too few rate hikes over the next two years. On the other hand, markets are pricing in too many rate cumulative hikes over the next 2-3 years in Europe, Australia and Japan (Table 1). Table 1Markets Have Pulled Forward Rate Hikes Everywhere Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The definitions for the wage cohorts can be found in the footnote of Chart 7. Cyclical Recommendations (6-18 Months) Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now Tactical Overlay Trades

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary Cyclical UST Curve Flattening, But With Unusually Low Rate Expectations Deciphering The Messages From The US Treasury Curve Deciphering The Messages From The US Treasury Curve The US Treasury curve is unusually flat given high US inflation and with the Fed not having begun to raise interest rates. The dichotomy between deeply negative real interest rates and a flattening yield curve is not only evident in the US, but in other major developed countries like Germany and the UK. A low term premium on longer-term US Treasury yields is one factor keeping the curve so flat, but the term premium will likely rise as the Fed begins to hike rates. An overly flat US Treasury curve more likely reflects a belief that the neutral real fed funds rate (r-star) is actually negative. This is consistent with markets pricing in a very low peak in the funds rate for the upcoming tightening cycle, despite the current high inflation and tight labor market. Bottom Line: The Fed will hike by less than the market expects in 2022 and longer-term Treasury yields remain too low versus even a moderate 2-2.5% peak in the fed funds rate. Stay in US curve steepeners, as the Treasury curve is already too flat and will not flatten as much as discounted in forward rates this year. Feature Last week’s FOMC meeting essentially confirmed that the Fed will begin lifting rates in March and deliver multiple rate hikes this year. This was considered a hawkish surprise as the Fed signaled imminently tighter monetary policy even with the elevated financial market volatility seen so far in 2022. Fed Chair Jerome Powell noted that the US economy was in a stronger position compared to the 2016-18 tightening cycle, justifying a faster pace of hikes – and an accelerated pace of QE tapering – this time around. Markets have responded to the increasingly hawkish guidance of the Fed by pushing up rate expectations for 2022, continuing a path dating back to last September’s FOMC meeting when the Fed first signaled that QE tapering was imminent (Chart 1). There are now 163bps of Fed rate hikes by year-end discounted in the US overnight index swap (OIS) curve. Some Wall Street investment banks are calling for the Fed to hike as much as 6 or 7 times in 2022. We see this as much too aggressive. Chart 1Fed Hawkishness Pushing Up Rate Expectations For 2022/23 - But Not Beyond That Fed Hawkishness Pushing Up Rate Expectations For 2022/23 - But Not Beyond That Fed Hawkishness Pushing Up Rate Expectations For 2022/23 - But Not Beyond That Our base case scenario calls for the Fed to lift rates “only” 3-4 times this year. The persistently high inflation that is troubling the Fed is likely to peak in the first half of 2022, taking some heat off the FOMC to move as aggressively as discounted in markets this year. Although inflation will remain high enough, and the labor market tight enough, to keep the Fed on a tightening path into 2023. The US Treasury Curve Looks Too Flat What is unique about the upcoming Fed tightening cycle is that it is starting with such a flat US Treasury curve. The spread between the 2-year and 10-year yield now sits at 61bps, the lowest level since October 2020. This dynamic is not unique to the US, as yield curves are quite flat in other major countries where policy rates are near 0% and inflation remains relatively high, like the UK and Germany (Chart 2). In the US, the modest slope of the Treasury curve is notably unusual given a growth and inflation backdrop that would be more consistent with much higher bond yields: The US unemployment rate fell to 3.9% in December, well within the range of full employment estimates from FOMC members (Chart 3, top panel) Chart 2Bond Bearish Yield Curve Flattening In The US & UK Bond Bearish Yield Curve Flattening In The US & UK Bond Bearish Yield Curve Flattening In The US & UK US labor costs are accelerating; the wages and salaries component of the Employment Cost Index for Private Industry Workers rose to a 38-year high of 5.0% on a year-over-year basis in Q4/2021 (middle panel) Chart 3Challenges To The Fed's Inflation Fighting Credibility Challenges To The Fed's Inflation Fighting Credibility Challenges To The Fed's Inflation Fighting Credibility ​​​​​​ Higher inflation is becoming more embedded in medium term consumer inflation expectations measures like the University of Michigan 5-10 year ahead series that climbed to 3.1% last month (bottom panel). Importantly, market-based measures of inflation expectations have pulled back, even with little sign of inflation pressures easing. The 5-year TIPS breakeven, 5-years forward has fallen 35bps from the October 2021 peak of 2.41%. The bulk of that decline occurred in January of this year, alongside a rising trend in real TIPS yields as markets began pricing in a faster pace of Fed rate hikes. TIPS breakevens can often be something of a “vote of confidence” by the markets in the appropriateness of the Fed’s policy stance; rising when policy appears overly stimulative and vice versa. Thus, the decline in the TIPS 5-year/5-year forward breakeven, which climbed steadily higher since the Fed introduced massive monetary easing in March 2020 in response to the pandemic, can be interpreted as a sign that markets agree with the Fed’s recent hawkish turn. However, while the move in TIPS breakevens is sensible, the flatness of the Treasury curve appears unusual. In Chart 4, where we look at the previous times since 1975 that the 2-year/10-year US Treasury spread flattened to 70bps (just above the current level). In past cycles, the Treasury curve would be flattening into such a level after the Fed had already hiked rates a few times, which is obviously not the case today. Also, US unemployment was typically approaching, or falling through, the full employment NAIRU when the 2/10 Treasury curve fell to 70bps, suggesting diminished spare economic capacity and rising inflation pressures – similar to the current backdrop. Chart 4The UST Curve Is Unusually Flat Right Now The UST Curve Is Unusually Flat Right Now The UST Curve Is Unusually Flat Right Now Chart 5UST Curve Too Flat Relative To Inflation Pressures UST Curve Too Flat Relative To Inflation Pressures UST Curve Too Flat Relative To Inflation Pressures In those past cycles, the funds rate was rising at a faster pace than that of core inflation, suggesting that the Fed was pushing up real interest rates. The backdrop looks very different today, with US realized inflation soaring and the real funds rate now deeply negative. In the top panel of Chart 5, we show a “cycle-on-cycle” chart of the 2/10 Treasury curve versus an average of the previous five instances where the curve flattened to 70bps. The green line is the median outcome of all the cycles, while the shaded region represents the range of all the outcomes. In the other panels of the chart, we show US economic variables (the Conference Board leading economic index and the ISM Manufacturing index) and US inflation variables (the wages and salaries component of the Employment Cost Index and the US Congressional Budget Office estimate of the US output gap). The panels are all lined up so that the vertical line in the middle of the chart represents the date that the 2/10 curve falls to 70bps. The conclusion from Chart 5 is that the US economic variables shown are currently at the high end of the range of past curve flattening episodes, but the inflation variables are well above the high end of the historical range. In other words, the current modest slope of the 2/10 Treasury curve is in line with US growth momentum but is too flat relative to US inflation trends. So Why Isn’t The US Treasury Curve Steeper? There are a few possible reasons why the US curve is as flat as it is before the Fed has even begun tightening amid above-trend US growth and very high US inflation: Fears of a deeper financial market selloff The Fed believes strongly in the role of financial conditions in transmitting its monetary policy into the US economy. That often means that, during tightening cycles, the Fed hikes rates “until something breaks” in the financial markets, like a major equity market downturn or a big widening in corporate credit spreads. Such moves act as a brake on US growth through negative wealth effects for investors and by raising the cost of capital for businesses – reducing the need for additional Fed tightening. If bond investors thought that a major market selloff was likely before the Fed could successfully lift rates back to neutral (or even restrictive) levels during a tightening cycle, then they would discount a lower peak level of the funds rate. This would also lower the expected peak level of longer-term Treasury yields, resulting in a flatter Treasury yield curve. Given the current elevated valuations on so many asset classes – like equities, corporate credit and housing – it is likely that the relatively flat Treasury curve incorporates some believe that the Fed will have difficulty delivering a lot of rate hikes in this cycle. However, it should be noted that the US financial conditions remain quite accommodative, even after the recent equity market turbulence (Chart 6), and represent no impediment to US growth that reduces how much tightening the Fed will need to do. Longer-term bond term premia are too low A relatively flat yield curve could reflect a lack of a term premium on longer-maturity bonds. That is certainly the case when looking at the slope of the 2/10 government yield curve in the US, as well as in the UK and Germany (Chart 7).1 Chart 6US Financial Conditions Are No Impediment To US Growth US Financial Conditions Are No Impediment To US Growth US Financial Conditions Are No Impediment To US Growth ​​​​​​ Chart 7Flatter Yield Curves? Or Just Lower Bond Term Premia? Flatter Yield Curves? Or Just Lower Bond Term Premia? Flatter Yield Curves? Or Just Lower Bond Term Premia? ​​​​​ The term premium is the defined as the extra yield that investors require to commit to own a longer-maturity bond instead of the compounded yield from a series of shorter-maturity bonds. The latter can also be expressed as the “expected path of short-term interest rates”, which is often proxied by an average expected path of the monetary policy rate over the life of the longer-maturity bond. So the term premium on a 10-year US Treasury yield is the difference between the actual 10-year Treasury yield and the expected (or average) path of the fed funds rate over the next ten years. The term premium can also be thought of as a risk premium to holding longer-term bonds. On that basis, the term premium should correlate to measures of bond risk, like bond price volatility or inflation volatility. That is definitely true in the US, where the 10-year Treasury term premium shows a strong correlation to the MOVE index of Treasury market option-implied volatility or a longer-term standard deviation of headline CPI inflation (Chart 8). Estimated term premia can also rise during periods of slowing economic growth momentum, but that is typically due to a rapid decline in the expected path of interest rates rather than a rise in bond risk premia (in this case, this is probably more accurately described as a rise in bond uncertainty). Currently, a low term premium on US Treasury yields is justified by the relatively low level of bond volatility and solid US growth momentum. However, the term premium looks far too low compared to the more volatile US inflation seen since the start of the COVID-19 pandemic. With the Fed set to respond to that higher inflation with rate hikes, rising real interest rate expectations could also give a lift to the Treasury term premium. Our favorite proxy for the market expectation of the peak/terminal real short-term interest rate for the major developed market economies is the 5-year/5-year forward OIS rate minus the 5-year/5-year forward CPI swap rate. That “real” 5-year/5-year forward rate measure is typically well correlated to our estimates of the 10-year term premium in the US, Germany and the UK (Chart 9). This correlation likely reflects the level of certainty bond investors have over the likely future path of real interest rates. When there is more uncertainty about how high rates will eventually go to in a tightening cycle, a higher term premium is required. The opposite is true during periods of very low and stable interest rates. Chart 8Drivers Of US Term Premia Pointing Upward Drivers Of US Term Premia Pointing Upward Drivers Of US Term Premia Pointing Upward ​​​​​​ Chart 9Bond Term Premia Positively Correlated To Real Rate Expectations Bond Term Premia Positively Correlated To Real Rate Expectations Bond Term Premia Positively Correlated To Real Rate Expectations ​​​​​​ Chart 10Global Yield Curves Are Too Flat Versus Real Policy Rates Global Yield Curves Are Too Flat Versus Real Policy Rates Global Yield Curves Are Too Flat Versus Real Policy Rates Currently, the estimated 10-year US term premium is increasing alongside a rising market-implied path for the real fed funds rate. We anticipate these trends will continue as the Fed lift rates over the next couple of years, boosting longer-term Treasury yields and potentially putting some steepening pressure on the US Treasury curve (or at least limiting the degree of flattening as the Fed tightens). Markets believe that the neutral real rate (r*) is negative Historically, yield curve slopes for government bonds were well correlated to the level of real interest rates, measured as the central bank policy rate minus headline inflation. That relationship has broken down in the US, with the Treasury curve flattening in the face of soaring US inflation and an unchanged fed funds rate (Chart 10). Similar dynamics can also be seen in the German and UK yield curves. The most plausible reason for such a dramatic shift in the relationship between curve slopes and real policy rates is that bond investors now believe that the neutral real interest rate, a.k.a. “r-star”, is negative … and perhaps deeply so. The New York Fed has produced estimates of the US r-star dating back to the 1960s. The gap between the real fed funds rate and that r-star estimate has typically been fairly well correlated to the slope of the Treasury curve (Chart 11). When the real fed funds rate is below r-star, indicating that the policy is accommodative, the Treasury curve is usually steepening, and vice versa. Under this framework, the recent flattening trend of the Treasury curve would indicate that policy is actually getting tighter, despite the falling, and deeply negative, real fed funds rate of -5.4% (deflated by core inflation). Chart 11UST Curve Slope Is Positively Correlated To The 'Real Policy Gap' UST Curve Slope Is Positively Correlated To The 'Real Policy Gap' UST Curve Slope Is Positively Correlated To The 'Real Policy Gap' The last known estimate of r-star from the New York Fed was 0%, but no update has been provided for almost two years. Blame the pandemic for that. The sharp lockdown-fueled collapse in US GDP growth in 2020, and the rapid recovery in growth as the economy reopened, made it impossible to estimate the the “neutral” level of real interest rates given such massive swings in demand that were not related to monetary policy. One way to try and “back out” the implicit pricing of r-star currently embedded in US Treasury yields is to estimate a model linking the gap between the real fed funds rate and r-star to the slope of the Treasury curve. We did just that, with the results presented in Chart 12. This model estimates the “Real Policy Gap”, or r-star minus the real fed funds rate, as a function of the 2/10 Treasury curve slope. In other words, the model shows the Real Policy Gap that is consistent with the current slope of the curve. Chart 12Current UST Yield Curve Makes Slope Sense ... If The Fed Followed The Taylor Rule With 7% Inflation Current UST Yield Curve Makes Slope Sense ... If The Fed Followed The Taylor Rule With 7% Inflation Current UST Yield Curve Makes Slope Sense ... If The Fed Followed The Taylor Rule With 7% Inflation The model estimates that the current 2/10 curve slope is consistent with a Real Policy Gap of 96bps. With US core CPI inflation currently at 5%, and assuming r-star is still 0% as per the last New York Fed estimate, the fed funds rate would have to rise to 4% to justify the current slope of the 2/10 curve. While that may sound like an implausibly large increase in the funds rate, similar results are produced using straightforward Taylor Rules.2 We can also use our Real Policy Gap model to infer the level of inflation that is consistent with a Gap of 96bps, for various combinations of the funds rate and r-star. Those are shown in Table 1. Assuming the funds rate rises in line with current market expectations to 1.7% and r-star remains close to 0%, the current slope of the 2/10 Treasury curve suggests a fall in US inflation to just around 3% - still above the Fed’s inflation target - from the current 5%. Table 1The UST Curve Slope Has Already Discounted A Big Drop In US Inflation Deciphering The Messages From The US Treasury Curve Deciphering The Messages From The US Treasury Curve We see this as the most plausible reason for the relatively flat level of the 2/10 US Treasury curve. Markets expect somewhat lower US inflation and a moderate rise in the funds rate over the next couple of years, making the real funds rate less negative but not pushing it above a negative r-star expectation. This would suggest upside risk for US Treasury yields, and potential bearish steepening pressure, as markets come to realize that the neutral real fed funds rate is actually positive, not negative. Fight The Forwards, Stay In US Treasury Curve Steepeners While it may sound counter-intuitive with the Fed set to begin a rate hiking cycle, we continue to see better value in tactically positioning in US Treasury curve steepening trades. Specifically, we are keeping our recommended trade in our Tactical Overlay on page 19, where we are long a 2-year Treasury bullet versus a duration-neutral barbell of cash (a 3-month US Treasury bill) and a 10-year Treasury bond. The trade is currently underwater, but we see good reasons to expect the performance to rebound over the next few months. The front end of the curve now discounts more hikes than we expect will unfold in 2022, which should limit further increases in the 2-year Treasury yield. At the same time, the 10-year yield looks too low relative to the expected cyclical peak for the fed funds rate (Chart 13). One way we can assess this is by comparing 5-year/5-year forward Treasury rates to survey estimates of the longer run, or terminal, fed funds rate. The median FOMC forecast (or “dot”) for the terminal funds rate is 2.5%, the median terminal rate forecast from the New York Fed’s Survey of Primary Dealers is 2.25% and the median terminal rate forecast from the New York Fed’s Survey of Market Participants is 2%. This sets a range of estimates of the longer-run terminal rate of 2-2.5%, in line with the current expectations of the BCA Research bond services. The current 5-year/5-year forward Treasury rate is 2.0%, at the low end of that range. We see those forwards rising to the upper part of that 2-2.5% range by the end of 2022, which will push the 10-year Treasury yield toward our year-end target of 2.25%. Chart 13The 5-Year/5-Year UST Forward Rate Is Too Low The 5-Year/5-Year UST Forward Rate Is Too Low The 5-Year/5-Year UST Forward Rate Is Too Low ​​​​​​ Chart 14Stay In UST Curve Steepeners, Even With Fed Liftoff Imminent Stay In UST Curve Steepeners, Even With Fed Liftoff Imminent Stay In UST Curve Steepeners, Even With Fed Liftoff Imminent ​​​​​​ Some of our colleagues within the BCA family see the longer-term neutral funds rate as considerably higher than survey estimates, perhaps as high as 3-4%. We are sympathetic to that view, but it will take signs of US economic resiliency in the face of rate hikes before bond investors – and more importantly, the Fed – arrive at that conclusion. This would make steepening trades more attractive on a strategic, or medium-term, basis as the market realizes that the Fed is further behind the policy curve (i.e. the funds rate even further below a higher terminal rate) than previously envisioned. For now, we do not see the US Treasury curve flattening at the pace discounted in the Treasury forward curve over the next 3-6 months (Chart 14, top panel). However, this will be more of a carry trade by betting against the forwards over time. A bearish steepening of the Treasury curve with a swift upward move in the 10-year Treasury yield is less likely with bond investor/trader positioning already quite short (bottom two panels).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com       Footnotes 1      The term premium estimates shown here are derived from our own in-house framework. For those familiar with the various term premium estimates on the 10-year US Treasury yield produced by the Fed, our estimates are currently in line with those produced by the ACM model and the Kim & Wright model. 2     A fun US Taylor Rule calculator, which can be used to generate Taylor Rules under a variety of assumptions, is available on the Atlanta Fed’s website here. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Deciphering The Messages From The US Treasury Curve Deciphering The Messages From The US Treasury Curve The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The Software and Services Industry is undergoing a fundamental transformation in its business model catalyzed by a momentous migration of software applications to the cloud and broad-based digitization of the economy. This shift is accompanied by displacement of the traditional on-prem license and support model with a more lucrative cloud-based subscription model.  While on-prem software sales are contracting, cloud revenue is growing in double digits. As a result, the industry enjoys spectacular margins and earnings growth. Its earnings have also proven to be resilient across the business cycle because software and IT services increase companies’ productivity in good times and bad. Rising rates are a headwind, but a temporary one. Margins Will Continue To Expand Margins Are To Continue Expanding Margins Are To Continue Expanding Bottom Line: The Software and Services industry group is an all-weather industry with resilient earnings and strong growth throughout the business cycle. It is also in the epicenter of technological innovation: Migration to the cloud and digital transformation enhance the industry’s growth and profitability.  We continue recommending both a tactical and a structural overweight. Feature Performance Technology stocks found themselves in the eye of this month’s market rout. After falling 19% from its peak, the NASDAQ is now firmly in correction territory. The Technology sector is down 11%, while the Software and Services industry group is down 10% (Chart 1). In the “Are We There Yet?” report published last week, we posited that it is not yet the right time to bottom fish: While the Technology sector appears oversold, macroeconomic headwinds from the imminent monetary tightening and a slowdown in demand for technology goods and services may prolong the pain. The interplay of valuations and fundamentals for the sector is not yet favorable. While we are underweight the Technology sector, thanks to our underweight positions in Semiconductors and Hardware and Equipment, we remain overweight Software and Services (S&S). In this report, we will conduct a “deep dive” into S&S and reevaluate our positioning (Table 1). Although S&S is down more than 10% from the peak,  it has outperformed the S&P 500 by 88% since 2011 (Chart 2). The million-dollar question we will try to answer is whether this outperformance continues over the tactical and structural time horizons. Chart 1Software And Services Outperformed Other Tech Industries Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Chart 2S&S Outperformed The S&P 500 By 88% Over The Past 10 Years S&S Outperformed The S&P 500 By 88% Over The Past 10 Years S&S Outperformed The S&P 500 By 88% Over The Past 10 Years Table 1Performance Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Sneak Preview: We maintain our overweight of the Software and Services sector thanks to positive market trends, the all-weather nature of the industry, and resilient earnings. Industry Group Composition The Software And Services Industry Group Is Top Heavy The S&P 500 Software and Services industry group is the largest in the Technology sector and is 48% of the sector market cap. The industry group is split between Software, which is about two-thirds of its market cap, and IT Services, which is one-third (Chart 3). Just like other technology industries, it is dominated by one of the FAANGs+M, Microsoft in this case, which makes up 42% of the industry group index weight. The top 10 constituents out of 36 comprise 80% of the industry’s weight (Table 2). During the current pullback, the S&S industry group has fallen by more than 10%, cushioned by the performance of its larger players. But this masks the pain of the smaller and less profitable constituents, which have fallen by more than 30% (Chart 4). Chart 3Software Dwarfs IT Services Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Chart 4Some Smaller Constituents Have Fallen More Than 15% YTD Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Table 2S&S Industry Is Dominated By A Handful Of Successful Companies Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud However, market dominance runs much deeper than just market capitalization: Microsoft, Adobe, Salesforce, and Oracle account for 87% of the Software Industry revenue, while Visa, Mastercard, Accenture, and PayPal generate 42% of the IT Services industry revenue. Larger industry players are also more profitable thanks to the high operating leverage the industry enjoys. Clearly, just a few companies drive sales and earnings growth, valuations, and performance. On the bright side, these are some of the most successful US technology companies, and their size is their competitive moat. We believe that the industry group is in “good hands.” Key Trends Cloud Migration Following the success of offshoring the US manufacturing base to China that allowed corporations to reduce labor costs, companies are now experimenting with outsourcing other key infrastructure elements. This time, however, the migration is happening to digital cloud platforms. Instead of investing in pricey servers and other hardware assets, corporations have the choice of going with Software-as-a-Service (SaaS), Platform-as-a-Service (PaaS), or Infrastructure-as-a-Service (IaaS) solutions offered by the tech titans. Not only are cloud solutions more cost-effective, but they also offer the convenience and flexibility to scale corporate hardware infrastructure by simply purchasing more or less computational power. COVID-19 lockdowns and the migration of the white-collar workforce towards remote work have motivated companies to transition their technology and operations to the cloud, and have acted as a catalyst for “digital offshoring.” Digital Transformation Digital transformation is in many ways similar to cloud migration. Essentially, it represents broader software penetration into the US economy. Whether it is a manufacturing production or customer relationship management process, wider adoption of software allows for a more efficient business solution via automation and process optimization. Airbnb and Uber are the poster children of digital transformation. While some industries have already undergone digital transformation, there are notable areas which lag behind. For instance, banks’ failure to modernize their digital infrastructure to speed up transactions and to increase overall user convenience has arguably led to the development of the crypto space as an alternative to the slow-evolving traditional financial institutions. The broader implication is that there are still major sectors in the economy that are yet to ramp up automation and increase efficiencies via digital transformation, meaning that there is a healthy demand pipeline for the tech companies. Types Of Software And Services Companies Software: Migration To The Cloud Is A Key Driver Of Growth In the past, classifying software companies was a relatively straightforward exercise: They were divided into system software vs. application software. System software included such categories as operating systems for PCs, and other hardware and database software. Application software covered Enterprise Resource Planning (ERP), Customer Relationship Management (CRM), Communications and Collaborations, etc. However, over time, the industry landscape has changed, first by the mergers that blurred the distinction across these lines, and lately, thanks to ubiquitous migration to the cloud model and digitization of the economy. Therefore, it is most practical to classify software companies by their type of business model, i.e., legacy license and support model, or cloud-based, or hybrid.  Pure cloud-first: These companies derive 100% of their sales from the cloud model – Salesforce.com (CRM), ServiceNow (Now), and Twilio (TWLO) are among the biggest winners. Cloud/license hybrid: These are companies that derive 50%+ of their sales from the cloud, such as Microsoft (MSFT), Atlassian (TEAM), Autodesk (ADSK), and Adobe (ADBE). Legacy license and support model (aka On-Premises): Constellation Software (CSU), Citrix Systems (CTSX) – these companies are likely to struggle to grow organically. Types Of Cloud Application Services The cloud-based business model in turn can be classified under three different types of service: Software-as-a-Service (SaaS), Infrastructure-as-a-Service (IaaS), or Platform-as-a-Service (PaaS). Software-as-a-Service: Customers configure and access a web-based application operated by a SaaS provider over the internet. Salesforce.com, Workday (DAY), ServiceNow, and Oracle are some of the most established players. Infrastructure-as-a-Service: This service gives customers access to virtual storage and servers over the internet, enabling them to develop and run any application just as if it were running in their own data center. Amazon’s AWS, Microsoft’s Azure, and IBM are the key competitors in this space. Platform-as-a-Service: This service occupies a middle ground between SaaS and IaaS, i.e. between a full-fledged app that can be used “out-of-the-box” and a “raw server and storage” instance, making the customer responsible for installing and configuring its own “full stack.” PaaS offerings tend to be less standardized. Salesforce.com, Microsoft, and Oracle are the leaders. IDC projects the continued strength of this segment and expects it to grow at an annualized rate of 29.7% over the next five years. The following table from Microsoft presents a perfect explanation of the different software service models (Table 3). Table 3Differences In Cloud Computing Service Models Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud License And Support Vs. Cloud Subscription Model Growth Rates Broad-based migration to the cloud is shifting the industry’s revenue composition, with accelerating bifurcation between cloud and on-prem models: Cloud subscription revenue is replacing the traditional license and support model. As a result, legacy on-prem revenue has recently been contracting, and once the last of the legacy enterprise applications are retired, it will be fully replaced by cloud revenue. According to estimates by CFRA,1  the software industry grew by 4% in 2021, with a 22% year-on-year increase in cloud subscription revenue, which now constitutes 37% of total industry revenue, and a 3% decline in traditional software revenue. The surge in cloud growth is likely to continue, thanks to the accelerating pace of digital transformation. This trend is also promulgated by some of the largest players, such as Microsoft, whose cloud subscription revenue now constitutes more than half of the overall revenue and is an engine of growth in the software space. Strong cloud revenue growth is not just a function of recruiting new users but is also supported by the proliferation of new cloud apps and upgrades to the existing ones.  Importantly, the cloud subscription model is also more profitable than the license model, whose EBITDA margins rarely exceed 40%. Cloud-based services take longer to become profitable but have much higher operating leverage: Once profitable, cloud and hybrid companies often have operating margins around 50-60%.  Software is one of the most resilient technology industries, performing equally well in a growing economy and during downturns: Subscription pricing is sticky, and switching costs are high. As a result, companies, which derive a large share of their revenue from the cloud, have stable and predictable sales. Once clients are onboarded, cloud providers may also be able to exercise their pricing power. IT Services IT services is a smaller segment of the Software and Services industry group and is a hodge-podge of different companies that provide a wide range of services from IT consulting to FinTech. The following is a brief description of the key categories: IT Consulting: The S&P 500 IT Consulting companies are Accenture, Gartner, and Cognizant.  Companies offer Professional advice in IT, management, HR, logistics, and many others. Since the pandemic, these companies’ key focus is on assisting their clients with digital transformation and improving companies’ operations. This industry is one of the key beneficiaries of accelerated migration to the cloud and has enjoyed exponential growth over the past decade. Its revenue stream is highly resilient, as even during economic downturns, clients are seeking advice on the best ways to navigate an uncertain market environment. Outsourcing: Companies such as ADP and Paychex provide HR and business services solutions for mid-sized and small companies. Their services cover payroll, benefits, retirement, and insurance services.   This industry has been growing its sales and profits at a healthy clip over the past few years. Now it is focused on modernizing itself by moving its own operations to the cloud and deploying Artificial Intelligence to improve operations. These companies are also undergoing digital transformation and are moving towards the SaaS model. Financial Transaction Services: This is a FinTech industry that includes card and payment processors, such as Visa, Mastercard, and PayPal, and each of these players operates their own proprietary payment networks.  Digital payments and the wide acceptance of e-commerce drive this space. Lately, these companies have been at the forefront of the adoption of digital currencies as viable payment options. Payment companies are among the earliest adopters of the cloud, and their business model is best described as Transaction-processing-as-a-service. These are highly profitable companies that consistently generate an operating margin above 60%. Key Industry Drivers Software Enhances Productivity And Improves Profitability Broadly speaking, the Software and Services industry group is considered a defensive holding owing to the resiliency of its earnings (Chart 5). Software enhances productivity: During economic downturns, it helps reduce costs, and during expansions, it helps overcome capacity constraints and labor shortages. While pandemic labor shortages and lockdowns produced a spike in productivity, more recently it has been falling, which has warranted a year-over-year increase in software investment (Chart 6). Chart 5S&S Earnings Are Resilient Across The Business Cycle S&S Earnings Are Resilient Across The Business Cycle S&S Earnings Are Resilient Across The Business Cycle Chart 6Investing In Software Improves Productivity Investing In Software Improves Productivity Investing In Software Improves Productivity Further, both labor shortages and rising wages are prompting companies to redesign their operations to contain costs and preserve margins. To do so, many are accelerating investments in Capex and automation, much of which is achieved through investment in software and IT services, replacing both labor and capital.  According to CFRA, “software is no longer used to manage a means of production, but rather IS means of production .” Software-related Capex is not only garnering a larger slice of tech spending budgets but also of the overall Capex pie (Chart 7). Chart 7Share Of Software In Overall Capex Has Been Rising Steadily Share Of Software In Overall Capex Has Been Rising Steadily Share Of Software In Overall Capex Has Been Rising Steadily Macroeconomic Backdrop Imminent Rate Hikes Tighter monetary policy and runaway inflation are at the fore of investors’ minds and, arguably, a cause of the current market rout.  Software stocks have outperformed the other long-duration technology stocks. To gauge the reaction of S&S to the upcoming rate hike, we have repeated an exercise we conducted for the Technology sector last week – historical performance of the industry six months before and after the first rate hike (Chart 8).   Clearly, industry returns fall two to three months before the first rate hike, but eventually recover once a new monetary regime is priced in. The year-to-date correction of the software stocks is textbook behavior. Chart 8S&S Underperforms Before The First Rate Hike Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Software And Services Is A Global Industry – Beware Of A Strong Dollar The Technology sector is one of the most global sectors in the S&P 500 and derives 40% of sales from abroad; similarly, Software and Services has a broad international footprint. As US rates trend higher, and the interest rate differential favors the US vs. other countries, the USD is likely to appreciate further. With a stronger dollar, products of US software firms are more expensive to foreigners, which may have a dampening effect on demand. The US firms’ profitability has also been hit by an unfavorable translation from foreign currency back to the USD. Historically, the path of the dollar and the returns of S&S were inversely correlated (Chart 9). Chart 9Historically, Stronger Dollar Has Been A Headwind For The Industry Historically, Stronger Dollar Has Been A Headwind For The Industry Historically, Stronger Dollar Has Been A Headwind For The Industry The redeeming grace is that, as we mentioned before, software subscription revenue is sticky, and switching costs for customers are high. As such, we expect the adverse effect on demand to be minor. Fundamentals Sales Growth According to Grandview Research , the business software and services market is expected to grow at a compound annualized rate of 11.3% from 2021 to 2028. This strong growth is underpinned by the robust pace of enterprise application cloud migration and digital transformation, which see no end in sight. The street expects the Software and Services industry to grow on par with the Technology sector at just under 20% over the next 12 months, and growth is slowing off high levels.  The pandemic has shifted forward some of the spending on software, as companies rushed to adjust to remote work.  However, the industry continues to grow at a healthy clip (Chart 10). Chart 10Sales Growth Is Slowing Sales Growth Is Slowing Sales Growth Is Slowing Labor Costs Are Contained For Now The S&S companies first and foremost rely on the talent and ingenuity of their workforce to deliver cutting-edge technological solutions. Wages are one of the largest expenses in the industry. Recent increases in salaries accompanied by labor shortages and “the great resignation” are bound to cut into the margins of these companies. So far, software and services companies have been able to counter the trend (Chart 11) by deploying creative solutions, offering their employees a wide range of perks, and throwing their net wide in search of talent by offering remote work.   Chart 11Industry Labor Costs Have Been Contained Industry Labor Costs Have Been Contained Industry Labor Costs Have Been Contained Resilient Earnings Growth For the reasons discussed above, S&S earnings growth is remarkably resilient and stable throughout the business cycle (Chart 12). Currently, earnings expectations of S&S over the next 12 months exceed growth expectations for both the Technology sector and the S&P 500. Over the next 12 months, S&S earnings are expected to grow at 14% compared to 8.6% for the S&P 500 (Table 4). Chart 12S&S EPS Growth Bests The Tech Sector And The S&P 500 S&S EPS Growth Bests The Tech Sector And The S&P 500 S&S EPS Growth Bests The Tech Sector And The S&P 500 Table 4Earnings Growth Vs. Valuations Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Despite the slowdown in sales growth and the pick-up in labor costs, EBITDA margins have exceeded the previous peak, and are projected to trend higher towards 40% over the course of the year (Chart 13). Expecting a growth slowdown, analysts have been revising earnings expectations down for S&S companies, but by now the downgrading process has run its course, and the bar is set low (Chart 14). Chart 13Margins Will Continue To Expand Margins Will Continue To Expand Margins Will Continue To Expand Chart 14Downgrades Are Bottoming Downgrades Are Bottoming Downgrades Are Bottoming   Valuations Since the S&S industry group’s earnings are expected to grow faster than the earnings of the Tech sector and the S&P 500, it is not surprising that it trades with a 44% premium to the S&P 500 on a forward earnings basis – a steep mark-up. The current correction has taken some froth off the industry’s valuations , with multiples contracting by 3.9 points. Even after the correction, the sector appears overvalued (Chart 15). Adjusting for expected 12-month EPS growth, S&S appears more attractively valued and trades with a discount both to tech and the broad market (Table 4). It is also important to note that the industry group is home to a plethora of quite a few smaller companies, which tend to be more expensive and more volatile: Chart 16 plots companies’ forward earnings multiples against their weight in the industry group.   Chart 15Valuations Are Still Dear... Valuations Are Still Dear... Valuations Are Still Dear... Chart 16Significant Valuation Dispersion Among The Constituents Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Technicals Recently, the BCA Technical Indicator has moved into the oversold territory, indicating investor capitulation. This means that this bar is cleared, and from a technical standpoint alone, Software and Services is a buy (Chart 17). Chart 17... But Technicals Indicate That S&S Is Oversold ... But Technicals Indicate That S&S Is Oversold ... But Technicals Indicate That S&S Is Oversold Investment Implications We are both tactically and structurally bullish on the Software and Services industry group. Tactically Bullish The Software and Services industry group is an all-weather industry with an unprecedented combination of both earnings resiliency and strong growth throughout the business cycle. It is also undergoing a fundamental transformation in its business model catalyzed by a ubiquitous shift in software applications to the cloud, accompanied by displacement of the traditional on-prem license and support model with a more lucrative subscription model. The industry is expected to grow earnings in double digits and expand margins, unhindered by rising labor costs. Rising rates are certainly a headwind, but hopefully a temporary one. Froth has come off valuations, and a new monetary regime is gradually getting priced in. According to the technical indicator, the sector is oversold. On balance, we have a positive outlook on the industry group (Table 5) and maintain our overweight position. Table 5Software And Services Scorecard Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Structurally Bullish Our long-held belief is that the broader push to the cloud, augmented reality, AI, cybersecurity, and autonomous driving, which are all software dependent, are not fads but are here to stay. Software and Services are at the epicenter of technological innovation and are home to some of the best American companies.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     CFRA, Industry Surveys, Software, July 2021 Recommended Allocation

Dear client, In lieu of our weekly bulletin next week, I will be hosting a webcast on Friday, January 28 at 11:00 am EST, to discuss recent dollar trends. I hope you all tune in. Kind regards, Chester Ntonifor Highlights While not often discussed, it is well known that the dollar is expensive. It is true that valuations tend to matter less until they trigger a tipping point. Such inflections usually coincide with huge external imbalances, especially generated by an overvalued exchange rate. The US dollar could be stepping into such a paradigm - the DXY is 1.5 standard deviations above fair value, at the same time as the goods trade deficit is hitting record lows, and real interest rates are deeply negative. More importantly, there has been limited precedence to such a dollar configuration. Historically, it has required much higher real interest rates, or an improving balance of payments backdrop, to justify such lofty valuations. Our trading model shows that selling a currency when it is expensive and buying it when it is cheap generates excess returns over time. Within our valuation ranking, the cheapest currencies are JPY, SEK and NOK. On a terms-of-trade basis, the AUD stands out as a winner. Feature Chart 1High Dollar Valuation And Ultra-Low Real Rates Is Unprecedented High Dollar Valuation And Ultra-Low Real Rates Is Unprecedented High Dollar Valuation And Ultra-Low Real Rates Is Unprecedented Valuations usually get little respect when it comes to medium-term currency movements. This has been especially the case over the last few years, where the macroeconomic environment has been by far the biggest driver of the US dollar. The bull market in the dollar from 2011 to 2020 coincided with higher real interest rates in the US, relative to the rest of the developed world. In fact, since 2008, no developed market central bank has been able to hike rates by more than 200bps, except for the US Federal Reserve. Our report last week focused on why aggressive interest rate increases by the Federal Reserve could be bullish for the US dollar in the short term, but eventually set the stage for depreciation. In this report, we argue that valuations will also become a more important factor for currency strategy over the next 1-2 years (Chart 1). The Dollar And The External Balance The framework to understand currencies and the external balance is straightforward - a rising trade deficit (imports > exports) requires a lower exchange rate to boost competitiveness in the manufacturing sector, or less spending to reduce the trade deficit. Reduced domestic spending is unlikely in most developed economies, given ample pent-up demand and loose fiscal policy. Therefore, the natural adjustment mechanism for countries running wide trade deficits will have to be the exchange rate. Within a broad spectrum of developed and emerging market currencies, the US dollar stands out as overvalued on a real effective exchange rate basis (Chart 2A and 2B). It is true that valuations tend to matter less until they trigger a tipping point. Such inflections usually occur with a shift in animal spirits, coinciding with huge external imbalances. Chart 2 Chart 2 In the US, these imbalances are already starting to trigger a shift. The US trade deficit is deteriorating, with the goods deficit hitting a record low of -$98bn in November. Over the last few years, it has become increasingly difficult to fund this widening trade deficit via foreign purchases of US Treasuries (Chart 3). Meanwhile, as we highlighted last week, substantial equity inflows over the last few years have started to roll over. In a nutshell, the basic balance in the US (the sum of the current account and foreign direct investment) is deteriorating at an accelerated pace (Chart 4). The US current account deficit for Q3 came in at -$214.8 billion, the widest in over a decade. This has reversed a lot of the improvement in the basic balance since the Global Financial Crisis. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts deteriorating. Chart 4Deteriorating Balance Of Payments Dynamics US Balance Of Payments Deteriorating Balance Of Payments Dynamics US Balance Of Payments Deteriorating Balance Of Payments Dynamics US Balance Of Payments Chart 3It Is Becoming Increasingly Difficult To Fund The Widening Deficit It Is Becoming Increasingly Difficult To Fund The Widening Deficit It Is Becoming Increasingly Difficult To Fund The Widening Deficit Fiscal policy is likely to become tighter in the next couple of years, easing the domestic spending constraint for the exchange rate. That said, fiscal policy will remain loose compared to pre-pandemic levels and relative to underlying employment conditions. This has historically led to a deterioration in the external balance and pulled the real effective exchange rate of the dollar down (Chart 5). Chart 5The Dollar And The Budget Deficit The Dollar And The Budget Deficit The Dollar And The Budget Deficit Real Interest Rates And The Dollar It is remarkable that at a time when real rates are the most negative in the US, the dollar is as overvalued as it has been in decades on a simple PPP model. This is a perfect mirror image of the dollar configuration at the start of the bull market in 2010, where the dollar was cheap and real rates were more supportive (Chart 1). According to economic theory, a currency should adjust to equalize returns across countries. This is a no-arbitrage condition. In the early 80s, an overvalued dollar was supported by very positive real rates. The subsequent dollar declines thereafter also coincided with falling real interest rates. In fact, over the last decade, it has been an anomaly that the dollar is so strong despite relative real interest rates being so negative (Chart 6). Our view remains that the terminal interest rate for the US should be higher than what is currently discounted in the 10-year Treasury yield. According to the overnight index swap curve, the Fed will not hike interest rates past 1.75%. This is much lower than past cycles and will keep real interest rates low. This does not justify an expensive greenback. Our shorter-term interest rate model also shows the DXY as slightly expensive, even though short-term interest rates have moved in favor of the dollar over the past year (Chart 7). Chart 6The Level Of Relative Real Yields Also Matters The Level Of Relative Real Yields Also Matters The Level Of Relative Real Yields Also Matters Chart 7Our Timing Model Suggests ##br##A Pullback Our Timing Model Suggests A Pullback Our Timing Model Suggests A Pullback Other Considerations While real effective exchange rates and purchasing power parity models are among our favorite valuation gauges, they are not foolproof. Countries with structurally higher inflation (and so a higher real effective exchange rate), could also have higher productivity. According to the Balassa-Samuelson Hypothesis, competitiveness in the tradeable goods sector will boost wages across all sectors of the economy, leading to higher prices. This argument particularly resonates with proponents that suggest the US is a fast-growing economy, and so will tend to run a current account deficit, like Australia during the commodity boom of the early 2000s. Meanwhile, the US earns more on its overseas assets than it spends on its liabilities, suggesting that the funding gap will eventually close. Unfortunately, the overvaluation of the dollar has not been due to higher relative productivity in the US, especially when compared to other economies. Across a broad spectrum of developed and emerging market economies, the dollar is expensive according to our productivity models. The Chinese RMB (which is much overvalued on a PPP basis) is closer to fair value when productivity is taken into consideration (Chart 8). Chart 8 Meanwhile, the sizeable US deficit is not completely offset by its positive investment balance (Chart 9). This is occurring at a time when many faster growing countries (such as China for example) are generating current account surpluses (Chart 10A and 10B). In a nutshell, whether one looks at relative price levels, relative productivity trends, or relative real returns on government assets, the dollar is expensive. Chart 9The Positive Income Balance Has Not Helped The Us Investment Position The Positive Income Balance Has Not Helped The Us Investment Position The Positive Income Balance Has Not Helped The Us Investment Position Chart 10 Chart 10 Conclusion Last summer, we introduced a trading model for FX valuation enthusiasts. We used both our in-house purchasing power parity models (PPP) and our intermediate-term timing models as valuation tools. Since the 2000s, both valuation models have outperformed a buy-and-hold currency strategy with much lower volatility (Chart 11). Currency valuation tends to matter over the longer term, while the macro environment tends to dominate short-term currency trading. Given that the dollar has been overvalued for the last three to five years, the above analysis suggests we might be entering this “longer-term” tipping point where valuations will start to matter more going forward. Within our valuation ranking, the cheapest currencies are JPY, SEK and NOK. On a terms-of-trade and productivity basis, the AUD stands out as a winner. This is being reflected in a record-high basic balance surplus (Chart 12). In our trade tables, we went long AUD at 70 cents, and will upgrade this to a high conviction bet on signs that currency volatility is ebbing. Chart 11A Trading Rule Solely Based On Valuation A Trading Rule Solely Based On Valuation A Trading Rule Solely Based On Valuation Chart 12AUD And Balance Of Payments AUD And Balance Of Payments AUD And Balance Of Payments Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Forecast Summary