Sectors

Executive Summary   Lower Rates Are A Tailwind For Growth Stocks We remain in the bearish camp. While the market bottom is getting closer, there are still hurdles to overcome such as elevated economic and earnings growth expectations, which need to come down to prevent new disappointments. Notably, the market focus has shifted away from inflation and has turned towards worries about growth as is evident in the falling 10-year Treasury yield. The environment of slowing growth and falling rates is a tailwind for growth stocks, warranting an upgrade of Growth to at least a benchmark weight. Technicals also signal that Growth is oversold relative to Value. The valuation differential has also moderated. However, we are wary of upgrading Growth to an outright overweight and downgrading Value to underweight as there is still plenty of economic uncertainty. We also posit that in the next several months the markets will be “fat and flat”, i.e., a bear market punctuated by rallies and pullbacks. In this environment, a balanced allocation between Growth and Value will reduce portfolio volatility and result in higher compound returns. Bottom Line: In a commentary to our chart pack report, we upgrade the Growth/Value style preference to benchmark allocation. Feature This week we provide you with a style chart pack. In this accompanying note, we will make a case for upgrading Growth and downgrading Value, bringing these style allocations to equal weight. We are booking a profit of 13% since we established the position in January 2022. We are getting closer to upgrading Growth to overweight. Performance May started as another tough month for equities, but, as they say, all’s well that ends well. After pulling back 10% since the beginning of May, and briefly touching bear market territory of -20%, the S&P 500 rebounded in the last 10 days of the month bringing the index to where it ended April. As a result, the S&P 500 was flat, and the NASDAQ was down 2.4% in May. As expected, the rally brought about a change in leadership (Chart I-1), with Consumer Discretionary and Technology leading the pack. Energy and Utilities are the only sectors that avoided rotation. Since May 20, Growth has outperformed Value by 3%. Chart I-1Recent Performance Bear Market Rally Or The Real Thing? Since the start of the May rally, investors have been debating whether it has legs. Bulls argue that we are in the early innings of a sustainable rebound in equities – after all, much of the bad news is already priced in, 45% of NYSE and 70% of NASDAQ have recently hit new 12-month lows, screaming oversold conditions, and making bottom fishing tempting  (Chart I-2). Bears consider this surge in performance a garden-variety bear market rally: Growth is slowing and none of the problems that have been haunting the markets over the past five months, such as inflation, war, China, and a hawkish Fed, have yet been resolved. Our views are closer to the bearish camp: We believe that, even if the market bottom is getting closer, there are still hurdles to overcome, such as elevated economic and earnings growth expectations, which need to come down to prevent new disappointments. As we discussed in the recent “What Is Next For Equities: They Will Be Fat And Flat” report, we believe that equities are likely to be range-bound over the next several months: A turn in inflation and a downshift in growth may ignite rallies on hopes of a gentler, data-driven Fed, and a shallower trajectory for the rate-hiking cycle  (Chart I-3). However, we argue that the Fed “put” is no longer in play and the Fed will stay focused on inflation, inadvertently puncturing any budding rallies. In addition to a hawkish Fed, investors will have to process what may become a sharp economic growth slowdown and an earnings recession in the US on the back of rising costs, a stronger dollar, and slowing global demand for US goods. Chart I-2Is Much Of The Bad News Already Priced In? Chart I-3Many Hope For A Shallower Hiking Cycle Growth Vs. Value: Shifting Positioning To Equal Weight When Growth Is Harder To Find, Growth Stocks Shine As we argued in the “Fat and Flat” report, there are multiple signs that economic growth is slowing, and that earnings growth will disappoint. Our Business Cycle Indicator, which is a compilation of soft and hard data across production, consumer, and credit dimensions, is also signaling a slowdown  (Chart I-4). Here we would like to emphasize our view: As of now, US economic growth is strong, and it is only its second derivative, i.e. a deceleration of growth, that is the root of our concerns. In a world where growth is becoming scarcer, companies that can deliver growth will shine. These are “growth” companies, i.e. large, stable companies with strong balance sheets that are able to generate positive cash flow and churn out strong earnings even under economic duress  (Chart I-5). Quality growth outperforms during slowdowns  (Chart I-6). This reasoning does not apply to speculative, barely profitable, growth companies which will fight for survival in a slow-growth world. Chart I-4We Are In A Slowdown Stage Of The Business Cycle Chart I-5Large Cap Growth Is Synonymous With Quality Chart I-6Growth Outperforms During Economic Slowdowns Of course, one might argue that economic growth has been slowing for about a year, initially by returning towards the pre-pandemic trend and, lately, as a result of monetary tightening. Yet, over the past six months, Growth has underperformed Value by nearly 11%. What is different now? First, inflation, and the monetary tightening that inevitably follows it, are the mortal enemies of growth stocks: Higher discount rates deflate the present value of future cash flows. Rising inflation and sharply rising Treasury yields are behind the recent sell-off in Growth stocks. However, recently, the market focus has shifted away from inflation, and seems to finally be turning towards worries about growth. As a result, the 10-year Treasury yield decreased from 3.12% to 2.75%, and its relentless climb may now be behind us  (Chart I-7). Lower rates are a tailwind for Growth stocks which rebounded at the first whiff of rate stabilization  (Chart I-8). Chart I-7Investors Concerns Have Shifted From Inflation To Growth Further, our research on macroeconomic regimes suggests that a turn in inflation heralds a change in market leadership from Value to Quality and Growth  (Chart I-9). Chart I-8Lower Rates Are A Tailwind For Growth Stocks Chart I-9Growth And Quality Will Lead Markets When Inflation Abates Growth Not Yet Cheap But Oversold This year’s sell-off is characterized by a multiple contraction. Growth is a poster child of this trend: Its forward multiple has decreased by 8 points, with the style currently trading at just under 20x forward earnings, which is the 61st percentile relative to its 10-year history (compare that to 28x and the 94th percentile back in January). As for Value, it also became cheaper, contracting from 16.8x in January to 14.9x (Table I-1). Table I-1Valuations And EPS Growth Expectations According to the BCA Valuations Indicator  (Chart I-10), the Growth/Value valuations spread has moderated but by itself, is not an impetus for a switch. However, looking at technicals, Growth is extremely oversold relative to Value and is at levels last seen in 2006. Why Neutral, Not Overweight? We hope we made a compelling case for shifting allocation from Value to Growth. Then why not go overweight, but just neutral? Mostly because many of the macroeconomic developments we have described are tentative and are just conjecture at this point – there is still plenty of uncertainty about inflation, rates, and the Fed monetary response. Second, while Growth stocks are supposed to grow faster than Value stocks, at the moment analysts expect them to grow at 8% and 11% respectively. We expect earnings growth expectations for Value stocks to be downgraded since they are dominated by cyclicals. However, until the new numbers are in for both styles, we need to be careful. Chart I-10Growth Is Getting Cheaper Relative To Value... It Also Appears Oversold Last, if we are right, and US equities are to test their bottom this summer in a “fat and flat” manner, there will be a frequent change in leadership, with Growth and Small outperforming during the rallies, and Value outperforming during pullbacks. Portfolios need exposure to both styles to achieve the highest compound returns as diversification reduces portfolio volatility. Once macroeconomic uncertainty dissipates, we will be able to pounce and shift Growth to overweight, and Value to underweight. For now, we are going to stay neutral out of an abundance of caution. Bottom Line Macroeconomic conditions are becoming more favorable for Growth as Treasury yields stabilize and economic growth slows, making the strong fundamentals and stable earnings of large-cap growth stocks more valuable. Growth is oversold relative to Value, and the relative performance differential of Growth vs. Value over the past six months has been staggering – it is time to book profits and prepare for the next chapter.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     S&P 500 Chart II-1Macroeconomic Backdrop Chart II-2Profitability Chart II-3Valuations And Technicals Chart II-4Uses Of Cash Cyclicals Vs Defensives Chart II-5Macroeconomic Backdrop Chart II-6Profitability Chart II-7Valuation And Technicals Chart II-8Uses Of Cash Growth Vs Value Chart II-9Macroeconomic Backdrop Chart II-10Profitability Chart II-11Valuations And Technicals Chart II-12Uses Of Cash Small Vs Large Chart II-13Macroeconomic Backdrop Chart II-14Profitability Chart II-15Valuations and Technicals Chart II-16Uses Of Cash Table A1Performance Table A2Valuations And Forward Earnings Growth   Footnotes Recommended Allocation Recommended Allocation: Addendum 

Executive Summary Investors face a dilemma. The faster that inflation comes down, the better it will be for valuations via a stronger rally in the bond price. But if a collapse in inflation requires a sharp deceleration in growth, the worse it will be for profits. Bond yields are likely in a peaking process, but the sharpest declines may come a few months down the road, after an unambiguous roll-over in food and energy inflation. The stock market’s valuation-driven sell-off is likely over, but the danger is that it morphs into a profits-driven sell-off. As such, the stock market will remain under pressure through 2022, though it is likely to be higher 12 months from now in June 2023. High conviction recommendation: Overweight healthcare versus basic resources. In other words, tilt towards sectors that benefit the most from rising bond prices and that suffer the least from contracting profits. New high conviction recommendation: Go long the Japanese yen. As bond yield differentials re-tighten, the yen will rally. Additionally, the yen will benefit from its haven status in a period of recessionary risk. Fractal trading watchlist: JPY/USD, GBP/USD, and Australian basic resources. If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market Bottom Line: The risk is that the valuation-driven sell-off morphs into a profits-driven sell-off. Feature In May, many stock markets reached the drawdown of 20 percent that defines a technical bear market. Yet what has caught many people off guard is that the bear market in stocks has happened during a bull market in profits. Since the start of 2022, US profits are up by 5 percent.1 The bear market in stocks has happened during a bull market in profits… so far. This shatters the shibboleth that bear markets only happen when there is a profits recession. The 2022 bear market has been a valuation-driven bear market. US profits rose 5 percent, but the multiple paid for those profits collapsed by 25 percent, taking the market into bear territory. None of this should come as any surprise to our regular readers. As we have pointed out many times, a stock market can be likened to a bond with a variable rather than a fixed income. So, just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like. It turns out that that long-duration US stock market has the same duration as a 30-year bond. This means that: The US stock market = (The 30-year T-bond price) multiplied by (US profits) It follows that if the 30-year bond price falls by more than profits rise, then the stock market will sell off. And if the 30-year bond price falls by much more than profits rise, then the stock market will enter a valuation-driven bear market. Therein lies the story of 2022 so far (Chart I-1). Chart I-1The Bear Market Is Valuation-Driven. Profits Are Up... For Now Just As In 1981-82, Will The Sell-Off Morph From Valuation-Driven To Profits-Driven? In Markets Echo 1981, When Stagflation Morphed Into Recession, we argued that a good template for what happens to the economy and the markets in 2022-23 is the experience of 1981-82. Does 2022-23 = 1981-82? Then, just as now, the world’s central banks were obsessed with ‘breaking the back’ of inflation, and piloting the economy to a ‘soft landing’. Then, just as now, the central banks were desperate to repair their badly damaged credibility in managing the economy. And then, just as now, an invasion-led war between two major commodity producers – Iran and Iraq – was disrupting commodity supplies and adding to inflationary pressures. In 1981, just as now, the equity market sell-off started as a valuation sell-off, driven by a declining 30-year T-bond price. Profits held up through most of 1981, just as they have so far in 2022. In September 1981, US core inflation finally peaked, with bond yields following soon after. In the current experience, March 2022 appears to have marked the equivalent peak in US core inflation (Chart I-2 and Chart I-3). Chart I-2Does September 1981... Chart I-3...Equal March 2022? In late 1981, when the 30-year T-bond price rebounded, the good news was that beaten-down equity valuations also reached their low point. The bad news was that just as the valuation-driven sell-off ended, profits keeled over, and the valuation-driven sell-off morphed into a profits-driven sell-off (Chart I-4). In 2022-23, could history repeat? Chart I-4In September 1981, The Sell-Off Morphed From Valuation-Driven To Profits-Driven Recession Or No Recession? That Is Not The Question History rhymes, it rarely repeats exactly. What if the 2022-23 experience can avoid the outright economic recession of the 1981-82 experience? This brings us to another shibboleth that needs to be shattered. You don’t need the economy to go into recession for profits to go into recession. To understand why, we need to visit the concept of operational leverage. Profits is a small number that comes from the difference of two large numbers: sales and the costs of generating those sales. As any company will tell you, sales can be volatile, but costs – which are dominated by wages – are sticky and much slower to change. The upshot is that if sales growth exceeds costs growth, there is a massively leveraged impact on profits growth. This is the magic of operational leverage. But if sales growth falls below sticky cost growth, the magic turns into a curse. The operational leverage goes into reverse, and profits collapse. Using US stock market profits as an example, the magic turns into a curse at real GDP growth of 1.25 percent, above which profits grow at six times the difference, and below which profits shrink at six times the difference (Chart I-5). Chart I-5A Model For US Profits Growth: (Real GDP Growth - 1.25) Times 6 Strictly speaking, we should compare US profits growth with world GDP growth because multinationals generate their sales globally rather than domestically. But to the extent that the US has both the world’s largest stock market and the world’s largest economy, it is a reasonable comparison. We should also compare both profits and sales in either nominal or real terms, rather than a mixture. But even with these tweaks, we would still find that the dominant driver of profit growth is operational leverage. ‘Recession or no recession?’ is a somewhat moot question, because even non-recessionary low growth is enough to tip profits into contraction. Therefore, the conclusion still stands – ‘recession or no recession?’ is a somewhat moot question, because even non-recessionary low growth is enough to tip profits into contraction. Such a period of low growth is now likely. If 2022-23 = 1981-82, What Happens Next? To repeat: The US stock market = (The 30-year T-bond price) multiplied by (US profits) This means that investors face a dilemma. The faster that inflation comes down, the better it will be for valuations via a stronger rally in the bond price. But if a collapse in inflation requires a sharp deceleration in growth, the worse it will be for profits. This was the precise set-up in December 1981, the equivalent of June 2022 in our historical template. In which case, what can we expect next? 1. Bond yields are likely in a peaking process, but the sharpest declines may come a few months down the road, after an unambiguous roll-over in food and energy inflation (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To The Bond Yield 2. The stock market’s valuation-driven sell-off is likely over, but the danger is that it morphs into a profits-driven sell-off. As such, the stock market will remain under pressure through 2022, though it is likely to be higher 12 months from now in June 2023 (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market 3. Long-duration defensive sectors will outperform short-duration cyclical sectors. In other words, tilt towards sectors that benefit the most from rising bond prices and suffer the least from contracting profits. As such, a high conviction recommendation is to overweight healthcare versus basic resources (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To Healthcare Versus Resources 4. In foreign exchange, the setup is very bullish for the Japanese yen through the next 12 months. The yen’s recent sell-off is explained by bond yields rising outside Japan. As these bond yield differentials re-tighten, the yen will rally. Additionally, the yen will benefit from its haven status in a period of recessionary risk. A new high conviction recommendation is to go long the Japanese yen (Chart I-9). Chart I-9The Yen's Sell-Off Is Due To Bond Yields Rising Outside Japan Fractal Trading Watchlist Supporting our bullish fundamental case for the Japanese yen, the sell-off in JPY/USD has reached the point of fragility on its 260-day fractal structure that marked previous major turning points in 2013 and 2015 (Chart 10). Hence, a first new trade is long JPY/USD, setting the trade length at 6 months, and the profit target and symmetrical stop-loss at 5 percent. Chart I-10The Sell-Off In JPY/USD Has Reached A Potential Turning Point Supporting our bearish fundamental case for resources stocks, the outperformance of Australian basic resources has reached the point of fragility on its 130-day fractal structure that marked previous turning points in 2013, 2015, and 2021 (Chart I-11). Hence, a second new trade is short Australian basic resources versus the world market, setting the trade length at 6 months, and the profit target and symmetrical stop-loss at 10 percent. Chart I-11The Australian Basic Resources Sector Is Vulnerable To Reversal Finally, we are adding GBP/USD to our watchlist, given that its 260-day fractal structure is close to the point of fragility that marked major turns in 2014, 2015, and 2016. Our full watchlist of 29 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions GBP/USD At A Turning Point Chart 1AUD/KRW Is Vulnerable To Reversal   Chart 2Canada Versus Japan Is Reversing Chart 3Canada's TSX-60's Outperformance Might Be Over Chart 4US Healthcare Providers Vs. Software At Risk of Reversal Chart 5BRL/NZD At A Resistance Point Chart 6Homebuilders Versus Healthcare Services Has Turned Chart 7CNY/USD Has Reversed Chart 8CAD/SEK Reversal Has Started Chart 9Financials Versus Industrials To Reverse Chart 10The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 11The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 12FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 13Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 14The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 15The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 16Food And Beverage Outperformance Has Been Exhausted Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 18The Strong Trend In The 3 Year T-Bond Is Fragile Chart 19A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Chart 21Norway's Outperformance Could End Chart 22Cotton Versus Platinum Is Reversing Chart 23Switzerland's Outperformance Vs. Germany Has Started To End Chart 24The Rally In USD/EUR Has Ended Chart 25The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 26A Potential New Entry Point Into Petcare Chart 27Czech Outperformance Near Exhaustion Chart 28US REITS Are Oversold Versus Utilities Chart 29GBP/USD At A Turning Point   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Defined as 12-month forward earnings per share. Fractal Trading System 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Executive Summary European Spreads Have Cheapened Up More Than US Spreads Corporate bond spreads in the US and Europe have widened since early April, with European credit taking a bigger hit because of worsening growth and inflation momentum. European corporate bond valuations look fairly cheap, both for investment grade and high-yield.  This is true in absolute terms but also relative to the US, where spread valuations are more mixed.  An easing of stagflation fears in Europe is a necessary condition for a valuation convergence with the US. The US investment grade credit curve is steep relative to the overall level of credit spreads, making longer-maturity corporates more attractive. Energy bonds offer the most compelling combination of valuation and fundamental support (from high oil prices) within US investment grade. Within US high-yield, Energy valuations look much less compelling after the recent outperformance. The best medium-term industry values in European credit are in investment grade Financials and high-yield Consumer Cyclicals & Non-Cyclicals. Bottom Line: Continue to favor both US high-yield and European investment grade corporates versus US investment grade.  Stay neutral high-yield exposure on both sides of the Atlantic.  Within Europe, stay up in quality within both investment grade and high-yield until near-term macro risks on growth & inflation subside. Feature Corporate bonds in the US and Europe have gone through a rough patch in recent weeks, underperforming government bonds in response to the “triple threat” of high inflation, tightening monetary policy and slowing growth momentum.  European credit has taken the more severe hit compared to the US, with markets pricing in greater risk premia because of additional regional threats to growth (and inflation) from the Ukraine war. In this Special Report, jointly presented by BCA Research US Bond Strategy and Global Fixed Income Strategy, we assess credit spread valuations in US and European corporates after the latest selloff, across credit tiers, maturities and industry groups.  Stay Cautious On US Corporate Bonds Chart 1US Credit Spreads In a recent Special Report, we argued in favor of a relatively defensive allocation to US corporate bonds. Specifically, we advised investors to adopt an underweight (2 out of 5) allocation to US investment grade corporates and a neutral (3 out of 5) allocation to US high-yield. Our rationale was that a flat US Treasury curve signaled that we were in the middle-to-late stages of the economic recovery. Additionally, at the time, corporate bond spreads weren’t all that attractive compared to the average levels seen during the last Fed tightening cycle (Chart 1). Spreads have widened somewhat since we downgraded our allocation and, as such, we see some scope for spread tightening during the next few months as inflation rolls over and the Fed lifts rates by no more than what is already priced in the curve. That said, with the Fed in the midst of a tightening cycle, we think it’s unlikely that spreads can stay below average 2017-19 levels for any meaningful length of time. As a result, we maintain our current cautious allocation to US corporate bonds. US High-Yield Versus US Investment Grade The recent period of US corporate bond underperformance can be split into two stages based on the relative performance of investment grade and high-yield. US investment grade underperformed junk in the early stages of the selloff (between September and mid-March), as spread widening was driven by the Fed’s shift toward a more restrictive policy stance and not a meaningful uptick in the perceived risk of a recession and/or default wave (Chart 2A). Chart 2ACorporate Bond Excess Returns* Versus Duration-Times-Spread: September 27, 2021 To March 14, 2022 But recession and default fears started to ramp up in mid-March, and this caused high-yield to join the selloff (Chart 2B). In fact, US investment grade corporates managed to recoup some of their earlier losses while lower-rated junk bonds struggled to keep pace. Chart 2BCorporate Bond Excess Returns* Versus Duration-Times-Spread: March 14, 2022 To Present We contend that the risk of a meaningful uptick in corporate defaults during the next 12 months is low. In fact, we estimate that the US high-yield default rate will fall to between 2.7% and 3.7% during the next year, well below the 5.2% currently priced into junk spreads. Going forward, we expect the US corporate bond landscape to be defined by increasingly restrictive monetary policy and a benign default outlook. As we noted in the aforementioned Special Report, this environment is reminiscent of the 2004-06 Fed tightening cycle when high-yield bonds performed much better than investment grade. Investors should maintain a preference for high-yield over investment grade within an otherwise defensive allocation to US corporate bonds. US Industry Groups Chart 3A shows the performance of US corporate bonds in the early stages of the recent selloff, but this time split by industry group. High-yield Energy sticks out as a strong outperformer, though we also notice that every high-yield sector performed better than its investment grade counterpart. Chart 3ACorporate Bond Excess Returns* Versus Duration-Times-Spread: September 27, 2021 To March 14, 2022 Chart 3B once again shows how the relative performance between investment grade and high-yield has flipped since mid-March, though we see that high-yield Energy, Transportation and Utilities have performed better than the rest of the index.  Chart 3BCorporate Bond Excess Returns* Versus Duration-Times-Spread: March 14, 2022 To Present Interestingly, despite the strong outperformance of high-yield Energy bonds, investment grade Energy credits performed mostly in line with other investment grade sectors. We believe this presents an excellent opportunity.  The vertical axis of Chart 4A shows our measure of the risk-adjusted spread available in each investment grade industry group. Our risk-adjusted spread is the residual after adjusting for each sector’s credit rating and duration. The horizontal axis shows each sector’s Duration-Times-Spread as a simple measure of risk. Our model shows that Financials, Technology, Energy, Utilities, Communications and Basic Industry all stand out as attractive within the investment grade corporate bond universe. We identify the investment grade Energy sector as a particularly compelling buy. Chart 4AUS Investment Grade Corporate Sector Valuation In a prior report, we demonstrated, unsurprisingly, that the oil price is an important determinant of whether Energy bonds perform better or worse than the rest of the corporate index. With our commodity strategists calling for the Brent crude oil price to average $122/bbl next year, this will provide strong support to Energy bond returns. Cheap starting valuations for investment grade Energy bonds make them look even more compelling. Chart 4B repeats our valuation exercise but for high-yield industry groups. Within high-yield, we find that Financials, Transportation, Communications and Consumer sectors stand out as attractive. Interestingly, high-yield Energy bonds now look slightly expensive compared to the rest of the junk bond universe, a result of the sector’s recent incredibly strong performance. Chart 4BUS High-Yield Corporate Sector Valuation US Credit Curve We define the credit curve as the difference in option-adjusted spread between the “Long Maturity” and “Intermediate Maturity” sub-indexes for each investment grade credit tier, as defined by Bloomberg. We exclude high-yield from this analysis because very few high-yield bonds are classified as “Long Maturity”. To analyze the credit curve, we observe that credit curves tend to be steeper when credit spreads are tight, and vice-versa. This is because tight spreads indicate that the perceived near-term risk of default is low. As a result, short-maturity spreads tend to be lower than spreads at the long-end of the curve. Conversely, a wide spread environment indicates that the perceived near-term risk of default is high, and this risk will be more reflected in shorter maturity credits. Charts 5A, 5B and 5C show the slopes of the credit curves for Aa, A and Baa-rated securities. Immediately we notice that credit curves are positively sloped in each case, and also that each credit curve is somewhat steeper than would be predicted based on the average spread for the overall credit tier. Chart 5AAa-Rated Credit Curve Chart 5BA-Rated Credit Curve Chart 5CBaa-Rated Credit Curve This strongly suggests that investors should favor long-maturity over short-maturity US investment grade corporate bonds. European Corporates Look Cheap Vs. US Equivalents – For Patient Investors Chart 6European Credit Spreads At Past 'Non-Crisis' Peaks Turning to the euro area, the Bloomberg investment grade OAS and high-yield OAS currently sit at 167bps and 490bps, respectively (Chart 6). These levels are well below the peaks seen during the 2020 COVID recession and the 2011/12 European debt crisis, but are in line with the spread widening episodes in 2014/15 and 2018. Our preferred measure of credit spread valuation, 12-month breakeven spreads, show that European investment grade and high-yield spreads are in the 75th and 67th percentile of outcomes, respectively, dating back to the inception of the euro in 1998 (Chart 7).1 These are both higher compared to the breakeven percentile rankings for US investment grade (48%) and US high-yield (52%). The gap between the breakeven percentile rankings for investment grade bonds in the euro area versus the US is the widest seen over the past two decades.  That gap reflects the fact that European economic growth has softened versus the US according to the S&P Global manufacturing PMIs, while European inflation has accelerated towards very elevated US levels (Chart 8).  Chart 7European Spreads Have Cheapened Up More Than US Spreads Chart 8European Corporate Underperformance Reflects Relative Growth & Inflation Both of those trends are a product of the Ukraine war, which has led to a massive spike in European energy costs given the region's huge reliance on Russian energy supplies, particularly for natural gas. While the US has also suffered a massive increase in its own energy bills, the inflation spike has been higher in Europe, leading to a bigger drag on economic confidence and growth. Thus, the widening spread differential between corporate bonds in Europe relative to the US likely reflects a growth-related risk premium. Chart 9A Turning Point For European Corporate Bond Performance? As euro area inflation has ratcheted higher, so have expectations of ECB monetary tightening. The euro area overnight index swap (OIS) curve now discounts 172bps over the next 12 months, a huge swing from the start of 2022 when markets were expecting the European Central Bank (ECB) to stand pat on the interest rate front. In comparison, markets are pricing in another 224bps of Fed tightening over the next 12 months, even after the Fed has already delivered 75bps of tightening since March. Importantly, the gap between our 12-month discounters, which measure one-year-ahead interest rate changes discounted into OIS curves, for the US and Europe has proven to be a reliable leading indicator – by around nine months - of the relative year-over-year excess returns (on a USD-hedged basis) of European and US corporate bonds, especially for investment grade (Chart 9). The fact that this is a leading relationship suggests that the upward repricing of ECB rate expectations seen so far in 2022 is not yet a reason to turn more cyclically negative on European corporate bonds versus the US. The earlier upward repricing of expected Fed tightening is the more relevant factor, and is signaling that both US investment grade and high-yield corporates should underperform European equivalents over at least the rest of 2022.  BCA Research Global Fixed Income Strategy already has a recommended allocation along those lines, with an overweight to euro area investment grade and an underweight to US investment grade. While the trade has underperformed of late, the combined messages from the relative 12-month breakeven spread rankings (cheaper European valuations) and 12-month discounters (the Fed is further ahead in the tightening cycle) leads us to stick with that relative cross-Atlantic tilt. The main risk to that stance is any deterioration of the flow of energy supplies from Russia to Europe that results in a stagflationary outcome of a bigger growth slowdown with even faster inflation. That is a scenario that would make it difficult for the ECB to back down from its recent hawkish forward guidance, resulting in European corporate spreads incorporating an even wider risk premium.  Given that near-term uncertainty, we are advocating that investors maintain no relative tilt on more growth-sensitive, and riskier, European high-yield relative to the US – stay neutral on both. Stay Up In Quality On European Corporates Looking at euro area corporate debt across credit ratings and maturity buckets, there are few compelling immediate valuation stories in absolute terms, although there are potential opportunities unfolding on a relative basis.  Within investment grade, credit quality curves have steepened during the recent selloff, with lower-rated credit seeing larger spread widening (Chart 10). The gap between Baa-rated and A-rated European corporate spreads now sits at 52bps, right in the middle of the 25-75bps range since 2014. In high-yield, the gap between Ba-rated and B-rated credit spreads is 222bps, and the gap between B-rated and Caa-rated spreads is 370bps (Chart 11) – both are still below the previous peaks in those relationships seen in 2012, 2015 and 2020. Chart 10European IG Credit Quality Curve Can Steepen ##br##More Chart 11European HY Credit Quality Curve Still Below Previous Peaks For both investment grade and high-yield, there is still room for credit curves to steepen if European growth expectations continue to deteriorate. However, when looking at spread valuations across the credit quality spectrum, and across maturity buckets, euro area corporate spreads look much cheaper than US equivalents. In Chart 12, we show a snapshot of the current 12-month breakeven percentile rankings for individual credit quality tiers and maturity groups, for investment grade and high-yield in the euro area and US.  The relative attractiveness of European credit relative to the US is evident, with European spreads now at higher percentile rankings across all quality tiers and maturity buckets. The largest gaps between 12-month breakeven percentile rankings are in the +10 year maturity bucket, the AAA-rated and AA-rated investment grade credit tiers, and the Ba-rated high-yield credit tier. This suggests any trades favoring European corporates versus the US should stay up in credit quality. Chart 12Corporate Spread Valuations By Maturity & Credit Rating Favor Europe Comparing European & US Industry Spread Valuations When looking at the industry composition of the euro area and US corporate bond indices, there are a few major notable differences. Within investment grade, there is a greater concentration of Energy and Technology names in the US, while Financials are more represented in the European index (Chart 13).  Those same three industries also have the largest relative weightings in the high-yield indices (Chart 14), although there is also a slightly larger weighting of high-yield Transportation companies in Europe compared to the US.  This means that a bet on European credit versus the US is essentially a bet on European Financials versus US Energy and Technology. Chart 13Investment Grade Corporate Bond Market Cap Weights Chart 14High-Yield Corporate Bond Market Cap Weights When looking at the same sector metrics that were shown earlier in this report for the US – comparing risk-adjusted spreads to Duration-Times-Spread – we find some interesting cross-Atlantic valuation differentials. For investment grade in Europe (Chart 15), only Energy and Financials have positive risk-adjusted spread valuations (after controlling for duration and credit quality), while having the highest level of risk expressed via Duration-Times-Spread. This contrasts to the US where more sectors have positive risk-adjusted spreads - Energy, Financials, Utilities, Basic Industry and Communications. Investors should favor the latter three industries in the US relative to Europe. Chart 15Euro Area Investment Grade Corporate Sector Valuation Within high-yield in Europe, Energy and Financials also offer positive risk-adjusted valuations, but so do Consumer Cyclicals and Consumer Non-Cyclicals (Chart 16). This lines up similarly to US high-yield valuations. The notable valuation gaps exist in Transportation and Communications, which look cheap in the US and expensive in Europe, creating potential cross-Atlantic relative value trade opportunities between those sectors (and within an overall neutral allocation to junk in both regions). Chart 16Euro Area High-Yield Corporate Sector Valuation Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 12-month breakeven spreads measure the amount of spread widening that would be necessary to make the return on corporate bonds equal to that of duration-matched government bonds over a one-year horizon.  The spread is calculated as a ratio of the index OAS and index duration for the relevant credit market. We look at the historical percentile ranking of that ratio to make a more “apples for apples” comparison of spreads that factors in index duration changes over time. 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Special Report

Highlights The Fed’s hawkish shift over the past six months has caused a sharp increase in US interest rates. In this report we examine the US housing market for signs of an imminent recession, given the housing sector’s strong interest rate sensitivity. In addition to a severe contraction in real home improvement spending, there are several other housing-related indicators that are ostensibly pointing in a bearish direction. The growth in total home sales and the MBA mortgage application purchase index are already in negative territory, housing affordability has deteriorated meaningfully, and the National Association of Home Builders’ (NAHB) housing market index is falling sharply. However, the breadth of house prices and building permits, consumer surveys, housing equity sector relative performance, and the fact that mortgage rates have likely peaked for the year point to a more optimistic outlook for housing. At a minimum, they do not yet suggest that the current slowdown in housing-related activity is recessionary. Structural factors are also supportive of the pace of housing construction in the US. While a slowdown in the housing market is clearly underway, it is not occurring after a period of excessive housing construction. The opposite is true: the US and several other developed market economies have underbuilt homes over the past decade. This should limit the drag on economic growth from housing-related activity, and reduces the odds that a housing market slowdown will morph into a housing-driven US recession. Feature Chart II-1The Fed's Hawkish Shift Has Caused An Extremely Sharp Rise In Interest Rates The Fed’s hawkish shift over the past six months has caused US interest rates to rise at an extremely rapid pace. Panel 1 of Chart II-1 highlights that the spread between the US 2-year Treasury yield and the 3-month T-bill yield reached a 20-year high in early April of this year. Panel 2 shows that the two-year change in the 30-year mortgage rate will reach the highest level since the early 1980s by the end of this year if mortgage rates remain at their current level. Over the longer run, it is the level of interest rates that matters more than their change. However, changes in interest rates and other key financial market variables are also important drivers of economic activity, especially when they happen very rapidly. Given the speed of the recent adjustment in US interest rates, and the fact that the Fed funds rate will have likely reached the Fed’s neutral rate forecast by the end of this year, investors have understandably become concerned about the potential for a recession in the US. In this report we examine the US housing market for signs of an imminent recession, given the housing sector’s strong interest rate sensitivity. We conclude that while a slowdown in the housing market is clearly underway, several signs suggest that this slowdown is not recessionary. Investors should remain laser-focused on the pace of housing-related activity over the coming 6-12 months, but for now our assessment of the housing market is consistent with a modest overweight stance towards stocks within a multi-asset portfolio. A Brief Review Of The Housing Sector’s Contribution To Growth Table II-1 highlights the importance of the housing sector as a driver/predictor of US recessions. This table highlights that real residential investment is not a particularly important contributor to real GDP growth during nonrecessionary quarters, but it is the only main expenditure component exhibiting negative growth on average in the year prior to a recession.1 Table II-1Real Residential Investment Tends To Contract In The Year Prior To A Recession When examining the contribution to economic growth from the housing sector, investors and housing market analysts often fully equate real residential investment with housing construction. In fact, while direct construction of housing units accounts for a sizeable portion of the contribution to growth from housing, it is just one of four components. This is an important point, as one of the often-overlooked elements of real residential investment has strongly leading properties and is currently providing a very negative signal about the housing sector. Chart II-2 breaks down what we consider as aggregate real “housing-related activity”, and Chart II-3 presents the contributions to annualized quarterly growth in housing activity from the four components. For the sake of completeness, we include personal consumption expenditures on furnishings and household equipment as part of housing-related activity, alongside the two main components of real residential investment: permanent site construction (including single and multi-family properties), and “other structures.” In reality, “other structures” is not predominantly accounted for by the construction of different types of residential properties; it is almost entirely composed of spending on home improvements and brokerage commissions on the sale of existing residential properties. Chart II-2Housing Construction Is An Important Part Of Residential Investment, But There Are Other Contributing Factors Chart II-3Home Improvement Spending And Brokerage Commissions Also Drive Residential Investment     Aside from the link between existing home sales and the general demand for newly-built homes, the prominence of brokerage commissions in other residential structures investment helps explain why existing home sales are strongly correlated with real residential investment (Chart II-4, panel 1). Given that a distributed lag of monthly housing starts maps closely to permanent site construction (panel 2), starts and existing home sales explain a good portion of the contribution to growth from housing-related activity. Of the two remaining components of housing-related activity, Chart II-5 highlights that personal consumption expenditures on furniture and household equipment generally coincide with the pace of housing construction and new home sales. We take this to mean that the consumption component of housing-related activity is typically a derivative of the decision to build a new home or sell an existing one. Chart II-4Existing Home Sales Explain Commissions, And Housing Starts Explain Permanent Site Construction Chart II-5The Pace Of Contraction In Home Improvement Spending Is Worrying   What is not coincident with construction and existing home sales is residential home improvement: Panel 2 of Chart II-5 highlights that it has strongly leading properties, and is currently contracting at its worst rate since the 2008 recession. Data on real home improvement spending is only available quarterly from 2002, so the ability to compare the current situation to previous housing market cycles is limited. But the pace of contraction is worrying and underscores that investors should be on the lookout for corroborating signs of a major contraction in the housing market. Is The Housing Data Sending A Recessionary Signal? In addition to the severe contraction in real home improvement spending shown in Chart II-5, there are several other housing-related indicators that are ostensibly pointing in a bearish direction. In particular, Chart II-6 highlights that both the growth in total home sales and the MBA mortgage application purchase index are already in negative territory, that housing affordability has deteriorated meaningfully, and that the National Association of Home Builders’ (NAHB) housing market index is falling sharply. However, there are also several signs pointing to a more optimistic outlook for housing, or at least indicating that the current slowdown in housing-related activity is not recessionary. We review these more optimistic indicators below. The Breadth Of House Prices And Building Permits In sharp contrast to previous periods of serious housing market weakness and/or recessionary periods, there is no sign yet of a major slowdown in US house price appreciation including cities with the weakest gains. In fact, Chart II-7 highlights that house prices have recently been reaccelerating on a very broad basis after having slowed in the second half of last year, which hardly bodes poorly for new home construction. Chart II-6A US Housing Sector Slowdown Is Certainly Underway Chart II-7No Sign Yet Of A Major Deceleration In House Prices   It is true that US house price data is somewhat lagging, so it is quite likely that price weakness is forthcoming. However, there has been no sign of a major slowdown in prices through to March 2022, by which point 30-year mortgage rates had already risen 200 basis points from their 2021 low. More importantly, Chart II-8 highlights that a state-by-state diffusion index of authorized housing permits has done a very good job at leading the growth in permits nationwide, and is currently not pointing to a contraction in activity. Chart II-9 presents explanatory models for the growth in US housing starts and total home sales based on our state permits diffusion index, pending home sales, the change in mortgage rates, and housing affordability. The chart underscores that a contraction in housing activity is not what these variables would predict, even though starts and sales should be growing at a much more modest pace than what has prevailed on average over the past two years. Chart II-8Our Building Permits Diffusion Index Leads Housing Construction Activity, And Is Not Pointing To A Major Slowdown Chart II-9Reliably Leading Indicators Of Construction And Home Sales Do Not Point To A Recessionary Outcome     Consumer Surveys The University of Michigan consumer survey shows that consumers feel it is the worst time to buy a home since the early-1980s (Chart II-10), which seems like a clearly negative sign for the housing market and an indication of the likely impact of tighter policy on housing-related activity. And yet, panel 2 highlights that this is the result of the fact that house prices in the US have surged during the pandemic, not that mortgage rates have risen too high. It is true that the number of survey respondents citing “interest rates are too high” is rising sharply, but this factor as a share of all “bad time to buy” reasons given is not meaningfully higher than it was in 2018, 2011, or 2006. It is clear that high prices are also the culprit for why consumers report that it is a bad time to buy large household durables and not that large household durables are unaffordable or that interest rates are too high (Chart II-11). Chart II-10Nearly The Worst Time To Buy A Home, Mostly Due To Prices (Not Interest Rates) Chart II-11Same Story For Large Household Durables   It may seem counterintuitive for investors to see Charts II-10 and II-11 as in any way positive for the housing market. But, to us, the notion that elevated house prices are the main source of poor affordability supports the idea that a normalization of the housing market will occur through a combination of marginally lower demand, a slower pace of house price appreciation, and a sustained pace of housing market construction. This implies that existing home sales may be weaker than housing construction over the coming year, but the latter will help to support the contribution to overall economic growth from housing-related activity. Housing Sector Relative Performance Despite the significant slowdown in real home improvement spending and the recent decline in the NAHB’s housing market index, Chart II-12 highlights that home improvement retail and homebuilding stocks have not exhibited significantly negative abnormal returns over the past year – as they did in 1994/1995 and in the lead up to the global financial crisis. The chart, which presents a rolling 1-year “Jensen’s alpha” measure for both industries, attempts to capture the risk-adjusted performance of the industry versus the S&P 500. While the chart shows that both industries have generated negative alpha over the past year, the magnitude does not appear to be consistent with a recession. In the case of homebuilder stocks in particular, negative abnormal returns over the past year should have been meaningfully worse given the year-over-year change in mortgage rates. Chart II-13 highlights that homebuilder performance has not been cushioned by a deep valuation discount in advance of the rise in mortgage rates. Chart II-12Housing-Related Equity Sectors Are Not Warning Of A Housing-Driven Recession Chart II-13Homebuilders Were Not Excessively Cheap Before Mortgage Rates Spiked   In short, the important takeaway for investors is that the relative performance of housing-related stocks is not yet consistent with a housing-led US recession. Mortgage Rates Are Not Restrictive, And Have Likely Peaked As we highlighted in Chart II-1, the two-year change in the US 30-year conventional mortgage rate will be the largest in history by the end of this year, save the Volcker era, if the mortgage rate remains at its current level. However, it is not just the change in interest rates that matters for economic activity, but rather also the level. Encouragingly, Chart II-14 highlights that the level of mortgage rates has not yet risen into restrictive territory relative to the economy’s underlying potential rate of growth. In addition, it appears that mortgage rates have overreacted to the expected pace of monetary tightening – and thus have likely peaked for this year. Two points support this view: First, panel 2 of Chart II-14 highlights that the 30-year mortgage rate is one standard deviation too high relative to the 10-year Treasury yield, underscoring that the former has overshot. And second, Chart II-15 highlights that the mortgage rate is still too high even after controlling for business cycle expectations, current coupon MBS yields, and bond & equity market volatility. Chart II-14Mortgage Rates Are Not Yet Restrictive, But Have Likely Peaked For The Year Chart II-15No Matter How You Slice It, US Mortgage Rates Are Stretched   Structural Factors Supporting Housing Construction Chart II-16The US And Several Other DM Countries Have Underbuilt Homes Since The Global Financial Crisis Our analysis above points to a scenario in which the housing market slows in a nonrecessionary fashion, supported by relatively buoyant construction activity. Structural factors, which are mostly a legacy of the global financial crisis, are also supportive of the pace of housing construction in the US and other developed market economies. We presented Chart II-16 in our June 2021 Special Report, which shows the most standardized measure of cross-country housing supply available for several advanced economies: the trend in real residential investment relative to real GDP over time. These series are all rebased to 100 as of 1997, prior to the 2002-2007 US housing market boom. The chart makes it clear that advanced economies generally fall into two groups based on this metric: those that have seen declines in real residential investment relative to GDP, especially after the global financial crisis (panel 1) and those that have experienced either an uptrend in housing construction relative to output or a flat trend (panel 2). The US, along with the euro area, the UK, and Japan, all belong to the first group, with commodity-producing and Scandinavian countries belonging to the second group. The point of the chart is that the US and most other major DM economies have seemingly experienced a chronic undersupply of homes in the wake of the global financial crisis, which should continue to support housing construction activity even if demand for housing is slowing because of a sharp increase in mortgage rates. Given that the trend in real residential investment to GDP is a somewhat crude metric of housing supply, Chart II-17 presents a more precise measure for the US. It shows the standardized trend in permanent site residential structures investment (both single- and multi-family) relative to both the US population and the number of households. The chart makes it clear that the US vastly overbuilt homes from the late-1990s to 2007, but also vastly underbuilt since 2008. Relative to the number of households, real permanent site residential structures investment is still half of a standard deviation below its long-term average – even after the surge in construction that occurred in 2020. Chart II-18 highlights a similar message: it shows that the US homeowner vacancy rate (the proportion of the housing stock that is vacant and for sale) was at a 66-year low at the end of the first quarter. Chart II-19 shows that the monthly supply of existing one-family homes on the market is also at a multi-decade low, but that the supply of new homes for sale spiked in April. Chart II-17More Precise Home Supply Measures Underscore That The US Needs To Build More Houses Chart II-18The Homeowner Vacancy Rate Is Extremely Low     At first blush, this spike in the monthly supply of new homes relative to sales is quite concerning, as it has risen back to levels that prevailed in 2007. One point to note is that the increase in new home inventory relates to homes still under construction; the inventory of completed homes for sale remains quite low. In addition, from the perspective of a homebuilder, a rise in the monthly supply of new homes relative to home sales is only concerning if it translates into a significant increase in the amount of time to sell a completed home, as has historically been the case (Chart II-20). Chart II-19Existing Home Inventories Remain Low Relative To Sales... Chart II-20...And Higher New Home Inventories Are Not Affecting Time-To-Sale Of Completed Homes   Chart II-20 highlights that a fairly significant divergence between these two series has emerged over the past decade. Despite roughly five-six months’ supply of new home inventory on average since 2012, the median number of months required to sell a new home rarely exceeded four. In early-2019 the monthly supply of new homes also spiked, and a relatively modest and nonrecessionary slowdown in housing starts was sufficient to prevent any meaningful rise in the amount of time required to sell a newly completed home. Notably, the models that we presented in Chart II-9 led the slowdown in total home sales and starts in late-2018/early-2019, and they are not pointing to a major contraction today. The key point for investors is that while a slowdown in the housing market is clearly underway, it is not occurring after a period of excessive housing construction. In fact, the opposite is true: despite a surge in construction during the pandemic, it remains below its historical average relative to the population and especially the number of households. This should act to limit the drag on economic growth from housing-related activity, and therefore reduces the odds that a housing market slowdown will morph into a housing-driven US recession. Investment Implications We noted in our May report that the inversion of the 2-10 yield curve has set a recessionary tone to any weakness in US macroeconomic data, and that a recession scare was likely. Recent negative housing market data surprises underscore that a slowdown in the US housing market is clearly underway, and that this will likely feed recessionary concerns for a time. Investors should continue to be highly focused on the evolution of US macro data when making asset allocation decisions over the coming 6-12 months, as the current economic and financial market environment remains highly uncertain. This should include a strong focus on the housing market, as consumer surveys highlight that the overall impact of falling real wages and high house prices could cause a more pronounced slowdown in housing-related activity than we expect – and that the change and level of interest rates would imply. Nevertheless, our analysis of the historical predictors of housing construction and sales points to the conclusion that the ongoing housing market slowdown is not likely to be recessionary in nature. This, in conjunction with the factors that we noted in Section 1 of our report, support maintaining a modest overweight towards stocks within a multi-asset portfolio over the coming 6-12 months. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1     This is aside from the contribution to growth from imports, which mechanically subtract from consumption and investment when calculating GDP.

Chart 1 The S&P Media & Entertainment (M&E) index remains under fire due to its exposure to high beta names like GOOG(L), NFLX, FB, and DIS. These four companies dominate the industry group, comprising nearly 80% of the market cap. Initially, the group pulled back as a victim of stretched valuations, unreasonable growth expectations, and a broad ruckus within Big Tech on the back of the swift tightening of financial conditions (see chart). Notably, the M&E index’s forward P/E multiple contracted by nearly 50% moving from 30x to 16.7x in absolute terms, and now trading on par with the S&P 500. It may appear that these stocks have sold off, technicals are attractive, and valuations are no longer a concern. However, we are concerned that the M&E stocks are actually more expensive than they appear: Earnings are likely to come under more pressure. Netflix and Disney are consumer stocks, with entertainments falling under the discretionary column of a family budget.  With American families struggling with rising prices and negative real wage growth, discretionary spending may be curtailed. As for the other media companies, like FB, Alphabet, and their less famous brethren, SNAP earnings have just flashed a warning sign: Advertising spending is highly economically sensitive and is often one of the first expenses companies cut back on when tightening the belt. Therefore, it appears, that the M&E industry group is not out of the woods yet and is likely to face even more challenges over the next several months.  As such, we recommend using the next bear market rally to lighten the allocation. Sell the rip! Bottom Line: The sector's high exposure to discretionary spending and high economic sensitivity of advertising expenditures point to continued earnings disappointment. Today, we downgrade the S&P Media & Entertainment industry group from overweight to neutral, with an eye on eventually taking the allocation to underweight.

Executive Summary Credit Demand Collapsed Business activity data from April showed a broad-based contraction in China’s economy. Credit growth tumbled as demand collapsed. Bank loan expansion slowed by the most in nearly five years and annual change in new household loans declined to an all-time low. Exports decelerated sharply in April. China’s export sector faces headwinds from Omicron-related supply chain disruptions and weakening global demand for goods. Export growth will rebound following the resumption of business activity in China’s major cities, but is set to decelerate from 2021 as external demand for goods weakens. The PBOC lowered the 5-year loan prime rate (LPR) by 15bps last Friday, following a cut in the floor rate of first-home mortgages to 20bp below the benchmark. These moves will help to arrest the ongoing deep contraction in the property market. However, these policies alone will not generate strong recovery in housing demand, amid near-term Covid-related disruptions and dampened household income growth. Barring major lockdowns, China’s economy will likely bottom around mid-2022. We expect a muted recovery in the second half of the year, despite an acceleration in policy easing. From a cyclical perspective, we continue to recommend a neutral allocation to Chinese onshore stocks in a global portfolio. Bottom Line: China’s economy has been hit by a relapse in demand and Covid-induced production disruptions. The economy will likely bottom by mid-year, but the ensuing recovery may be subdued. A Subdued Recovery In 2H 2022 A broad-based contraction in China’s economy in April reflects hit by a combination of slumping domestic demand and Covid-related disruptions. Growth in retail sales and industrial production contracted from a year ago and home sales shrunk further. Economic activity will rebound when the current Covid wave is under control and lockdown restrictions are lifted. However, we expect a much more muted recovery in the second half of this year compared with two years ago when China’s economy staged an impressive V-shaped recovery as it emerged from the first wave of lockdowns in spring 2020. Presently, reported virus cases have steadily declined in cities in the Yangtze River region, including Shanghai which aims to lift its lockdown on June 1st. The number of regions and cities under stringent confinement also fell. However, China firmly maintains its dynamic zero-Covid policy, which means tight mobility restrictions and some forms of lockdowns will occur across the country on a rolling basis going forward.  China’s leadership has stepped up its pro-growth policy measures, such as a 15bps cut in the 5-year LPR last week. Given the pace of credit expansion collapsed in April and private-sector sentiment remains in the doldrums, a recovery will not be imminent or strong despite this rate cut (Chart 1). In the near term, the poor economic outlook in China, coupled with jitters in the global equity market, will continue to depress the performance of Chinese stocks in absolute terms (Chart 1, bottom panel). From a cyclical perspective, we maintain our neutral view on China’s onshore stocks and underweight view on China’s investable stocks within a global equity portfolio. China’s economy is set to underwhelm investor expectations and stock prices probably are unlikely to outperform their global counterparts (Chart 2). Chart 1Weak Economic Fundamentals Undermine Stock Performance Chart 2Too Early To Upgrade Chinese Stocks In A Global Portfolio Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Credit Growth Slowed Notably As Loan Demand Slumps Credit expansion in April relapsed, as lockdowns exacerbated the weakness in business activity and further depressed the demand for credit. Bank loan growth plummeted to its worst level in almost five years (Chart 3). Notably, annual change in new household loans origination contracted the most since data collection began because Covid lockdowns and the property market slump sapped consumers’ willingness to borrow (Chart 4). In addition, household propensity to spend declined to an all-time low, highlighting that bleak sentiment will continue to curb demand for loans (Chart 4, bottom panel). Moreover, a rapid deceleration in corporate medium-and long-term loans versus soaring short-term bill financing indicates corporates’ weak demand for credit and investment (Chart 5). The deterioration in corporate sentiment is also reflected in business condition surveys (Chart 6). Chart 3Subdued TSF Growth Due To Collapsed Loan Demand Chart 4Annual Change In New Household Loans Contracted The Most In April Chart 5Corporate Demand For Credit Remains in The Doldrums … Chart 6... And Unlikely To Turn Around Soon Despite Accommodative Monetary Conditions Chart 7Early Signs Of Authorities Loosening Their Grip On Shadow Banking Local government bond issuance unexpectedly moderated in April after most of the front-loaded local government special purpose bonds (SPBs) was issued in Q1. In the January-April period this year, the amount of SPBs issuance was RMB 1.41 trillion. The SPBs quota for 2022 is 3.65 trillion, along with 1.1 trillion of SPB proceeds that can be carried over from last year. Given that most of the planned SPBs will be issued by the end of June, we will likely see a peak in SPB issuance in Q2.This entails about RMB 3 trillion of SPBs will be issued in May-June. The intensified SPB issuance will underpin total social financing (TSF) growth in the next two to three months. However, barring an increase in the SPB quota or an approval to issue Special Treasury bonds as occurred in 2H 2020, the support from government bonds issuance to TSF will likely decline sharply in the second half of this year. Notably, there has been stabilization in shadow bank financing growth, although it remains below zero (Chart 7). It may be an early sign that China’s leadership is allowing some shadow banking activity; a meaningful relaxation of local governments’ shadow banking activity would be positive for infrastructure investment. Exports: Weaker Than Last Year China’s exports growth softened sharply in April, led by an extensive reduction in shipments to major developed markets (Chart 8). In addition, exports by product group also indicate a wide ranging slowdown in both exports of lower-end consumer goods and tech products (Chart 9). The softness in China’s exports reflects Omicron-related supply chain and logistical disruptions along with a weakening external demand for goods. Chart 8China's Exports To Developed Markets Fell Chart 9A Broad-Based Decline Among Categories of Exported Goods Chart 10Weakening Global Demand For Goods South Korean exports, a bellwether for global trade, have also been easing in line with Chinese exports, which indicates dwindling global demand for manufacturing goods (Chart 10). In addition, the sharp underperformance of global cyclical stocks versus defensives heralds a worldwide manufacturing downturn (Chart 11). Falling US demand for consumer goods corroborates diminishing external demand (Chart 12). China’s exports will likely rebound from its April levels when manufacturing production resumes in Shanghai and supply-chain interruptions subside in the Yangtze River Delta region. Nonetheless, we expect a contraction in exports this year, as global consumer demand for goods dwindles. Chart 11Global Manufacturing Sector Is Heading Into A Downturn Chart 12External Demand For Chinese Export Goods Is Dwindling Recovery In China’s Manufacturing Sector Will Be Muted In 2H 2022 Manufacturing production growth contracted in April at the fastest rate since data collection began. The contraction was due to Covid-induced production troubles and weak demand (Chart 13). Chart 13Manufacturing Output Growth Contracted The Most Since Data Reporting Began Chart 14Mounting Product Inventory Chart 15Chinese Manufacturing Output And Capacity Utilization Face Headwinds From Weakening Exports The inventory of finished products soared to the highest point in the past 10 years due to port closures and domestic logistical issues (Chart 14).  Even when the impact of the current Covid wave wanes in the second half of this year, destocking pressures will dampen manufacturing production. In addition, Chinese manufacturing output and capacity utilization face headwinds from decelerating exports (Chart 15). While upstream industries, such as the mining, resources and materials sectors, benefit from strong pricing trends, profit margins for middle-to-downstream manufacturers remain very subdued (Chart 16). The large gap between prices for producer goods and consumer goods is a reflection of the inability of manufacturers to pass on higher input costs to consumers (Chart 17). Elevated input cost pressures and, hence, disappointing corporate profits, will continue to curb manufacturing investments and production in 2H 2022. Chart 16Manufacturing Sector's Profit Margins Are Further Squeezed Chart 17Manufacturers Are Under Rising Cost Pressures Housing Market Outlook Remains Gloomy The PBOC lowered the 5-year LPR by 15bps from 4.6% to 4.45% on May 20, the largest LPR rate cut since 2019. The easing measure followed a reduction in first-home mortgages to 20bps below the benchmark announced on May 15. The national-level mortgage rate floor and benchmark rate drops are clear signals that policymakers are ramping up policy easing measures in the property sector, given the failure of previous efforts to revive housing demand. Historically, mortgage rates tend to lead household loans and home sales by two quarters, suggesting that the housing market may see some improvement by year-end (Chart 18). However, as we pointed out in previous reports, without large-scale and direct fiscal transfers to consumers to boost household income, these housing measures will unlikely generate a strong rebound in household sentiment and home purchases (Chart 19). Chart 18Mortgage Rates Tend To Lead Consumer Loans And Home Sales By Two Quarters Chart 19Housing Market Sentiment Shows Little Signs Of Revival Lockdowns in April exacerbated the slump in all housing market indicators, with the exception of a moderate improvement in floor space completed (Chart 20). Home prices, which tend to lead housing starts, decelerated even more in April following seven consecutive month-to-month declines. Moreover, our housing price diffusion index suggests that home prices on a year-on-year basis will contract in the next six to nine months, a further drop from the current 0.7% growth (Chart 21, top panel). Falling home prices will curb housing starts and construction activity (Chart 21, bottom panel). In addition, real estate developers’ financing conditions have not improved because the “three red lines” policy is still in place and home sales have collapsed (Chart 22). Chart 20A Further Deterioration In Housing Market Indicators In April Chart 21Housing Prices Are Set To Contract In 2H 2022 Chart 22Slumping Home Sales Exacerbate Real Estate Developers’ Funding Woes   A Collapse In Household Consumption Due To Covid Confinement Measures City lockdowns have taken a heavy toll on China’s household consumption. Both retail sales and service sector business activity experienced their deepest contractions since March 2020 (Chart 23). Notably, the growth of online goods sales slipped under zero in April, below that recorded in early 2000 and the first contraction since data collection began. Furthermore, both core and service consumer prices (CPI) weakened again in April, reflecting lackluster consumer demand (Chart 24). Chart 23Chinese Retail Sales Contracted The Most Since March 2020 Chart 24Weak Core And Service CPIs Also Reflect Lackluster Household Demand Labor market dynamics went downhill rapidly. The nationwide urban unemployment rate rose to its highest level since mid-2020, while the unemployment rate among younger workers climbed to an all-time high (Chart 25). Meanwhile, sharply slowing wage growth since mid-2021 has contributed to a deceleration of household income (Chart 26). The gloomy sentiment on future income also impedes a household’s willingness to consume (Chart 27). Chart 25Labor Market Situation Is Dramatically Worse Chart 26Household Income Growth Has Been Falling All in all, China’s household consumption will be hindered not only by renewed threats from flareups in domestic COVID-19 cases, but also by a worsening labor market situation and depressed household sentiment in the medium term. Chart 27Poor Sentiment On Funture Income Contributes To Consumers' Unwillingness To Spend Table 1China Macro Data Summary Table 2China Financial Market Performance Summary   Strategic Themes Cyclical Recommendations

Special Report

Executive Summary Real Estate Is A Poor Inflation Hedge The real estate sector is experiencing a robust post-pandemic recovery fueled by easy monetary and fiscal policy, with vacancy rates falling, earnings growing, and balance sheets looking healthy.  Despite being a real asset, our in-depth analysis shows that the sector appears to be a poor inflation hedge and underperforms the market when inflation is elevated. There is a great dispersion within the sector – correlations across REIT segments are low. Residential REITs offer solid protection against inflation: Rent growth outpaces inflation thanks to chronic housing underbuilding and a recent rebound in new household formation.  Likewise, we expect the Industrial REITs segment to offer inflation protection.  Following recent supply disruptions, companies are shifting away from the “just-in-time” to “just-in-case” model, spurring strong demand for warehousing, fulfillment, and logistics centers, and pushing up rents.  Office and Retail REITs segments will be the two industry laggards due to structural shifts in consumer and worker behavior. Bottom Line: Today we downgrade the S&P Real Estate sector from overweight to neutral while keeping a granular intra-sector allocation. Specifically, we recommend investors overweight Specialized, Industrial, and Residential REITs, while underweighting Office and Retail segments. Feature Related Report  US Equity StrategyHave US Equities Hit Rock Bottom? The last few months have been marred by a violent sell-off in US equities, with stubbornly high inflation, and the Fed’s well-telegraphed hawkishness being front and center of the market rout. While this is a toxic brew for most equity sectors, Real Estate finds itself in a crosscurrent of two opposing trends. It is a high-yielding real asset that, at least in principle, is well-positioned to withstand inflation (most landlords are able to raise rents at least in line with inflation). However, tightening monetary policy and rising mortgage rates present unique challenges for the sector, suppressing demand for real estate and compressing the present value of future cash flows, thus handicapping capital appreciation. The recent downside surprise in the NAHB housing market reading is a case in point: 69 reported while the consensus range was 75 -77, signaling a sharp deceleration in house price growth. There is also a pronounced turn in sales activity (Chart 1). However, just as the real economy is not the stock market, the housing market is only one of the segments of the Real Estate sector. In this report, we will provide an overview of the entire sector, including valuations and fundamentals, and will consider the effects of inflation and rate regimes on sector performance. We will also take a look at the various segments of the REIT equity sector and the key drivers of their performance in our quest for the best inflation hedge. Chart 1Real Estate Sales Have Turned Down The US REIT Overview The REIT Sector Has Experienced Strong Growth Over The Past Decade There are more than 225 REITs in the US registered with the SEC, 175 of which trade on the NYSE. The ever-expanding cohort of NYSE-traded REITs has experienced explosive growth over the past 10 years, as a result of investors' search for yield, and this cohort now has a combined equity market capitalization of more than $1.4 trillion (Chart 2). These are mostly equity REITs – trusts that own and operate income-producing assets and earn income mostly through rents. Thirty of these equity REITs comprise the S&P 500 Real Estate sector. The Real Estate sector is small at 3% of S&P 500 market capitalization but its share has been growing steadily over time (Chart 3). Chart 2Equity REITs Have Gained Popularity Over The Past Decade Chart 3Real Estate Is A Small Sector But Its Share Has Been Growing Steadily REITs Are Equities, But Not Quite The business model of most REITs is rather simple: Lease space and collect rent on the properties, then distribute income as a dividend to shareholders. There are a number of IRS provisions that REITs have to comply with, of which the following are most relevant to investors: Invest at least 75% of total assets in real estate, cash, or US Treasuries; Derive at least 75% of gross income from rents, interest on mortgages that finance property, or real estate sales; and Pay a minimum of 90% of taxable income in the form of shareholder dividends each year.1 REITs are total return investments as they provide income as well as capital appreciation. Sector Composition The S&P 500 Real Estate sector consists of two industries – REITs, which represent roughly 98% of the sector, and Real Estate Management and Development, which is about 2% of the sector. We will focus on the REITs. The S&P 500 REIT industry is comprised of eight broad categories (Chart 4), of which Specialized REITs are by far the largest, at 45% of the sector market capitalization. The composition of the REIT market has changed over the years. While the traditional retail and residential segments dominated the market in the first years of the millennium, structural changes have shifted the balance towards specialized segments such as infrastructure, data centers, as well as industrial REITs (Chart 5). The pandemic and a shift toward remote work have accelerated many of the existing trends, such as a decline in the office segment. Consolidations of health care facilities and hospitals have reduced the Health Care REIT segment. Chart 4The S&P 500 REIT Industry Composition Chart 5REITs Composition Is Changing Over Time Sector Performance Since 2010, in the aftermath of the GFC, the Real Estate sector has underperformed the S&P 500 by 20% (Chart 6). However, within the sector, there is a wide divergence in relative performance, with Industrial REITs beating the index by 10%, while Office, Hotels, and Health Care REITs lagging by some 50%. More recently, the Real Estate Sector has performed more or less in line with the S&P 500 (Table 1), in contrast to the wild swings in relative performance experienced by other sectors. Like their corporate brethren in the Health Care sector, defensive Health Care REIT performance was stellar, beating the S&P 500 by 10% over the past 12 months. Hotel REITs bounced back strongly after a prolonged period of underperformance because of a nascent post-pandemic recovery in travel. Clearly, there is significant dispersion in both long- and short-term performance within the sector – correlations across segments are low (Chart 7). It is important to understand the key drivers of each segment for better asset selection. Chart 6In The Aftermath Of The GFC, The Real Estate Sector Has Underperformed Chart 7Correlations Across REIT Segments Are Low Table 1Performance Relative To The S&P 500 REIT Dividend Yield And TINA One of the main attractions of REITs is their IRS-mandated high dividend payout. Indeed, currently, the Real Estate sector dividend yield is 2.9%, a whole 130 bps higher than for the S&P 500. In fact, all REIT sectors and subsectors (with the exception of the lodging/resorts sector) currently have dividend yields higher than those of public equities (Chart 8). However, for many investors, yield comparison goes beyond equities alone. For multi-asset investors, the REIT yield is usually competing with the yield on other fixed-income instruments (Chart 9). Currently, REITs offer yields on par with investment-grade bonds, but arguably they are more attractive thanks to capital appreciation potential. Chart 8Almost All REIT Segments Yield More Than The S&P 500 Chart 9REIT Yield Is Attractive Performance Of The Real Estate Sector In Different Inflation And Rate Regimes Real estate is a real asset and resilience to inflationary pressures is literally embedded in its name. Unfortunately, empirical analysis of the performance of Real Estate sectors during periods of high inflation disappoints. Chart 10 demonstrates that Real Estate is quite simply not a good inflation hedge. The sector tends to have the strongest performance when inflation is in the 2-3.5% range, beating the S&P 500 54% of the time. As inflation rises, RE tends to lag the broad market. This result is surely confounding. The likely explanation is that rising inflation is literally an invitation to tighter monetary policy. As rates rise, Real Estate underperforms (Chart 11). Higher interest rates decrease the value of real estate assets by discounting future cash flows at a higher rate, thus impairing the capital appreciation component of the Real Estate total return. As such, cap rates and interest rates move in lockstep (Chart 12). Chart 10Real Estate Is A Poor Inflation Hedge Chart 11REITs Tend To Underperform When Rates Are Rising   Thus, when inflation is high and rates are on the rise, the sector is caught in the crosscurrents: While overall, the ability to raise rents insulates the sector from the adverse effects of inflation, higher rates dampen capital appreciation. Hence, it is not surprising that high inflation and the rising rate regime are unfavorable for the sector (Chart 13), with the sector’s median three-month performance in this regime since 1970 lagging the S&P 500 by 1.8%. In this regime, RE beats the market only 38% of the time. Chart 12Cap Rates And Interest Rates Move In Lockstep Chart 13High Inflation And Rising Rates Are Unfavorable For Real Estate While the S&P 500 Real Estate Sector is a poor inflation hedge, for investors with the ability to be more granular in REIT allocations, drilling down to sub-categories of the market might be beneficial. The real estate market is diverse and different segments do not react the same way to rising interest rates or inflation. Bottom Line: It appears that in a battle between inflation (favorable for the sector yield) and rising rates (unfavorable for capital appreciation), rates have the upper hand. Fundamentals And Valuations Even though REITs are technically equities, their analysis requires different metrics. Whereas equity investors rely on multiples such as price-to-earnings (P/E) or price-to-book (P/B), for REITs price-to-funds from operations (P/FFO) is a more important valuation tool. FFO is favored over earnings since it adds back depreciation and amortization expense. FFO also adds any gains (or subtracts any losses) from sales of underlying assets to net income. REITs traded at a steady 17x FFO between the end of the GFC and the start of the pandemic. FFO fell by 30% in the first two quarters of 2020 compared to Q4 2019, pushing the P/FFO multiple to 24.7 – a level that appears to be an expensive “post-pandemic normal” (Chart 14). The risk premium for REITs (calculated as the FFO yield minus the real 10-year Treasury yield) – currently at 5.4% – remains higher than the pre-GFC bottom of 3.5%. Consider Chart 15: On this basis, REITs are attractive. Chart 14REITs Are Trading At An Easy Money Post-Pandemic High Chart 15Risk Premium Is Still Reasonable In terms of profitability, the sector appears to be thriving: Occupancy rates are rising (Chart 16) and FFO is growing. However, it is important to note that US economic growth is slowing, and that may reverse the fortunes of the sector, weakening demand for properties, and lifting vacancy rates. Bottom Line: Earnings continue to rise, and cap rates – while declining – remain high compared to the risk-free rate. A post-pandemic recovery is underway. However, slowing economic growth has a potential to reverse these favorable trends. Chart 16Occupancy Rates Are Rising Again REIT Balance Sheets Are Healthy The real estate sector has historically been seen as risky due to its high leverage, but leverage has been on the decline. Over the past decade, REIT reliance on equity capital has increased, with the equity/asset ratio rising from 32% in 2008 to 45% in 2022. The ratio of debt-to-book assets stands at around 48% , much lower than 58% during the GFC (Chart 17). REITs have also extended the average maturity of their debt from five years in 2008 to over 7.5 years today. The fall in interest rates over the past two decades has benefited equity REITs: As rates fell, so did the interest they paid on their debt. Liquidity ratios also improved, with coverage ratio (earnings relative to interest expense) rising to a solid 6.5x. Bottom Line: REIT balance sheet health has improved significantly as the share of equity financing continues to grow. Also, a downward trend in interest rates has made existing debt more manageable. Chart 17A Shift Towards Equity Financing And Falling Rates Have Fortified REIT Balance Sheet REIT Segments And Their Economic Drivers The pandemic has accelerated some existing trends in the real estate sector and established new ones. Some sectors will struggle in this new environment, while others will flourish. There is a broad dispersion across the REIT segments in terms of yield vs capitalization, and the ability to withstand inflation and rising rates. REIT Segments In Charts – Residential and Industrial Appear Most Attractive Vacancy Rates are declining across all segments. The industrial segment has the lowest vacancy rate at 4.1%, followed by residential at 4.9%. Offices have the highest vacancy rates at 12.2% (Chart 18). Rents are rising. Apartments have experienced the steepest increase from 1.3% growth in 2020 to 11.3% in Q1-2022. Industrial rent growth has accelerated from 5.3% to 11%. Office rent growth is decelerating (Chart 19). Chart 18Vacancy Rates Recovered For All Segments But Office Chart 19Residential And Industrial Rent Increases Outpace Inflation Acquisitions are increasing at a robust pace with apartments experiencing the most activity (Chart 20). Sales Prices are also increasing (Chart 21). Industrial sales prices on average were up 15% from one year ago, while multifamily property prices rose 10.5%. Both these assets are earning rental income and returns that are higher than the current inflation rate, which makes them attractive assets to hold at a time of high inflation. Chart 20Sales Activity Is Robust Chart 21Industrial And Residential Properties Are Most Popular Among Investors The Cap Rate is experiencing compression (Chart 22) as higher rents boost sales prices, making properties more expensive. As a result, multi-family properties, which boast the highest rent growth and the lowest occupancy rate, have the lowest cap rate at 3.2%. Low demand for office space due to the pandemic has pushed the cap rate to 4.9%. Total Return is a combination of the rising value of a property and its yield, which moves in the opposite direction. As of April, Apartments had the highest total annual return of 12.7%, followed by Industrial at 10.7%. The total return of all commercial segments, except for Office, has exceeded the rate of inflation. Furthermore, we will comment on each of the segments to explain the trends observed in the charts (Chart 23). Chart 22Cap Rates Are Relatively Low Across The Board Chart 23Industrial and Residential Produced The Highest Total Returns Specialized REITs Are A Play On The Digitalization Of The Economy While other segment names are self-explanatory, Specialized is a little trickier. The specialized REITs segment accounts for properties not classified elsewhere. These REITs own and manage a unique mix of property types such as movie theaters, farmland, and energy pipelines. Also, a REIT that consists of, say, both office and retail properties, would also be classified as Specialized. This is the broadest and most diversified category, and it is not surprising that it accounts for nearly half of the sector by market cap. It is also the highest-yielding category with a dividend yield of 4.7%. The specialized category is particularly attractive as it includes many high-tech geared categories, such as communication networks and data centers. Properties that support the digital economy have attracted a lot of demand over the past couple of years, and FFO growth is strong (Chart 24). With a host of new technologies in the wings, demand for data centers is expected to continue to grow. Due to the high and complex technical set-up specifications, leases are usually longer (upwards of five years). Since lease terms are long, owners can’t reset rent to keep up with inflation. On the other hand, strong demand for data centers is pushing new rents up. Fundamentals for the segment are supportive: The cap rate, at 4.4%, is in line with the REIT benchmark (Chart 25). Chart 24Strong Demand For Data Centers Chart 25Data Center Cap Rate Is In Line With The Benchmark   Bottom Line: We favor the Specialized REIT segment. It is well diversified and resilient to market swings. It also has significant exposure to the technology sector and benefits from a shift towards a more digitalized economy. This should also immunize the sector over the economic cycle as dependence on data increases structurally. Key tickers for this segment are: AMT, CCI. Retail REITs Are Battling Headwinds From E-commerce The “death of retail” is not a new phenomenon – consumer spending continues to shift from in-store to online. Over the past two decades, non-store retail sales in the US have grown at an annualized 9.5%, compared to 3.1% for in-store sales. E-commerce has risen to almost 14% of total retail sales. This shift is reflected in the halving of the weight of retail REITs in the Real Estate sector over the past decade. The headwinds facing the sector – particularly shopping centers – have not abated. The retail REIT occupancy rate is among the lowest in the CRE: 96% as of Q4-2021. However, with little construction underway, rent growth is not likely to decline, and will rise to mid-3%. With rents not keeping up with inflation, retail properties are a poor inflation hedge. Bottom Line: We recommend investors underweight the retail sector within their broad real estate exposure. The structural headwinds are not likely to disappear, while inflation will remain a major headwind. Key tickers for this segment are: O, SPG. Office REITs – Workers Are Not Coming Back There has long been a close link between office demand and employment. As the labor market tightens, demand for offices increases, and rents rise. However, “this time is different” due to the tectonic shift brought about by the pandemic. According to the NAR, not all workers are returning to the office (Chart 26): 17% of office employees are still telecommuting. Worse yet, there is an ongoing decline in small business formatting, impairing demand for new office space. As a result, the sector is currently flush with supply, and the occupancy rate is down from 94% to 89% (Chart 27). Yet, asking rents continue to recover, albeit slowly, and lag the rate of inflation: As of April 2022, the average year-over-year growth was 1.3%.2 Given the ongoing construction of about 150 MSF, the vacancy rate will likely remain above 10%, but rents will continue to increase modestly as more workers return to the office.3 Chart 26Many Workers Are Not Returning To The Office Chart 27The Pandemic Has Changed Office Demand Dynamics Bottom Line: Underweight the office sector within broad real estate exposure. A shift to remote work, elevated vacancy rates, and ongoing construction are likely to put the brakes on rent growth. Real rent growth is expected to be negative – this segment is a poor inflation hedge. Key tickers for this segment are: ARE, BXP. Residential REITs – Housing Shortages Are A Tailwind Residential REITs are primarily focused on apartments, but single-family homes and mobile homes fall under the same category (Chart 28). This segment is the closest proxy to the US housing market. The housing sector has been undersupplied for decades: The ratio of annual housing starts to the total number of households is 1.2 – 0.7 percentage points below its pre-GFC average (Chart 29). Chart 28Apartments Make Up The Majority Of Residential REITs Chart 29Housing Undersupply Is Not A New Issue...   This has pushed up prices, increasing unaffordability, particularly for first-time buyers (Chart 30). This increased the percentage of US housing inventory occupied by renters rather than owners (Chart 31). Chart 30...Making Home Prices Unaffordable Chart 31Pushing More People Towards Renting Recently, housing shortages have been further exacerbated by a post-pandemic rebound in new household formation (Chart 32). Rising mortgage rates tend to further increase the demand for rental units. Vacancy rates are bound to fall further, leading to sustained double-digit rent and price growth.  As of April, multi-family rents are up 9.4% year-over-year, higher than this inflation rate of 8.5%. Bottom Line: Chronic underbuilding and a recent rebound in new household formation have spurred demand for housing, putting upward pressure on rents, making the category an excellent inflation hedge. Key tickers for this segment are: AVB, EQR. Chart 32Household Formation Has Rebounded Industrial Property Industrial REITs manage industrial facilities, with the logistics segment being a key growth driver thanks to high exposure to e-commerce. Industrial properties include warehouses, fulfillment centers, and last-mile delivery and distribution. Research by Prologis shows that e-commerce requires more than 3x the logistics space of brick-and-mortar sales. That is why occupancy rates have been rising over the past decade, and are currently at an all-time high, four percentage points higher than their 20-year average (Chart 33). The pandemic has also revealed how vulnerable current supply chains are and has accelerated a trend BCA Research has highlighted for years: The decline of globalization. Going forward, companies will move to re-shore some of their production to gain greater control over supply chains transitioning from “just-in-time” to “just-in-case” inventory management to minimize supply disruptions. This shift will amplify the need for industrial space. As a result, Industrial REIT rent growth has been robust, with rents up 11% year-over-year, with 37% of 390 markets posting double-digit rent growth. Rent growth lower down the value chain closer to the end-consumer has been particularly strong: Asking rents for logistics space are up on average 12.4% year-over-year mostly due to the scarcity of permittable land (Chart 34). Chart 33Increase Demand For Warehouses Pushed Up Occupancy Rates Chart 34Logistics Rent Growth Is The Fastest Due To Scarcity Bottom Line: We expect the Industrial sector to continue to outperform the broad REIT market, supported by strong demand for fulfillment and logistics centers which is pushing rents up. Industrial REITs are an excellent inflation hedge. Key tickers for this segment are: PLD, DRE. Investment Implications The real estate sector is experiencing a robust post-pandemic recovery fueled by easy monetary and fiscal policy, with vacancy rates falling, earnings growing, and balance sheets looking healthy. However, despite being a real asset, the sector appears to be a poor inflation hedge, underperforming the market when inflation is elevated. High inflation is often accompanied by rising rates, which reduce the value of future cash flows, impair capital appreciation, and offset income gains brought about by rent increases. Further, slowing growth may become a significant headwind, reversing gains in occupancy rates. Out of an abundance of caution, we are downgrading Real Estate from overweight to equal weight. However, Real Estate is a diverse sector, with segments almost uncorrelated to each other. As such, we recommend a granular allocation within the sector. Overweight Specialized, Industrial, and Residential segments which benefit from positive long-term trends, enjoy low vacancy rates, and positive real rent growth. We also recommend underweight allocations to Office and Retail segments, which suffer from adverse trends brought about by changes in consumer behavior, that translate into elevated vacancy rates and negative real rent growth. Bottom Line: The Real Estate sector is sensitive to rising rates and is a poor inflation hedge. We are downgrading the sector from overweight to equal weight. However, the sector is diverse, and commercial real estate sectors have a low correlation to each other. Within the sector, we favor Specialized, Industrial, and Residential segments that benefit from favorable long-term trends, and offer strong wage growth and potential for capital appreciation. These segments are likely to be strong inflation hedges.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     Investopedia 2     Commercial Market Insights, April 2022, National Association of REALTORS® Research Group 3    Ibid   Recommended Allocation Recommended Allocation: Addendum 

Inflation continues to put pressure on the US consumers. Negative real wage growth (Chart 1) and soaring prices of food and energy are pushing many low and middle-class Americans to shift spending away from discretionary items toward necessities (Chart 2). We have written about this here.  Chart 1CHART 1​​​​​​ Chart 2​​​​​​ Table 1 The recent earnings commentary from Walmart and Target are attesting the trend. Both noted that consumers are switching from the high-margin items (non-necessities) to the lower-margin necessity items like food. Both companies have also commented on the ongoing supply chain challenges and rising costs of both goods (COGS) and wages. Target reported a 430bps contraction in gross margins. Peak margins for the sector are surely in the rear-view mirror. Both Walmart and Target provided negative guidance. As a result, a retail “carnage” has ensued, WMT is down 20%, COST 15%, and TGT 30% over the past three days.  The sell-off was exacerbated by the Powell’s comments that combating inflation is likely to incur economic pain, hinting at a possibility of a recession on the back of the Fed’s actions. These comments have reiterated the Fed’s hawkish stance, and have removed any hope of the Fed’s put, i.e., the Fed coming to the rescue of the spluttering equity market.  What’s next? We believe that the markets can continue to fall. A few conditions of our Equity Capitulation scorecard have not been yet met (Table 1).  Rate stabilization – The Fed’s hawkish stance and a plan to front-load a rate hiking cycle suggest that monetary conditions will continue to tighten (-1)  Economic growth expectations do not yet reflect the deteriorating economic backdrop. US GDP forecasts will be further downgraded (-1)  Earnings growth expectations need to come down to reflect supply disruptions, raging input prices, and the stronger dollar (-1)  Oil prices have somewhat stabilized (+1)  Valuations have retraced, signaling that the market is reasonably priced. However, earnings downgrades will push forward multiples higher (0)  Technicals signal that the market is oversold (+2)  “Black swans” – headwinds from the war in Ukraine and lockdowns in China (-2)  Bottom Line: On balance, risks for US equities slightly outweigh the upside opportunity. A market bottom is still a few weeks, or even months, away.   

Special Report

Executive Summary Indian Voter’s Economic Miseries Are Ascendant India has a strong strategic geopolitical position but is likely to face turbulence in the short term. This is because India remains expensive, and investors worry if the record political stability shown by India since 2014 can last. We highlight that the ruling Bhartiya Janata Party (BJP) may lose some seats in the near term. India’s most populous states could witness a few cases of social conflict as economic miseries grow. India may also temporarily resort to a degree of fiscal populism. But the BJP will be able to hold power for a third consecutive term in 2024, that too with a simple majority. The burst of fiscal populism will be temporary. Moreover, the next tier of India’s most populous states are well-positioned to drive India’s growth story in the long run. We urge investors to tactically short India / long Brazil financials given that India may see some turbulence in the short run. Strategic investors should consider long India tech / short China tech. Trade Recommendation Inception Date Return SHORT INDIA / LONG BRAZIL FINANCIALS 2022-02-10 12.5% Bottom Line: The ruling political party in India may face some political setbacks in the short term. It could even resort to fiscal populism. But the ruling party in a base case, should be able to retain power for a third term in 2024. On a tactical timeframe we advise caution on India but remain constructive on a strategic horizon. Feature The woods are lovely, dark and deep, But I have promises to keep, And miles to go before I sleep, And miles to go before I sleep. – Robert Frost, Stopping By Woods On A Snowy Evening (New Hampshire, 1923)   The protagonist in this famous poem is overwhelmed by the beauty of the wintry woods, but then must stay vigilant about the here and now. The situation that confronts an investor into India today, is surprisingly similar. India has a strong strategic geopolitical position, a position that has strengthened following the Ukraine war. However, Indian markets might face turbulence in the short term. This is because India remains expensive and its ability to keep promises (about high degrees of political stability or about its fiscal discipline) could be tested on a tactical time horizon. In specific, investors with exposure to India worry about three politico-economic challenges: The Anti-Incumbency Challenge Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em 13 September 2013 is a key date in India’s modern history. On this day the Bhartiya Janata Party (BJP) announced Narendra Modi as BJP’s prime ministerial (PM) candidate just a few months ahead of the 2014 general elections. From 13 September 2013 till date, MSCI India has incidentally outperformed MSCI EM by a resounding 94.8%. In 2013, markets celebrated the rise of the Modi-led BJP government since such a dispensation was new, and it promised to deliver structural reform. But now when general elections will be held in 2024, the BJP must deal with a middling report card on reforms and a two-term anti-incumbency to boot. Given this clients worry if 2024 could see India go back to an era of coalition governments? The Fiscal Challenge India under BJP has displayed impressive degrees of fiscal discipline. With rising inflation now adding to Indian voters’ miseries and with a loaded state election calendar due in 2023, investors ask if India’s notable streak of fiscal fortitude can last? The Demographics Challenge As China’s weak demographic future becomes clearer, India’s youthful demographics keep attracting paeans. This is partially responsible for the fact that India has traded at a five-year average premium of 54.5% to China on forward price to earnings. With increasing reports of communal violence and inflation-related protests breaking out in India, investors also worry about India’s so-called demographic dividend and how best to play the game? In a foundational GPS Special Report published in 2018 we had made the point that, “Predicting political outcomes is difficult, but to generate geopolitical alpha investors should focus on ‘beating the spread’ not predicting the match winner”. At a time when there is much uncertainty about India’s immediate future, we highlight three key base case predictions with respect to India. By highlighting these key predictions, we hope investors can position themselves for generating geopolitical alpha. We conclude the report with actionable investment recommendations. India’s High Political Stability, Likely To Stay In 2024 Chart 1Bhartiya Janata Party’s (BJP) Win In India In 2014 Was Historic The Bhartiya Janata Party (BJP) stormed into power in 2014. Its assumption of power under PM Modi’s leadership was historic. This is because this was the first time since 1984 that a single political party had managed to secure a simple majority on its own steam (Chart 1). The rise of BJP in this resurrected avatar marked a structural break from the past, in three distinct ways: End To Instability Of Nineties: The rise of BJP 2.0 in 2014 marked an end to the political instability seen in the nineties when governments struggled to complete their full five-year terms. This is a problem that India’s South Asian neighbors like Sri Lanka and Pakistan are yet to overcome. End Of Coalition Politics Of Early 2000s: BJP’s rise in 2014 also marked an end to the coalition politics of the early 2000s. While three coalition governments in India managed to complete their five-year terms from 1999-2014, the reform agenda over this period was often held at ransom by smaller coalition partners. India’s ability to break away from coalition governments back in 2014 was commendable given that several developing countries as well as developed countries still have coalition governments at the helm. Regime Continuity: The BJP’s rise in 2014 and their re-election in 2019 meant that the same political party was able to hold power in India (that too with a simple majority) for a decade. Other EMs have not seen this quality of continuity over the last few years.  Owing to this streak of unprecedented political stability that India has been able to offer since 2014, India has attracted a high premium relative to democratic EM peers (Chart 2). But with India’s general elections due in 2024, investors into India are keen to know if India will continue to attract this high political stability premium. This worry is justified for two sets of reasons: (1)    The last time any government in India was able to pull off three consecutive full five-year terms, was way back in the sixties. There is no recent precedent to BJP’s pursuit for a third consecutive term in India. (2)   The most recent election held in India’s largest state i.e., Uttar Pradesh saw the BJP retain power but saw its seat count fall by 18%. This, investors worry could be an indicator of BJP losing traction in the politically critical region of northern India. Reading the tea leaves left behind after all recent elections suggests that India is most likely to see a single political party maintain a simple majority for a third consecutive term in 2024. BJP’s footprint northern in India will be dented owing to anti-incumbency. But despite this, the BJP should be able to maintain a simple majority at the national level in 2024. This is because the BJP appears to be working on deploying a crucial strategy i.e., to offset declines in north India with gains elsewhere. India’s northern states account for 45% of India’s population. Whilst the BJP’s rise in 2014 was pivoted on this geography, its ability to retain power beyond a decade will be dependent on its ability to offset losses in India’s sprawling north with gains in other large states. Interestingly, the BJP’s predecessor i.e., the Congress party had to deal with the reciprocal of this problem. The Congress party stayed in power for a decade (from 2004-14) owing to support from southern and western Indian states. But then the Congress party’s reign could not last beyond a decade because it failed to break into northern India (Chart 3); at a time when it was losing popularity in India’s west and south. Chart 2India Has Been Trading At A Premium To EM Democracies​​​​​​ Chart 3Congress Party-Led UPA Alliance Could Not Break Into North India​​​​​​ The fact that the BJP is now working to straddle both i.e. (1) its traditional base in the north and west as well as (2) new geographies in the east and south is evident from the recent election results: 2019 General Elections: Even as BJP’s seat count in the north Indian states of Uttar Pradesh and Bihar fell in 2019 (Chart 3) it managed to offset this decline by increasing presence in India’s east (in states like West Bengal and Orissa) and in India’s south (in states like Karnataka and Telangana). Consequently, the share of BJP’s seats accounted for by major states outside north India notably increased in 2019 from 2014 (Chart 4). Recent State Elections: The BJP has evidently been able to offset losses in its core northern base (in states like Uttar Pradesh), by increasing its presence in India’s east (in states like West Bengal and Bihar) (Chart 5). Chart 4BJP Is Growing Its Influence Outside North India​​​​​​ Chart 5BJP Is Offsetting Losses In North With Gains In East​​​​​​ Chart 6In a Base Case, BJP Should Cross The Halfway Mark At 2024 General Elections In fact, it is critical to note that state elections are due in Gujarat in December 2022, where the BJP is highly likely to lose seat share as it faces a five-term anti-incumbency. Given that Gujarat as a region too is part of BJP’s core voter base, BJP’s seat losses in Gujarat could trigger a wave of selling on India’s bourses. If this leads India’s expensive valuations to be driven down, then this could present a buying opportunity because as long as the BJP keeps compensating for losses in traditional constituencies with inroads into newer realms (like say Karnataka where state elections are due in May 2023 or in Rajasthan and Madhya Pradesh where elections are due in end-2023); BJP’s standalone seat count in 2024 is highly likely to cross the half-way mark (Chart 6). To conclude, we re-iterate our constructive outlook on India on a strategic horizon, in view of the high probability of regime continuity lasting in this EM beyond a decade. In a worst-case scenario, we expect a BJP-led coalition to assume power in India in 2024 but this coalition too will be stable and should need the support of a maximum of two regional parties. Bottom Line: The BJP will lose seat share in parts of north and west India but should be able to retain power in 2024 by offsetting these losses with gains in India’s east and south. Most recent election results confirm that the BJP is working meticulously to make this formula work. If BJP’s political losses in its traditional constituencies triggers a market correction, then this should be used as a buying opportunity by strategic investors. Fiscal Risks In India Are Not Dead; They Will Surface, Before Receding Again In 1952 when India’s first national assembly was formed, left-leaning parties were the mainstay of India’s national politics. Back then a left-of-center party i.e., the Congress Party was in power with +70% seats in the national assembly. Then, the leftist Communist Party of India (CPI) was the second largest political party. As the decades went by left-leaning policies kept losing importance in India but the left-of-center national parties influenced Indian politics in a big way right up until 2014. Cut to 2014, the rise of the Bhartiya Janata Party (BJP) meant that the mainstay of Indian politics now became right-of-center politics. Left-leaning parties became too insignificant to matter at the national level with the Congress Party and the Communist Party of India (M) now cumulatively accounting for only about 11% seats in the national assembly. India’s political pendulum swinging to the right was accompanied by another key development i.e., India’s fiscal management became more prudent (Chart 7). Doles and transfer payments were restrained, and efforts were also made to shore-up tax revenues. But does the BJP-led transition to right-of-center politics mean that left-of-center politics in India are dead, as are the associated risks of fiscal populism? The Indian bond market seems to think so. India’s 10-year bond yield is up only 85 bps since 1 Jan 2020 to date, which is lower than a 106 bps increase seen in the US or 573 bps increase seen in a large emerging market like Brazil. Notwithstanding the superior fiscal discipline maintained by BJP-led governments so far, it is worth asking if this streak of fiscal resilience can last over the next two years? We highlight that even as the right-of-center BJP will remain a force to reckon with, we expect the BJP’s fiscal policy to temporarily swerve to the left owing to three sets of reasons: Miseries Breed Populism: It is true that recent BJP-led governments have maintained superior fiscal discipline (Chart 7). However high levels of inflation are known to feed populist tendencies of governments globally. India will be no exception to this trend because economic miseries of India’s median voter have worsened over the last six months (Chart 8). Chart 7BJP Led Governments Have Maintained Tighter Fiscal Deficits In India​​​​​​ Chart 8Economic Miseries Of India's Median Voter Have Been Worsening​​​​​​ Chart 9Government Spends Tend To Pick Up In The Run-Up To General Elections Political Cycle: History also suggests that there is a cyclical element to fiscal laxity in India. Populism as a theme tends to become more defined in the two years leading to a general election (Chart 9). This cyclicality in fiscal expansion could also be driven by the fact that India tends to have a loaded state election calendar in the year just before a general election. Competition: As the BJP’s reign matures, it will increasingly face competition from regional parties (Chart 10). Given that most major regional political parties in India operate on the segment between the center and the left of political spectrum (Chart 10), BJP may see sense in metamorphosizing its fiscal policy into one which is closer to the left, albeit temporarily. Chart 10Regional Parties Like SP And AAP Could Grow Their National Footprint Chart 11India’s Debt Levels Are High And Rising It is worth noting that as compared to major EMs, India’s debt levels are high today (Chart 11). Against this backdrop an expansion of India’s fiscal deficit could result in turbulence in Indian markets. Bottom Line: The BJP is highly likely to temporarily switch to an expansive fiscal policy stance in the run up to the 2024 general elections. This shift will be driven by the need to retain power in the face of rising miseries of its median voter and to overcome competition from influential regional players. Most Populous Regions, May Not Necessarily Be Drivers Of India’s Growth The ‘demographic dividend’ narrative is often used to justify a bullish stance on India. But such a narrative oversimplifies India’s investment case and may even yield poor investment outcomes. India’s demographics power its consumption engine, but the same demographics can also be a liability sometimes. This is because while India is young, its populace is also poor and large. The combination of a massive population (that creates pressure on limited resources) and nascent institutions (that are yet to ensure a fair use of resources) is at the heart of corruption in India. For instance, the coming to light of the 2G-spectrum scam a decade ago on 16 November 2010 saw Indian markets correct by 6% over the next ten days. Hence ‘corruption’ is one of the ways in which India’s demographics can end-up being a drag on India’s investment returns. Chart 12Six Indian States Account For India’s Political Nucleus With China’s population likely to have peaked last year, India’s population which is likely to peak in the 2040s - keeps attracting investor interest. In this report we peel the onion around India’s demographics in a way that allows investors to make the most of its demographics, whilst avoiding pitfalls associated with the same. We highlight that paradoxically; India’s most populous states may not be the main drivers of India’s growth over the next decade. On the other hand, investing in the ‘next eight’ most populous states, could present a superior opportunity to profit from India’s demographics. Six Indian states account for more than half of India’s population (Chart 12) and each of these states are larger than Germany or Turkey in terms of population (Map 1). Despite being populous, these states could emerge as flashpoints of social conflict over the next decade. This is because it is possible that these states’ economic growth fails to be brisk enough to meet aspirations of its vast populace. Early signs of this phenomenon are evident from the fact that these states’ share in India’s population has been rising, but their share in national income has fallen (Chart 13). Today these six states account for more than half of India’s population but generate less than half of its national GDP (Chart 14). Map 1India’s Most Populous States, May Not Necessarily Lead On Growth Chart 13Most Populous States Of India, Are Not Necessarily Leading On Growth​​​​​​ Chart 14Next Eight Largest States Of India Are Economically Dynamic​​​​​​ Despite accounting for the lion’s share of India’s population, these six states’ growth potential could be compromised by: Economic Weakness: Primary sectors account for an unusually large share of the local economies of the most populous states today (Chart 15). Social Complexity: Most of the populous states are also characterized by greater social complexity as compared to other Indian states (Chart 16). In other words, their populations are young but are also poor and more heterogenous, which in turn exposes these states to a higher risk of social conflict. Chart 15Primary Activities Account For A Large Chunk Of Populous States’ GDP​​​​​​ Chart 16The Risk Of Social Conflict Is Higher, In The More Populous States ​​​​​​ ​​​Leverage: The debt to GDP ratio of the more populous states often tends to be higher too (Chart 17).​​​​​​​ Now contrary to the situation in India’s most populous states, India’s ‘next eight’ largest states (by population) could emerge as hubs of economic dynamism (Map 1). This is because: Faster Growth: These states' share in national GDP is growing faster than the pace at which their share in India’s population is growing (Chart 13). As of today, the next eight states account for less than a third of India’s population but more than a third of India’s national income (Chart 14). Fewer Constraints: The next eight most populous states have more modern economic structures (Chart 15), lower risk of social conflict (Chart 16) and mildly superior public finances (Chart 17). Last but not the least, the ‘next eight’ states are poised favorably from a political perspective as well. This is because the Bhartiya Janta Party (i.e., BJP) has a weak footprint in these states (Chart 18) and will be keen to offer supportive economic policies to win over their median voter. Chart 17More Populous States, Also Can Be More Leveraged​​​​​​ Chart 18Next Eight Most Populous States Likely To Attract More Political Attention Going Forward​​​​​​ Bottom Line: While the demographic dividend that India enjoys is real, its benefits will not be spread uniformly across India’s geographies. For instance, some of the most populous states of India could lag on the growth front. To profit from India’s demographics and yet mitigate risks associated with the same, we urge investors to build portfolios that maximize exposure to the second tier of populous states in India. Investment Conclusion The Bhartiya Janta Party (BJP) in India appears set to emerge as the first party in India’s modern history to retain power beyond a decade with a simple majority. But to pull off this rare feat, it will have to metamorphosize and may exhibit some changes such as: Develop a focus on regions that are outside its core constituency, in a bid to offset anti-incumbency in its core constituencies. Sharpen its policy focus on the next tier of populous states, given that some of these states have greater growth potential and given that the BJP’s footprint in the second tier of populous states has room to grow. Adopt an expansive fiscal policy in the run up to the 2024 elections, to combat the rising economic miseries of India’s median voter. To play these dynamics, we urge clients to consider the following trades: Strategic Trades For clients with a holding period mandate of more than 12 months, we urge such investors to go strategically long Indian tech / short Chinese tech (Chart 19). The trade allows investors to play the unique and high degrees of political stability that India will offer on a strategic horizon. Chart 19Strategic Trade: Long Indian Tech / Short Chinese Tech​​​​​​ Chart 20Tactical Trade: Short India / Long Brazilian Financials​​​​​​ Moreover, it is notable the Indian tech industry’s key bases are concentrated in Karnataka, Andhra Pradesh and Telangana. All three states fall within the next tier of populous states of India. Thus, this trade allows investors to maximize exposure to both an economically vibrant region and sector of India. Tactical Trades For investors with a holding period mandate of less than 12 months, a trade that can be activated to profit from India’s short-term geopolitical risks is to short India / long Brazilian Financials (Chart 20). This allows investors to profit from the cyclical risks that will affect India (1) as commodity prices stay high and (2) as rising economic miseries fan fiscal risks.​​​​​​​   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Listen to a short summary of this report.         Executive Summary The US Inflation Surprise Index Has Rolled Over Global equities are nearing a bottom and will rally over the coming months as inflation declines and growth reaccelerates. While equity valuations are not at bombed-out levels, they have cheapened significantly. Global stocks trade at 15.3-times forward earnings. We are upgrading tech stocks from underweight to neutral. The NASDAQ Composite now trades at a forward P/E of 22.6, down from 32.9 at its peak last year. The 10-year Treasury yield should decline to 2.5% by the end of the year, which will help tech stocks at the margin. The US dollar has peaked. A weakening dollar will provide a tailwind to stocks, especially overseas bourses. US high-yield spreads are pricing in a default rate of 6.2% over the next 12 months, well above the trailing default rate of 1.2%. Favor high-yield credit over government bonds within a fixed-income portfolio.   Bottom Line: The recent sell-off in stocks provides a good opportunity to increase equity allocations. We expect global stocks to rise 15%-to-20% over the next 12 months. Back to Bullish We wrote a report on April 22nd arguing that global equities were heading towards a “last hurrah” in the second half of the year as a Goldilocks environment of falling inflation and supply-side led growth emerges. Last week, we operationalized this view by tactically upgrading stocks to overweight after having downgraded them in late February. This highly out-of-consensus view change, coming at a time when surveys by the American Association of Individual Investors and other outfits show extreme levels of bearishness, has garnered a lot of attention. In this week’s report, we answer some of the most common questions from the perspective of a skeptical reader.   Q: Inflation is at multi-decade highs, global growth is faltering, and central banks are about to hike rates faster than we have seen in years. Isn’t it too early to turn bullish? A: We need to focus on how the world will look like in six months, not how it looks like now. Inflation has likely peaked and many of the forces that have slowed growth, such as China’s Covid lockdown and the war in Ukraine, could abate.   Q: What is the evidence that inflation has peaked? And may I remind you, even if inflation does decline later this year, this is something that most investors and central banks are already banking on. Inflation would need to fall by more than expected for your bullish scenario to play out. A: That’s true, but there is good reason to think that this is precisely what will happen.  Overall spending in the US is close to its pre-pandemic trend. However, spending on goods remains above trend while spending on services is below trend (Chart 1). Services prices tend to be stickier than goods prices. Thus, the shift in spending patterns caused goods inflation to rise markedly with little offsetting decline in services inflation. To cite one of many examples, fitness equipment prices rose dramatically, but gym membership fees barely fell (Chart 2). Chart 1Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Chart 2Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices As goods demand normalizes, goods inflation will come down. Meanwhile, the supply of goods should increase as the pandemic winds down, and hopefully, a detente is reached in Ukraine. There are already indications that some supply-chain bottlenecks have eased (Chart 3). Q: Even if supply shocks abate, which seems like a BIG IF to me, wouldn’t the shift in spending towards services supercharge what has been only a modest acceleration in services inflation so far? A: Wages are the most important driver of services inflation. Although the evidence is still tentative, it does appear as though wage inflation is peaking. The 3-month annualized growth rate in average hourly earnings for production and nonsupervisory workers slowed from 7.2% in the second half of 2021 to 3.8% in April (Chart 4). Assuming productivity growth of 1.5%, this is consistent with unit labor cost inflation of only slightly more than 2%, which is broadly consistent with the Fed’s CPI inflation target.1 Chart 4Wage Pressures May Be Starting To Ease Moreover, a smaller proportion of firms expect to raise wages over the next six months than was the case late last year according to a variety of regional Fed surveys (Chart 5). The same message is echoed by the NFIB small business survey (Chart 6). Consistent with all this, the US Citi Inflation Surprise Index has rolled over (Chart 7).   Chart 6... Small Business Owners Included Chart 7The US Inflation Surprise Index Has Rolled Over   Q: What about the “too cold” risk to your Goldilocks scenario? The risks of recession seem to be rising. A: The market is certainly worried about this outcome, and that has been the main reason stocks have fallen of late. However, we do not think this fear is justified, certainly not in the US (Chart 8). US households are sitting on $2.3 trillion excess savings, equal to about 14% of annual consumption. The ratio of household debt-to-disposable income is down 36 percentage points from its highs in early 2008, giving households the wherewithal to spend more. Core capital goods orders, a good leading indicator for capex, have surged. The homeowner vacancy rate is at a record low, suggesting that homebuilding will be fairly resilient in the face of higher mortgage rates.   Q: It seems like the Fed has a nearly impossible task on its hands: Increase labor market slack by enough to cool the economy but not so much as to trigger a recession. You yourself have pointed out that the Fed has never achieved this in its history. A: It is correct that the unemployment rate has never risen by more than one-third of a percentage point in the US without a recession occurring (Chart 9). That said, there are three reasons to think that a soft landing can be achieved this time. Chart 9When Unemployment Starts Rising, It Usually Keeps Rising First, increasing labor market slack is easier if one can raise labor supply rather than reducing labor demand. Right now, the participation rate is nearly a percentage point below where it was in 2019, even if one adjusts for increased early retirement during the pandemic (Chart 10). Wages have risen relatively more at the bottom end of the income distribution. This should draw more low-wage workers into the labor force. Furthermore, according to the Federal Reserve, accumulated bank savings for the lowest-paid 20% of workers have been shrinking since last summer, which should incentivize job seeking (Chart 11). Chart 10Labor Participation Has Further Scope To Recover Chart 11Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Second, long-term inflation expectations remain well contained, which makes a soft landing more likely. Median expected inflation 5-to-10 years out in the University of Michigan survey stood at 3% in May, roughly where it was between 2005 and 2013 (Chart 12). Median expected earnings growth in the New York Fed Survey of Consumer Expectations was only slightly higher in April than it was prior to the pandemic (Chart 13). Chart 12Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Chart 13US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period A third reason for thinking that a soft landing may be easier to achieve this time around is that the US private-sector financial balance – the difference between what the private sector earns and spends – is still in surplus (Chart 14). This stands in contrast to the lead-up to both the 2001 and 2008-09 recessions, when the private sector was living beyond its means.   Q: You have spoken a lot about the US, but the situation seems dire elsewhere. Europe may already be in recession as we speak! A: The near-term outlook for Europe is indeed challenging. The euro area economy grew by only 0.8% annualized in the first quarter. Mathieu Savary, BCA’s Chief European Strategist, expects an outright decline in output in Q2. To no one’s surprise, the war in Ukraine is weighing on European growth. The Bundesbank estimates that a full embargo of Russian oil and gas would reduce German real GDP by an additional 5% on top of the damage already inflicted by the war (Chart 15). Chart 14The US Private-Sector Financial Balance Remains In Surplus Chart 15Germany’s Economy Will Sink Without Russian Energy While such a full embargo is possible, it is not our base case. In a remarkable about-face, Putin now says he has “no problems” with Finland and Sweden joining NATO, provided that they do not place military infrastructure in their countries. He had previous threatened a military response at the mere suggestion of NATO membership. In any case, there are few signs that Putin’s increasingly insular and dictatorial regime would respond to an oil embargo or other economic incentives. The wealthy oligarchs who were supposed to rein him in are cowering in fear. It is also not clear if Europe would gain any political leverage over Russia by adopting policies that push its own economy into a recession. It is worth noting that the price of the December 2022 European natural gas futures contract is down 39% from its peak at the start of the war (Chart 16). It is also noteworthy that European EPS estimates have been trending higher this year even as GDP growth estimates have been cut (Chart 17). This suggests that the analyst earnings projections were too conservative going into the year. Chart 16European Natural Gas Futures Are High But Below Their Peak Chart 17European And US EPS Estimates Have Been Trending Higher This Year Chart 18Chinese Property Sector: Signs Of Contraction Q: What about China? The lockdowns are crippling growth and the property market is in shambles. A: There is truth to both those claims. The government has all but said that it will not abandon its zero-Covid policy anytime soon, even going as far as to withdraw from hosting the 2023 AFC Asian Cup. While the number of new cases has declined sharply in Shanghai, future outbreaks are probable. On the bright side, China is likely to ramp up domestic production of Pfizer’s Paxlovid drug. Increased availability of the drug will reduce the burden of the disease once social distancing restrictions are relaxed. As far as the property market is concerned, sales, starts, completions, as well as home prices are all contracting (Chart 18). BCA’s China Investment Strategy expects accelerated policy easing to put the housing sector on a recovery path in the second half of this year. Nevertheless, they expect the “three red lines” policy to remain in place, suggesting that the rebound in housing activity will be more muted than in past recoveries.2  Ironically, the slowdown in the Chinese housing market may not be such a bad thing for the rest of the world. Remember, the main problem these days is inflation. To the extent that a sluggish Chinese housing market curbs the demand for commodities, this could provide some relief on the inflation front.   Q: So bad news is good news. Interesting take. Let’s turn to markets. You mentioned earlier that equity sentiment was very bearish. Fair enough, but I would note the very same American Association of Individual Investors survey that you cited also shows that investors’ allocation to stocks is near record highs (Chart 19). Shouldn’t we look at what investors are doing rather than what they’re saying? A: The discrepancy may not be as large as it seems. As Chart 20 illustrates, investors may not like stocks, but they like bonds even less. Chart 19Individual Investors Still Hold A Lot Of Stock   Chart 20B... But They Like Bonds Even Less Chart 21Global Equities Are More Attractively Valued After The Recent Sell-Off Global equities currently trade at 15.3-times forward earnings; a mere 12.5-times outside the US. The global forward earnings yield is 6.7 percentage points higher than the global real bond yield. In 2000, the spread between the earnings yield and the real bond yield was close to zero (Chart 21). It should also be mentioned that institutional data already show a sharp shift out of equities. The latest Bank of America survey revealed that fund managers cut equity allocations to a net 13% underweight in May from a 6% overweight in April and a net 55% overweight in January. Strikingly, fund managers were even more underweight bonds than stocks. Cash registered the biggest overweight in two decades.   Q: Your bullish equity bias notwithstanding, you were negative on tech stocks last year, arguing that the NASDAQ would turn into the NASDOG. Given that the NASDAQ Composite is down 29% from its highs, is it time to increase exposure to some beaten down tech names? A: Both the cyclical and structural headwinds facing tech stocks that we discussed in These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth and The Disruptor Delusion remain in place. Nevertheless, with the NASDAQ Composite now trading at 22.6-times forward earnings, down from 32.9 at its peak last year, an underweight in tech is no longer appropriate (Chart 22). A neutral stance is now preferable.   Chart 22Tech Stock Valuations Have Returned To Earth Q: I guess if bond yields come down a bit more, that would help tech stocks? A: Yes. Tech stocks tend to be growth-oriented. Falling bond yields raise the present value of expected cash flows more for growth companies than for other firms. While we do expect global bond yields to eventually rise above current levels, yields are likely to decline modestly over the next 12 months as inflation temporarily falls. We expect the US 10-year yield to end the year at around 2.5%.   Q: A decline in US bond yields would undermine the high-flying dollar, would it not? A: It depends on how bond yields abroad evolve. US Treasuries tend to be relatively high beta, implying that US yields usually fall more when global yields are declining (Chart 23). Thus, it would not surprise us if interest rate differentials moved against the dollar later this year. Chart 23US Treasuries Have A Higher Beta Than Most Other Government Bond Markets It is also important to remember that the US dollar is a countercyclical currency (Chart 24). If global growth picks up as pandemic dislocations fade and the Ukraine war winds down, the dollar is likely to weaken. Chart 24The Dollar Is A Countercyclical Currency A wider trade deficit could also imperil the greenback. The US trade deficit has increased from US$45 billion in December 2019 to US$110 billion. Equity inflows have helped finance the trade deficit, but net flows have turned negative of late (Chart 25). Finally, the dollar is quite expensive – 27% overvalued based on Purchasing Power Parity exchange rates.   Q: Let’s sum up. Please review your asset allocation recommendations both for the next 12 months and beyond. A: To summarize, global inflation has peaked. Growth should pick up later this year as supply-chain bottlenecks abate. The combination of falling inflation and supply-side led growth will provide a springboard for equities. We expect global stocks to rise 15%-to-20% over the next 12 months. Historically, non-US stocks have outperformed their US peers when the dollar has been weakening (Chart 26). EM stocks, in particular, have done well in a weak dollar environment Chart 26Non-US Stocks Will Benefit From A Weaker US Dollar Chart 27The Market Is Too Pessimistic On Default Risk Within fixed-income portfolios, we recommend a modest long duration stance over the next 12 months. We favor high-yield credit over safer government bonds. US high-yield spreads imply a default rate of 6.2% over the next 12 months compared to a trailing 12-month default rate of only 1.2% (Chart 27). Chart 28Falling Inflation Will Buoy Consumer Sentiment Our guess is that this Goldilocks environment will end towards the end of next year. As inflation comes down, real wage growth will turn positive. Consumer confidence, which is now quite depressed, will improve (Chart 28). Stronger demand will cause inflation to reaccelerate in 2024, setting the stage for another round of central bank rate hikes.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn Twitter       Footnotes 1    The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. 2    The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores