Valuations

In this report, we assess that sterling likely bottomed below 1.04. We expect volatility in the currency to remain in place but are buyers below current levels. On balance, there is a tug of war between irresponsible fiscal policy and the pound as a global reserve currency. This will create a buy-in opportunity for investors who missed the latest dip.

In Section I, we note that the Fed’s new interest rate projections show that US monetary policy is set to rise soon into restrictive territory even relative to what we consider to be the neutral rate of interest, and to a level that has been consistent with the onset of recession since the 1960s. Imminent supply-side and pandemic-related disinflation is crucial for the US to avoid a recession over the coming year. Stay neutral stocks versus bonds for now, but the next shift in our recommended asset allocation stance is more likely to be a downgrade to underweight rather than an upgrade to overweight. In Section II, a guest piece from our European Investment Strategy service discusses the outlook for European assets.

Executive Summary Turkey is staring into an abyss: economic crisis that will morph into political crisis in the June 2023 election cycle. President Erdoğan will pursue populist economic policies and foreign policy adventurism to try to stay in power, leading to negative surprises and “black swan” risks over the coming 9-12 months. While Erdoğan and the ruling party are likely to be defeated in elections, which is good news, investors should not try to front-run the election given high uncertainty. Neither Turkey’s economy and domestic politics nor the global economy and geopolitics warrant a bullish view on Turkish assets. GEOPOLITICAL STRATEGY  Recommendation (TACTICAL) Initiation Date Return LONG JPY/TRY 2022-09-23     Erdoğan’s Net Negative Job Approval Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Bottom Line: The Lira will depreciate further versus the dollar. Both Turkish stocks and local currency bonds merit an underweight stance in an EM basket. EM sovereign credit investors, however, should be neutral on Turkish sovereign credit relative to the EM sovereign credit benchmark. Feature Turkey – now technically Türkiye – is teetering on the verge of a national meltdown. The inflation rate is the fastest in G20 countries, both because of a domestic wage-price spiral and soaring global food and fuel prices. President Recep Tayyip Erdoğan and his Justice and Development Party (AKP) have been in power since 2002, making them highly vulnerable to demands for change in the general election slated for June 18, 2023. Yet Erdoğan is a strongman who won a popular vote to revise the constitution in 2017 and increase his personal power over institutions. His populist Islamist movement is starkly at odds with the country’s traditional elite, including the secular military establishment. Given the poor state of the economy, Erdoğan will likely lose the 2023 election but he could refuse to leave office … or he could win the election and be ousted in a coup d'état, as happened in Turkey in 1960, 1971, and 1980.1 Meanwhile Turkey is beset by foreign dangers – including war in Ukraine and instability in the Middle East. Erdoğan will try to use foreign policy to bolster his popular standing. Turkey has inserted itself in various regional conflicts and could instigate conflicts of its own. While global investors are eager to buy steeply discounted Turkish financial assets ahead of what could be a monumental change in national policy in 2023, the country is extremely unstable. It is a source of “black swan” risks. The best bet is to remain underweight Turkish assets unless and until a pro-market election outcome shakes off the two-decade trend toward economic ruin. Turkish Grand Strategy Turkey is permanently at a crossroads. The land-bridge between Europe and Asia, it is secular and cosmopolitan but also Islamist and traditional. Its past consists of the greatness of empires – Byzantine, Ottoman – while its present consists of a frustrating search for new opportunities in a chaotic regional context. The core of the country consists of the disjointed coastal plains around the Bosporus and Dardanelles straits and the Sea of Marmara, where Istanbul is located. The Byzantine and Ottoman empires were seated on this strategic location at the juncture of the world’s east-west trade. To secure this area, the Turks needed to control the larger Anatolian peninsula – Asia Minor – to prevent roving Eurasian powers from invading, just as they themselves had originally invaded from Central Asia. During times of greatness the Turks could also expand their empire to control the Balkan peninsula and Danube river valley up to Vienna, Crimea and the Black Sea coasts, and the eastern Mediterranean island approaches. During the Ottoman empire’s golden days Turkish power extended all the way into North Africa, Mesopotamia, the Nile river valley, and Mecca and Medina. The empire – and the Islamic Ottoman Caliphate – collapsed in 1924 after centuries of erosion and the catastrophes of World War I. Subsequently Turkey emerged as a secular republic. It adapted to the post-WWII world order by allying with the United States and NATO, in conflict with the Soviet Union which encircled the Turks on all sides. The Russians are longstanding rivals of Turkey, notably in the Black Sea and Crimea, and Stalin wanted to get his hands on the Dardanelles and Bosporus straits. Hence alliance with the US and NATO fulfilled one of the primary demands of Turkish grand strategy: a navy that could defend the straits and Turkish interests in the Black Sea and eastern Mediterranean. The collapse of the Soviet Union seemed to usher in an era of opportunity for Turkey. Turkey benefited from democratization, globalization, and foreign capital inflows. But then America’s wars and crises, Russia’s resurgence, and Middle Eastern instability created a shatter-belt surrounding Turkey, impinging on its national security. In this context of limited foreign policy options, Turkey’s domestic politics coalesced around Erdoğan, the AKP, political Islam, and investment-driven economic growth. Erdoğan and the AKP represent the Anatolian, religious, and Middle Eastern interests in Turkey, as opposed to the maritime, secular, and Euro-centric interests rooted in Istanbul. This point can be illustrated by observing that the poorer interior regions have grown faster than the national average over the period of AKP rule, whereas the more developed coastal regions have tended to lag (Map 1). Voting patterns from the 2018 general election overlap with these economic outcomes. The AKP has steered investment capital into the interior to fund infrastructure and property construction while currency depreciation, rather than productivity enhancement, has merely maintained the status quo with the manufacturing export sector in the coastal regions (Chart 1). Map 1Turkey’s Anatolian Model And The Struggle With The Coasts Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Chart 1Turkey's Export Competitiveness Turkey's Export Competitiveness Turkey's Export Competitiveness Today Turkey faces three distinct obstacles to its geopolitical expansion: Russian aggression: Russia’s resurgence, especially with the seizure of Crimea in 2014 and broader invasion of Ukraine in 2022, threatens Turkey’s interests in the Black Sea and eastern Mediterranean. Turkey must always deal with Russia carefully but over the past 14 years Russia has become belligerent, forcing Turkey to come to terms with Putin while maintaining the NATO alliance. Today Erdoğan tries to mediate the conflict as it does not want to encourage Russian aggression but also does not want NATO to provoke Russia. For instance, Turkey is willing to condone Finland and Sweden joining NATO but only if the West grants substantial benefits to Turkey itself. Ultimately Turkish ties with Russia are overrated. For both economic reasons and grand strategic reasons outlined above, Turkey will cleave to the West (Chart 2). Chart 2Turkey Still Linked To The West Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan ​​​​​ Chart 3Turkish Energy Ties With Russia Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Western liberal hegemony: The EU and NATO foreclosed any Turkish ambitions in Europe. The EU has consolidated with each new crisis while rejecting Turkish membership. This puts limits on Turkish access to European markets and influence in the Balkans. Turkey has guarded its independence jealously against the West. After the Cold War the US expected Turkey to serve American interests in the Middle East and Eurasia. The EU expected it to serve European interests as an energy transit state and a blockade against Middle Eastern refugees. But Turkish interests were often sidelined while its domestic politics did not allow blind loyalty to the West. This led Turkey to push back against the West and cultivate other options, such as deeper economic ties with Russia and China. Turkish dependency on Russian energy is substantial and Turkey has tried to play a mediating role in Russia’s conflict with NATO (Chart 3). Recently Turkey offered to join the Shanghai Cooperation Organization (SCO), a military alliance of Asian powers. However, as with trade, Turkish defense and security ties with the Russo-Chinese bloc are ultimately overrated (Chart 4).  There is room for some cooperation but Turkey is not eager to abandon American military backing in a period in which Russia is threatening to control the Black Sea rim, cut off grain exports arbitrarily, and use tactical nuclear weapons. Chart 4Turkey’s Defense Alliance With The West Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Middle Eastern instability: The Middle East is a potential area for Turkey to increase influence, especially given the AKP’s embrace of political Islam. Turkey benefits from regional economic development and maintains relations with all players. But the region’s development is halting and Turkey is blocked by competitors. The US toppled Iraq in 2003, which strengthened Iran’s regional clout over the subsequent decades. But Iran is not stable and the US has not prevented Iran from achieving nuclear breakout capacity. Turkey cannot abide a nuclear-armed Iran. At the same time, the US continues to support Israel and the Gulf Arab monarchies, which oppose Turkey’s combination of Islam and democratic populism. Russia propped up Syria’s regime in league with Iran, which threatens Turkey’s border integrity. Developments in Syria, Iraq, and Iran have all complicated Turkey’s management of Kurdish militancy and separatism. Kurds make up nearly 20% of Turkey’s population and play a central role in the country’s political divisions. Erdoğan’s Anatolian power base is antagonistic toward the Kurds and regional Kurdish aspirations. China’s strategic rise brings both risks and rewards for Turkey but China is too distant to become the focus of Turkish strategy: China’s dream of reviving the Silk Road across Eurasia harkens back to the glory days of Ottoman power. The Belt and Road Initiative and other investments help to develop Central Asia and the Middle East, enabling Turkey to benefit once again as the middleman in east-west trade (Chart 5). Chart 5Turkey Benefits From East-West Trade Turkey Benefits From East-West Trade Turkey Benefits From East-West Trade But insofar as China’s Eurasian strategy is successful, it could someday impinge on Turkish ambitions, particularly by buttressing Russian and Iranian power. In recent years Erdoğan has experimented with projecting Turkish power in the Middle East (Syria), North Africa (Libya), the Caucasus (Armenia), and the eastern Mediterranean (Cyprus). He cannot project power effectively because of the obstacles outlined above. But he can manipulate domestic and foreign security issues to try to prolong his hold on power. Bottom Line: Boxed in by Russian aggression, western liberal hegemony, and Middle Eastern instability, Turkey cannot achieve its geopolitical ambitions and has concentrated on internal development over the past two decades. However, the country retains some imperial ambitions and these periodically flare up in unpredictable ways as the modern Turkish state attempts to fend off the chaotic forces that loom in the Black Sea, Middle East, North Africa, and Caucasus. The Erdoğan regime is focused on consolidating Anatolian control of Turkey and projecting military power abroad so that the military does not become a political problem for his faction at home. Erdoğan’s Domestic Predicament President Erdoğan has stayed in power for 20 years under the conditions outlined above but he faces a critical election by June 18, 2023 that could see him thrown from power. The result will be extreme political turbulence over the coming nine months until the leadership of the country is settled by hook or by crook. Erdoğan has pursued a strongman or authoritarian leadership style, especially since domestic opposition emerged in the wake of the Great Recession. By firing three central bankers, he has pressured the central bank into running an ultra-dovish monetary policy, producing a 12% inflation rate prior to the Covid-19 pandemic and an 80% inflation rate today. He has also embraced populist fiscal handouts and foreign policy adventurism. Taken together his policies have eroded the country’s political as well as economic stability. From the last general election in 2018 to the latest data in 2022: Real household disposable income  growth has fallen from -7.4% to -18.7% (Chart 6). Chart 6Real Incomes Falling Real Incomes Falling Real Incomes Falling ​​​​​​ Chart 7Turkish Activity Slows Ahead Of Election Turkish Activity Slows Ahead Of Election Turkish Activity Slows Ahead Of Election ​​​​​ The manufacturing PMI has fallen from 49.0 to 47.4 (Chart 7). Consumer confidence has fallen from 92.1 to 72.2 (Chart 8). Chart 8Consumer Confidence: Not Better Off Than At Last Election Consumer Confidence: Not Better Off Than At Last Election Consumer Confidence: Not Better Off Than At Last Election ​​​​​​ Chart 9Erdoğan’s Net Negative Job Approval Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan ​​​​​​ Bad economic news is finally altering public opinion, with polls now shifting against the president and incumbent party: Since the pandemic erupted, Erdoğan’s approval rating has fallen from a peak of 57% to 40% today. Disapproval has Erdoğan’s risen to 54%, leaving him a net negative job approval (Chart 9). Bear in mind that Erdoğan won the election with 52.6% of the vote in 2018, only slightly better than the 51.8% he received in 2014 and well below the 80% that his AKP predecessor received in 2007. Meanwhile the AKP, which never performs as well as Erdoğan himself, has fallen from a 45% support rate to 30% today in parliamentary polls, dead even with the main opposition Republican People’s Party (Chart 10). The AKP won 42.6% of the vote in 2018, down from 49.5% in the second election of 2015, 49.8% in 2011, and 46.6% in 2007. Chart 10Justice And Development Party Neck And Neck With Republican Opposition Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan The gap between Erdoğan and his Republican rivals has narrowed sharply since the global food and fuel price spike began to bite in late 2021 (Chart 11). Chart 11Erdoğan Faces Tough Re-Election Race Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan However, the 2023 election is not straightforward. There are several caveats to the clear anti-incumbent tendency of economic and political data: Soft Economic Landing? The election takes place in nine months, enough time for surprises to salvage Erdoğan’s presidential campaign, given his and his party’s heavily entrenched rule. For example, it is possible – not probable – that Russia will resume energy exports, enabling Europe to recover, and that central banks will achieve a “soft landing” for the global economy. Turkey’s economy would bounce just in time to help the incumbent party. This is not what we expect (see below) but it could happen. Foreign Policy Victories? Erdoğan could achieve some foreign policy victories. He has negotiated a tenuous deal with Russia and Ukraine, along with the UN, to enable grain exports out of Odessa. He could build on this process to negotiate a broader ceasefire in Ukraine. He could also win major concessions from the US and NATO to secure Finnish and Swedish membership in that bloc. If he did he would come off looking like a grand statesman and might just buy another term in office. Unfortunately what is more likely is that Erdoğan will pursue an aggressive foreign policy in an attempt to distract voters from their bread-and-butter woes, only to destabilize Turkey and the region further. Stolen Election? Erdoğan revised the constitution in 2017 – winning 51.4% of the votes in a popular referendum – to give the presidency substantial new powers across the political system. Using these powers he could manipulate the election to produce a favorable outcome or even cling to power despite unfavorable election results. He does not face nearly as powerful and motivated of a liberal establishment as President Trump faced in 2020 or as Brazilian President Jair Bolsonaro faces in 2022. As noted Erdoğan has a contentious relationship with the Turkish military, so while investors cannot rule out a stolen election, they also cannot rule out a military coup in reaction to an attempted stolen election. Thus the election could produce roughly four outcomes, which we rank below from best to worst in terms of their favorability for global investors: 1.  Best Case: Decisive Opposition Victory – 25% Odds – A resounding electoral defeat for the AKP would reverse its unorthodox economic policies in the short term and serve as a lasting warning to future politicians that populism and economic mismanagement lead to political ruin. This outcome would also provide the political capital and parliamentary strength necessary to impose tough reforms and restore a semblance of macroeconomic stability. 2.  Good Case: Narrow AKP Defeat – 50% Odds – A narrow or contested election would produce a weak new government that would at least put a stop to the most inflationary AKP policies. It would improve global investor sentiment around Turkey’s eventual ability to stabilize its economy. The new government would lack the ability to push through structural reforms but it could at least straighten out the affairs of the central bank so as to ensure a cycle of monetary policy tightening, which would stabilize the currency. 3.  Bad Case: Narrow AKP Victory – 15% Odds – A narrow victory would force the AKP to compromise with opposition parties in parliament and pacify social unrest. Foreign adventurism would continue but harmful domestic policies would face obstructionism. 4.  Worst Case: Decisive AKP Victory – 10% Odds – A resounding victory for the ruling party would vindicate Erdoğan and his policies despite their negative economic results, driving Turkey further down the path of authoritarianism, populism, money printing, currency depreciation, and hyper-inflation. He could also be emboldened in his foreign adventurism. Bottom Line: We expect Erdoğan and the AKP to be defeated and replaced. However, Turkey is in the midst of an economic and political crisis and the next 12 months will bring extreme uncertainty. The election could be indecisive, contested, stolen, or overthrown. The aftermath could be chaotic as well as the lead-up. If the AKP stays in power then investors will abandon Turkey and its economy will suffer a historic shock. Therefore investors should underweight Turkey – at least until the next phase in the economic downturn confirms our forecast that the AKP will fall from power. Macro Outlook: Fade The Equity Rally Chart 12Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM The Turkish economy is beset by hyper-inflation. Headline consumer prices are rising at upwards of 80% and core inflation is 65%. Yet Turkish government 10-year bond yields are low and falling: they are down to 11% currently, from a high of 24% at the beginning of the year. Turkish stocks have also outperformed their Emerging Markets counterparts this year in common currency terms even though the lira has been the worst performing EM currency (Chart 12). So, what’s going on in this market? The answer is hidden in the slew of unorthodox policies adopted by the authorities. These measures caused massive distortions in both the economy and the markets. Specifically, late last year, despite very high inflation, the central bank began to cut policy rates encouraging massive loan expansion. As a result, both local currency loans and money supply surged. Which, in turn, completely unhinged inflation (Chart 13). As inflation rose, so did government bond yields. In a bid to keep government borrowing costs low, policymakers changed several bank regulations to force commercial banks to buy government bonds.2  The upshot was that the bond yields stopped tracking inflation and instead began to fall even as inflation skyrocketed. The rampant inflation meant Turkish non-financial firms’ nominal sales skyrocketed. Indeed, sales of all MSCI Turkey non-financials companies have risen by 40% in US dollar terms and 200% in local currency (Chart 14). Chart 13Massive Bank Credit And Money Growth Completely Unhinged The Inflation Massive Bank Credit And Money Growth Completely Unhinged The Inflation Massive Bank Credit And Money Growth Completely Unhinged The Inflation This was at a time when policy rates were being cut. The policy rate has fallen to 12% today from 19% a year earlier. Firms’ local currency real borrowing costs have fallen deeply into negative territory (Chart 15). It helped reduce firms’ costs significantly. Chart 14Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits ​​​​​ Chart 15Policy Rates Are Being Cut Even As The Inflation Reigns Havoc Policy Rates Are Being Cut Even As The Inflation Reigns Havoc Policy Rates Are Being Cut Even As The Inflation Reigns Havoc ​​​​​ Chart 16Wage Costs Have Risen Too, But Not As Much As Inflation Wage Costs Have Risen Too, But Not As Much As Inflation Wage Costs Have Risen Too, But Not As Much As Inflation ​​​​​ Meanwhile, even though wage growth accelerated, it still fell short of inflation, and therefore of nominal sales of the firms (Chart 16). Firms’ wage costs did not rise as much as their prices. All this boosted non-financial firms’ margins. Total profits have risen by 35% in US dollar terms from a year earlier (200% in lira terms). ​​​​​​​ Chart 17The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket ​​​​​​​ On their part, listed financials’ profits have surged by 50% in USD terms and 220% in local currency terms. They benefited both from surging interest income due to rapid loan growth and from massive capital gains on their holding of government securities (see Chart 14 above). All this is reflected in Turkish companies’ earnings per share as well. The spike in EPS has propped up Turkish stocks for past few months. Over the past year, not only have corporate profits and share prices surged, but also house prices have skyrocketed by 170% in local currency terms and 30% in USD terms (Chart 17). In sum, the abnormally low nominal and deeply negative real borrowing costs have produced a money/credit deluge, which has generated a massive inflationary outbreak and has inflated revenues/profits as well as various asset prices. The Lira To Depreciate Further This macro setting is a recipe for a major currency sell-off.  First, Europe – the destination of 90% of Turkish exports – will likely slide into recession over the coming year (Chart 18).  Chart 18A Slowing Europe Will Materially Dent Turkish Growth Too A Slowing Europe Will Materially Dent Turkish Growth Too A Slowing Europe Will Materially Dent Turkish Growth Too A fall in exports will widen Turkey’s current account deficit. Notably, imports will not fall much since the authorities are pursuing easy money policy. Second, the lack of credible macro policies as well as political crisis will assure that foreign capital escapes Turkey. Turkey will find the current account deficit nearly impossible to finance. Third, the country’s net foreign reserves, after adjusting for the central bank’s foreign currency borrowings and commercial banks’ deposits with the central bank, stand at minus 30 billion dollars. In other words, the central bank now has large net US dollar liabilities. As such, it has little wherewithal to defend the currency. There are very high odds that the lira depreciation will accelerate in the months ahead. Fourth, the slew of unorthodox measures taken by the Turkish authorities will encourage banks to buy more government local currency bonds to suppress the government’s borrowing costs. When commercial banks buy government securities from non-banks, they create money “out of thin air.” Hence, the ongoing money supply deluge will continue. This is bearish for the currency. Notably, the economy will likely enter into recession next year – and yet core inflation will stay very high (30% and above). Recent unorthodox bank regulations are meant to encourage a certain kind of lending – loans to farmers, exporters, and small and medium-sized businesses – while discouraging other kinds. Consequently, the overall loan growth will likely slow in nominal terms. There are already signs that credit is decelerating on the margin (Chart 19). Given the very high inflation, slower credit growth will likely lead to a liquidity crunch for many businesses – forcing them to curtail their activity.  Chart 19Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations ​​​​​​ Chart 20Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP ​​​​​​ Indeed, in real terms (deflated by core CPI), local currency loan growth has already slipped into negative territory. This is a bad omen for the overall economy: contracting real loan growth is a harbinger of recession (Chart 20). In short, Turkey is looking into an abyss: a recession amid high inflation (i.e., stagflation) as well as a brewing political crisis (with Erdoğan likely doubling down on unorthodox and populist policies). All this point to another period of a large currency depreciation. While the country will likely change direction to avoid the abyss, investors should wait to allocate capital until after the change in direction is confirmed.    Investment Takeaways The Turkish lira will fall much more vis-à-vis the US dollar in the year ahead. Both Turkish stocks and local currency bonds merit an underweight stance in an EM basket. EM sovereign credit investors, however, should be neutral on Turkish sovereign credit relative to the EM sovereign credit benchmark. Turkey is involved in an economic crisis that will devolve into a political crisis over the election cycle. While Erdoğan and the AKP are likely to fall from power as things stand today, they are heavily entrenched and will be difficult to remove, creating large risks of an indecisive or contested election in 2023 that will increase rather than decrease policy uncertainty and the political risk premium in Turkish assets. As a strongman leader Erdoğan has consolidated political power in his own hands, so there is no one to take the blame for the country’s economic mismanagement – other than foreigners. Hence there is a distinct risk that his foreign policy adventurism will escalate between now and next year, resulting in significant military conflicts or saber-rattling. These will shake out western investors who try to speculate on the likelihood that the election or the military will oust Erdoğan and produce sounder national and economic policies. That outcome is indeed likely but Erdoğan is not going without a fight. Our Geopolitical Strategy also recommends tactically shorting the lira versus the Japanese yen in light of global slowdown, extreme geopolitical risk, and the Bank of Japan’s desire to prevent the yen from falling too far.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Andrija Vesic Consulting Editor Footnotes 1      Sinan Ekim and Kemal Kirişci, “The Turkish constitutional referendum, explained,” Brookings Institution, April 13, 2017, brookings.edu. 2     The central bank replaced an existing 20% reserve requirement ratios for credits with a higher 30% treasury bond collateral requirement. Lenders will have to cut interest rates on commercial loans (except for loans to farmers, exporters, and SMEs). Otherwise, banks will have to maintain additional securities. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Highlights The risk of a US recession has increased sharply over the past several months. We have not yet concluded that a recession over the coming year is inevitable, but substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. The increased risk of a contraction has caused investors to ponder what the next recession might look like. One very important question concerns the likely behavior of short-term interest rates during the next recession, especially if it occurs sooner rather than later. The historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition, there are several arguments pointing to the next US recession being a mild one. For fixed-income investors, the implication is that investors should not overstay their welcome in a long-duration position during the next US recession, and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. Feature Over the past several months, investors have been faced with a sharp increase in the odds of a US recession. Gauging the risk of a recession has featured prominently in our recent reports, and we have concluded, for now, that a US recession over the coming year is not yet inevitable. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Economic expansions do not last forever. This means that the US economy will eventually succumb to a recession at some point over the coming few years. One very important question for investors concerns the likely behavior of short-term interest rates during the next recession, especially if a contraction occurs sooner rather than later. A key aspect of this question is whether the Fed is likely to be forced back towards a zero or negative interest rate policy, and whether it will need to employ asset purchases as part of its stabilization efforts as it has during the last two recessions. If so, long-maturity bond yields are likely to fall significantly during the next recession; if not, investors may be surprised by how modestly long-maturity yields decline. In this report, we examine the historical record of short-term interest rates during recessions and discuss whether the next US recession is likely to be severe or mild. We conclude that the next US recession is more likely to be mild than severe, and that the 10-year Treasury yield is unlikely to fall below 2% during the recession (or fall below this level for very long). In the case of a more severe recession driven by unanchored inflation expectations, the implications would be clearly bearish for bonds. Within a fixed-income portfolio, one conclusion of our analysis is that investors should not overstay their welcome in a long-duration position during the next recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. The Historical Recessionary Path Of Short-Term Interest Rates When projecting how the Fed funds rate is likely to evolve during the next US recession, most investors typically look to the average decline in short-term interest rates during previous recessions as a guide. Based on that approach, Table II-1 highlights that the Fed would likely have to cut rates into negative territory if a recession occurred over the coming 12-18 months, unless it is able to hike interest rates significantly more over the coming year than the market is currently expecting and the FOMC itself is projecting. But in our view, focusing on the historical recessionary decline in interest rates from their peak is not the right approach, because it ignores the fact that recessions typically occur when monetary policy is tight. If a recession occurs within the next 18 months, it will have happened in large part because of a collapse in real wage growth, not just because of the increase in interest rates that has occurred. Chart II-1 highlights that short-term interest rates remain well below potential GDP growth, highlighting that monetary policy would still be easy today – despite the quick pace of increase in short rates – if real wages were growing rather than contracting sharply. In our view, the right approach is to examine how much short-term interest rates have typically fallen during recessions relative to potential or average historical GDP growth. This method captures the degree to which monetary policy easing has typically been required relative to neutral levels to catalyze an economic recovery. Table II-1Based Only On The Historical Decline In Short-Term Interest Rates, The Fed Would Ostensibly Have To Cut Rates Into Negative Territory During The Next Recession September 2022 September 2022 Chart II-1Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Based on this approach, Chart II-2 highlights that the Fed might have to cut the target range for the Fed funds rate to 0-0.25% during the next recession, but there are some examples (like the 1990-1991 recession) that point to a cut to just 0.25-0.5%. The goal of this exercise is not to be specific about the exact level to which the Fed will have to cut the Fed funds rate, but rather whether the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases is likely. Chart II-2The Fed May Have To Cut To Zero During The Next Recession, But Probably Not Into Negative Territory September 2022 September 2022 Structural bond bulls might note that there are five recessions in the post-war era that could potentially point to that outcome based on Chart II-2. However, these episodes involved circumstances that we doubt would be present during the next US recession, especially if one were to emerge over the coming 12-18 months. The 1950s Recessions The recessions of 1953-54 and 1957-58 were fairly sizeable based on the total rise in the unemployment rate, but the monetary policy stance at that time was wildly stimulative in a way that is very unlikely to repeat itself today. In the 1950s, the level of interest rates was still an artifact of WWII (with the Treasury-Fed accord having only been agreed upon in March 1951). Monetary policy was both overly responsive to a period of pent-up disinflation following the initial burst of government spending associated with the Korean war and insufficiently responsive to a strongly positive output gap (Chart II-3). This was meaningfully compounded by a poor understanding of the size of the output gap at that time; the deviation of the unemployment rate from its 10-year average was significantly smaller than its deviation from today’s estimate of NAIRU (Chart II-4). In sum, the economic and monetary policy conditions that existed in the 1950s and that contributed to an interest rate level that was well below the prevailing rate of economic growth do not exist today. As such, we strongly doubt that the Fed’s response to the next US recession would resemble what occurred during that decade. Chart II-3We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s Chart II-4Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates   1973-1975 The recession that began in 1973 occurred because of a huge energy shock that proved to be stagflationary in the true sense of the word. Excluding the 2020 recession, this was the third largest rise in the unemployment rate of any recession since WWII, following 2008/2009 and the 1981/1982 recessions. There are some parallels between this recession and the current economic environment, but the stability of inflation expectations so far does not point to a truly stagflationary outcome. As such, we do not see the 1973-74 recession as a reasonable parallel to today’s environment. In addition, manufacturing employment – which was heavily impacted by the permanent rise in oil prices due to the sector’s energy intensity – stood at 24% of total nonfarm employment in 1973, compared with 8% today. Finally, the weight of food and energy as a share of total consumer spending today is roughly half of what it was during the 1970s (Chart II-5). 2001 Of the five recessions potentially implying that the Fed may have to cut interest rates into negative territory during the next US recession, the 2001 recession is the most relevant parallel to today. It was a modern recession in which the Fed maintained very easy monetary policy for a significant amount of time, in response to concerns about a significant tightening in financial conditions and the impact of prior corporate sector excesses on aggregate demand. The total rise in the unemployment rate during this recession was not very large, but it took some time for the unemployment rate to return to NAIRU. Still, even though this justified a later liftoff, a Taylor rule approach makes it clear that the Fed overstimulated the economy in response to the recession – a view that is reinforced by the enormous rise in household debt that fueled the housing market bubble during that period (Chart II-6). The Fed was very concerned about the negative wealth effects of the bursting of the equity market bubble, which had been caused by a massive decline in the equity risk premium in the second half of the 1990s. These conditions are simply not present today. Chart II-5Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Chart II-6The Fed Clearly Overstimulated In Response To The 2001 Recession The Fed Clearly Overstimulated In Response To The 2001 Recession The Fed Clearly Overstimulated In Response To The 2001 Recession 2008/2009 Chart II-7A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario Chart II-2 highlighted that the Fed would have to cut interest rates to -1% were the 2008/2009 recession to repeat itself, but we judge that to be a totally implausible scenario given the improvement in US household sector balance sheets and financial sector health since the global financial crisis (Chart II-7). As we discuss below, the next US recession is likely to be meaningfully less severe than the 2008/2009 and 2020 recessions, which we believe carries important significance for the path of interest rates and the response of long-maturity bond yields. The bottom line for investors is that, based on the historical experience of rate cuts during recessions, the Fed may end up cutting interest rates back to or close to the zero lower bound in response to the next recession. But the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seems quite unlikely unless the recession is severe, which we do not expect. Will The Next US Recession Be Severe Or Mild? Chart II-8The Most Severe US Recessions Have Had Aggravating Factors That Do Not Appear To Be Present Today September 2022 September 2022 How drastically the Fed will be forced to cut interest rates during the next recession will be driven by its severity. Chart II-8 presents the total rise in the unemployment rate during post-WWII recessions (excluding 2020), in order to gauge whether the factors that have led to severe recessions in the past are likely to be present during the next contraction in output. From our perspective, the most severe US recessions in the post-WWII era have been driven by factors that are very unlikely to repeat themselves in the current environment. We noted above that a repeat of the 2008/2009 recession is a totally implausible scenario, leaving the 1981-1982, 1973-1975, and 1950s recessions as potential severe recession analogues. In three of these four cases we see clear signs of an aggravating factor that we do not (yet) believe will be present during the next US recession. Chart II-9Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s In the 1981-1982 recession, the unemployment rate rose significantly as the Federal Reserve confronted the fact that inflation expectations had become severely unanchored to the upside, causing a persistent wage/price spiral. While unanchored inflation expectations is a risk today, so far the evidence suggests that both households and market participants expect that currently elevated inflation will not persist over the long run (Chart II-9). If inflation expectations do become unanchored to the upside at some point over the coming 12-18 months (or beyond), we are very likely to change our view about the severity of the next recession. However, this would be a bond bearish outcome (at least initially), as it would imply sharply higher yields at both the short and long end of the yield curve in order to tame inflation and re-anchor inflation expectations. As noted above, in the 1973-74 recession, the unexpected and permanent rise in oil prices and outright energy shortages rendered a significant amount of capital and labor uneconomic, which is different than what has been occurring during the pandemic. Were the recent rise in natural gas prices to be permanent and no alternatives available, Europe’s current energy situation would be more reminiscent of the 1973-1974 recession than the pandemic-driven price pressures and supply shortages affecting the US and other developed economies. Chart II-10The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year Finally, while the 1957-58 recession appears to be somewhat of an anomaly driven by a mix of factors, the 1953-54 recession was clearly exacerbated by a sharp slowdown in government spending following the end of the Korean war. It is true that the US is currently experiencing fiscal drag (Chart II-10), but this has occurred against the backdrop of a strong labor market, and IMF forecasts imply that the drag will be significantly smaller over the coming year than what the US is currently experiencing. There are several additional points suggesting that the next US recession will be comparatively mild: Chart II-11The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) Chart II-11 highlights that the milder recessions, those which have seen the unemployment rate rise by less than 3% from their previous low, have generally been the recessions that appear to have simply been triggered by monetary policy becoming tight or nearly tight. This would likely be the case during the next US recession. In the lead up to the 1970, 1990-91, and 2001 recessions, short-term interest rates approached or exceeded either potential growth or the rolling 10-year average growth rate of nominal GDP. The 1960-61 recession stands out slightly as an exception to this rule, in that interest rates were still moderately easy, which is based on our definition of the equilibrium short-term interest rate. But interest rates had risen close to 400 basis points from 1958 to 1960 (suggesting a change in addition to a level effect of interest rates on aggregate demand), and it is notable that the 60-61 recession was the mildest in post-war history, based on the total rise in the unemployment rate. Chart II-12Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession We argued in Section 1 of our report that monetary policy is not currently restrictive on its own, and that the recessionary risk currently facing the US is the result of a combination of the speed of adjustment in interest rates, the fact that real wages have fallen sharply, and the fact that the Fed is determined to see inflation quickly return to target levels. However, what this also highlights is that a recession would likely cause a rise in real wages via a significant slowdown in inflation (at least for a time); this would likely help stabilize aggregate demand and cause a comparatively mild rise in the unemployment rate. While the odds and magnitude of this effect are difficult to quantify, the fact that the labor market has been so tight over the past year and that the participation rate has yet to recover to its pre-pandemic levels suggests that some firms may be reluctant to shed labor during a recession (Chart II-12), suggesting that the total rise in unemployment in the next recession could be relatively small. Finally, Chart II-13 shows that the excess savings that have accumulated over the course of the pandemic, now primarily the result of reduced spending on services, dwarf the magnitude of precautionary savings that were generated in the prior three recessions as a % of GDP. We agree that the savings rate would likely still rise during the next recession, but the existence of excess savings implies that the rise in the savings rate may be surprisingly small – which would, in turn, imply a comparatively mild rise in the unemployment rate. We noted above that the household sector has deleveraged significantly, which is strong evidence against an outsized or long-lasting decline in consumer spending as a possible driver of an above-average rise in the unemployment rate during the next recession. One question that we often receive from clients is whether excessive corporate sector leverage could cause a more severe decline in economic activity once a recession emerges. Chart II-14 illustrates that the answer is “probably not.” The chart presents one estimate of the US nonfinancial corporate sector debt service ratio, based on national accounts data. The chart highlights that the current debt burden for the nonfinancial corporate sector is very low, underscoring that elevated corporate sector debt would not likely act as an aggravating factor driving an outsized rise in the unemployment rate were a recession to occur today. The chart also shows that even if the 10-year Treasury yield were to rise to 4% and corporate bond spreads were to widen in the lead up to a recession, the nonfinancial corporate sector debt service burden would rise to a lower peak than seen in the last three recessions. One key risk to a mild recession view is a scenario in which inflation does not return to or below the Fed’s target during the recession. In that kind of environment, the Fed would not likely cut interest rates to as low a level as they have in the past relative to potential growth. But the historical record is clear that recessions cause a deceleration in inflation, and if a recession emerges over the coming 12-18 months it will likely happen after supply-side and pandemic-related disinflation has already occurred. That means that inflation is likely to move back to or below the Fed’s target in a recessionary environment. We should note that this assessment differs somewhat from the scenario described by my former colleague Martin Barnes, who wrote a guest report on inflation published in our July Bank Credit Analyst.1 Chart II-13Today’s Pandemic-Related Excess Savings Dwarf Precautionary Savings During The Prior Three Recessions September 2022 September 2022 Chart II-14US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment   Long-Maturity Bond Yields And The Next US Recession What does our analysis imply for long-maturity bond yields and the duration call over the coming few years? In order to judge what is likely to happen to long-maturity bond yields in a recession scenario over the coming 12-18 months, we first project the fair value of the 5-year Treasury yield based on the following hypothetical circumstances: The onset of recession in March 2023 and a peak in the Fed funds rate at a target range of 3.75-4%. A recession duration of eight months, over which time the Fed steadily cuts the policy rate to 0-0.25%. An initial Fed rate hike in September 2024, nine months following the end of the recession, consistent with a relatively short return of the unemployment rate to NAIRU as an expansion takes hold. A rate hike pace of eight quarter-point hikes per year, with the Fed again raising rates to a peak of 4% A longer-term average Fed funds rate of 3%, which we regard as a low estimate. Chart II-15The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario Chart II-15 highlights the fair value path for the 5-year Treasury yield in this scenario. Not surprisingly, the fair value today is lower than the current level of the 5-year yield, highlighting that a shift to a long duration stance will be warranted at some point over the coming year if the US economy enters a non-technical, typical income-statement recession. However, the chart also highlights that a long duration position is not likely to be warranted for very long, given that the lowest level of the 5-year fair value path is substantially higher than it was in 2020 and 2021 and is also higher than its 10-year average. Chart II-16 reveals the importance of forecasting the near-term path of interest rates when predicting the likely behavior of long-maturity bond yields. Even though near- and long-term interest rate expectations should be at least somewhat differentiated, the chart highlights that the real 5-year/5-year forward Treasury yield is very closely explained by the real 5-year Treasury yield and a 3-year lag of our adaptive inflation expectations model (which is highly consistent with BCA’s Golden Rule of bond investing framework). Chart II-16 shows that long-maturity bond yields should be higher than they are based on the current level of real 5-year yields and lagged inflation expectations, underscoring the point that we made in Section 1 of our report that significant upside risk exists for long-maturity bond yields in a non-recessionary outcome over the coming year. In a recessionary outcome, it is clear that bond yields will fall as the Fed cuts interest rates, as Chart II-15 demonstrated. But, Chart II-17 highlights that during recessions, there is little precedent for a negative 5-10 yield curve slope outside of the context of the persistently high inflation environment of the late 1960s and 1970s. Applying that template to the fair value path that we showed in Chart II-15 suggests that the 10-year Treasury yield will not fall below 2% during the next recession. As we noted in our August report,2 a 10-year Treasury yield decline to 2% would result in significant performance for long-maturity bonds, but it would not end the structural bear market in bonds that began two years ago – a fact that we suspect would be very surprising to bond-bullish investors. Chart II-165-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward 5-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward 5-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward Chart II-17There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession It is true that bond yields may deviate from the fair value levels shown in Chart II-15 if investors expect a different outcome for the path of the Fed funds rate than we described. However, it is worth noting that changes in our assumed post-recession peak Fed funds rate and the long-term average do not substantially change the outcome shown in Chart II-15. If investors instead assume that the Fed funds rate will peak at 3% during the next expansion, that lowers the fair value path for the 5-year yield by approximately 5 basis points. Changing the long-term average Fed funds rate to 2.4%, the Fed’s current neutral rate expectation, would reduce it by about 25 basis points. These levels would still be significantly above the lows reached in 2011-2013 and in 2020, underscoring that the length of the recession and the speed at which the Fed begins to raise interest rates will be far more important determinants of the path of US Treasury yields. We strongly suspect that investors will recognize that a comparatively mild recession will not result in the same hyper-accomodative monetary policy stance that occurred during the past two recessions, implying that long-maturity bond yields will have less downside during the next recession than may be currently recognized. Investment Conclusions As we have presented, the historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition to this, there are several arguments pointing to the next US recession being a mild one. In a mild recession scenario, we doubt that the 10-year Treasury yield would fall below 2%, or fall below this level for very long. For fixed-income investors, while bond yields will fall for a time if a recession emerges, the implication is that investors should not overstay their welcome in a long-duration position during the recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. We noted in our July report that if a recession occurred within the coming 6-12 months, that the S&P 500 would likely fall to 3100, even if the recession were average. A mild recession may see the S&P 500 decline less severely than this, but stocks are still likely to incur significant losses during the next recession unless investors price in a much shallower path for short-term interest rates than we believe will be warranted. As noted in Section 1 of our report, we have not yet concluded that a US recession is inevitable over the coming 6-12 months. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Additional changes to our recommended cyclical allocation may thus occur over the coming few months, in response to incoming data, our assessment of the likely implications for monetary policy, and the response of long-maturity government bond yields. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1  Please see The Bank Credit Analyst "Inflation Whipsaw Ahead," dated June 30, 2022, available at bca.bcaresearch.com 2  Please see The Bank Credit Analyst "August 2022," dated July 28, 2022, available at bca.bcaresearch.com

Please note that there will no US Bond Strategy publication next week. Our regular publishing schedule will resume on September 6th with our Portfolio Allocation Summary for September. Executive Summary This report describes a framework for implementing long/short positions in the TIPS market relative to duration-matched nominal Treasuries. The framework is modeled after the Golden Rule of Bond Investing that we use to implement portfolio duration trades. The TIPS Golden Rule states that investors should buy TIPS versus nominal Treasuries when their 12-month headline inflation expectations are above those priced into the market, and vice-versa. We demonstrate a method for forecasting headline CPI inflation and conclude that it will fall into a range of 2.4% to 4.8% during the next 12 months, with risks to the upside. This suggests a high likelihood that headline inflation will exceed current market expectations. The TIPS Golden Rule’s Track Record The TIPS Golden Rule's Track Record The TIPS Golden Rule's Track Record Bottom Line: We see value in TIPS on a 12-month investment horizon but anticipate that an even better entry point to get long TIPS versus nominal Treasuries will emerge during the next couple of months as headline CPI weakens. We recommend a neutral allocation to TIPS for now, though we are looking for a good opportunity to increase exposure. Feature Regular readers will no doubt be familiar with our Golden Rule Of Bond Investing, the framework we use to think about our portfolio duration recommendations. In brief, the Golden Rule states that investors should set their overall bond portfolio duration based on how their own 12-month fed funds rate expectations differ from the expectations that are priced into the market. Our research shows that this investment strategy has a strong historical track record.1 The thing we like most about the Golden Rule framework is that it provides us with a good method for filtering incoming information. Does this new piece of news or economic data change our 12-month rate expectations? If not, then we probably don’t want to assign much weight to it when setting our portfolio duration. In this Special Report we demonstrate that the same Golden Rule logic that we apply to duration trading can also be applied to the TIPS market. Specifically, it can be applied to long/short positions in TIPS versus duration-matched nominal Treasuries. Developing The TIPS Golden Rule Before diving into the TIPS Golden Rule, it’s worth running through the logic that underpins this investment strategy. The logic starts with the Fisher Equation – the well-known formula that relates nominal bond yields to real bond yields. Simply, the Fisher Equation can be stated as follows:     Nominal Yield = Real Yield + The Cost Of Inflation Protection In financial market terms, we can re-write the equation as:     Nominal Treasury Yield = TIPS Yield + TIPS Breakeven Inflation Rate Two of the three variables in this equation have what we call valuation anchors. The nominal Treasury yield’s valuation is anchored by expectations about the future path for the federal funds rate. Put differently, if you buy a 5-year Treasury note and hold it until maturity, your excess returns versus a position in cash are purely determined by the path of the federal funds rate over that 5-year investment horizon. Similarly, the TIPS breakeven inflation rate’s valuation is anchored by expectations about CPI inflation. If held to maturity, the profits from an inflation protection position (long TIPS/short nominals or short TIPS/long nominals) are purely determined by the path of CPI inflation during the investment horizon. It’s worth noting that, unlike the nominal Treasury yield and the TIPS breakeven inflation rate, the TIPS yield has no independent valuation anchor. Within our framework, the best way to forecast the TIPS yield is to follow a 3-step process: Forecast the nominal yield based on a view about the fed funds rate. Forecast the TIPS breakeven inflation rate based on a view about inflation. Use the Fisher Equation to combine the results from steps 1 and 2 into a forecast for the TIPS yield. As an aside, while our framework relies on viewing the nominal Treasury yield and the TIPS breakeven inflation rate as reflective of expectations for the fed funds rate and CPI inflation respectively, we do not argue that those bond yields can be used to accurately forecast the fed funds rate or CPI inflation. In fact, history tells us that bond markets are usually poor predictors of future outcomes for the fed funds rate and for CPI inflation. Chart 1 shows that there is only a loose correlation (R2 = 22%) between 12-month bond-market implied expectations for the change in the fed funds rate and the actual change in the fed funds rate. Similarly, Chart 2 shows that there is hardly any correlation (R2 = 3%) between market-implied inflation expectations and the 12-month rate of change in headline CPI. Chart 1Market Prices Are A Poor Predictor Of The Fed Funds Rate The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart 2Market Prices Are A Poor Predictor Of Inflation The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing In other words, it’s more advisable to view the expectations priced into bond markets as a breakeven threshold for trading, not as a tool for forecasting. Stating The TIPS Golden Rule To apply the TIPS Golden Rule, investors should follow these three steps: Calculate market-implied expectations for what headline CPI inflation will be over the next 12 months. This can be done by looking at the 1-year CPI swap rate or the 1-year TIPS breakeven inflation rate.2 Develop an independent forecast for 12-month headline CPI inflation. We demonstrate one method for doing this later in the report.3 Compare your own headline CPI forecast with the forecast that is priced in the market. If your own forecast is higher, then you should go long TIPS/short nominal Treasuries. If your own forecast is lower, then you should go short TIPS/long nominal Treasuries. Testing The TIPS Golden Rule Chart 3 shows the historical track record of the TIPS Golden Rule going back to 2005.4 The top panel shows 12-month excess returns from the Bloomberg Barclays TIPS index relative to a duration-matched position in nominal Treasuries. The bottom panel shows whether inflation surprised market expectations to the upside or to the downside during the investment horizon. We can see that, visually, it looks as though TIPS tend to outperform nominal Treasuries when there is an inflationary surprise and underperform when there is a deflationary surprise. Chart 3The TIPS Golden Rule's Track Record The TIPS Golden Rule's Track Record The TIPS Golden Rule's Track Record Chart 4 shows the same relationship in a little more detail. The 12-month inflation surprise is placed on the x-axis and 12-month TIPS excess returns are on the y-axis. For the TIPS Golden Rule to be useful, we would need to see most of the datapoints in the top-right and bottom-left quadrants of the chart, and indeed this is the case. Chart 412-Month TIPS Excess Returns Vs. Inflation Surprises The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Finally, Table 1 shows the relationship in even more detail. It shows that inflationary surprises coincide with positive TIPS excess returns 73% of the time for an average excess return of 2.6%. It also shows that deflationary surprises coincide with negative TIPS excess returns 80% of the time, for an average excess return of -3.2%. Table 112-Month TIPS Excess Returns* And Inflation Surprises (2005 – Present) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Please note that all the above return calculations are performed on the overall Bloomberg Barclays TIPS Index relative to a duration-matched position in nominal Treasuries. However, the TIPS Golden Rule also performs well when applied to TIPS of any maturity. The Appendix of this report replicates the above analysis for every point along the TIPS curve and shows that the results are consistently excellent. Applying The TIPS Golden Rule Now that we have stated the TIPS Golden Rule and demonstrated its effectiveness as an investment strategy, it is time to apply it to the current market. To do that, we first determine 1-year market-implied inflation expectations by looking at the 1-year CPI swap rate. As of last Friday’s close, the 1-year CPI swap rate is 3.16%. This means that if we think headline CPI inflation will be above 3.16% during the next 12 months, then we should go long TIPS versus duration-matched nominal Treasuries. If we think headline CPI inflation will come in below 3.16% during the next 12 months, then we should go short TIPS versus duration-matched nominal Treasuries. Next, we must build up our own forecast of headline CPI inflation for the next 12 months. To do this, we follow a bottom-up approach where we split the CPI basket into five components (energy, food, shelter, core goods, and core services ex. shelter) and model each one individually. Energy Inflation (9% Of Headline CPI) Chart 5Modeling Energy Inflation Modeling Energy Inflation Modeling Energy Inflation Energy accounts for roughly 9% of headline CPI, though its often violent price swings mean that this component usually accounts for a much larger percentage of the volatility in headline CPI. In practice, we can accurately model Energy CPI using the prices of retail gasoline, natural gas, and heating oil (Chart 5). To get a 12-month forecast for Energy CPI we therefore need forecasts for the prices of retail gasoline, natural gas, and heating oil. In this analysis, we will consider two possible scenarios for energy prices. First, a benign ‘low oil price’ scenario where we assume that the prices of retail gasoline, natural gas and heating oil follow the paths discounted in their respective futures curves. Second, we consider a ‘high oil price’ scenario that incorporates the view of our Commodity & Energy Strategy service that a drop in Russian oil supply, among other factors, will cause the Brent crude oil price to reach $119 per barrel by the end of this year and average $117 per barrel in 2023.5 To incorporate this outlook into our model, we regress the prices of retail gasoline, natural gas and heating oil on the Brent crude oil price and extrapolate forward using our commodity strategists’ forecasts. The ‘low oil price’ scenario has Energy CPI inflation falling from its current 32.9% level all the way down to -9.9% during the next 12 months. In contrast, our ‘high oil price’ scenario has it falling to just 15.8%. Food Inflation (13% Of Headline CPI) Chart 6Modeling Food Inflation Modeling Food Inflation Modeling Food Inflation Our Food CPI model is based on the cost of fertilizer, agricultural commodity prices and diesel prices. This model has done a reasonably good job explaining trends in Food CPI inflation over time, but the last few months have seen food inflation jump well above the levels suggested by our model (Chart 6). Given that the inputs to our Food CPI model are highly correlated with the oil price, we also apply the ‘low oil price’ and ‘high oil price’ scenarios discussed above to our Food CPI forecast. Using this method, the ‘low oil price’ scenario has Food CPI inflation falling to 3.8% during the next 12 months and the ‘high oil price’ scenario has it coming down to 4.2%. One key risk to these forecasts is that they both assume that the current gap between food inflation and our model’s fair value will close. It’s possible that other factors not included in our model could prevent the gap from closing. We therefore consider our Food CPI forecast to be quite optimistic. Core Goods Inflation (21% Of Headline CPI) Chart 7Modeling Goods Inflation Modeling Goods Inflation Modeling Goods Inflation Core goods inflation, currently running at 6.9%, appears to have already peaked following its post-pandemic surge. We model Core Goods CPI using the New York Fed’s Global Supply Chain Pressure Index, as it is the supply chain constraints that arose during the pandemic that explain the bulk of the movement in core goods prices since that time (Chart 7).6 To forecast Core Goods CPI, we assume that global supply chain constraints continue to ease and that the New York Fed’s index reverts to its pre-pandemic level during the next 12 months. This gives us a forecast for 12-month Core Goods CPI inflation of 0%. Shelter Inflation (32% Of Headline CPI) Chart 8Modeling Shelter Inflation Modeling Shelter Inflation Modeling Shelter Inflation We model shelter inflation, currently running at 5.6%, using the unemployment rate, rental vacancy rate and home prices (Chart 8). Except for the unemployment rate, all our model’s independent variables enter with a lag of at least 12 months. In other words, we wouldn’t expect any near-term change in home prices to impact Shelter CPI for at least a year. To forecast Shelter CPI, we assume that the unemployment rate rises to 4% during the next 12 months. This results in a shelter inflation forecast of 4.7% for the next 12 months. Much like with food inflation, we tend to view this forecast as relatively optimistic as it assumes a large reversion from the current rate of shelter inflation back to our model’s fair value. It’s conceivable that other factors not included in our model, such as rapid wage growth, could prevent this reversion from occurring. Services ex. Shelter Inflation (24% Of Headline CPI) Chart 9Modeling Services Inflation Modeling Services Inflation Modeling Services Inflation This final component of CPI is a bit of a hodgepodge of different service industries that may not have much in common. However, we find that wage growth does a good job of tracking its trends (Chart 9). We therefore model Services ex. Shelter CPI using the Employment Cost Index, which enters our model with a 10 month lag. To forecast Services ex. Shelter CPI, we assume that the Employment Cost Index holds steady at its current growth rate. This gives us a Services ex. Shelter CPI inflation forecast of 5.5% for the next 12 months. Combining Our Bottom-Up Inflation Forecasts & Investment Conclusions Combining our bottom-up forecasts, we calculate a 12-month headline CPI inflation rate of 2.4% for the ‘low oil price’ scenario and a rate of 4.8% for the ‘high oil price’ scenario. For core CPI inflation, we calculate a 12-month forecast of 3.6%. Given the optimistic assumptions that we incorporated into our forecasts, particularly the large reversions of food and shelter inflation back to our estimated fair value levels, we view the risks to our forecasts as heavily tilted to the upside. We also acknowledge that the re-normalization of global supply chains may not proceed as smoothly as the scenario that is baked into our forecasts. Any hiccup in that process would cause our goods inflation forecast to be too low. Chart 10Inflation Forecasts Inflation Forecasts Inflation Forecasts Chart 10 shows our 12-month headline and core CPI forecasts alongside the market-implied forecast from the CPI swap curve, currently 3.16%. Notice that the market-implied inflation forecast is much closer to the bottom-end of our range of headline CPI estimates, and we have already acknowledged that a lot of things will have to go right for our estimates to pan out. In other words, we see a high likelihood that 12-month headline CPI will be above 3.16% for the next 12 months which, according to our TIPS Golden Rule, tells us that we should go long TIPS versus duration-matched nominal Treasuries. While we acknowledge that there is likely some value in going long TIPS versus nominal Treasuries today, we are inclined to maintain our recommended neutral allocation to TIPS versus nominals for now. Given the recent drop in oil prices, we anticipate further weakness in headline inflation during the next couple of months. This could push TIPS breakeven inflation rates even lower in the near term, creating even more value. The bottom line is that we see attractive value in TIPS versus nominal Treasuries on a 12-month investment horizon. While we maintain a neutral allocation to TIPS for now, we anticipate turning more bullish in the near future, hopefully from a better entry point after one or two more weak CPI prints. Appendix Chart A112-Month TIPS Excess Returns Vs. Inflation Surprises (1-3 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A112-Month TIPS Excess Returns* And Inflation Surprises (1-3 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A212-Month TIPS Excess Returns Vs. Inflation Surprises (3-5 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A212-Month TIPS Excess Returns* And Inflation Surprises (3-5 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A312-Month TIPS Excess Returns Vs. Inflation Surprises (5-7 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A312-Month TIPS Excess Returns* And Inflation Surprises (5-7 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A412-Month TIPS Excess Returns Vs. Inflation Surprises (7-10 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A412-Month TIPS Excess Returns* And Inflation Surprises (7-10 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A512-Month TIPS Excess Returns Vs. Inflation Surprises (10-15 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A512-Month TIPS Excess Returns* And Inflation Surprises (10-15 Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Chart A612-Month TIPS Excess Returns Vs. Inflation Surprises (15+ Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Table A612-Month TIPS Excess Returns* And Inflation Surprises (15+ Year Maturities) The Golden Rule Of TIPS Investing The Golden Rule Of TIPS Investing Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Timper Research Analyst robert.timper@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. 2 In this report we use the 1-year CPI swap rate because it is easier to access. 3 To make the TIPS Golden Rule easy to implement, we use seasonally adjusted headline CPI for all our calculations even though TIPS are technically linked to the non-seasonally adjusted index. We also ignore the fact that TIPS coupons adjust to CPI releases with a lag. Our analysis shows that the rule works very well even without incorporating these complications. 4 CPI swap rates are only available from 2004 onwards, so this is the largest historical sample we can use. 5 Please see Commodity & Energy Strategy Weekly Report, “EU Russian Oil Embargoes, Higher Prices”, dated August 18, 2022. 6 For more details on the Global Supply Chain Pressure Index: https://www.newyorkfed.org/research/policy/gscpi#/overview Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary The Fed Versus The Market The Fed Versus The Market The Fed Versus The Market In today’s report, we summarize the arguments of bulls and bears to examine the possible longevity of the rally. The Bulls’ view is centered around several key themes:  Inflation has turned.  The Fed is less hawkish than initially assumed, and Jay Powell is not Paul Volcker.  The economy is resilient, and consumers are spending.  Corporate earnings will surprise on the upside thanks to consumer strength. Meanwhile, the bears argue that:  Growth is slowing and a soft landing is elusive, which will lead to earnings disappointment.  Valuations and Technicals are no longer attractive – the best part of the rally is likely over, and risk-reward is skewed to the downside.  Inflation is embedded and broad-based and it will take many months to reach the level that is palatable to the Fed. Bottom Line: The rally was expected, but its force and durability took us by surprise. Now, after a strong rebound, risks are skewed to the downside and the markets are fragile, but the rally may continue.  We offer our take on what can bring this rally to a halt, and the “danger” signs investors need to be on the lookout for. Feature The fast and furious rally off the June 16 lows has taken many investors by surprise. Over the past two months, the S&P 500 has rebounded by 17%, the NASDAQ is up 22%, while Growth has outperformed Value by 9%. Thematic small-cap growth ETFs have fared even better (Chart 1) with Cathie Wood’s ARKG and ARKK up nearly 50%. The Technology and Consumer Discretionary sectors are up 23% and 28% respectively, while Energy and Materials are relatively flat, showcasing a rotation away from the inflation winners to losers. In this week’s report, we will “dissect” the rally and its key drivers to better understand what can bring this rally to a halt. We will also summarize the arguments of the bulls and present our “bearish” rebuttal to some of the assumptions. Sneak Preview: After the powerful rebound, the market is fragile, and risks are skewed to the downside. By summarizing the arguments of bulls and bears, we are offering our take on what can bring this rally to a halt, i.e., hawkish Fed speeches, disappointing inflation readings, rising rates, and bad earnings. However, a positive surprise along each of these dimensions may also result in the next leg up. Chart 1ETF Universe Overview What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? Anatomy Of The Rally To understand what fuels the rally, we need to understand what its key catalysts are. Oversold: First and foremost, in mid-June, US equities were severely oversold – the BCA Capitulation Indicator hit levels last seen in the spring of 2020 (Chart 2). The BoA institutional survey has also reported an extreme level of bearishness. Pull back in the price of energy: This created fertile ground for a rebound, but the catalyst came from the turn in commodities and energy prices. Extreme pessimism about global growth after the Fed’s aggressive response to a disappointing inflation print has triggered a sell-off in oil and metals. Since mid-June, the GSCI Commodities and the GSCI Energy index are in a bear market downtrend, 21% and 25% off their peaks. Inflation moderating: This disinflationary development has unleashed a positive reinforcement loop: Lower energy prices led to a turn in the CPI print. And many still believe that, after all, inflation is transitory: With supply disruptions clearing and prices of energy and commodities turning, inflation will dissipate just as fast as it arrived. We know this because inflation breakevens are currently at levels last seen a year ago (Chart 3). Chart 2Capitulated Capitulated Capitulated Chart 3Cooling Off : Back To 2021 Cooling Off : Back to 2021 Cooling Off : Back to 2021 Gentler Fed: That is when the market decided that easing price pressures in concert with slowing growth would compel the Fed to pursue a shallower and shorter path of interest rate increases than initially expected – rate increases derived from OIS started to undershoot the “dot plot” (Chart 4). Effectively, the bond market started to forecast that the Fed will end the year at 3.5% and ease as soon as early 2023. In other words, the Fed is nearing the end of the hiking cycle. Naturally, the long end of the Treasury curve has pulled back to April levels, despite a much higher Fed rate. One way or another, yields have stabilized. Lower rates are a boon for equities: As a long-duration asset, equity valuations are inversely correlated with long yields (Chart 5). A better-than-expected Q2 earnings season was the icing on the cake. Chart 4The Market Expects Cuts As Soon As Early 2023 The Market Expects Cuts As Soon As Early 2023 The Market Expects Cuts As Soon As Early 2023 Chart 5Falling Yields Propelled Equities Higher Falling Yields Propelled Equities Higher Falling Yields Propelled Equities Higher Was The Rally Surprising? The rally itself did not surprise us – after all, we did expect the market to turn on a dime at the earliest whiff of falling inflation (Chart 6). Admittedly, we were taken aback by its strength and longevity. With inflation turning, we also expected a change in leadership from the Energy and Materials sectors to Technology and Consumer Discretionary (Chart 7). We also predicted back in January in our “Are We There Yet?!” report that, based on the previous hiking cycles, Tech would rebound roughly three months after the first rate hike (Chart 8), which was taking us to June. Chart 6When Inflation Turns, Equities Rebound What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? Chart 7Turn in Inflation Triggers A Change In Sector Leadership What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? Chart 8A Closer Look At Technology What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? In early July, we upgraded Growth to overweight as an asset that would benefit from an anticipated turn in CPI, rate stabilization, and slowing growth (Chart 9). We have also reaffirmed our overweight in Software and Services as a way to play Growth on a sector level. We have downgraded Energy to underweight to reduce exposure to Value. Chart 9Growth And Quality Lead Markets Higher When Inflation Abates What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? What The Bulls Think Let’s summarize what the bulls think are the catalysts for the next leg up: Inflation has turned. Looking for further signs that inflation is easing. The Fed is less hawkish than initially assumed, and Jay Powell is not Paul Volcker. Looking for signs that the Fed is getting closer to the end of the hiking cycle. So far, the economy is resilient, and consumers are spending – excess savings and excess demand for labor will soften the blow. Looking for signs that the recession can be avoided. Corporate earnings will surprise on the upside thanks to consumer strength. In the next section, I will juxtapose these optimistic expectations with those of a bear, i.e., of yours truly. A full disclosure – I am not a perma-bear but even eight weeks into the best recovery rally ever, I can’t shake off my pessimism. After all, I am used to the markets going up on injections of liquidity and expect them to shudder when liquidity is mopped out of the system. What The Bears Think, Or A Litany Of Worries Inflation is embedded and broad-based Broad-based: While headline inflation is turning, mostly thanks to prices of energy and materials, it will take a long time for core inflation to revert to the desired 2% as it is broad-based. This is evident from trimmed and median CPI metrics, which continue their ascent. Inflation has also spilled into sticky service items, such as rent (Chart 10). Wage-price spiral: Then there is that pesky wage-price spiral that is manifesting itself in soaring labor costs (Chart 11), which companies pass on to their customers. In the meantime, productivity is falling, and unit labor costs are increasing at 9.5% per year, a rate of growth last seen in 1980s (Chart 12). Demand for labor still exceeds supply with 1.8 job openings for every job seeker, and much more tightening is required to bring supply and demand into balance. Chart 10Entrenched? Entrenched? Entrenched? Chart 11Wage-price Spiral Wage-price Spiral Wage-price Spiral Chart 12ULC Soaring ULC Soaring ULC Soaring Wages and service inflation are more important to structural inflation than energy. Rent and its equivalents constitute 30% of the CPI basket, while wages are roughly 50% of corporate sales and by far the largest component of the cost structure. Inflation is embedded and broad-based and it will take many months to reach the level that is palatable to the Fed. What Does The Fed Think? Fed minutes: Fortunately, we don’t need to guess. The Fed minutes state that "participants agreed that there was little evidence to date that inflation pressures were subsiding" and that inflation “would likely stay uncomfortably high for some time.” Further, “though some inflation reduction might come through improving global supply chains or drops in the prices of fuel and other commodities … Participants emphasized that a slowing in aggregate demand would play an important role in reducing inflation pressures," the minutes said. The Fed minutes state that in moving expeditiously to neutral and then into restrictive territory, “the Committee was acting with resolve to lower inflation to 2% and anchor inflation expectations at levels consistent with that longer-run goal.” In its previous communications, the Fed emphasized that its commitment to a 2% target is unconditional. Is powell more like burns or volcker? In addition, there is an ongoing debate between bulls and bears on the character of the Fed – is Jay Powell a strong-willed hawk like Paul Volker, or more of a waverer like Arthur Burns, who presided over the relentless march of inflation in the seventies? We think that the Chairman can channel Paul Volcker. After all, the Fed has surprised investors by acting swiftly and decisively. Back in March, the Fed dot plot indicated that by the end of the year, the target rate will reach a mere 1.75%. However, we hit a 2.25%-2.50% rate range as soon as July. Jay Powell is concerned about his legacy: He would not want to be remembered as a Chair who mishandled inflation by keeping rates too low despite historically low unemployment and resilient consumers whose accounts are padded with excess post-pandemic savings. The Fed is more hawkish than what the majority of market participants, unscathed by the inflation of the seventies and eighties, believe. The Fed dot plot, to which the Chairman referred on multiple occasions, projects a Fed funds rate of 4% at year-end and of 4.5-5.0% next year (Chart 13). Meanwhile, Fed funds futures are only pricing a rate of about 3.4% for December 2022, even after the hawkish talk from both ex-dove Kashkari and a hawk Bullard (3.75%-4.0% by year-end and 4.4% by the end of 2023). Further, the Fed itself states in its minutes that rates would have to reach a "sufficiently restrictive level" and remain there for "some time" to control inflation that was proving far more persistent than anticipated. The Chicago Fed President Charles Evans has also affirmed that the Fed is definitely not cutting rates in March 2023. Chart 13The Fed Versus The Market The Fed Versus The Market The Fed Versus The Market Doves latch on to comments from the meeting that the Fed will be data-driven, and that it is concerned about overtightening. To us, these are just the musings of the “responsible grown-ups.” Quantitative Tightening: Now let’s not forget another leg of the stool – Quantitative Tightening. QT has been very tame so far and, since the program commenced, the size of the Fed’s balance sheet, $8.9 trillion, has barely budged. In September, the Fed is scheduled to step up QT to a maximum pace of $95 billion from $47.5 billion— running off up to $60 billion in Treasuries, and $35 billion of mortgage securities. Shortages of securities available for run-off due to a dearth of refinancing may trigger a shift to outright selling, further tightening financial conditions. Equities are at odds with the Fed: Last, but not least, equity markets are on a collision course with the Fed. Since June, financial conditions have eased as opposed to tightened, making the Fed’s job so much harder (Chart 14). Chart 14The Rally Eased Financial Conditions The Rally Eased Financial Conditions The Rally Eased Financial Conditions The Fed may prove to be more hawkish than in the past as it is on a quest to combat inflation and takes its mission very seriously. “Don’t fight the Fed” the adage holds. Economic Growth Is Slowing The BCA Business Cycle Indicator signals that economic growth is slowing (Chart 15), which is also evident from a host of economic data releases, ranging from GDP growth to business surveys to housing data. One of the few data series that has defied gravity so far is the jobs report, but the job creation rate is a coincidental indicator at best, and a lagging one at worst. Jobs are usually lost after the start of a recession (Chart 16). Chart 15Economy Is Slowing Economy Is Slowing Economy Is Slowing Chart 16Unemployment Never "Just Ticks Up" Unemployment Never "Just Ticks Up" Unemployment Never "Just Ticks Up" Can consumers save the day? After all, $2.2 trillion in excess savings should help to handle the pressures of negative real wage growth and income growth that is below trend. Yes and no. Gasoline savings can certainly support increases in discretionary spending, all else equal. As for excess savings – adding this money back into the economy may ignite another bout of inflation, working against the Fed, and triggering more rate increases. Many clients ask us if we anticipate a recession. Broadly speaking we do, as the Fed has an arduous task ahead of it in balancing the supply and demand of labor. However, we do not expect a recession in 2022 or even early 2023. Can the Fed succeed by only reducing excess job openings from 1.8 to 1, thus avoiding a rise in unemployment? This is possible, but the probability of such an outcome is low as unemployment never “just ticks up” (Chart 16). However, what the market is pricing is also important. At the moment, the rally shows that it considers the current growth slowdown just a growth scare to be shrugged off. Will there be more disappointments? We think so, as the US economy is facing multiple headwinds from slowing demand for exports due to geopolitical turbulence and payback of overstimulated consumer demand at home. And it is not a recession per se, but a growth disappointment, that may take equities on the next leg down. Growth is slowing and a soft landing is illusive. Earnings Growth Will Continue Its March Towards Zero We believe that earnings growth will continue to slow into year-end – flagging consumer demand at home and abroad, a strong dollar, and soaring unit labor costs that can no longer be fully passed on to stretched consumers, as corporate pricing power is decelerating. Even in Q2-2022, ex-Energy EPS growth is already negative at -1.5%, with Consumer Discretionary, Financials, Communications, and Utilities reporting an earnings contraction. As we predicted back in October, the S&P 500 margins are also compressing, currently at 50bps off their peak, with consensus expecting them to lose another two points within the next 12 months as companies are grappling with rising costs (Chart 17). Analysts are finally in a downgrading mode (Chart 18), with growth over the next 12 months now expected to be 7.7% compared to 10% earlier this summer. Analyst downgrades will continue, and an earnings recession is highly probable as early as Q4-2022. Chart 17Profitability Is Under Pressure Profitability Is Under Pressure Profitability Is Under Pressure Chart 18Earnings Are Finally Being Downgraded Earnings Are Finally Being Downgraded Earnings Are Finally Being Downgraded In terms of the durability of the rally – earnings growth disappointment will be enough to cause equities to pull back. Earnings growth is slowing and more disappointments may be in store. Valuations And Technicals The S&P 500 is currently trading at 18x forward earnings, which is nearly a two-point rebound off the market trough of 15.8x. This is roughly where PE NTM was in April when the 10-year yield stood at 2.80%. Therefore, the multiple reverted on the back of falling rates, and the market is fairly valued considering where rates are now. And another factor to consider: Analysts are slashing earnings expectations, and with E in a P/E likely to be downgraded further – the “true” forward multiple is likely higher than it appears. The BCA Valuation Indicator is also flashing “overvalued” (Chart 19). From the equity risk premium standpoint, 3% is low by historical standards (Chart 20). And if we consider Shiller PE, it has come down from an eye-watering 38x to a still elevated 29x. Chart 19Pricey Again? Pricey Again? Pricey Again? Chart 20Equities Are No Longer Cheap By ERP Or Shiller PE Metrics Equities Are No Longer Cheap By ERP Or Shiller PE Metrics Equities Are No Longer Cheap By ERP Or Shiller PE Metrics Therefore, it is hard to call equities cheap at this point. But being generous, we will call them “fairly priced.” Regardless – at these levels of valuations, the best part of the rally is likely over, and risk-reward is no longer favorable. From a technical standpoint, this rally is broad-based with nearly 90% of the S&P 500 industries trading above their 50-day moving average (Chart 21). But according to the BCA Technical Indicator, equities are no longer oversold and have just crossed into neutral territory (Chart 22). Interestingly, once the Technical indicator starts to rise, it usually ascends for a while, making us wary to boldly call an immediate end to this rally. Chart 21Thrusting Thrusting Thrusting Chart 22No Longer Oversold? No Longer Oversold? No Longer Oversold? Valuations and Technicals are no longer attractive – the best part of the rally is likely over and risk-reward is skewed to the downside. Investment Implications Or Can This Rally Continue? Timing the market is hard at best, impossible at worst. After a 17% rise from the bottom, the S&P 500 is no longer cheap or oversold. Buying equities for valuations or technical reasons is too late – risks are skewed to the downside. Our working assumption is that the rally will pause waiting for the new data that will trigger a new leg up or down. Further, as we pointed out in the Fat and Flat report, the current period is reminiscent of the 1980-1982 Volcker era. So far, the market is following this pattern to a T (Chart 23). The problem is that each leg of the up-and-down market may take months. As such, being (eventually) right and principled does not pay off. After all, the economy is not a market. Therefore, until one of the following happens, the music will continue and the markets can keep dancing, which may be for a while. Chart 23Volcker Era Redux Volcker Era Redux Volcker Era Redux The rally will continue until: There is a communication from the Fed re-emphasizing its hawkish stance and determination to get inflation back to 2%. It may be as one of the FOMC member’s speeches broadcast at Jackson Hole. Long-term Treasury yields pick up either because of the Fed’s actions or speeches or because the economy is overheating. Negative inflation surprise – it may come as either a higher-than-expected inflation reading or evidence that inflation is entrenched, such as rising service or rent inflation, soaring wages, a pick-up in the price of oil or commodities, or a growth surprise out of China, to name but a few. Negative earnings surprise – guidance from a number of companies indicating that economic growth is slowing, and earnings will disappoint. A negative economic surprise may be perceived by the market as “bad news is good news.” We recommend the following: Maintain a well-diversified portfolio, with sufficient allocation to both cyclicals and defensives. Increase exposure to Growth sectors, such as Technology. We particularly favor Software and Services as it leverages the pervasive theme of digitization and migration to the cloud. Reduce allocation to Energy and Materials – these sectors tend to underperform when inflation turns. They are also quintessential value sectors. Maintain some allocation to cyclicals – we are overweight the Industrial sector as it leverages a long-term theme of onshoring and automation. We may be upgrading the Consumer Discretionary sector in the near future. We are also overweight Banks and Insurance for portfolio diversification – these sectors benefit from rising rates and positive growth surprise. Markets turn on a dime and it is good to be prepared. Allocate capital to long-term investment themes: Green and Clean and EV, benefiting from the funds allocated by the IRA bill, Cyber Security, and Defense. Bottom Line: The rally was expected, but its force and durability took us by surprise. Now, after a strong rebound, risks are skewed to the downside and the markets are fragile, but the rally may still continue. We offer our take on what can bring this rally to a halt, and the “danger” signs investors need to be on the lookout for. In the meantime, overweight Growth and maintain a well-diversified portfolio.     Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation   Recommended Allocation: Addendum What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up  

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (August 16 at 10:00 AM EDT, 15:00 PM BST, 16:00 PM CEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist Treasury Index Returns Spread Product Returns

Listen to a short summary of this report.     Executive Summary The odds of a recession in the US are lower than widely perceived. The probability of a recession is higher in Europe, although this week’s partial resumption of gas flows through the Nord Stream 1 pipeline, along with increased use of coal-fired power plants, should soften the blow. Chinese growth should rebound in the second half of the year. However, the specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening property sector will continue to weigh on activity. With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus. Fading recession risks will buoy stocks in the near term. However, a brighter economic outlook also means that the Fed, and several other central banks, may see little need to cut policy rates in 2023, as the markets are currently discounting. The end result is that government bond yields will rise from current levels, implying that stock valuations will not return to last year’s levels even if a recession is averted. After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year The Downside Of A Soft Landing The Downside Of A Soft Landing Bottom Line: We recommend a modest overweight on global equities for now but would turn neutral if the S&P 500 were to rise above 4,050.   Dear Client, I am delighted to announce that Ritika Mankar, CFA, has joined the Global Investment Strategy team. Ritika will be writing occasional special reports on a variety of topical issues. Next week, she will make the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade. Best regards, Peter Berezin, Chief Global Strategist The Case for a Soft Landing in the US Chart 1Cyclicals Underperformed Defensives As Recession Risks Intensified Cyclicals Underperformed Defensives As Recession Risks Intensified Cyclicals Underperformed Defensives As Recession Risks Intensified Over the last few months, investors have become concerned that the Fed and many other central banks will need to engineer a recession in order to bring inflation down to more comfortable levels. While these fears have abated over the past trading week, they still continue to dominate market action (Chart 1). We place the odds of a US recession at about 40%. This is arguably more optimistic than the consensus view. According to Bank of America, the majority of fund managers saw recession as likely in this month’s survey. Not surprisingly, investors consider recession to be a major risk for equities over the next 12 months (Chart 2). Chart 2Many Investors Now See Recession As Baked In The Cake The Downside Of A Soft Landing The Downside Of A Soft Landing Even if a recession does occur, we have contended that it will likely be a mild one, perhaps so mild that it will be difficult to distinguish it from a soft landing. A number of things make a soft landing in the US more probable than in the past: Labor supply has scope to increase. The labor participation rate is still 1.2 percentage points below its pre-pandemic level, two-thirds of which is due to decreased participation among workers under the age of 55 (Chart 3). The share of workers holding multiple jobs is also below its pre-pandemic level (Chart 4). The number of multiple job holders has been rising briskly lately. That is one reason why job growth in the payroll survey – which double counts workers if they hold more than one job – has been stronger than job growth in the household survey. Increased labor supply would obviate the need for the Fed to take drastic actions to curtail labor demand in its effort to restore balance to the labor market. Chart 3Labor Supply Has Scope To Rise Labor Supply Has Scope To Rise Labor Supply Has Scope To Rise Chart 4The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels A high level of job openings creates a moat around the labor market. There are almost two times as many job openings as there are unemployed workers in the US (Chart 5). Many firms are likely to pull job openings before they cut jobs in response to a slowing economy. A high level of job openings will also allow workers who lose their jobs to find employment more quickly than usual, thus limiting the rise in so-called frictional unemployment. It is worth noting that the job openings rate has declined from a record 7.3% in March to a still-high 6.9% in May, with no change in the unemployment rate over this period. Chart 5A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A steep Phillips curve implies that only a modest increase in unemployment may be necessary to knock down inflation towards the Fed’s target. Just as was the case in the 1960s, the Phillips curve has proven to be kinked near full employment (Chart 6). Unlike in the late 1960s, however, when rising realized inflation caused long-term inflation expectations to reset higher, expectations have remained well anchored this time around (Chart 7). Chart 6The Phillips Curve Is Kinked At Very Low Levels Of Unemployment The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 7Long-Term Inflation Expectations Are Well Anchored Long-Term Inflation Expectations Are Well Anchored Long-Term Inflation Expectations Are Well Anchored   The unwinding of pandemic and war-related dislocations should push down inflation. A recent study by the San Francisco Fed estimates that about half of May’s PCE inflation print was the result of supply-side disturbances (Chart 8). While the ongoing war in Ukraine and the threat of another Covid wave in China will continue to unsettle global supply chains, these problems should fade over time. Falling inflation would allow real wages to start rising again. This would bolster confidence, making a soft landing more likely (Chart 9). Chart 8Supply Factors Explain Half Of The Increase In Prices Over The Past Year The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 9Positive Real Wage Growth Will Bolster Consumer Confidence Positive Real Wage Growth Will Bolster Consumer Confidence Positive Real Wage Growth Will Bolster Consumer Confidence A lack of major financial imbalances makes the US economy more resilient to economic shocks. As a share of disposable income, US household debt is 34 percentage points below its 2008 peak (Chart 10). Relative to net worth, household debt is at multi-decade lows. About two-thirds of mortgages carry a FICO score above 760 compared to only one-third during the housing bubble (Chart 11). Non-mortgage consumer credit also remains in good shape, as my colleague Doug Peta elaborated in this week’s US Investment Strategy report. While corporate debt has risen over the past decade, the ratio of corporate debt-to-assets today is still below where it was during the 1990s. Moreover, thanks to stronger corporate profitability, the interest coverage ratio is near an all-time high (Chart 12).   Chart 10AUS Household Debt Is Not Especially High Anymore (I) US Household Debt Is Not Especially High Anymore (I) US Household Debt Is Not Especially High Anymore (I) Chart 10BUS Household Debt Is Not Especially High Anymore (II) US Household Debt Is Not Especially High Anymore (II) US Household Debt Is Not Especially High Anymore (II) Chart 11FICO Scores For Residential Mortgages Have Improved Considerably Since The Pre-GFC Housing Bubble The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 12Corporate Balance Sheets Are In Decent Shape Corporate Balance Sheets Are In Decent Shape Corporate Balance Sheets Are In Decent Shape Chart 13Tight Supply Limits The Downside Risks To Housing Tight Supply Limits The Downside Risks To Housing Tight Supply Limits The Downside Risks To Housing Just like the US does not suffer from major financial imbalances, it does not suffer from any major economic imbalances either. The homeowner vacancy rate is near a record low, which should put a floor under residential investment (Chart 13). Outside of investment in intellectual property, which is not especially sensitive to the business cycle, nonresidential investment is still below pre-pandemic levels and not much above where it was as a share of GDP during the Great Recession (Chart 14). Spending on consumer durable goods has retraced four-fifths of its pandemic surge, with little ill-effect on aggregate employment (Chart 15). Chart 14Outside Of IP, Nonresidential Investment Is Still Low Outside Of IP, Nonresidential Investment Is Still Low Outside Of IP, Nonresidential Investment Is Still Low Chart 15Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Europe: A Deep Freeze Will Likely Be Avoided Chart 16Russia Can Potentially Cause Significant Economic Damage In The EU If It Closes The Taps The Downside Of A Soft Landing The Downside Of A Soft Landing The macroeconomic picture is less benign outside the US. Four years ago, German diplomats laughed off warnings that their country had become dangerously dependent on Russian energy. They are not laughing anymore. German industry, just like industry across much of Europe, is facing a major energy crunch. The IMF estimates that output losses associated with a full Russian gas shutoff over the next 12 months could amount to as much as 2.7% of GDP in the EU (Chart 16). In Central and Eastern Europe, output could shrink by 6%. Among the major economies, Germany and Italy are the most at risk. Fortunately, Europe is finally stepping up to the challenge. The highly ambitious REPowerEU plan seeks to displace two-thirds of Russian gas by the end of 2022. The plan does not include any additional energy that could be generated by increased usage of coal-fired power plants, a strategy that the European political establishment (including the German Green Party!) has only recently begun to champion. It is possible that EU leaders felt the need to generate a crisis mentality to justify the decision to burn more coal. Dire warnings about how Europe is prepared to ration gas also send a message to Russia that the EU is ready to suffer in order to thwart Putin’s despotic regime. Whether Europe actually follows through is a different story. It is worth noting that the Nord Stream 1 pipeline resumed operations this week after Germany received, over Ukrainian objections, a repaired turbine from Canada. The resumption of partial flows through the pipeline, along with increased fiscal support for households and firms, reduces the risks of a “deep freeze” recession in Europe. The unveiling of the ECB’s new Transmission Protection Instrument (TPI) this week should also help anchor sovereign credit spreads across the euro area. While the exact conditions under which the TPI will be engaged have yet to be fleshed out, we expect the terms to be fairly liberal, reflecting not only the lessons learned from last decade’s euro debt crisis, but also to serve as a powerful bulwark against Putin’s efforts to destabilize the EU economy. China: Government’s Growth Target Looks Increasingly Unrealistic Stronger growth in China would help European exporters (Chart 17). Chinese real GDP grew by just 0.4% in the second quarter from a year earlier as the economy was battered by Covid lockdowns. Activity should pick up in the second half of the year, but at this point, the government’s 5.5% growth target looks completely unachievable. The specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening Chinese property sector are all weighing on the economy (Chart 18). Chart 17European Exporters Would Welcome A Stronger Chinese Economy European Exporters Would Welcome A Stronger Chinese Economy European Exporters Would Welcome A Stronger Chinese Economy The authorities will likely seek to stimulate the economy by allowing local governments to bring forward $220 billion in bond issuance that had been originally slated for 2023. The problem is that land sales – the main source of local government revenue – have collapsed. Worried about the ability of local governments to service their obligations, both retail investors and banks have shied away from buying local government debt. Chart 18A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy Meanwhile, the inability of property developers to secure adequate financing to complete construction projects has left a growing number of home buyers in the lurch. In most cases, these properties were purchased off-the-plan. Understandably, home buyers have balked at the prospect of having to make mortgage payments on properties that they do not possess.  With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus, including increased assistance for property developers and banks, as well as income-support measures for households. While such measures will not address China’s myriad structural problems, they will help keep the economy afloat. Equity Valuations in a Soft-Landing Scenario A few weeks ago, the consensus view was that stocks would tumble in the second half of the year as the global economy fell into recession but would then rally in 2023 as central banks began lowering rates. We argued the opposite, namely that stocks would likely rebound in the second half of the year as the economy outperformed expectations but would then face renewed pressure in 2023 as it became clear that the Fed and several other central banks had no reason to cut rates (Chart 19). Chart 19After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 20Real Rates Have Jumped This Year Real Rates Have Jumped This Year Real Rates Have Jumped This Year In a baseline scenario where a recession is averted, we argued that the S&P 500 could rise to 4,500 (60% odds). In contrast, we noted that the S&P 500 could fall to 3,500 in a mild recession scenario (30% odds) and to 2,900 in a deep recession scenario (10% odds). It is worth stressing that even at 4,500, the S&P 500 would still be 11% lower in real terms than it was on January 4th. At the stock market’s peak in January, the 10-year TIPS yield stood at -0.91%, while the 30-year TIPS yield stood at -0.27%. Today, they stand at 0.58% and 0.93%, respectively (Chart 20). If real rates do not return to their prior lows, it is unlikely that equity valuations will return to their prior highs. This limits the upside for stocks, even in a soft-landing scenario. The sharp rally in stocks over the past week has priced out some of this recession risk, moving equity valuations closer towards what we regard as fair value. As we noted last week, we will turn neutral on equities if the S&P 500 were to rise above 4,050. As we go to press, we are only 1.3% from that level.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on         LinkedIn & Twitter Global Investment Strategy View Matrix The Downside Of A Soft Landing The Downside Of A Soft Landing Special Trade Recommendations Current MacroQuant Model Scores The Downside Of A Soft Landing The Downside Of A Soft Landing    

Executive Summary Bond investors can’t seem to decide whether the US economy is in the midst of an inflationary boom or hurtling toward recession. Our sense is that, while US economic growth is clearly slowing, we don’t see the unemployment rate rising enough for the Fed to abandon its tightening cycle any time soon. The 5-year US Treasury yield has tightened relative to the rest of the curve in recent weeks, and the 2-year maturity now looks like the most attractive spot for investors. TIPS breakeven inflation rates have also declined markedly in recent weeks, and TIPS no longer look expensive on our models. TIPS Are No Longer Expensive TIPS Are No Longer Expensive TIPS Are No Longer Expensive Bottom Line: US bond investors should keep portfolio duration close to benchmark. They should also shift Treasury curve allocations from the 5-year maturity to the 2-year maturity and upgrade TIPS from underweight to neutral. Whipsaw Inflationary boom or recession? US bond investors can’t seem to decide and yields are swinging back and forth depending on the latest economic data. Just in the past month we’ve seen the 10-year US Treasury yield peak at 3.49%, fall to 2.82% and then finally move back above 3% following last week’s strong employment report. Not surprisingly, implied interest rate volatility is the highest it’s been since the Global Financial Crisis (Chart 1). Our sense is that, while US economic growth is clearly slowing, we don’t see the unemployment rate rising enough for the Fed to abandon its tightening cycle any time soon. This is especially true because the Fed will tolerate a significant rise in the unemployment rate as long as inflation stays above target.1 Turning to the evidence, decelerating US economic activity is apparent in the manufacturing and non-manufacturing PMIs, which are both falling rapidly from high levels (Chart 2). Though both indexes remain firmly above the 50 boom/bust line, trends in financial conditions suggest that they could dip below 50 within the next few months. Chart 1A Highly Volatile Rates Market A Highly Volatile Rates Market A Highly Volatile Rates Market Chart 2US Growth Is Slowing US Growth Is Slowing US Growth Is Slowing The employment components of both indexes are already in contractionary territory (Chart 2, bottom panel), but this is due to concerns about labor supply, not demand. For example, last week’s ISM non-manufacturing PMI release included three representative quotes from respondents about labor market conditions.2 All three quotes reference concerns about labor supply: Unable to fill positions with qualified applicants. Extremely hard to find truck drivers. Demand for talent is higher, but availability of candidates to fill open roles continues to keep employment levels from increasing. This doesn’t sound like an economy that is on the cusp of surging unemployment, and this is exactly what the Fed is counting on. The Fed’s hope is that slower demand will bring down the large number of job openings without leading to a significant increase in layoffs or a significant rise in the unemployment rate. In that regard, it is notable that job openings ticked down in May, both in absolute terms and relative to the number of unemployed. Meanwhile, the rates of hiring and layoffs held steady (Chart 3). Chart 3Some Hope For A Soft Landing Some Hope For A Soft Landing Some Hope For A Soft Landing Investment Implications Our investment strategy hinges on two key economic views related to the labor market and inflation. First, while a surge doesn’t seem imminent, slowing economic activity means that the unemployment rate is more likely to edge higher between now and the end of the year than it is to fall. Second, as we’ve written in previous reports, US inflation has a relatively easy path back to its underlying trend of approximately 4%.3 After that, it will be more difficult for policymakers to bring inflation from 4% back down to 2%, and we could see the Fed push rates above 4% next year to accomplish this task. Taken together, these two views suggest that growth will be slowing and inflation falling between now and the end of the year. This combination could easily push bond yields lower, especially if recession worries flare up again. High frequency bond yield indicators such as the CRB Raw Industrials / Gold ratio and the relative performance of cyclical versus defensive equities also suggest that bond yields have room to fall (Chart 4). That said, the market is currently priced for the fed funds rate to peak at 3.74% in May 2023 and to fall back to 3.19% by the end of 2023. We see strong odds that inflation will be sticky enough (and the labor market resilient enough) for the Fed to push rates above those levels next year. This leaves us with an ‘at benchmark’ stance on portfolio duration for the time being, with an inclination to turn more bearish on bonds later this year if our base case forecast pans out. More specifically, we would likely reduce portfolio duration if the 10-year Treasury yield falls back to 2.5% or if inflation reverts to its 4% underlying trend. Conversely, we will turn more bullish on bonds if we see signs in the labor market data that point to a Fed pause (or Fed rate cuts) being necessary. For now, growth in nonfarm employment and aggregate weekly payrolls (wages x hours x employment) suggest we aren’t close to this outcome (Chart 5). Chart 4High-Frequency Bond Yield Indicators High-Frequency Bond Yield Indicators High-Frequency Bond Yield Indicators Chart 5The US Labor Market Is Strong The US Labor Market Is Strong The US Labor Market Is Strong Sliding Down The Yield Curve Since early April we’ve been recommending that investors position long the 5-year Treasury note and short a duration-matched barbell consisting of the 2-year and 10-year notes to take advantage of a US yield curve that was quite steep out to the 5-year maturity point and quite flat beyond that. That trade is now played out. The 5 over 2/10 butterfly spread has tightened back to zero and the 2-year note is now the most attractively priced security on the US Treasury curve. Chart 6 shows that the spread between the 2-year note and a duration-matched barbell consisting of cash and the 5-year note offers an extraordinary yield advantage of 92 bps. What’s more, Table 1 shows that, with the exception of the unloved 20-year bond, the 2-year note offers the most attractive 12-month carry on the curve, largely a result of the 18 bps of rolldown attributable to the still-steep slope between the 1-year and 2-year maturity points. Chart 6Shift Into 2s Shift Into 2s Shift Into 2s Table 112-Month Carry Across The US Treasury Curve A Low Conviction US Bond Market A Low Conviction US Bond Market This large shift in relative pricing compels us to close our prior position (long 5-year bullet versus 2/10 barbell) and open a new position: long the 2-year note and short a duration-matched cash/5 barbell. This new position (long 2yr over cash/5) offers attractive 12-month carry, but given the current volatile interest rate environment, it should mainly be expected to profit in the event of a steepening of the 2/5 Treasury slope. With that in mind, it’s notable that the 2/5 slope recently inverted. Inversions of the 2/5 slope are historically rare. They tend to occur near the end of Fed tightening cycles and, with the exception of the early-1980s, they tend to not last that long (Chart 7). Chart 72/5 Inversions Are Rare And Fleeting 2/5 Inversions Are Rare And Fleeting 2/5 Inversions Are Rare And Fleeting Going forward, we see three plausible scenarios for the 2/5 slope during the next 6-12 months. First, the Fed achieves something close to the soft landing it is aiming for. Inflation starts to fall and the unemployment rate edges higher. However, unemployment never reaches levels that necessitate a complete reversal of Fed tightening. The 2/5 Treasury slope bear-steepens in this scenario as the market discounts that the Fed will have to push rates above 4% to hit its inflation target. Second, a deep recession and complete reversal of Fed tightening occur much more quickly than we anticipate. The 2/5 Treasury slope would bull-steepen in this scenario as the front-end of the curve is pulled down by the Fed’s pivot. Third, inflation shows no signs of reversing course. Long-dated inflation expectations jump and the Fed determines that it has no choice but to follow the example of Paul Volcker and tighten, even if the economy falls into a deep recession. As was the case in the early-1980s, the 2/5 Treasury slope could become deeply inverted in this scenario. Our sense is that the first two scenarios are much more likely than the third. We have written in prior reports about how the current spate of inflation is much different than what was seen in the early 1980s.4  This makes us willing to bet against a prolonged deep inversion of the 2/5 slope. Bottom Line: US Treasury curve investors should exit their positions long the 5-year bullet versus a duration-matched 2/10 barbell. They should initiate a position long the 2-year bullet versus a duration-matched cash/5 barbell. Upgrade US TIPS To Neutral Finally, we note that TIPS breakeven inflation rates have declined markedly during the past month. The 10-year TIPS breakeven inflation rate is currently 2.38%, near the lower-end of the Fed’s 2.3%-2.5% target range, and the 5-year/5-year forward TIPS breakeven inflation rate is a mere 2.12%, well below target (Chart 8). We also note that the 5-year/5-year forward TIPS breakeven inflation rate is back below survey estimates of what inflation will be 5-10 years in the future (Chart 8, bottom panel). Chart 8TIPS Breakevens TIPS Breakevens TIPS Breakevens We have been recommending an underweight position in TIPS versus nominal US Treasuries since early April, but the recent valuation shift means it’s time to add some exposure. Critically, our TIPS Breakeven Valuation Indicator has also increased to +0.6, moving into “TIPS cheap” territory (Chart 9). Historically, the 10-year TIPS breakeven inflation rate has averaged an increase of 28 bps in the 12 months following a reading between +0.5 and +1.0 from our Indicator (Table 2). Chart 9TIPS Are No Longer Expensive TIPS Are No Longer Expensive TIPS Are No Longer Expensive Table 2TIPS Breakeven Valuation Indicator Track Record A Low Conviction US Bond Market A Low Conviction US Bond Market The drop in TIPS breakeven inflation rates has been most prominent at the front-end of the curve. The 2-year TIPS breakeven inflation rate is down to 3.22% from a peak of 4.93%. The high correlation between short-maturity TIPS breakevens and realized CPI inflation means that short-dated breakevens can fall further as inflation continues to trend down, but already we see that 3.22% looks like a much more reasonable estimate of average inflation for the next two years than did the 4.93% peak. While we advise investors to upgrade TIPS from underweight to neutral relative to nominal US Treasuries, we continue to recommend an outright short position in 2-year TIPS. The 2-year TIPS yield has risen sharply since its 2021 low (Chart 10), but recent comments from Fed officials imply that the Fed would like to see positive real yields across the entire curve before it declares monetary policy sufficiently restrictive.5 This means that there is still some room for the 2-year TIPS yield to increase, from its current level of -0.10% back into positive territory. Such a move should also lead to more flattening of the 2/10 TIPS curve, and we continue to recommend holding that position as well (Chart 10, bottom panel). Chart 10Stay Short 2-Year TIPS Stay Short 2-Year TIPS Stay Short 2-Year TIPS Bottom Line: Investors should upgrade TIPS from underweight to neutral relative to nominal US Treasuries but maintain outright short positions in 2-year TIPS. 2/10 TIPS curve flatteners and 2/10 inflation curve steepeners also continue to make sense. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on how to think about the tradeoff between the Fed’s inflation and employment goals please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 2 https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/services/june/ 3 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “No End In Sight For Fed Tightening”, dated June 21, 2022. 4 Please see US Bond Strategy Weekly Report, “No Relief From High Inflation”, dated June 14, 2022. 5 Please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Listen to a short summary of this report.       Executive Summary A Tremendous Inflow Into US Government Bonds A Tremendous Inflow Into US Government Bonds A Tremendous Inflow Into US Government Bonds Multiple frameworks exist for managing currencies. These include forecasting growth differentials, watching central banks, gauging terms of trade and balance of payment dynamics or even assigning a probability to the occurrence of black swans. For us, the most useful tool has been to simply track portfolio flows. In today’s paradigm, portfolio flows into US equities are rapidly dwindling, while those flowing into fixed income have picked up meaningfully. Gauging what happens next will be critical for the dollar call (Feature chart). The Fed is being viewed as the most credible central bank to curb inflation. As a result, US rates have risen more than in other markets. This has also pushed valuation and sentiment of the dollar to very elevated levels. If inflation peaks and the world economy achieves a soft landing, downside in the dollar will be substantial. On sentiment, being a contrarian can make you a victim, but when the stars are aligned where valuation, sentiment and the appropriate macro analysis point towards a single direction, our framework proves extremely useful. In a nutshell, many currencies, especially the euro, are already pricing in a nasty recession into their respective economies. If a recession does occur, they could undershoot. If one does not, they are poised for a coiled spring rebound. Bottom Line: Tactical investors should be neutral to overweight the dollar in the near term, as the probability of a recession rises. Longer-term investors should be slowly accumulating assets in countries where fundamentals make sense, and their currencies are deeply undervalued. Feature The real neutral rate of interest in the US is difficult to estimate ex ante, but Chart 1 highlights that the real Fed Funds rate is well below many estimates of neutral. In a world where inflation has become a widespread problem, and a few economies (like the US) are overheating, markets have moved to test the credibility of their respective central banks. The consensus has been that the Federal Reserve will be the most credible in taming runaway inflation by being able to raise rates faster than other central banks (Chart 2). This is especially the case as many European economies remain at firing range from the Russia-Ukraine conflict and, as such, face more supply-side driven inflation. Chart 1The Fed Has Scope To Tighten Further The Fed Has Scope To Tighten Further The Fed Has Scope To Tighten Further Chart 2Interest Rates Have Moved In Favor Of The Dollar Interest Rates Have Moved In Favor Of The Dollar Interest Rates Have Moved In Favor Of The Dollar The typical pattern for the dollar is that it tends to rise when growth is falling and inflation is also subsiding, which triggers tremendous haven flows into US Treasurys. Right now, inflation remains strong but growth is rolling over, which has historically painted a mixed picture for the dollar (Chart 3). Chart 3The Dollar Rises On Falling Growth A Lens For Managing Currencies In Today’s Paradigm A Lens For Managing Currencies In Today’s Paradigm What happens next is critical. The dollar tends to rise 10%-15% during downturns. We are already there. The DXY index is up 8.8% this year, and up 16.3% from the trough last year. European currencies like the SEK and the EUR have already priced in a recession as deep as in 2020. If this indeed proves to be the case, commodity currencies will be next, which could push the DXY to fresh highs. But as we outline below, even in a pessimistic scenario, a systematic approach to looking at currencies warns against fresh bets in favor of the dollar. Inflation And Central Banks One of the key themes we outlined in our outlook for this year is that inflation is a global problem, and not centric to the US. So, while supply side factors have had an outsized effect on energy deficient countries like Germany, the UK, Sweden and, to an extent Japan, inflation is also well above target in Canada, Australia, Norway, New Zealand, and many other developed and emerging market countries. In fact, the inflation impulse is slowing in the US, relative to a basket of G10 countries (Chart 4). Related Report  Foreign Exchange StrategyLessons From Fed Interest Rate Hikes Falling inflation will be a welcome relief valve from the tension in markets over much tighter financial conditions. It will also lower the probability of a global recession. For currency markets however, the starting point is that the market has priced the Fed to continue leading the tightening cycle until something breaks. If inflation does subside, then hawkish expectations by the Fed will be heavily priced out of the curve, which will remove a key source of support for the greenback. From a chartist point of view, the dollar has already overshot the level of rates the markets expect from the Fed, relative to more dovish central banks (Chart 5). This suggests a hefty safety premium is already embedded in the dollar. Chart 4US Inflation Is Peaking, Relative To Other ##br##Economies US Inflation Is Peaking, Relative To Other Economies US Inflation Is Peaking, Relative To Other Economies Chart 5The Dollar Has Overshot The Path Implied By Interest Rates The Dollar Has Overshot The Path Implied By Interest Rates The Dollar Has Overshot The Path Implied By Interest Rates The Dollar And Global Growth If the Fed and other central banks tame the inflation genie, then we will have achieved a soft landing. The dollar has tended to track the path of the US yield curve, and a flattening usually underscores longer-term worries about a recession (Chart 6). A steepening curve will signal mission accomplished. In the view of the Foreign Exchange Strategy service, recession risks could be relatively balanced. While major central banks have been tightening policy (the US and most of the G10), China, a big whale in terms of its monetary policy impact, has been easing monetary conditions. Chart 7 highlights that most procyclical currencies have tracked the Chinese credit impulse tick for tick. Bond yields in China are near the lows for the year. Unless China enters another economic down-leg in growth that matches the 2015 slowdown, we might just witness a rotation in economic vigor from the US towards other economies, led by China, allowing the world to achieve a soft landing. Chart 6The Dollar Is Tracking The US Yield ##br##Curve The Dollar Is Tracking The US Yield Curve The Dollar Is Tracking The US Yield Curve Chart 7Commodity Currencies Are Tracking The Chinese Credit Impulse Commodity Currencies Are Tracking The Chinese Credit Impulse Commodity Currencies Are Tracking The Chinese Credit Impulse   In the currency world, typical recessionary indicators are not yet flashing red. Cross-currency basis swaps remain well contained, suggesting dollar funding pressures, or that the ability to service dollar debt abroad remains healthy. The Fed’s liquidity swap lines, which allow foreign central banks to obtain dollar funding, also remain untapped (Chart 8). That said, currency put-call ratios are rising, suggesting the cost of obtaining downside protection has increased. Chart 8The Fed"s Recession Models Are Still Sanguine The Fed"s Recession Models Are Still Sanguine The Fed"s Recession Models Are Still Sanguine The Dollar And Portfolio Flows Aside from hedging against downside protection for the EUR, the AUD or even the CAD, one driver of dollar strength has been huge portfolio inflows into US Treasurys (Chart 9). That has occurred while equity inflows have collapsed. Admittedly, this took us by surprise since by monitoring the big Treasury whales (Japan and China), holdings have been rolling over for quite some time (Chart 10). This has also occurred amidst an accumulation of speculative short positions on US Treasurys. Chart 9A Tremendous Inflow Into US Government Bonds A Tremendous Inflow Into US Government Bonds A Tremendous Inflow Into US Government Bonds Chart 10Japan And China Remain Treasury Sellers Japan And China Remain Treasury Sellers Japan And China Remain Treasury Sellers Historically, bond inflows are the driver of portfolio flows into the US, but the equity market has also dictated the trend in the dollar from time to time. Overall, the basic balance in the US, sum of all portfolio flows, has done a good job capturing turning points in the dollar. Our focus on equity flows this time around is due to the conundrum the US faces. Relative profits tend to drive the performance of relative stock prices, and US profits tend to be more defensive – rising on a relative basis when bond yields and commodity prices are collapsing and falling otherwise (Chart 11). As such, the rise in bond yields has already derated US equity multiples but profits have held up remarkably well. An underperformance in US equities during a downturn has been unprecedented with a strong dollar since the end of the Bretton Woods system. So should a market shakeout lead to a violent rotation out of US equities, the profile for the dollar could be a mirror image of what we witnessed in 2008 or even 2020. The conundrum for bond inflows is that according to traditional measures, real rates in the US remain deeply negative, but they have improved significantly under the lens of market-based measures (Chart 12). This partly explains the dollar overshoot. A scenario of faster growth outside the US could see real rates improve more quickly abroad. Chart 11US Profits Have Held Up Remarkably Well US Profits Have Held Up Remarkably Well US Profits Have Held Up Remarkably Well Chart 12Market-Based Real Yields In The US Have Improved A Lens For Managing Currencies In Today’s Paradigm A Lens For Managing Currencies In Today’s Paradigm A final point: managing currencies is about anticipating the next macroeconomic driver. In our view, this could be fears about balance of payments dynamics, especially as the world becomes marginally less globalized. Since the 1980s, we have never had a configuration where the dollar is very overvalued, US real rates are extremely low, and the trade deficit is near a record high (meaning it needs to be financed externally). A bet on US exceptionalism has a natural limit, as competitiveness abroad is improving tremendously vis-à-vis many of the goods and services the US exports. Currencies And Valuations Currencies should revert to fair value. The question then becomes "which fair value should they mean-revert to?" In our view, simple works best – purchasing power parity values. A simple chart shows that selling the dollar when it is expensive and buying it when cheap according to its purchasing power generates alpha over the long term (Chart 13). In A Simple Trading Rule For FX Valuation Enthusiasts, we showed that a shorter-term trading strategy also based on valuation adds value. Granted, the dollar started to become overvalued in 2015, but it is now sitting close to a historical extreme. A fair assessment is that currencies will revert to their fair value, but that takes time (3-5 years). As such, longer-term investors should be slowly accumulating assets in countries where fundamentals make sense, and their currencies are deeply undervalued. These include Japan, Australia, Sweden and even Mexico (Chart 14). Chart 13The Dollar Is Overvalued On a PPP Basis The Dollar Is Overvalued On a PPP Basis The Dollar Is Overvalued On a PPP Basis Chart 14The Real Effective Exchange Rate For The Dollar Is High A Lens For Managing Currencies In Today’s Paradigm A Lens For Managing Currencies In Today’s Paradigm The Dollar And Momentum There is quite simply a dearth of dollar bears. Internally at BCA, a lot of strategists who see more downside to US (and global) equities, simply cannot be negative on the dollar. Within the foreign exchange strategy, we have been short the DXY index since 104.8, and are sticking with that bet on a 12-18-month horizon. For risk management purposes, our stop loss is at 107. First, we are seeing record long positions by speculators (Chart 15). Fielding clients, or even the media, no one wants to be a dollar bear when the Fed is clearly an inflation vigilante. If inflation keeps surprising to the upside, then speculators will keep bidding up the dollar. But it is also fair to say that most investors who want to be long the greenback at this point already have that position on.  Our intermediate-term indicator, a combination of technical variables, also warns against initiating dollar-long positions at the current juncture (Chart 16). This series mean-reverts quite quickly, so it does not dictate the trend in the dollar, but warns of capitulation extremes. Chart 15Speculators Are Very Long The Dollar Speculators Are Very Long The Dollar Speculators Are Very Long The Dollar Chart 16Technical Dollar Indicators Are Overbought Technical Dollar Indicators Are Overbought Technical Dollar Indicators Are Overbought Finally, the dollar has been used as a bet on rising volatility. The dollar is well above levels that a correction in the S&P 500 index would dictate (Chart 17). It has also moved in tandem with bond volatility (Chart 18). This suggests much of equity downside risk has been priced into the dollar. Chart 17The Dollar Has More Than Compensated For The Drawdown In Equities The Dollar Has More Than Compensated For The Drawdown In Equities The Dollar Has More Than Compensated For The Drawdown In Equities Chart 18The Dollar Is Tracking ##br##Volatility The Dollar Is Tracking Volatility The Dollar Is Tracking Volatility Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary