Technology

Highlights Industry Deep-dive Report: The Semiconductor and Semiconductor Equipment Industry (“Semis”) has had a fantastic run over the past 12 months. We have been overweight it since June and the trade is ahead of the market by 14%. In this deep-dive report into the sector, we aim to decipher the outlook for 2022. To do so, we review the supply chain, target markets, macroeconomic backdrop, and fundamentals. Production Model: Semiconductor production is divided among IC designers and manufacturers. This separation of design and manufacturing is called the fabless model, which has grown in prominence as the pace of innovation made it increasingly difficult for firms to manage both the capital intensity of manufacturing and the high levels of R&D spending for design. Designed In The US, Made In Asia: The entire semiconductor industry depends on the cooperation between two regions: North America that houses global leaders in designing the most sophisticated chips, and Asia which is home to companies that have the technology to manufacture them. Geopolitical risks: As a result, the Semis are in the crosshairs of rising tensions between China and the US with both countries seeking chips independence and pushing for onshoring. Conventional end-demand markets span the entire US economy but can be grouped into several main categories. Computing or data processing electronics is one of the largest markets, followed by Communications, Consumer Electronics, and Autos. Growth rates vary across segments. The novel markets for semis came on the back of emerging technologies, such as IoT, 5G, automation, AI, self-driving vehicles, and others, all of which require increasing chip sophistication. These markets present a tremendous long-term opportunity for the industry. Global semis sales grew at 25 percent in 2021. In 2022, market growth is expected to slow to 10 percent. Earnings growth has also been slowing. The industry is not immune to rising costs of raw materials, labor shortages, and supply-chain disruptions. While earnings growth is slowing, operating margins are set to expand over the next 12 months. Valuations are extended: The semis' earnings growth expectations are on par with the S&P 500, but trade with a 14% premium to forward multiple. The macroeconomic backdrop is unfavorable: Tighter monetary policy, slowing economic growth, and a slowdown in China, are headwinds for this hyper-cyclical industry. Investment Outlook: We conclude that we are bullish on the industry on a structural basis but are more ambivalent about its prospects over the next 3-6 months downgrading our portfolio overweight to an equal-weight. Chart 9 Feature Performance The Semiconductors and Semiconductor Equipment industry (“Semis”) has received an unexpected boost during the pandemic: Lockdowns, coupled with helicopter cash drops, have spurred demand for durable goods, and foundries could not work fast enough to produce chips, direly needed by autos, consumer electronics, and computer manufacturers. Since the beginning of the pandemic, Semis have outperformed the S&P 500 by roughly 62%, and the Tech sector by just under 30% (Chart 1). Only this year, Semis are almost 20% ahead of the market (Table 1). This poses a question – can this outperformance continue in 2022, or will the economic growth slowdown and waning demand for goods end this superior run? Chart 1Shortages Boosted Performance Of Semis Shortages Boosted Performance Of Semis Shortages Boosted Performance Of Semis Sneak Preview: While we believe in Semis as a multi-year structural theme, we recommend a tactical equal weight. We have been overweight Semis since June and the trade is ahead of the market by 14.5%. We are closing the overweight on the back of a strong run, rich valuations, slowing earnings growth, and an unfavorable macroeconomic backdrop. Table 1Semis Had A Strong Run Over The Past 12 Months Semiconductors: Aren't They Fab?! Semiconductors: Aren't They Fab?! Semiconductor Primer What Are Semiconductors? I have a confession to make – I have always had only the fuzziest idea of what is inside my computer or under the hood of my car. Well, apparently, it is semis, aka chips, that are the brains of any electronic device that we come across in our daily life. I like the comparison of chips to modern-day bricks, serving a wide range of industries. The American Semiconductor Association (ASA) calls them a “marvel of modern technology,” which they truly are, being a foundation of modern life, packed with up to tens of billions of transistors on a piece of silicon the size of a quarter. Chips power not only our phones and vacuum cleaners, but also innovative medical devices, robots, and wireless internet. Semiconductors make all sectors of the US economy, from farming to manufacturing, more efficient. The number of applications of semis is innumerable, and recent shortages made all of us more aware of these, behind-the-scenes, engines of our daily life. The US Semis Brag Sheet The US semiconductor industry is the worldwide industry leader with about half of the global market share (47%) and sales of $208B in 2020.1 The industry employs over a quarter-million people and supports nearly 1.6 million additional US jobs. Semis are a top-five US export, with more than 80% of industry sales going to overseas customers. The US exported $49B in semiconductors in 2020. Rapid innovation has allowed the industry to produce exponentially more products at a lower cost, a principle known as Moore’s law. How Are Semiconductors Made? R&D is the first step in the production process. Firms involved in semiconductor design develop nanometer-scale integrated circuits that perform the critical tasks that make electronic devices work, such as connectivity to networks, computing, storage, and power management. Chip designers must use highly advanced electronic design automation (EDA) software and reusable architectural building blocks (“IP cores”) to do this task.2 The process requires significant investment: Developing a new chip can cost over 100M dollars and requires many years of work by hundreds of engineers. As chips have become increasingly complex, development costs have rapidly risen. Design is the part of the process that differentiates one type of chips from another and constitutes a competitive moat for the companies that design them. Design is chiefly knowledge- and skill-intensive, accounting for 65% of the total industry R&D and has the highest value-add of the entire production process. Manufacturing is a complex process. Once chips are designed, the process moves to production. Often the chip production starts with processing sand that contains a large amount of silicon. Sand is purified and melted into solid cylinders, that are then sliced into very thin silicon discs, polished to a flawless finish, called “blank wafer.” Wafers are then printed with intricated circuit designs, which are later divided into tiny individual semiconductors, called dies. Dies are later packaged into finished semiconductors that can be embedded into electronic devices. This process is summarized in Chart 2. Chart 2 Cross-Border Supply Chains Types Of Semiconductor Production Companies The chip production process is usually divided between the three types of players that operate in the different segments of the supply chain. IC designing companies or fabless firms focus only on design and outsource fabrication to pure-play foundries and outsourced assembly and test (OSAT) firms. This segment of the value chain is dominated by the US firms such as Qualcomm, Broadcom, Nvidia, and AMD, which account for roughly 60% of all global fabless firm sales (Chart 3). Semiconductor manufacturing companies, aka foundries, receive orders from the IC designing companies and purchase raw materials and equipment to proceed in the chip manufacturing process. TSMC, Global Foundries, and United Microelectronics Corporation (UMC) are some of the largest and are located in Asia. The share of chips manufactured in China, South Korea, Southeast Asia, Taiwan, and other regions in East Asia has soared to 75% (Chart 4). Integrated Device Manufacturers (IDM) cover the entire production process from design to manufacturing. In terms of revenue, Samsung, Intel, and SK Hynix are the world’s three top IDM companies. Recently, there was a global push towards reintegration for geopolitical reasons (more about that later). Chart 3 Chart 4 The fabless model, or separation of chip design and manufacturing, has grown along with the demand for semiconductors since the 1990s, as the pace of innovation made it increasingly difficult for many firms to manage both the capital intensity of manufacturing and the high levels of R&D spending for design. Since China joined the WTO in late 2001, global manufacturing offshoring switched to a higher gear with the semiconductor industry becoming a poster child for the movement. Except for Intel, which is the only US company that both designs and manufacturers chips, other US corporations completely outsourced their manufacturing to Asia. Designed In The US, Made In Asia As of 2020, the US market share of the global semiconductor market was 47% (Chart 5), dominated by fabless firms. Given the importance of semiconductor design in terms of value-added in the manufacturing process, the US must remain a leader in this stage of production. The US firms spend 17% of sales on R&D, more than any other country, to maintain a competitive edge (Chart 6). And this decisive advantage translates into a disproportionate share of industry revenue. Chart 5 Chart 6 While specializing in chip design creates a competitive moat for the US semi companies, it also makes them vulnerable to supply-chain disruptions: At present only a little over 10% of all chips are manufactured in the US compared to 37% back in the ‘nineties (Chart 7), with the lion’s share of the most sophisticated chips manufactured in Asia. With the separation of design and manufacturing, the US, which is a leader in design, is falling behind as a location for manufacturing technology. As a result, the entire semiconductor industry depends on the cooperation between two regions: North America that houses global leaders in designing the most sophisticated chips, and Asia that is home to companies that have the technology to manufacture the most complex of chips. Both ends (design and manufacturing) of the semiconductor industry also have high barriers to entry due to the technology required to compete in the field, which creates a big problem since major geopolitical players now aim to break down existing supply-chains and to push their corporations towards domestic vertical integration. Chart 7 Supply Chain Fragility The fragility of the semiconductor supply chains was best revealed during the pandemic-induced shutdown. With the global economy coming to a virtual hold, various industries had to cancel their semi orders, and foundries took some of the capacity offline. However, demand for goods rebounded unexpectedly and sharply, jump-started by global fiscal and monetary stimulus. It is important to note that a semiconductor manufacturing plant cannot be simply turned on after a period of inactivity. Not only does it require time to be brought back to life, but also the chip production itself is a month-long process. Semiconductor companies did their best during the lockdown to meet demand and even got an exemption from government-imposed lockdowns as “essential” businesses. The industry managed to increase production to address high demand, shipping more semiconductors every month than ever before by the middle of 2021 (Chart 8). However, chip shortages ensued, because supply, despite its best efforts, could not keep pace with the demand. Expanding semi manufacturing capacity was not an option: Building a fab and bringing it up to full capacity can take anywhere from 24 to 42 months at a price tag of anywhere from $1.7bn to $5.4bn, depending on the quality of the chips manufactured.3 Most industry analysts expect the shortage to linger into 2022.4 Chart 8The Industry Worked Hard To Meet Demand For Chips The Industry Worked Hard To Meet Demand For Chips The Industry Worked Hard To Meet Demand For Chips Geopolitics Semiconductor Industry Is At The Epicenter Of Geopolitical Tensions The semi shortages also came within the broader context of the changing world order and the resulting competition for the key resource. As a result, governments around the globe took action to secure the key commodity for themselves and to establish its production on domestic soil. In the US, once semi-conductor shortages started crippling US manufacturing back in April 2021, President Biden held a semiconductor summit at the White House. In addition, he signed an executive order calling for a 100-day review of the US supply chains. In June, the US Senate passed the bipartisan US Innovation and Competition Act, which includes $52 billion in federal investments for semiconductors (building from the CHIPS for America Act announced in January). The House of Representatives excluded the $52 billion from its version of the bill but most of this semiconductor funding will likely be reinstated in the final compromise version of the bill. We expect the funding to help US-based firms, like Intel, as well as non-US firms, such as Taiwan Semiconductor, which is putting billions of dollars into its next-generation production plant in Arizona. And last, the administration agreed with Japan to cooperate on semiconductor development and supply chains.5 Moving east, the European Commission also expressed its concerns that the Old Continent was naïve to outsource chip manufacturing and now plans to double the EU’s share of global chip production from the current 10% to 20% by 2030 under its new Digital Compass plan which aims to boost “digital sovereignty” by funding various high-tech initiatives. In China, policymakers realized the importance of semis in 2013, and while China will not achieve full self-sufficiency anytime soon, ongoing US sanctions and political pressure will only accelerate the Middle Kingdom’s push for semiconductor supply independence. Already, the new five-year plan that was released this year, prioritizes technological innovation including in the semiconductor space. Japan and South Korea are also devoting state resources to the industry, and global policymakers are seeking ways to reduce dependency on Taiwan due to the risk of conflict over the long run. The broader implication of the global semiconductor production onshoring is two-fold. First, existing supply chains will come under pressure as nations will force their respective semiconductor companies to undergo a complete vertical integration, resulting in much steeper chip prices, unless governments come out with further extravagant subsidies. This transformation also implies higher demand for the output of semiconductor equipment manufacturers as nations are scrambling to build onshore manufacturing facilities. Target Markets Most industries are run on chips, but overall usage can be grouped into several key categories, such as Computers, Communications, Consumer Goods, Autos. These traditional markets account for most of the demand for chips. Conventional Chip Uses Computing aka Data Processing Electronics is one of the largest segments and comprises nearly one-third of all semiconductor usage. This segment represents the demand for chips used for personal computers, servers, and cloud storage. This is one of the fastest-growing categories, which SIA projects to grow at 21% per year6 (Chart 9). While this expected rate of growth is impressive, it is set to slow in the coming year as demand for personal computers is starting to decelerate (Chart 10). On the upside, annual growth in servers continues to rebound, with the year-on-year increase in global server shipments close to 15% (Chart 11). Chart 9 Chart 10Demand For PCs Is Coming Off High Levels... Demand For PCs Is Coming Off High Levels... Demand For PCs Is Coming Off High Levels... Chart 11While Demand For Servers Is On The Rise While Demand For Servers Is On The Rise While Demand For Servers Is On The Rise   Communications Electronics is the second largest chips market. These chips power wireless communications and are getting a boost from the rollout of 5G networks. This segment also benefits from the recently passed US Infrastructure Bill, which has funds earmarked for wireless communication. However, communications chips expect tepid growth of just 1% as the speed of the 5G rollout is disappointing, and many consumers are unwilling to upgrade their phones: Demand for smartphones has only recently turned up (Chart 12). Consumer Electronics is a segment that is expected to contract in the coming year as spending on consumer goods has already exceeded the pre-pandemic trend and has turned down (Chart 13). Chart 12Demand For Smart Phones Has Started To Pick Up Demand For Smart Phones Has Started To Pick Up Demand For Smart Phones Has Started To Pick Up Chart 13Demand For Consumer Goods Is Waning Demand For Consumer Goods Is Waning Demand For Consumer Goods Is Waning   Automotive segment – Modern vehicles are increasingly reliant on chips for advanced brakes, steering systems, fuel efficiency, safety, and other features. So missing chips can easily stall production. While the segment is only 12% of the total, it has gotten the industry’s most negative rap. Auto manufacturers, for example, could experience a $61bn loss in revenue due to supply constraints in 2021.7 However, this segment is expected to grow in the high single digits due to significant pent-up demand for autos (Chart 14). Interestingly, EV makers that deploy the most sophisticated chips were somewhat spared from shortages, which afflicted mostly mainstream chip categories. Chart 14Auto Segment Is Expected To Grow Due To Pent-Up Demand For Cars Auto Segment Is Expected To Grow Due To Pent-Up Demand For Cars Auto Segment Is Expected To Grow Due To Pent-Up Demand For Cars Chips Power The Fourth Industrial Revolution Besides these well-established markets, Semis are also intrinsically a play on every single emerging technology theme. Semiconductors are at the core of disruptive technologies and the fourth industrial revolution. Artificial Intelligence (AI) and Machine Learning (ML) rely heavily on computing power delivered by sophisticated chips to process massive datasets looking for insights. As AI becomes widely deployed in a wide range of industries, demand for powerful chips is bound to soar: The size of the AI chip market is forecast to increase eight-fold from an estimated $10.14bn in 2020 to $83.25bn by 2027.8 Internet of Things (IoT), or interconnectedness of electronics, is another source of demand for chips. However, to realize the full potential of this new-generation technology, processors, modems, and other communication infrastructure must be modernized. 5G adoption is starting to accelerate as new applications are being developed such as the metaverse, immersive gaming, and virtual reality. The higher data rates and lower latencies made possible by 5G are expected to be a driver of demand for advanced semiconductors. In a 2021 KPMG survey, 53% of semiconductor companies believe 5G will become a significant driver of revenue growth in one to two years, and 19% believe it could happen in less than a year.9 Automation: Be it self-driving cars or the installation of manufacturing assembly robots, both require semiconductors. Recent labor shortages and rising wages are another reason automation is to come to the fore: US manufacturers are a case in point, lagging their European and Asian counterparts in new robot installation and in dire need of catching up. While it’s true that automation does not bring an explosive demand shock like IoT and AI do, we would not underestimate the power of that structural force (Chart 15). Chart 15 Fundamentals Sales Growth And Profitability According to the WSTS, the worldwide semiconductor market is expected to show an outstanding growth rate of 25 percent in 2021. The largest growth contributors are Memory with 37.1 percent, followed by Analog with 29.1 percent, and Logic with 26.2 percent. By 2022, the global semiconductor market growth is expected to slow and is projected to grow by 10.1 percent. Americas are expected to grow at 12% next year.10 These forecasts align rather well with bottom-up sales growth forecasts by street analysts at 10.8% (Chart 16), which exceed projected nominal GDP growth of 7.6% and expected sales growth of the S&P 500. This industry continues to be powered by pent-up demand, backlogs of orders, and adoption of brand-new technologies. Earnings growth has recently slowed (Chart 17). Semis is an R&D intense industry, especially for the fabless US companies, which continue to plow funds into research and design of chips to retain a competitive edge. After a pandemic hiatus, the industry now is starting to ramp up its Capex outlays (Chart 18). Chart 16Sales Growth Is To Stay Robust... Sales Growth Is To Stay Robust... Sales Growth Is To Stay Robust... Chart 17But Earnings Growth Is Set To Decelerate But Earnings Growth Is Set To Decelerate But Earnings Growth Is Set To Decelerate Recent labor shortages and rising wages have not bypassed highly educated segments of the labor market, cutting into the profitability of these high-tech labor-intensive businesses. And of course, this industry is not immune to rising costs of raw materials and supply-chain disruptions, albeit less so than many businesses further downstream in the value chain, such as Autos. Chart 18After Pandemic Hiatus, Capex Is On The Way Back After Pandemic Hiatus, Capex Is On The Way Back After Pandemic Hiatus, Capex Is On The Way Back Chart 19Margins Are Expected To Expand Further Margins Are Expected To Expand Further Margins Are Expected To Expand Further Despite all the production challenges, Semis is one of the few industries that are projected to further expand its margins in the coming year (Chart 19). However, just like many other industries, their pricing power is overextended (Chart 20) and is likely to mean revert, constraining companies to pass on higher costs of design, raw materials, and manufacturing to customers. Chart 20Pricing Power Is Extreme And Is Likely To Mean Revert Pricing Power Is Extreme And Is Likely To Mean Revert Pricing Power Is Extreme And Is Likely To Mean Revert Valuations Semis is an industry whose earnings are expected to grow at 8% over the next 12 months, which is on par with the S&P 500. However, Semis are trading at 24x forward earnings, or with a 14% premium to the S&P 500 (21.3x) (Chart 21). Further, earnings growth is decelerating. It is hard to justify this valuation premium, especially in the context of imminent rate hikes. Of course, valuations may reflect the fact that demand for chips is still extremely strong both from conventional markets and nascent technology applications. The industry is also highly profitable, and margins are expected to expand in 2022. To break the tie, we will turn to the analysis of the macroeconomic backdrop in 2022 and whether it is going to be favorable for the industry. Chart 21Valuations Are Overextended Valuations Are Overextended Valuations Are Overextended Macroeconomic Backdrop Semiconductor stocks as a group aren’t just highly sensitive to economic growth, they’re nearly immediately so, sniffing out economic rebounds and downturns before they become evident in broad market data. As a result, investors have to remain on their guard and be very nimble. Subtle shifts in the economic outlook can have a big impact on relative performance. At the moment, several macro trends constitute a headwind for the outperformance of the industry: Global bond yields are expected to rise due to the concerted action of Central Banks, dampening demand for chips, dragging down the sales growth of the Semis, and diminishing future cash flows (Chart 22). The US ISM Manufacturing index has peaked, while the ISM New Orders index is in a downward trend, suggesting an emerging decline in production and diminished demand for chips (Chart 23) Chinese growth is slowing and BCA Research’s house view is that a rebound is not likely until later in 2022. Chart 22Rising Bond Yields Will Be A Headwind For Semis Rising Bond Yields Will Be A Headwind For Semis Rising Bond Yields Will Be A Headwind For Semis Chart 23Decline In The ISM New Orders Signal Less Demand For Semis Decline In The ISM New Orders Signal Less Demand For Semis Decline In The ISM New Orders Signal Less Demand For Semis Therefore, we conclude that, while economic growth is to remain strong in 2022, and will provide a tailwind for many cyclical sectors, semiconductor growth is set to slow, and valuations are likely to compress as a reaction to rising bond yields. The macroeconomic outlook for the industry is contingent upon the direction of the interest rates and is sensitive to economic growth disappointments. In short, the macroeconomic backdrop is unfavorable. Investment Implications The semiconductor industry is positioned at the very core of the global economy. It is one of the key growth engines of the US economy, and one of its top exports. This is an industry highly geared to economic growth and exposed to a variety of emerging technology themes, such as 5G, self-driving vehicles, and the metaverse among many others. It is R&D and Capex intensive and sophisticated. We believe in Semis as a long-term structural theme. Tactically, we are concerned that in 2022 this industry may face macroeconomic headwinds being highly sensitive to slowing growth and rising rates, which are detrimental to the performance of this growth-oriented and cyclical sector. From a fundamental standpoint, sales and earnings growth are slowing and are on par with that of a broad market, yet Semis are trading with a premium to the S&P 500. Tactically, we are neutral on a sector, but structurally we are bullish. We recommend investors with longer holding horizons explore the following ETFs (Table 2), that are designed to capture Semis as an investment theme. Table 2Semis ETFs Semiconductors: Aren't They Fab?! Semiconductors: Aren't They Fab?! Bottom Line In this deep-dive report on the Semiconductor industry, we review the supply chain, the key labor division between fabless chip designers and chips manufacturers, and the issues underpinning a recent push towards onshoring. We explore target markets and look at sales growth rates and fundamentals. We conclude that we are bullish on the industry on a structural basis but are more ambivalent about its prospects over the next 3-6 months downgrading our portfolio overweight to an equal-weight.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     Semiconductor Industry Association (SIA) "2021 Industry Facts" May 19, 2021 2     Semiconductor Industry Association (SIA) "2021 STATE OF THE U.S. SEMICONDUCTOR INDUSTRY" 3    Global X "Putting the Chip Shortage into the Context of Long-Term Trends" May 24, 2021 4    Ibid 5    Ibid 6    Ibid 7     Bloomberg, “Chip Shortage: Taiwan, South Korea’s Manufacturing Lead Worries U.S., China” March 3, 2021 8    Ibid 9    Ibid 10   World Semiconductor Trade Statistics "Semiconductor Market Forecast Fall 2021" November 30, 2021   Recommended Allocation

Dear Client, We are sending you our Strategy Outlook today where we outline our thoughts on the global economy and the direction of financial markets for 2022 and beyond. Next week, please join me for a webcast on Friday, December 10th at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) to discuss the outlook. Also, we published a report this week transcribing our annual conversation with Mr. X, a long-standing BCA client. Please join my fellow BCA strategists and me on Tuesday, December 7th for a follow-up discussion hosted by my colleague, Jonathan LaBerge. Finally, you will receive a Special Report prepared by our Global Asset Allocation service on Monday, December 13th. Similarly to previous years, Garry Evans and his team have prepared a list of books and articles to read over the holiday period. This year they recommend reading materials on key themes of the moment, such as climate change, cryptocurrencies, supply-chain disruption, and gene technology. Included in this report are my team’s recommendations on what to read to understand the underlying causes of inflation. Best regards, Peter Berezin, Chief Global Strategist   Highlights Macroeconomic Outlook: Despite the risks posed by the Omicron variant, global growth should remain above trend in 2022. Inflation will temporarily dip next year as goods prices come off the boil. However, the structural trend for inflation is to the upside, especially in the US. Equities: Remain overweight stocks in 2022, favoring cyclicals, small caps, value stocks, and non-US equities. Look to turn more defensive in mid-2023 in advance of a stagflationary recession in 2024 or 2025. Fixed income: Maintain below-average interest rate duration exposure. The US 10-year Treasury yield will rise to 2%-to-2.25% by the end of 2022. Underweight the US, UK, Canada, and New Zealand in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds next year. Favor HY over IG. Spreads will widen again in 2023. Currencies: As a momentum currency, the US dollar could strengthen some more over the next month or two. Over a 12-month horizon, however, the trade-weighted dollar will weaken. The Canadian dollar will be the best performing G10 currency next year. Commodities: Oil prices will rise, with Brent crude averaging $80/bbl in 2022. Metals prices will remain resilient thanks to tight supply and Chinese stimulus. We prefer gold over cryptos. I. Macroeconomic Outlook   Running out of Greek Letters Just as the world was looking forward to “life as normal”, a new variant of the virus has surfaced. While little is known about the Omicron variant, preliminary indications suggest that it is more transmissible than Delta. The emergence of the Omicron variant is coming in the midst of yet another Covid wave. The number of new cases has skyrocketed across parts of northern and central Europe, prompting governments to re-introduce stricter social distancing measures (Chart 1). New cases have also been trending higher in many parts of the US and Canada since the start of November. Chart 1 Despite the risks posed by Omicron, there are reasons for hope. BioNTech has said that its vaccine, jointly developed with Pfizer, will provide at least partial immunity against the new strain. At present, 55% of the world’s population has had at least one vaccine shot; 44% is fully vaccinated (Chart 2). China is close to launching its own mRNA vaccine next year, which it intends to administer as a booster shot. Chart 2 In a worst-case scenario, BioNTech has said that it could produce a new version of its vaccine within six weeks, with initial shipments beginning in about three months. New antiviral medications are also set to hit the market. Pfizer claims its newly developed pill cuts the risk of hospitalization by nearly 90% if taken within three days from the onset of symptoms. The drug-maker has announced its intention to produce enough of the medication to treat 50 million people in 2022. In addition, it is allowing generic versions to be manufactured in developing countries. The company has indicated that its antiviral pills will be effective in treating the new strain.   Global Growth: Slowing but from a High Level Assuming the vaccines and antiviral drugs are able to keep the new strain at bay, global growth should remain solidly above trend in 2022. Table 1 shows consensus GDP growth projections for the major economies. G7 growth is expected to tick up from 3.6% in 2021Q3 to 4.5% in 2021Q4. Growth is set to cool to 4.1% in 2022Q1, 3.6% in 2022Q2, 2.9% in 2022Q3, 2.3% in 2022Q4, and 2.1% in 2023Q1. Table 1Growth Is Slowing, But From Very High Levels Strategy Outlook - 2022 Key Views: The Beginning Of The End Strategy Outlook - 2022 Key Views: The Beginning Of The End Chart 3 According to the OECD, potential real GDP growth in the G7 is about 1.4% (Chart 3). Thus, while growth in developed economies will slow next year, it is unlikely to return to trend until the second half of 2023. Emerging markets face a more daunting outlook. The Chinese property market is weakening, and the recent collapse of the Turkish lira highlights the structural problems that some EMs face. Nevertheless, the combination of elevated commodity prices, forthcoming Chinese stimulus, and the resumption of the US dollar bear market starting next year should support EM growth. Relative to consensus, we think the risks to growth in both developed and emerging markets are tilted to the upside in 2022. Growth will likely start surprising to the downside in late 2023, however.   The United States: No Shortage of Demand US growth slowed to only 2.1% in the third quarter, reflecting the impact of the Delta variant wave and supply-chain bottlenecks. The semiconductor shortage hit the auto sector especially hard. The decline in vehicle spending alone shaved 2.2 percentage points off Q3 GDP growth. Chart 4Durable Goods Spending Is Still Above Pre-Pandemic Trend, While Services Spending Is Catching Up Durable Goods Spending Is Still Above Pre-Pandemic Trend, While Services Spending Is Catching Up Durable Goods Spending Is Still Above Pre-Pandemic Trend, While Services Spending Is Catching Up The fourth quarter is shaping up to be much stronger. The Bloomberg consensus estimate is for real GDP to expand by 4.9%. The Atlanta Fed’s GDPNow model is even more optimistic. It sees growth hitting 9.7%. The demand for goods will moderate in 2022. As of October, real goods spending was still 10% above its pre-pandemic trendline (Chart 4). In contrast, the demand for services will continue to rebound. While restaurant sales have recovered all their lost ground, spending on movie theaters, amusement parks, and live entertainment in October was still down 46% on a seasonally-adjusted basis compared to January 2020. Hotel spending was down 23%. Spending on public transport was down 25%. Spending on dental services was down 16% (Chart 5).   Chart 5 US households have accumulated $2.3 trillion in excess savings over the course of the pandemic. Some of this money will be spent over the course of 2022 (Chart 6). Increased borrowing should also help. After initially plunging during the pandemic, credit card balances are rising again (Chart 7). Banks are eager to make consumer loans (Chart 8). Chart 6Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Chart 7Credit Card Spending Is Recovering Following The Pandemic Slump Credit Card Spending Is Recovering Following The Pandemic Slump Credit Card Spending Is Recovering Following The Pandemic Slump Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 9). In an earlier report, we estimated that the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Chart 8Banks Are Easing Credit Standards For Consumer Loans Banks Are Easing Credit Standards For Consumer Loans Banks Are Easing Credit Standards For Consumer Loans Chart 9A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth   Business investment will rebound in 2022, as firms seek to build out capacity, rebuild inventories, and automate more production in the face of growing labor shortages. After moving sideways for the better part of two decades, core capital goods orders have broken out to the upside. Surveys of capex intentions have improved sharply (Chart 10). Nonresidential investment was 6% below trend in Q3 – an even bigger gap than for consumer services spending – so there is plenty of scope for capex to increase. Residential investment should also remain strong in 2022 (Chart 11). The homeowner vacancy rate has dropped to a record low, as have inventories of new and existing homes for sale. Homebuilder sentiment rose to a 6-month high in November. Building permits are 7% above pre-pandemic levels. Chart 10Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Chart 11Residential Construction Will Be Well Supported Residential Construction Will Be Well Supported Residential Construction Will Be Well Supported   US Monetary and Fiscal Policy: Baby Steps Towards Tightening Policy is unlikely to curb US aggregate demand by very much next year. While the Federal Reserve will expedite the tapering of asset purchases and begin raising rates next summer, the Fed is unlikely to raise rates significantly until inflation gets out of hand. As we discuss in the Feature section later in this report, the next leg in inflation will be to the downside, even if the long-term trend for inflation is to the upside. The respite from inflation next year will give the Fed some breathing space. A major tightening campaign is unlikely until mid-2023. Reflecting the Fed’s dovish posture, long-term real bond yields hit record low levels in November (Chart 12). Despite giving up some of its gains in recent days, Goldman’s US Financial Conditions Index stands near its easiest level in history (Chart 13). Chart 12US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows Chart 13Easy Financial Conditions In The US Easy Financial Conditions In The US Easy Financial Conditions In The US US fiscal policy will get tighter next year, but not by very much. In November, President Biden signed a $1.2 trillion infrastructure bill into law, containing $550 billion in new spending. BCA’s geopolitical strategists expect Congress to pass a $1.5-to-$2 trillion social spending bill using the reconciliation process. The emergence of the Omicron strain will facilitate passage of the bill because it will allow the Democrats to add some “indispensable” pandemic relief to the package. All in all, the IMF foresees the US cyclically-adjusted primary budget deficit averaging 4.9% of GDP between 2022 and 2026, compared to 2.0% of GDP between 2014 and 2019 (Chart 14). Chart 14 It should also be noted that government spending on goods and services has been quite weak over the past two years (Chart 15). The budget deficit surged because transfer payments exploded. Unlike direct government spending, which is set to accelerate over the next few years, households saved a large share of transfer payments. Thus, the fiscal multiplier will increase next year, even as the budget deficit shrinks. Chart 15While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend Chart 16European Banks Have Cleaned Up Their Act European Banks Have Cleaned Up Their Act European Banks Have Cleaned Up Their Act Europe: Room to Grow The European economy faces near-term growth pressures. In addition to Covid-related lockdowns, high energy costs will take a bite out of growth. After having dipped in October, natural gas prices have jumped again due to delays in the opening of the Nord Stream 2 pipeline, strong Chinese gas demand, and rising risks of a colder winter due to La Niña. The majority of Germans are in favor of opening the pipeline, suggesting that it will ultimately be approved. This should help reduce gas prices. Meanwhile, the winter will pass and Chinese demand for gas should abate as domestic coal production increases. The combination of increased energy supplies, easing supply-chain bottlenecks, and hopefully some relief on the pandemic front, should all pave the way for better-than-expected growth across the euro area next year. After a decade of housecleaning, European banks are in much better shape (Chart 16). Capex intentions have risen (Chart 17). Consumer confidence is even stronger in the euro area than in the US (Chart 18). Chart 17 Chart 18Consumer Confidence Is At Pre-Pandemic Levels In The Euro Area, Unlike In The US Consumer Confidence Is At Pre-Pandemic Levels In The Euro Area, Unlike In The US Consumer Confidence Is At Pre-Pandemic Levels In The Euro Area, Unlike In The US Euro area fiscal policy should remain supportive. Infrastructure spending is set to increase as the Next Generation EU fund begins operations. Germany’s “Traffic Light” coalition will pursue a more expansionary fiscal stance. The IMF expects the euro area to run a cyclically-adjusted primary deficit of 1.2% of GDP between 2022 and 2026, compared to a surplus of 1.2% of GDP between 2014 and 2019. For its part, the ECB will maintain a highly accommodative monetary policy. While net asset purchases under the PEPP will end next March, the ECB is unlikely to raise rates until 2023 at the earliest. In contrast to the US, trimmed-mean inflation has barely risen in the euro area (Chart 19). Moreover, unlike their US counterparts, European firms are reporting few difficulties in finding qualified workers (Chart 20). In fact, euro area wage growth slowed to an all-time low of 1.35% in Q3 (Chart 21). Chart 19Trimmed-Mean Inflation: Higher In The US Than In The Euro Area And Japan Trimmed-Mean Inflation: Higher In The US Than In The Euro Area And Japan Trimmed-Mean Inflation: Higher In The US Than In The Euro Area And Japan Chart 20   Chart 21Wage Growth Remains Contained Across The Euro Area Wage Growth Remains Contained Across The Euro Area Wage Growth Remains Contained Across The Euro Area The UK finds itself somewhere between the US and the euro area. Trimmed-mean inflation is running above euro area levels, but below that of the US. UK labor market data remains very strong, as evidenced by robust employment gains, firm wage growth, and a record number of job vacancies. The PMIs stand at elevated levels, with the new orders component of November’s manufacturing PMI rising to the highest level since June. While worries about the impact of the Omicron variant will likely cause the Bank of England to postpone December’s rate hike, we expect the BoE to begin raising rates in February.   Japan: Short-Term Stimulus Boost A major Covid wave during the summer curbed Japanese growth. Consumer spending rebounded after the government removed the state of emergency on October 1 but could falter again if the Omicron variant spreads. The government has already told airlines to halt reservations for all incoming international flights for at least one month. On the positive side, the economy will benefit from new fiscal measures. Following the election on October 31, the new government led by Prime Minister Fumio Kishida announced a stimulus package worth 5.6% of GDP. As with most Japanese stimulus packages, the true magnitude of fiscal support will be much lower than the headline figure. Nevertheless, the combination of increased cash payments to households, support for small businesses, and subsidies for domestic travel should spur consumption in 2022. The capex recovery in Japan has lagged other major economies. This is partly due to the outsized role of the auto sector in Japan’s industrial base. Motor vehicle shipments fell 37% year-over-year in October, dragging down export growth with it. As automotive chip supplies increase, Japan’s manufacturing sector should gain some momentum. Despite the prospect of stronger growth next year, the Bank of Japan will stand pat. Core inflation remains close to zero, while long-term inflation expectations remain far below the BOJ’s 2% target. We do not expect the BOJ to raise rates until 2024 at the earliest.   China: Crosswinds The Chinese economy faces crosswinds going into 2022. On the one hand, the energy crisis should abate, helping to boost growth. China has reopened 170 coal mines and will probably begin re-importing Australian coal. Chinese coal prices have fallen drastically over the past 6 weeks (Chart 22). Coal accounts for about two-thirds of Chinese electricity generation. Chart 22Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Chart 23China's Property Market Has Weakened China's Property Market Has Weakened China's Property Market Has Weakened   The US may also trim tariffs on Chinese goods, as Treasury Secretary Yellen hinted this week. This will help Chinese manufacturers. On the other hand, the property market remains under stress. Housing starts, sales, and land purchases were down 34%, 21%, and 24%, respectively, in October relative to the same period last year. The proportion of households planning to buy a home has plummeted. Loan growth to real estate developers has decelerated to the lowest level on record (Chart 23). Nearly half of their offshore bonds are trading at less than 70 cents on the dollar. The authorities have taken steps to stabilize the property market. They have relaxed restrictions on mortgage lending and land sales, cut mortgage rates in some cities, and have allowed some developers to issue asset backed securities to repay outstanding debt. Most Chinese property is bought “off-plan”. The government does not want angry buyers to be deprived of their property. Thus, the existing stock of planned projects will be built. Chart 24 shows that this is a large number; in past years, developers have started more than twice as many projects as they have completed. The longer-term problem is that China builds too many homes. Like Japan in the early 1990s, China’s working-age population has peaked (Chart 25). According to the UN, it will decline by over 400 million by the end of the century. China simply does not need to construct as many new homes as it once did. Chart 24Chinese Construction: Halfway Done Chinese Construction: Halfway Done Chinese Construction: Halfway Done Chart 25Demographic Parallels Between China And Japan Demographic Parallels Between China And Japan Demographic Parallels Between China And Japan Chart 26 Japan was unable to fill the gap that a shrinking property sector left in aggregate demand in the early 1990s. As a result, the economy fell into a deflationary trap. China is likely to have more success. Unlike Japan, which waited too long to pursue large-scale fiscal stimulus, China will be more aggressive. The authorities will raise infrastructure spending next year with a focus on clean energy. They will also boost social spending. A frayed social safety net has forced Chinese households to save more than they would otherwise for precautionary reasons. This has weighed on consumption.  The fact that China is a middle-income country helps. In 1990, Japan’s output-per-worker was nearly 70% of US levels; China’s output-per-worker is still 20% of US levels (Chart 26). If Chinese incomes continue to grow at a reasonably brisk pace, this will make it easier to improve home affordability. It will also allow China to stabilize its debt-to-GDP ratio without a painful deleveraging campaign. II. Feature: The Long-Term Inflation Outlook   Two Steps Up, One Step Down We expect inflation in the US, and to a lesser degree abroad, to follow a “two steps up, one step down” trajectory of higher highs and higher lows. The US is currently near the top of those two steps. Inflation should dip over the next 6-to-9 months as the demand for goods moderates and supply-chain disruptions abate. Chart 27 shows that container shipping costs have started to come down. The number of ships anchored off the ports of Los Angeles and Long Beach is falling. US semiconductor firms are working overtime (Chart 28). Chip production in Japan and Korea is rising swiftly. DRAM chip prices have already started to decline. Chart 27Signs Of Easing Supply Issues On The Rough Seas Signs Of Easing Supply Issues On The Rough Seas Signs Of Easing Supply Issues On The Rough Seas Chart 28Semiconductor Manufacturers Are Stepping Up Their Game Semiconductor Manufacturers Are Stepping Up Their Game Semiconductor Manufacturers Are Stepping Up Their Game Reflecting the easing of supply-chain bottlenecks, both the “prices paid” and “supplier delivery” components of the manufacturing ISM declined in November.  The respite from inflation will not last long, however. The US labor market is heating up. So far, most of the wage growth has been at the bottom end of the income distribution (Chart 29). Wage growth will broaden out over the course of 2022, pushing up service price inflation in the process. Chart 29Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution (I) Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution (I) Chart 30Rent Inflation Has Increased Rent Inflation Has Increased Rent Inflation Has Increased Rent inflation will also rise, as the unemployment rate falls further. The Zillow rent index has spiked 14% (Chart 30). Rents account for 8% of the US CPI basket and 4% of the PCE basket.   Biased About Neutral? Investors are assuming that the Fed will step in to extinguish any inflationary fires before they get out of hand. The widely-followed 5-year/5-year forward TIPS breakeven inflation rate has fallen back below the Fed’s comfort zone (Chart 31). Chart 31Long-Term Inflation Expectations Are Not A Source Of Worry For The Fed Long-Term Inflation Expectations Are Not A Source Of Worry For The Fed (II) Long-Term Inflation Expectations Are Not A Source Of Worry For The Fed (II) Chart 32Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate This may be wishful thinking. Back in 2012, when the Fed began publishing its “dots”, it thought the neutral rate of interest was 4.25%. Today, it considers it to be around 2.5% (Chart 32). Market participants broadly agree. Both investors and policymakers have bought into the secular stagnation thesis hook, line, and sinker. If the neutral rate turns out to be higher than widely believed, the Fed could find itself woefully behind the curve. Given the “long and variable” lags between changes in monetary policy and the resulting impact on the economy, inflation is liable to greatly overshoot the Fed’s target.   Structural Forces Turning More Inflationary Meanwhile, the forces that have underpinned low inflation over the past few decades are starting to fray: Globalization is in retreat: The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 33). Looking out, the ratio could decline as geopolitical tensions between China and the rest of the world continue to simmer, and more companies shift production back home in order to gain greater control over the supply chains of essential goods. Baby boomers are leaving the labor force en masse: As a group, baby boomers hold more than half of US household wealth (Chart 34). They will continue to run down their wealth once they retire. However, since they will no longer be working, they will no longer contribute to national output. Spending that is not matched by output tends to drive up inflation. Chart 33Globalization Plateaued Over a Decade Ago Globalization Plateaued Over a Decade Ago Globalization Plateaued Over a Decade Ago Chart 34 Social stability is in peril: The US homicide rate increased by 27% in 2020, the biggest one-year jump on record. All indications suggest that crime has continued to rise in 2021, coinciding with the ongoing decline in the incarceration rate (Chart 35). Amazingly, the murder rate and inflation are highly correlated (Chart 36). If the government cannot credibly commit to keeping people safe, how can it credibly commit to keeping inflation low? Without trust in government, inflation expectations could quickly become unmoored. Chart 35The Homicide Rate Has Tended To Rise When The Institutionalization Rate Has Declined The Homicide Rate Has Tended To Rise When The Institutionalization Rate Has Declined The Homicide Rate Has Tended To Rise When The Institutionalization Rate Has Declined Chart 36Bouts Of Inflation Tend To Coincide With Rising Crime Bouts Of Inflation Tend To Coincide With Rising Crime Bouts Of Inflation Tend To Coincide With Rising Crime The temptation to monetize debt will rise: Public-sector debt levels have soared to levels last seen during World War II. If bond yields rise as the Congressional Budget Office expects, debt-servicing costs will triple by the end of the decade (Chart 37). Faced with the prospect of having to divert funds from social programs to pay off bondholders, the government may apply political pressure on the Fed to keep rates low.​​​​​​ Chart 37   A Post-Pandemic Productivity Boom? Chart 38 Might faster productivity growth bail out the economy just like it did following the Second World War? Don’t bet on it. US labor productivity did increase sharply during the initial stages of the pandemic. However, that appears to have been largely driven by composition effects that saw many low-skilled, poorly-paid service workers lose their jobs. As these low-skilled workers have returned to the labor force, productivity growth has dropped. The absolute level of productivity declined by 5.0% at an annualized rate in the third quarter, leading to an 8.3% increase in labor costs. Productivity growth has been extremely weak outside the US (Chart 38). This gives weight to the view that the pandemic-induced changes in business practices have not contributed to higher productivity, at least so far. It is worth noting that a recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. Increased investment spending should eventually boost productivity. However, the near-term impact of higher capex will be to boost aggregate demand, stoking inflation in the process. III. Financial Markets   A. Portfolio Strategy Above-Trend Global Growth Will Support Equities Our golden rule of investing is about as simple as they come: Don’t bet against stocks unless you think that there is a recession around the corner. As Chart 39 shows, recessions and equity bear markets almost always overlap. Chart 39 Chart 40Sentiment Towards Equities Is Already Bearish Sentiment Towards Equities Is Already Bearish Sentiment Towards Equities Is Already Bearish Equity corrections can occur outside of recessionary periods. In fact, we are experiencing such a correction right now. Yet, with the percentage of bearish investors reaching the highest level in over 12 months in this week’s AAII survey, chances are that the correction will not last much longer (Chart 40). A sustained decline in stock prices requires a sustained decline in corporate earnings; the latter normally only happens during economic downturns. Admittedly, it is impossible to know for sure if a recession is lurking around the corner. If the Omicron variant is able to completely evade the vaccines, growth will slow considerably over the coming months. Yet, even in that case, the global economy is unlikely to experience a sudden-stop of the sort that occurred last March. As noted at the outset of this report, pharma companies have the tools to tweak the vaccines, and most experts believe that the soon-to-be-released antivirals will be effective against the new strain. If economic growth remains above trend, earnings will rise (Chart 41). S&P 500 companies generated $53.82 per share in profits in Q3. The bottom-up consensus is for these companies to generate an average of $54.01 in quarterly profits between 2021Q4 and 2022Q3, implying almost no growth from 2021Q3 levels. This is a very low bar to clear. We expect global equities to produce high single-digit returns next year. Chart 41Analysts Increased Earnings Estimates This Year Analysts Increased Earnings Estimates This Year Analysts Increased Earnings Estimates This Year The Beginning of the End Our guess is that 2022 will be the last year of the secular equity bull market that began in 2009. In mid-2023 or so, the Fed will come around to the view that the neutral rate is higher than it once thought. Unfortunately, by then, it will be too late; a wage-price spiral will have already emerged. A nasty bear flattening of the yield curve will ensue: Long-term bond yields will rise but short-term rate expectations will increase even more. A recession will follow in 2024 or 2025. The most important real-time indicator we are focusing on to gauge when to turn more bearish on stocks is the 5y/5y forward TIPS breakeven rate. As noted earlier, it is still at the bottom end of the Fed’s comfort zone. If it were to rise above 3%, all hell could break loose, especially if this happened without a corresponding increase in crude oil prices. The Fed takes great pride in the success it has had in anchoring long-term expectations. Any evidence that expectations are becoming unmoored would cause the FOMC to panic.   B. Equity Sectors, Regions, And Styles Favor Value, Small Caps, and Non-US Markets in 2022 Until the Fed takes away the punch bowl, a modestly procyclical stance towards equity sectors, styles, and regional equity allocation is warranted. Chart 42The Relative Performance Of Value Stocks Has Closely Tracked Bond Yields This Year The Relative Performance Of Value Stocks Has Closely Tracked Bond Yields This Year The Relative Performance Of Value Stocks Has Closely Tracked Bond Yields This Year The relative performance of value versus growth stocks has broadly followed the trajectory of the 30-year Treasury yield this year (Chart 42). Rising yields should buoy value stocks, with banks being the biggest beneficiaries (Chart 43). In contrast, rising yields will weigh on tech stocks. Chart 43Rising Bond Yields Will Help Bank Shares But Hurt Tech Stocks Rising Bond Yields Will Help Bank Shares But Hurt Tech Stocks Rising Bond Yields Will Help Bank Shares But Hurt Tech Stocks   Chart 44The Winners And Losers Of Covid Waves The Winners And Losers Of Covid Waves The Winners And Losers Of Covid Waves If we receive some good news on the pandemic front, this should disproportionately help value. As Chart 44 illustrates, the relative performance of value versus growth stocks has tracked the number of new Covid cases globally. The correlation between new cases and the relative performance of IT and energy has been particularly strong. Rising capex spending will buoy industrial stocks. Industrials are overrepresented in value indices both in the US and abroad (Table 2). Along with financials, industrials are also overrepresented in small cap indices (Table 3). US small caps trade at 15-times forward earnings compared to 21-times for the S&P 500. Table 2Breaking Down Growth And Value By Sector Strategy Outlook - 2022 Key Views: The Beginning Of The End Strategy Outlook - 2022 Key Views: The Beginning Of The End Table 3Financials And Industrials Have A Larger Weight In US Small Caps Strategy Outlook - 2022 Key Views: The Beginning Of The End Strategy Outlook - 2022 Key Views: The Beginning Of The End Time to Look Abroad? Given our preference for cyclicals and value in 2022, it stands to reason that we should also favor non-US markets. Table 4 shows that non-US stock markets have more exposure to cyclical and value sectors. Table 4Cyclicals Are Overrepresented Outside The US Strategy Outlook - 2022 Key Views: The Beginning Of The End Strategy Outlook - 2022 Key Views: The Beginning Of The End Admittedly, favoring non-US stock markets has been a losing proposition for the past 12 years. US earnings have grown much faster than earnings abroad over this period (Chart 45). US stock returns have also benefited from rising relative valuations. Chart 45The US Has Been The Earnings Leader In Recent Years The US Has Been The Earnings Leader In Recent Years The US Has Been The Earnings Leader In Recent Years At this point, however, US stocks are trading at a significant premium to their overseas peers, whether measured by the P/E ratio, price-to-book, or price-to-sales (Chart 46). US profit margins are also more stretched than elsewhere (Chart 47).   Chart 46 Chart 47US Profit Margins Look Stretched US Profit Margins Look Stretched US Profit Margins Look Stretched Chart 48Non-US Stocks Tend To Do Best When The US Dollar Is Weakening Non-US Stocks Tend To Do Best When The US Dollar Is Weakening Non-US Stocks Tend To Do Best When The US Dollar Is Weakening The US dollar may be the ultimate arbiter of whether the US or international stock markets outperform in the 2022. Historically, there has been a close correlation between the trade-weighted dollar and the relative performance of US versus non-US equities (Chart 48). In general, non-US stocks do best when the dollar is weakening. The usual relationship between the dollar and the relative performance of US and non-US stocks broke down in 2020 when the dollar weakened but the tech-heavy US stock market nonetheless outperformed. However, if “reopening plays” gain the upper hand over “pandemic plays” in 2022, the historic relationship between the dollar and US/non-US returns will reassert itself. As we discuss later on, while near-term momentum favors the dollar, the greenback is likely to weaken over a 12-month horizon. This suggests that investors should look to increase exposure to non-US stocks in a month or two. Around that time, the energy shortage gripping Europe will begin to abate, China will be undertaking more stimulus, and investors will start to focus more on the prospect of higher US corporate taxes.    C. Fixed Income Maintain Below-Benchmark Duration The yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium that compensates investors for locking in their savings at a fixed rate rather than rolling them over at the prevailing short-term rate. While expected policy rates have moved up in the US over the past 2 months, the market’s expectations of where policy rates will be in the second half of the decade have not changed much (Chart 49). Investors remain convinced of the secular stagnation thesis which postulates that the neutral rate of interest is very low. Chart 49 As for the term premium, it remains stuck in negative territory, much where it has been for the past 10 years (Chart 50). Chart 50Negative Term Premium Across The Board Negative Term Premium Across The Board Negative Term Premium Across The Board The Term Premium Will Increase The notion of a negative term premium may seem odd, as it implies that investors are willing to pay to take on duration risk. However, there is a good reason for why the term premium has been negative: The correlation between bond yields and stock prices has been positive (Chart 51). Chart 51Stocks And Bond Yields Have Not Always Been Positively Correlated Stocks And Bond Yields Have Not Always Been Positively Correlated Stocks And Bond Yields Have Not Always Been Positively Correlated When bond yields are positively correlated with stock prices, bonds are a hedge against bad economic news. If the economy falls into recession, equity prices will drop; the value of your home will go down; you may not get a bonus, or even worse, you may lose your job. But at least the value of your bond portfolio will go up! There is a catch, however: Bonds are a hedge against bad economic news only if that news is deflationary in nature. The 2001 and 2008-09 recessions all saw bond yields drop as the economy headed south. Both recessions were due to deflationary shocks: first the dotcom bust, and later, the bursting of the housing bubble. In contrast, bond yields rose in the lead up to the recession in the 1970s and early 80s. Bonds were not a good hedge against falling stock prices back then because it was surging inflation and rising bond yields that caused stocks to fall in the first place. This raises a worrying possibility that investors have largely overlooked: The term premium may increase as it becomes increasingly clear that the next recession will be caused not by inadequate demand but by Fed tightening in response to an overheated economy. A rising term premium would exacerbate the upward pressure on bond yields stemming from higher-than-expected inflation as well as upward revisions to estimates of the real neutral rate of interest. Again, we do not think that a “term premium explosion” is a significant risk for 2022. However, it is a major risk for 2023 and beyond. Investors should maintain a modestly below-benchmark duration stance for now but look to go maximally underweight duration towards the end of next year.   Global Bond Allocation BCA’s global fixed-income strategists recommend underweighting the US, Canada, the UK, and New Zealand in 2022. They suggest overweighting Japan, the euro area, and Australia. US Treasuries trade with a higher beta than most other government bond markets (Chart 52). Our bond strategists expect the US 10-year Treasury yield to hit 2%-to-2.25% by the end of next year. Chart 52High-And Low-Beta Bond Yields High-And Low-Beta Bond Yields High-And Low-Beta Bond Yields As discussed earlier, neither the ECB nor the BoJ are in a hurry to raise rates. Both euro area and Japanese bonds have outperformed the global benchmark when Treasury yields have risen (Chart 53). Chart 53 Chart 54UK Inflation Expectations Are Higher Than In Other Major Developed Economies UK Inflation Expectations Are Higher Than In Other Major Developed Economies UK Inflation Expectations Are Higher Than In Other Major Developed Economies While rate expectations in Australia have come down on the Omicron news, the markets are still pricing in four hikes next year. With wage growth still below the RBA’s target, our fixed-income strategists think the central bank will pursue a fairly dovish path next year. In contrast, they think New Zealand will continue its hiking cycle. Like Canada, the Reserve Bank of New Zealand has become increasingly concerned about soaring home prices and household indebtedness.  Inflation expectations are higher in the UK than elsewhere (Chart 54). With the BoE set to raise rates early next year, gilts will underperform the global benchmark.   Overweight High-Yield Corporate Bonds… For Now Chart 55High-Yield Spreads Are Pricing In A Default Rate Of Close To 4% High-Yield Spreads Are Pricing In A Default Rate Of Close To 4% High-Yield Spreads Are Pricing In A Default Rate Of Close To 4% The combination of above-trend economic growth and accommodative monetary policy will provide support for corporate bonds in 2022. For now, we prefer high yield over investment grade. According to our bond strategists, while high-yield spreads are quite tight, they are still pricing in a default rate of 3.8% (Chart 55). This is more than their fair value default estimate of 2.3%-to-2.8%. It is also above the year-to-date realized default rate of 1.7%.   As with equities, the bull market in corporate credit will end in 2023 as the Fed is forced to accelerate the pace of rate hikes in the face of an overheated economy and rising long-term inflation expectations.   D. Currencies and Commodities Dollar Strength Will Reverse in Early 2022 Since bottoming in May, the US dollar has been trending higher. The US dollar is a high momentum currency: When the greenback starts rising, it usually keeps rising (Chart 56). A simple trading rule that buys the dollar when it is trading above its various moving averages has delivered positive returns (Chart 57). This suggests that the greenback could very well strengthen further over the next month or two. Chart 56 Chart 57 Over a 12-month horizon, however, we think the trade-weighted dollar will weaken. Both speculators and asset managers are net long the dollar (Chart 58). Current positioning suggests we are nearing a dollar peak. Rising US rate expectations have helped the dollar this year. Chart 59 shows that both USD/EUR and USD/JPY have tracked the spread between the yield on the December 2022 Eurodollar and Euribor/Euroyen contracts, respectively. While the Fed will expedite the pace of tapering, the overall approach will still be one of “baby-steps” towards tightening next year. BCA’s bond strategists do not expect US rate expectations for end-2022 to rise from current levels. Chart 58Long Dollar Positions Are Getting Crowded Long Dollar Positions Are Getting Crowded Long Dollar Positions Are Getting Crowded Chart 59Interest Rates Have Played A Major Role On The Dollar's Performance This Year Interest Rates Have Played A Major Role On The Dollar's Performance This Year Interest Rates Have Played A Major Role On The Dollar's Performance This Year   The present level of real interest rate differentials is consistent with a much weaker dollar (Chart 60). Using CPI swaps as a proxy for expected inflation, 2-year real rates in the US are 42 basis points below other developed economies. This is similar to where real spreads were in 2013/14, when the trade-weighted dollar was 16% weaker than it is today. Chart 60AThe Dollar And Interest Rate Differentials (I) The Dollar And Interest Rate Differentials (I) The Dollar And Interest Rate Differentials (I) Chart 60BThe Dollar And Interest Rate Differentials (II) The Dollar And Interest Rate Differentials (II) The Dollar And Interest Rate Differentials (II) Meanwhile, growth outside the US will pick up next year as Europe’s energy crisis abates and China ramps up stimulus. If history is any guide, firmer growth abroad will put downward pressure on the dollar (Chart 61). Chart 61The Dollar Will Weaken As Global Growth Rotates From The US To The Rest Of The World The Dollar Will Weaken As Global Growth Rotates From The US To The Rest Of The World The Dollar Will Weaken As Global Growth Rotates From The US To The Rest Of The World Chart 62Dollar Headwinds Dollar Headwinds Dollar Headwinds Pricey Greenback The dollar’s lofty valuation has left it overvalued by nearly 20% on a Purchasing Power Parity (PPP) basis. The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply. Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 62). However, these inflows are starting to abate, and could drop further if global investors abandon their infatuation with US tech stocks.   Favor Commodity Currencies We favor commodity currencies for 2022, especially the Canadian dollar, which we expect to be the best performing G10 currency. Canadian real GDP growth will average nearly 5% in Q4 and the first half of next year. The Bank of Canada will start hiking rates next April. Oil prices should remain reasonably firm next year, helping the loonie and other petrocurrencies. Bob Ryan, BCA’s chief Commodity Strategist, expects the price of Brent crude to average $80/bbl in 2022 and 81$/bbl in 2023, which is well above the forwards (Chart 63). Years of underinvestment in crude oil production have led to tight supply conditions (Chart 64). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade. Chart 63 Chart 64   As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by Chinese fiscal stimulus. Looking further ahead, the outlook for metals remains bright. Whereas the proliferation of electric vehicles is bad news for oil demand over the long haul, it is good news for many metals. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids.   The RMB Will Be Stable in 2022 It is striking that despite the appreciation in the trade-weighted dollar since June and escalating concerns about the health of the Chinese economy, the RMB has managed to strengthen by 0.3% against the US dollar. Chinese export growth will moderate in 2022 as global consumption shifts from goods to services. Rising global bond yields may also narrow the yield differential between China and the rest of the world. Nevertheless, we doubt the RMB will weaken very much. China wants the RMB to be a global reserve currency. A weak RMB would run counter to that goal. Rather than weakening the yuan, the Chinese authorities will use fiscal stimulus to support growth.   Gold Versus Cryptos? Gold prices tend to move closely with real bond yields (Chart 65). Since August 2020, however, the price of gold has slumped from a high of $2,067/oz to $1,768/oz, even though real yields remain near record lows. The divergence between real yields and gold prices may partly reflect growing demand for cryptocurrencies. Investors increasingly see cryptos as not just a disruptive economic force, but as the premier “anti-fiat” hedge. Whether that view pans out remains to be seen. So far, the vast majority of the demand for cryptocurrencies has stemmed from people hoping to get rich by buying cryptos. To the extent that people are using cryptos for online purchases, it is usually for illegal goods (Chart 66).  Chart 65Gold Prices Tend To Correlate Closely With Real Interest Rates Gold Prices Tend To Correlate Closely With Real Interest Rates Gold Prices Tend To Correlate Closely With Real Interest Rates Chart 66 Crypto proponents like to say that the supply of cryptos is finite. While this may be true for individual cryptocurrencies, it is not true for the sector as a whole. Over the past 8 years, the number of cryptocurrencies has swollen from 26 in 2013 to 7,877 (Chart 67). At least with gold, they are not adding any new elements to the periodic table. Chart 67 At any rate, the easy money in the crypto space has already been made. Bitcoin has doubled in price seven times since the start of 2016. If it were to double just one more time to $120,000, it would be worth $2.2 trillion, equal to the entire stock of US dollars in circulation. Investors looking to hedge long-term inflation risk should shift back into gold. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Highlights Financial markets in both mainstream EM and China are undergoing an adjustment that is not yet complete. EM equity and currency valuations are neutral. When valuations are neutral, the profit and liquidity cycles become the key drivers of share prices. Both these factors are currently headwinds to equity prices. Our investment strategy is to remain defensive going into the new year. Yet, the longer-term outlook is brighter. We see with high odds that the first half of the year will present an opportunity to turn positive on EM assets in absolute terms, and upgrade EM versus DM within global equity and fixed-income portfolios. Our checklist of fundamental factors that will cause us to turn bullish on EM and China include: (1) significant stimulus in China leading to a strong recovery in its credit impulse; (2) a rollover in Latin America’s core inflation that will open the door for monetary policy easing in these economies; and (3) the Fed abandoning its plans to hike rates, creating conditions for durable US dollar weakness. Feature Introduction: Beyond Omicron There is low visibility regarding the Omicron variant of the COVID-19 virus’s impact on societies and economies. We do not pretend to be experts in virology and on pandemics. So, in this 2022 outlook, we will focus on the macro fundamentals that go beyond Omicron. If the latter proves to be very disruptive for many economies, EM risk assets will sell off materially in the coming weeks. If Omicron proves to be a non-issue, macro fundamentals will prevail. In this case (and if our analysis is correct) EM risk assets will still fare poorly, at least in the early months of 2022. Chart 1The EM Selloff Has Been Occurring Since February 2021 The EM Selloff Has Been Occurring Since February 2021 The EM Selloff Has Been Occurring Since February 2021 Notably, the cross rate between the Swedish krona and Swiss franc correlates well with EM share prices and both had already been falling well before Omicron arrived (Chart 1). Overall, our investment strategy is to remain defensive going into the new year. Nevertheless, odds are significant that in H1 2022 there will be a buying opportunity in EM assets in absolute terms, and a better entry point to upgrade EM relative to DM within global equity and fixed-income portfolios. China’s Business Cycle And Macro Policy Will China ease policy substantially? It depends on how bad the economy, financial markets and business/consumer sentiment get. Beijing has already initiated piecemeal monetary and fiscal easing. However, if the growth slowdown is gradual and orderly, and financial markets do not panic, then policy easing will be measured. On the contrary, if growth tumbles sharply, business and consumer confidence deteriorate markedly and onshore share prices sell off hard, then policymakers will accelerate the stimulus. In a nutshell, substantial policy easing is not likely unless Chinese onshore stocks experience a meaningful deterioration. In the meantime, the Mainland economy will continue disappointing, and the path of least resistance for China-related plays is down: The annual change in excess reserves – that PBOC injects into the banking system – leads the credit impulse by six months (Chart 2, top panel). The former has stabilized but has not yet turned up. Hence, in the near term, the credit impulse will be stabilizing at very low levels but will not revive materially until spring 2022. This entails more growth disappointments in China’s old economy (Chart 2, bottom panel). In turn, the average of the manufacturing PMI’s new orders and backlog of orders series heralds more downside in EM non-TMT share prices (Chart 3). Chart 2China: An Economic Revival Is Not Imminent China: An Economic Revival Is Not Imminent China: An Economic Revival Is Not Imminent Chart 3EM Non-TMT Stocks Remain At Risk EM Non-TMT Stocks Remain At Risk EM Non-TMT Stocks Remain At Risk Property construction will not recover quickly. Marginal easing of real estate regulations and restrictions will not be sufficient to revive animal spirits among property developers and buyers. As we argued in a recent special report on the property market, real estate in China benefited from the biggest carry trade in the world over the past decade. With borrowing costs below the pace of house price appreciation, property developers in China have done what any business would do: they borrowed as much as they could and accumulated real estate assets in the forms of land, incomplete construction, and completed but unsold properties. Chart 4The Carry Trade In China's Real Estate The Carry Trade In China's Real Estate The Carry Trade In China's Real Estate The top panel of Chart 4 illustrates that developers have been starting many more projects than they have been completing. As a result, their unfinished construction has ballooned (Chart 4, bottom panel). Such a business model was profitable since developers’ borrowing costs were below the pace of real estate asset price appreciation. This dynamic will reverse going forward: real estate asset price appreciation will be below developers’ borrowing costs. Thus, property developers have every incentive to shed their assets as quickly as possible. This will discourage new land investment and new construction. In brief, odds are rising that the property market downtrend will be an extended one. In 2015, when property inventories swelled (Chart 4, bottom panel), it took outright monetization of residential properties by the PBOC through the PSL program1 to revive real estate demand and construction. Currently, anything short of aggressive monetization or a very large policy boost will be insufficient to reignite property market sentiment. Thus, the real estate market will continue to struggle. Chart 5 illustrates that real estate developer financing has dried up, heralding a significant contraction in floor space completion, i.e., construction activity. This will weigh on industrial commodities (Chart 5, bottom panel). Even if the government approves a larger special bond quota for local governments, traditional infrastructure spending is unlikely to accelerate meaningfully (Chart 6). The basis is that local governments will continue facing financing constraints from an ongoing slump in their land sales. The RMB 3.65 trillion special bond issuance quota in 2021 accounted for only 18% of local government on- and off-budget revenues. Meanwhile, land sales by local governments account for 40% of their on- and off-budget revenues. As the property market travails continue, local governments will not be able to materially increase traditional infrastructure spending.  Chart 5Less Funding = Less Completions = Less Commodity Demand Less Funding = Less Completions = Less Commodity Demand Less Funding = Less Completions = Less Commodity Demand Chart 6China: Traditional Infrastructure Has Been Weak China: Traditional Infrastructure Has Been Weak China: Traditional Infrastructure Has Been Weak In sum, the Chinese economy has developed formidable downward momentum that will not be easy to reverse. That said, authorities will likely begin injecting more stimulus in 2022 to secure a stable economy and financial markets in the second half of 2022, ahead of the important Party Congress. Bottom Line: The slowdown in the Chinese old economy will continue for now with negative ramifications for China-related financial markets. A buying opportunity for China plays leveraged to its old economy is likely sometime in 2022. Chinese Internet Stocks Chart 7Chinese Internet Stocks Are Not Cheap Chinese Internet Stocks Are Not Cheap Chinese Internet Stocks Are Not Cheap The outlook for Chinese TMT stocks remains uninspiring. We maintain that the regulatory changes affecting Chinese internet stocks are structural rather than cyclical in nature. There could be periods when the pace of regulatory clampdown eases, but these regulations will not be rolled back in any meaningful way. While Chinese platform companies’ equity valuations have already de-rated, these stocks are not cheap: their trailing and forward P/E ratios stand at 35 and 30, respectively (Chart 7). Their multiples will compress further for the following reasons: Their business models have to change because of regulatory requirements. Higher uncertainty about their future business models currently entails a higher equity risk premium. Authorities will cap these companies’ profitability like regulators do with monopolies and oligopolies, which heralds a lower return on equity. In addition, in line with the common prosperity policy, these companies will perform social duties – redistributing profits from shareholders to the society. All these will lower their profitability, warranting permanently lower multiples than those in the past 10 years. Beijing’s involvement in their management and the prioritization of national and geopolitical objectives over shareholder interests will lead foreign investors to dis-invest from these companies. Some large companies face non-trivial risks of delisting from the US. Last week, Beijing reportedly asked Didi to delist from the US due to concerns over its data security. For very different reasons, US and Chinese authorities do not want Chinese companies to be listed in the US. And when Chinese and US authorities do not want to see some of these stocks listed in the US, they will not be. Odds are rising that a few of them might be delisted in the coming years. In such a scenario, US institutional investors will offload their holdings of these companies. Chart 8China: Online Retail Sales Have Slowed Down China: Online Retail Sales Have Slowed Down China: Online Retail Sales Have Slowed Down In addition to the risk to multiples, these internet companies’ profits are also under threat. Chart 8 shows that online retail sales of goods and services have been lackluster compared to their torrid pace in the past 10 years. Bottom Line: The path of least resistance for Chinese internet/platform share prices remains down. Mainstream EM Economies In the majority of EM economies ex-China, Korea and Taiwan (herein referred to as mainstream EM), domestic demand will remain in the doldrums in H1 2022: Monetary policy has tightened in Latin America and Russia while real interest rates are elevated/restrictive in the ASEAN region. In countries where central banks have been hiking rates, domestic demand is bound to decelerate (Chart 9, top panel). In fact, domestic demand remains below pre-pandemic levels in many mainstream EMs (Chart 9, bottom panel). Rate hikes and/or high borrowing costs in real terms will continue to weigh on money and credit growth. The annual growth rates of broad money and bank loans have already reached record lows in both nominal and real terms (Chart 10). These are equity market-weighted aggregates for EM ex-China, Korea and Taiwan. Chart 9Mainstream EM: Domestic Demand Is At Risk Of A Relapse Mainstream EM: Domestic Demand Is At Risk Of A Relapse Mainstream EM: Domestic Demand Is At Risk Of A Relapse Chart 10Mainstream EM: Tepid Money And Credit Growth Mainstream EM: Tepid Money And Credit Growth Mainstream EM: Tepid Money And Credit Growth Chart 11Mainstream EM: No Fiscal Reprieve In 2022 Mainstream EM: No Fiscal Reprieve In 2022 Mainstream EM: No Fiscal Reprieve In 2022 For the same universe, the fiscal thrust in 2022 will be around -1% of GDP (Chart 11). Chart 12 illustrates the 2022 fiscal thrust – defined as the yearly change in the cyclically adjusted budget deficit – for individual countries. Only Turkey is projected to have a small positive fiscal thrust next year. Chart 12 The slowdown in China’s old economy will weigh on Asian economies and commodity producers elsewhere. Table 1 demonstrates that China is the top destination for Asian and commodity producing economies’ exports. Finally, political uncertainty and volatility will remain high in Latin America while geopolitical tensions will linger and escalate from time to time around Russia and Taiwan. We do not think political and geopolitical risks are fully reflected in these financial markets. This leaves these bourses vulnerable to these risks. Bottom Line: Economic growth in mainstream EM economies will disappoint, at least in H1 2022. What We Are Looking To Turn Bullish On EM Assets? Equities: A combination of the following will make us consider issuing a buy recommendation on EM equities: Significant stimulus in China leading to a strong recovery in its credit impulse (shown in Chart 2 above). A rollover in Latin America’s core inflation that will open the door for monetary policy easing in these economies. Regarding indicators, we would need to see all three of the following: EM M1 growth accelerates (Chart 13) Analysts’ net EPS expectations drop to their previous lows (Chart 14) Investor sentiment on EM equities declines to its previous lows (Chart 15). EM equity valuations are neutral in absolute terms. When valuations are neutral, share prices could rise or fall. In these cases, the profit cycle is the key driver of share prices. EM equity market cap-weighted narrow money (M1) growth suggests that EM EPS growth will decelerate well into 2022 (Chart 13 above). Such a profit slump is not yet priced in according to Chart 14. Chart 13An EM Profit Slump Is Imminent An EM Profit Slump Is Imminent An EM Profit Slump Is Imminent Chart 14Analysts Are Not Pricing In An EM Profit Slump Analysts Are Not Pricing In An EM Profit Slump Analysts Are Not Pricing In An EM Profit Slump Chart 15Investor Sentiment On EM Stocks Is Not Downbeat Investor Sentiment On EM Stocks Is Not Downbeat Investor Sentiment On EM Stocks Is Not Downbeat Chart 16Mainstream EM Currencies: Spot And Total Return Indexes Mainstream EM Currencies: Spot And Total Return Indexes Mainstream EM Currencies: Spot And Total Return Indexes Exchange Rates: The mainstream EM equity market cap-weighted currency spot rate versus the US dollar is not far from its 2020 spring lows. On a total return basis – when carry is taken into account – mainstream EM currencies are still above their March 2020 lows (Chart 16). Chart 17Mainstream EM: Real Effective Exchange Rates Mainstream EM: Real Effective Exchange Rates Mainstream EM: Real Effective Exchange Rates Critically, EM currencies are not particularly cheap (Chart 17). Given the lingering headwinds, they are likely to depreciate further. The mainstream EM aggregate real effective exchange rate will likely drop to one or two standard deviations below its mean before these currencies find a bottom (Chart 17). Barring a scenario in which the Omicron variant becomes a major drag on the US economy, the Federal Reserve will maintain its recent hawkish rhetoric due to rising core US inflation. This will support the US dollar and weigh on EM currencies. If Omicron produces a major selloff in financial markets, EM currencies will depreciate. In a nutshell, weak domestic demand and return on capital, political volatility, a slowdown in China and potentially lower commodity prices will all continue depressing EM currencies in the early months of 2022. In the following section about local rates, we list signposts that will make us turn positive on EM currencies Local Rates: EM local rates have gone up a great deal and they offer good value. However, as long as EM currencies do not find a floor, interest rates in high-yield local bond markets will not decline. Critically, US dollar returns on EM local currency bonds are primarily determined by exchange rates. Hence, a buying opportunity for international investors in EM high-yield local bonds will coincide with a bottom in their currencies. We recommend turning positive on mainstream EM currencies versus the US dollar if two out of these three conditions are met: The Fed abandons its intention to hike rates. Significant stimulus in China leading to a strong recovery in its credit impulse Mainstream EM’s aggregate real effective exchange rate drops more than one standard deviation below its mean (Chart 17). Chart 18EM Credit Spreads Are Driven By The EM Business Cycle And Currencies EM Credit Spreads Are Driven By The EM Business Cycle And Currencies EM Credit Spreads Are Driven By The EM Business Cycle And Currencies Credit Markets: As we discussed in a report published earlier this year titled A Primer on EM USD Bonds, the two key drivers of EM sovereign and corporate credit spreads are economic growth and the exchange rate (Chart 18). A positive turn on the EM/China business cycles and their currencies will make us immediately bullish on EM sovereign credit. As for high-yield Chinese USD property developers’ bonds, they are not a buy given their extremely high indebtedness and the dismal outlook for real estate. Investment Strategy Odds are that there will be a buying opportunity in EM equities, fixed income and currencies in 2022. The checklists we highlighted above outline what we will be monitoring to make us turn positive on EM equities, local rates, exchange rates and credit. Our current investment stance is as follows: There is likely to be more downside in EM equities in absolute terms. They will also continue underperforming their DM peers. We downgraded EM equities from neutral to underweight on March 25, 2021 and this strategy remains intact. Within the EM benchmark, our overweights are Korea, Singapore, China (favoring A shares over investable stocks), Vietnam, Russia, central Europe and Mexico. Our equity underweights are Brazil, Chile, Peru, Colombia, South Africa, Turkey and Indonesia. We recommend a neutral allocation to all other bourses in mainstream EM. A word on India, Korea and Mexico is warranted. We will publish a report on India next week. Concerning our overweight in the Korean bourse, lower DRAM prices and China’s slowdown have weighed on its performance in 2021 (Chart 19). However, weakness in semiconductor prices will prove to be short lived as the semiconductor industry is in a structural upswing. Besides, Korea and Mexico are two countries in the EM universe that will benefit from the US industrial boom – one of our major multi-year themes. Chart 20 shows that Korea’s relative equity performance versus the overall EM benchmark closely tracks global industrials relative share prices versus global non-TMT stocks. Chart 19A Soft Spot In The DRAM Industry A Soft Spot In The DRAM Industry A Soft Spot In The DRAM Industry Chart 20Overweight The KOSPI Within The EM Equity Space Overweight The KOSPI Within The EM Equity Space Overweight The KOSPI Within The EM Equity Space The path of least resistance for EM currencies versus the US dollar is presently down. We continue to recommend shorting the following basket of EM currencies versus the US dollar: BRL, CLP, COP, PEN, ZAR, KRW, THB and PHP. Last week, we recommended adding the Indonesian rupiah to this list and today we are booking profits on the short position in TRY. The currencies that we currently favor are CNY, INR, MYR, SGD, TWD, RUB, CZK and MXN. In local rates, we have been betting on the yield curve flattening in Mexico and Russia, have been recommending receiving 10-year swap rates in China and Malaysia as well as paying 10-year rates in the Czech Republic. In the EM credit space, we continue to recommend underweighting EM versus US corporate credit, quality adjusted. As with equities, we downgraded this allocation from neutral to underweight on March 25, 2021. Within the EM credit space, we favor sovereign versus corporate credit, quality adjusted. For EM sovereign credit and domestic bond portfolios, our recommended allocations across various countries are shown in the tables enclosed below. Finally, today we are closing our volatility trades: long EM equity volatility and EM currency volatility. Both positions were initiated on February 4, 2021 and have been profitable.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1Pledged Supplementary Lending was in effect in 2014-2018: The PBOC lent at very low interest rates to the three policy banks who in turn re-lent to local governments and regional property developers (mainly in tier-2 and smaller cities). These entities then bought slums from their owners, putting cash in their hands to purchase new and better properties. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

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

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

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

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

Highlights Contrary to popular belief, the correlation between changes in interest rates and equity returns is not fixed: Stock prices have generally risen as yields have fallen over the last four decades, but there is no rule that states equity returns and bond yields will be inversely related. Tech stocks’ tight recent inverse correlation with interest rates is a new phenomenon and we expect it will be temporary: Relative differences in earnings have driven relative returns since the global financial crisis and their mirror image correlation with interest rates was a pandemic anomaly that has already withered. Rising interest rates are not a good reason for equity investors to reduce their Tech exposures: The conventional wisdom is not always wrong, but it almost never generates alpha. In this case, we believe the crowd has fallen for a fleeting illusion that will not persist. Feature Table 1Lapping The Field Tech Stocks And Interest Rates: Less Than Meets The Eye Tech Stocks And Interest Rates: Less Than Meets The Eye Perhaps nothing has lately generated more consensus agreement among equity strategists and other top-down observers than the claim that Tech stocks are particularly vulnerable to rising interest rates. Thanks to the Tech sector’s track record of generating outsized growth (Table 1), its future earnings streams are expected to be larger for longer than other sectors’, making them somewhat akin to long-maturity bonds from a duration perspective. Go-go growth stocks and Treasuries make for strange bedfellows, no matter how logical the earnings-stream reasoning may appear to be at first glance, and we view the application of duration concepts to equities as a stretch in any event. In this Special Report, we make the case that the recently observed tight inverse correlation between relative Tech sector performance and the 10-year Treasury yield is anomalous and should not be expected to persist. Right Church, Wrong Pew Duration is the weighted-average term to maturity of a bond’s cash flows and describes its price sensitivity to changes in interest rates. It is an essential feature of fixed income markets but attempts to extend the concept to equities necessarily fall flat. Bondholders receive interest and principal payments subject to a contractually fixed schedule that makes valuing a bond, especially one with negligible credit risk, a simple exercise in arithmetic. The present value of any bond (PV) is equal to the sum of its discounted series of cash flows, as in the equation Chart , where x = one of a series of n semi-annual payments, r = the discount rate and t = the time in years when the next payment will be received. Chart 1 Assuming that all the interest payments and the principal payment will be received on time, the only variable term in the bond present value equation is the discount rate, r. As r appears solely in the denominator, a bond’s present value is inversely related to its moves. The cash streams accruing to stockholders are inherently unpredictable, however, and the present value of an equity interest is subject to fluctuations in the realized and estimated future values of x as well as changes in discount rate r. Forces that move r may or may not also move x and it is uncertain whether the numerator or denominator will exert a greater impact if they move together, as they might be expected to do in the case of the high-growth Tech sector. The explanatory power of changes in interest rates weakens as cash flow uncertainty increases. Month-over-month changes in the 10-year Treasury note yield1 explain virtually all the variation in one-month Bloomberg Barclays Treasury Index total returns (Chart 1, top panel). As cash flows become more uncertain with the introduction of modest credit risk, the correlation slips to -40% (Chart 1, middle panel). It weakens even further and flips its sign with equities, which have done better since the financial crisis when the 10-year yield rises than when it falls (Chart 1, bottom panel). Bottom Line: Duration is a metric for measuring bonds’ price sensitivity to changes in interest rates. Because of the uncertain nature of a company’s future cash flows and the multitude of independent variables that influence them, duration is an ill fit with equities. The Post-Crisis Experience The empirical record poses several challenges to the conventional wisdom about Tech stocks and interest rates, beginning with their desultory relationship in the first ten years following the financial crisis. From 2009 through 2018, changes in the 10-year yield are unable to explain any of the variability in relative Tech returns, though they exhibit a tight correlation beginning in 2019 (Chart 2). Tech stocks were utterly indifferent to the yield spikes of 2009 and 2010-11, as well as the sharp intervening decline in 2010, and only began to separate themselves from the field following the Brexit vote, outperforming the overall S&P 500 by 30 percentage points in just two years while the 10-year yield rose from 1.5% to 3%. They then proceeded to blow away the index as yields fell from 2.75% at the end of 2018 to 0.5% at the mid-2020 COVID bottom and have since fought the index to a draw despite a 100-basis point backup above 1.6%. Chart 2Nothing More Than A Lockdown Fling Nothing More Than A Lockdown Fling Nothing More Than A Lockdown Fling In contrast to their all-over-the-map relationship with the level of interest rates, Tech stocks have exhibited a consistently tight fit with relative trailing earnings. A quantitatively inclined visitor from outer space viewing Chart 3 might reasonably conclude that relative Tech stock performance is fully explained by earnings, and all other variables are noise. The series have moved nearly in lockstep with each other and show that Tech’s relative trailing P/E multiple has been quite stable since the crisis. Until relative prices and relative earnings began heading in separate ways as the latter began to slip this Spring, Tech’s relative post-crisis outperformance had entirely been earned, not given. Chart 3Case Closed? Case Closed? Case Closed? Multiples provide an opportunity for interest rate changes to re-enter the discussion. In a direct sense, Tech earnings are comparatively immune to moves in interest rates (the sector’s biggest constituents have immaterial amounts of debt and do not sell big-ticket items that have to be financed), though one might expect the price investors are willing to pay to claim a share of their comparatively backloaded future cash flows may well fluctuate with them. Chart 4, however, shows that the Tech sector’s relative forward multiple has not exhibited a consistent relationship with rates – the correlation between multiples and rates was positive and fairly strong from 2009 through 2018 but weakened and turned negative beginning in 2019. From 1995, when the forward multiple series began, through 2008 (not shown in the chart) the relationship was very weak and negative, generating an r-squared of just 1.4%. Chart 4Defying The Duration Intuition Defying The Duration Intuition Defying The Duration Intuition The relationship between relative four-quarter forward earnings expectations and the 10-year yield sheds some light on how so many observers have been hoodwinked into mistaking correlation for causation. Excepting stretches at the beginning and the end of the 2009-2018 period, when relative forward estimates paid no heed to swings in interest rates, they exhibited a modest negative correlation with the 10-year yield (Chart 5). They moved together with one mind across all of 2020, but that solidarity appears anomalous when viewed against the entire post-crisis record generally and the years that bracket it specifically. In 2018-19, the two years preceding peak pandemic conditions, and 2021, the year following them, Tech’s relative forward earnings expectations have been flatly indifferent to the rate backdrop. Chart 5One-Off One-Off One-Off We submit that the recently observed tight correlation between the 10-year yield and relative forward earnings expectations is an isolated pandemic phenomenon. As bond yields plunged in 2020 due to extraordinary monetary accommodation and fears of a worst-case economic outcome, Tech’s heavy concentration of pandemic winners shot the lights out in terms of actual and projected earnings. Away from the narrow 2020 sample, however, the other twelve years of post-crisis data suggest that there’s no relationship between forward earnings expectations and interest rates. Tech outearned the broader market at a steady rate for the ten years preceding the pandemic without regard for the rates market’s gyrations. Investment Implications Interest rates are a red herring for explaining variations in relative Tech stock performance. The ubiquity of the view that Tech stocks’ relative performance will be heavily influenced by changes in interest rates turns out to be another instance in which something everybody knows turns out not to be true. This finding does not make us Tech bulls; we think the big-picture backdrop is sufficiently mixed to justify our US Equity Strategy and Global Asset Allocation services’ neutral recommendations. We simply wanted to call out the flaws in a popular notion before it becomes even more entrenched. Changes in interest rates do not solely effect equity prices via a denominator effect. They impact the numerator as well. The numerator impacts are multifaceted and vary based on which factor comes to the fore in a given instance. They are much harder to anticipate and therefore hold much more promise for investors who can suss them out in advance. The denominator effect is immediately apparent to any undergraduate who has been introduced to the time value of money and therefore isn’t likely to generate alpha. What’s more, as Tech stocks’ relative performance history illustrates, the relationship between equities and rates is not fixed. The rise of globalization and the Fed’s post-Volcker inflation vigilance ushered in a multi-decade disinflationary trend that ultimately culminated in rampant deflation fears following the global financial crisis. Now that concerns about stagflation have shunted aside concerns about secular stagnation, investors are much less likely to cheer rate backups while wringing their hands over rate declines. As Arthur Budaghyan, BCA’s Chief Emerging Markets strategist, has written, the about-face in market perceptions of interest rates could flip the correlations between equity prices and interest rates from positive (stocks advance as rising interest rates are perceived as evidence of economic improvement) to negative (stocks fall when rates rise and rise when rates fall). Our colleague Jonathan LaBerge, managing editor of the Bank Credit Analyst, has noted that extended valuations increase growth stocks’ vulnerability to rising interest rates. We do not disagree, but they do not have all that much to fear if the backup in Treasury yields is in line with our US Bond Strategy service’s year-end 2021 and 2022 targets of 1.75% and 2-2.25%, respectively. Tech’s outperformance may well have run its course – relative performance is extended, the law of large numbers makes it increasingly difficult to sustain historic growth rates, the legal and regulatory outlook is darkening and a shift from pandemic winners to pandemic losers may be in train – but rising rates alone are not a good basis for trimming Tech exposures.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Duration measures a bond’s sensitivity to a parallel shift in the yield curve, but we use the 10-year Treasury yield as a proxy for the entire curve in our simple regressions of asset class returns against price changes.

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

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