Global

Listen to a short summary of this report.     Executive Summary Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Following last week’s sharp post-FOMC rally, we shifted our 12-month equity recommendation from overweight to neutral. We expect stock prices to rise further during the remainder of the year as US recession risks abate, but then to give up most of their gains early next year as it becomes clear that the Fed has no intention of cutting rates and may even need to raise rates. We have more conviction that US growth will hold up over the next 12 months than we do that inflation will fall as fast as the Fed expects or the breakevens imply. These varying degrees of conviction stem from the same reason: The neutral rate of interest in the US is higher than widely believed. A high neutral rate implies that it may take significant monetary tightening to slow the economy. That reduces the risk of a recession in the near term, but it raises the risk that inflation will remain elevated. A recession is now our base case for the euro area. However, we expect the European economy to bounce back early next year, as gas supplies increase and fiscal policy turns more stimulative. The euro has significant upside over the long haul. Bottom Line: Stocks will continue to recover over the coming months before facing renewed pressure early next year. We are retaining our tactical (3-month) overweight on global equities but are shifting our 12-month recommendation to neutral. Taking Some Chips Off the Table Following last week’s sharp post-FOMC rally, we shifted our cyclical 12-month equity recommendation from overweight to neutral. This note lays out the key considerations in a Q&A format.   Q: Have any of your underlying views about the economy changed recently or has the market simply moved towards pricing in your benign outlook? A: Mainly the latter. While we continue to see a higher-than-normal risk of a US recession over the next 12 months, our baseline (60% odds) remains no recession.   Q: Many would say that we are in a recession already. A: While two consecutive quarters of negative growth does not officially constitute a recession, it is correct to say that every time real GDP has contracted for two quarters in a row, the NBER has ultimately deemed that episode a recession (Chart 1). Chart 1In The Past, Two Consecutive Quarters Of Negative Growth Have Always Coincided With A Recession That said, one should keep two things in mind. First, preliminary GDP estimates are subject to significant revisions. According to our calculations, there is a 35% chance that real GDP growth in Q2 will ultimately be revised into positive territory (Chart 2). Even Q1 may eventually show positive growth. Real Gross Domestic Income (GDI), which conceptually should equal GDP, rose by 1.8% in Q1. Chart 2After Further Revisions, It Is Possible That GDP Growth Ends Up Being Positive In Q2 2022 Second, every single US recession has seen an increase in the unemployment rate (Chart 3). So far, that has not happened, and there is good reason to think it will not happen for some time: There are 1.8 job openings per unemployed worker (Chart 4). For the foreseeable future, most people who lose their jobs will be able to walk across the street to find a new one. Chart 3Recessions And Spikes In The Unemployment Rate Go Hand-In-Hand Chart 4A High Level Of Job Openings Creates A Moat Around The Labor Market   Chart 5Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Q: Aren’t other measures of economic activity such as the ISM, consumer confidence, and homebuilder sentiment all signaling that a major slowdown is in progress? A: They are but we should take them with a grain of salt. The composition of consumer spending is shifting from goods to services. This is weighing on manufacturing output. As Chart 5 shows, goods spending has already retraced two-thirds of its pandemic surge, with no ill effects on the labor market. Consumer confidence tends to closely track real wages (Chart 6). Despite an extraordinarily tight labor market, real wages have been shrinking all year. As supply-chain bottlenecks abate, inflation will fall, allowing real wages to rise. This will bolster consumer confidence and spending. Falling gasoline prices will also boost disposable incomes. Prices at the pump have fallen for seven straight weeks and the futures market is pointing to further declines in the months ahead (Chart 7). Chart 6Falling Inflation Will Boost Real Wages And Consumer Confidence Chart 7The Futures Market Points To Further Declines In Gasoline Prices It is also critical to remember that the Fed is trying to slow the economy by tightening monetary policy. At the start of the year, investors expected the Fed funds rate to be 0.9% in early 2023. Today, they expect it to be 3.4% (Chart 8). Chart 8Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Chart 9Housing Activity Should Recover Now That Mortgage Rates Have Stabilized   Rising rate expectations curb aggregate demand. This temporarily leads to lower growth. However, once rate expectations stabilize – and demand resets to a lower level – growth will tend to return to trend. The 6-month mortgage yield impulse has already turned up. This suggests that housing and other interest-rate sensitive parts of the economy will begin to recover by the end of the year (Chart 9). Admittedly, if the unemployment rate rises in response to lower aggregate demand, this could set off a vicious circle where higher unemployment leads to less spending, leading to even higher unemployment. However, as noted above, given that the current starting point is one where labor demand already exceeds labor supply by a wide margin, the odds of a such a labor market doom loop are much lower than during past downturns.   Q: Does the question of whether we officially enter a recession or not really matter that much? A: It is a matter of degree. As Chart 10 shows, macroeconomic factors are by far the most important determinant of equity returns over medium-term horizons of about 12 months. As a rule of thumb, bear markets almost always coincide with recessions (Chart 11). Chart 10Macro Forces Are An Important Driver Of Equity Returns On Cyclical Horizons Chart 11Equity Bear Markets And Recessions Go Hand-In-Hand   Chart 12Soaring Energy Prices Have Boosted Earnings Estimates This Year Q: Are you surprised that earnings estimates have not come down faster this year as economic risks have intensified? A: Most analysts have not baked in a recession in their forecasts, so from that perspective, if our baseline scenario of no recession does not pan out, earnings estimates will almost certainly come down (Chart 12). That said, the bar for major downward earnings revisions is quite high. This is partly because we think that if a recession does occur, it is likely to be a mild one. It is also because earnings are reported in nominal terms. In contrast to real GDP, nominal GDP grew by 6.6% in Q1 and 7.8% in Q2.   Q: Let’s turn to interest rates. Why do you think the Fed will not cut rates next year as markets are discounting? A: It all boils down to the neutral rate of interest. In past reports, we made the case that the neutral rate in the US is higher than widely believed. The fact that job vacancies are so plentiful provides strong evidence in favor of our thesis. If the neutral rate were low, the labor market would not have overheated. But it did, implying that monetary policy must have been exceptionally accommodative. The good news for investors is that a high neutral rate implies that the Fed is unlikely to induce a recession by raising rates in accordance with its dot plot. That reduces the risk of a recession in the near term. The bad news is that a high neutral rate will essentially preclude the Fed from cutting rates next year. The economy will simply be too strong for that. Worse still, if the Fed is too slow in bringing rates to neutral, inflation – which is likely to fall over the coming months as supply-chain pressures ease – could reaccelerate at some point next year. That could force the Fed to start hiking rates again.   Chart 13Real Yields Have Scope To Rise Further Q: What is your estimate for the neutral rate in the US? A: In the past, we have written that the neutral rate in the US is around 3.5%-to-4%. However, I must admit, I’m not a big fan of this formulation. Real rates matter more for economic growth than nominal rates, and long-term rates matter more than short-term rates. Thus, a better question is what level of real long-term bond yields is consistent with stable inflation and full employment. Based on research we have published in the past, my best bet is that the neutral long-term real bond yield is between 1.5%-and-2%. That is substantially above the 10-year TIPS yield (0.27%) and the 30-year TIPS yield (0.79%) (Chart 13). Given that the yield curve is inverted, the Fed may have to raise policy rates well above 4% in order to drag up the long end of the curve. It is a bit like how oil traders say you need to lift spot crude prices in order to push up long-term futures prices when the oil curve is backwardated.   Chart 14Investors Expect Inflation To Fall Rapidly Over The Next Few Years Q: So presumably then, you would favor a short duration position in fixed-income portfolios? A: Yes, if the whole yield curve shifts higher, you will lose a lot less money in short-term bonds than in long-term bonds. Relatedly, we would overweight TIPS versus nominal bonds. The TIPS market is pricing in a very rapid decline in inflation over the next few years (Chart 14). The widely followed 5-year, 5-year forward TIPS inflation breakeven rate is trading at 2.28%, toward the bottom end of the Fed’s comfort zone of 2.3%-to-2.5%.1   Q: What about credit? A: US high-yield bonds are pricing in a default rate of 6.1% over the next 12 months. This is up from an expected default rate of 3.8% at the start of the year and is significantly higher than the trailing 12-month default rate of 1.4%. In a typical recession, high-yield default rates rise above 8% (Chart 15). Thus, spreads would probably increase if the US entered a recession. That said, it is important to keep in mind that many corporate borrowers took advantage of very low long-term yields over the past few years to extend the maturity of their debt. Only 7% of US high-yield debt, and less than 1% of investment-grade debt, held in corporate credit ETFs matures in less than two years. This suggests that the default cycle, if it were to occur, would be less intense and more elongated than previous ones. Chart 15High-Yield Bonds Are Pricing In Higher Default Rates On balance, we recommend a modest overweight to high-yield bonds within fixed-income portfolios.   Chart 16High Energy Prices Are Weighing On The European Economy Q: Let’s turn to non-US markets. The dollar has strengthened a lot against the euro this year as the economic climate in Europe has soured. Can Europe avoid a recession? A: Probably not. European natural gas prices are back near record highs and business surveys increasingly point to recession (Chart 16). That said, the nature of Europe’s recession could turn out to be quite different from what many expect. There are a few useful parallels between the predicament Europe finds itself in now and what the global economy experienced early on during the pandemic. Just like the Novel coronavirus, as it was called back then, represented an external shock to the global economy, the partial cut-off in Russian energy flows represents an external shock to the European economy. Policymakers in advanced economies responded to the pandemic by showering their economies with various income-support measures. European governments will react similarly to the energy crunch. In fact, the political incentive to respond generously is even greater this time around because the last thing European leaders want is for Putin to succeed in his efforts to destabilize the region. For its part, the ECB will set an extremely low bar for buying Italian bonds and the debt of other vulnerable economies. Just like the world eventually deployed vaccines, Europe is taking steps to inoculate itself from its dangerous addiction to Russian energy. The official REPowerEU plan seeks to displace two-thirds of Russian natural gas imports by the end of the year. While some aspects of the plan are probably too optimistic, others may not be optimistic enough. For example, the plan does not envision increased energy production from coal-fired plants, which is something that even the German Green Party has now signed on to. The euro is trading near parity to the dollar because investors expect growth in the common-currency bloc to remain depressed for an extended period of time. If investors start to price in a more forceful recovery, the euro will rally.   Q: China’s economy remains in the doldrums. Could that undermine your sanguine view on the global economy? A: China’s PMI data disappointed in July, as anxiety over the zero-Covid policy and a sagging property market continued to weigh on activity (Chart 17). We do not expect any change to the zero-Covid policy until the conclusion of the Twentieth Party Congress later this year. After that, the government is likely to ease restrictions, which will help to reignite growth. Chart 17The Zero-Covid Policy And Slumping Property Market Are Weighing On Chinese Economic Activity Chart 18China Faces A Structural Decline In The Demand For Housing The property market has probably entered a secular downturn (Chart 18). If a weakening property market were to cause a banking crisis, similar to what happened in the US and parts of Europe in 2008, this would destabilize the global economy. However, we doubt that this will happen given the control the government has over the banking system. In contrast, a soft landing for the Chinese real estate market might turn out to be a welcome development for the global economy, as less Chinese property investment would keep a lid on commodity prices, thus helping to ease inflationary pressures. 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. The TIPS breakeven is based on the CPI 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%. View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Special Report

Listen to a short summary of this report.     Executive Summary US Lead On Mega-Sized Firms: Is A Peak Nigh? The US has been the star protagonist of global equity markets for decades. It offers investors the rare combination of a big economy and a large universe of mega-sized listed companies. In fact, the overwhelming majority of the top 20 largest firms globally by revenue today are American. But can the US maintain this degree of presence on this list over the next decade? We think that this is unlikely. For starters, a decline in the US’s footprint could be driven by the fact that there is a peculiar stagnation in the works in the middle tier of American firms. Given that this tier acts as a talent pool for big firms, a stagnation here could mean that the US spawns fewer super-sized firms. The high market share commanded by big American firms could also end up being a liability. This dominance could bait regulatory attention, thereby affecting these firms’ growth prospects. Finally, slowing GDP growth in the US, as compared to its Asian peers, will prove to be another headwind that American firms must contend with. What should strategic investors do to prepare for this tectonic shift? We recommend reducing allocations to US equities over the long run since the US’s weight in global indices will peak soon (or may have already peaked). Bottom Line: Irrespective of what the Fed does (or does not do), the US’s footprint in the global league tables of big firms by revenue will weaken over the next decade. Strategic investors can profit from this change by reducing allocations to US equities while increasing allocations to China as well as a basket of countries including Korea, Japan, Taiwan, and Germany.   Dear Client, This week, we are sending you a Special Report by Ritika Mankar, CFA, who will be writing occasional special reports for the Global Investment Strategy service on a variety of topical issues. Ritika makes the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade. We will return to our regular publishing schedule next week. Best Regards, Peter Berezin, Chief Global Strategist US: Home To The Largest Number Of Big Listed Firms 2022 has been a turbulent year for US markets so far. But it is worth bearing in mind that the US has been the star protagonist of global equity markets for decades. This is because the US has offered investors a near-perfect trifecta constituting of: (1) A mega-sized economy; (2) A large universe of mega-sized listed companies; and (3) A track record of market outperformance. Specifically: Largest Economy: For over a century now, the US has been the largest economy in the world – a title it is expected to defend over the next few years (Chart 1). Large Listed Companies: The US’s high nominal GDP has also translated into high sales growth for its listed space. This, in turn, powered a great rise in the American equity market’s capitalization (Chart 2). In fact, the US’s market cap is so large today that it exceeds the cumulative market cap of the next four largest economies in the world, by a wide margin. So unlike Germany or China (which have large economies but small markets), the US has a large economy and is also home to some of the largest, most liquid stocks globally. Chart 1The US Will Remain The World’s Largest Economy For The Next Few Years Chart 2The Listed Universe In The US Has Grown From Strength To Strength Chart 3Growing Sales In The US Have Powered Its Outperformance Over The Past Decade Long History of Outperformance: And most importantly, the US market has a strong track record of outperformance. US markets have outperformed global benchmarks over the past decade thanks largely to the rapid sales growth seen by American firms (Chart 3). Notwithstanding the US’s star role in global markets thus far, in this report we highlight that the US’s heft will likely decline over the next decade. The Fed may or may not administer recession-inducing rate hikes in 2022. But irrespective of what the Fed does over the next 12-to-24 months, the US’s loss of influence in global equity markets appears certain because it will be driven by structural forces. Chart 4US Lead On Mega-Sized Firms: Is A Peak Nigh? Firstly, while behemoths such as Apple and Amazon have been attracting record investor attention, it is worth noting that the next tier of mid-sized American companies is no longer thriving as it used to. The reason why this matters is because history suggests that the pool of mid-sized companies acts as a superset for the big companies of tomorrow. So, if this talent pool is not booming today in the US, then there is likely to be repercussions tomorrow. Secondly, the US’s largest firms will have to contend with two structural headwinds over the next decade, namely increased regulatory attention and slowing growth. To complicate matters for American firms, competitors in Asia will not have this albatross around their neck. Hence, the US may remain the largest economy of the world a few years from now but is unlikely to be home to as many big, listed companies as it is today (Chart 4). The rest of this report quantifies the strength of these forces, and then concludes with actionable investment ideas.   Trouble In The Talent Pool Chart 5The US Is Home To Nearly A Dozen Mega-Sized Firms Today 2021 produced a special milestone for the American economy. This was the first year that ten listed American firms1 surpassed $200 billion in annual revenues (firms we refer to as ‘Big Shots’ from here on) (Chart 5). The US has been a global leader when it came to the size of its economy for decades, but last year it also became home to the largest number of big, listed corporations (Table 1). American Big Shots were striking both in terms of their number as well as their scale. In fact, such was their scale that the combined revenue of these ten Big Shots now exceeded the nominal GDP of major economies like India (Chart 6). Table 1The US Today Dominates The Global List Of Top 20 Firms Chart 6The Revenues Of US Big Shot Firms Are Comparable To India’s Nominal GDP! While the world has been captivated by the size that the US’s Big Shots have achieved (as well as the ideas of their unconventional founders), few have noticed that the talent pool for tomorrow’s Big Shots is no longer burgeoning. History suggests that most Big Shot firms tend to emerge from firms belonging to a lower revenue tier.  For instance, Amazon and Apple, which have revenues in the range of $350-to-$500 billion today, were mid-sized firms a decade ago with revenues in the vicinity of $50-to-$100 billion (Chart 7). Chart 7Most Big Shots Today Were The Mid-Sized Firms Of Yesterday This is why it is worrying that all is not well in the US’s ecosystem of mid-sized firms. If we define firms with annual revenues of $50-to-$200 billion as ‘core’ firms, then their share in the total number of American firms has stagnated over the past decade (Chart 8). Even the revenue share accounted for by core firms has been fading (Chart 9). This phenomenon contrasts with the situation in China, where the mid-sized firms’ cohort has been growing over the last decade (Charts 10 and 11). Chart 8Share Of Mid-Sized Firms In The US Has Stagnated Chart 9The Revenue Share Of US Mid-Sized Firms Is Also Falling Chart 10Share Of Mid-Sized Firms In China Is Expanding Chart 11The Revenue Share Of Chinese Mid-Sized Firms Is Rising Japan’s experience also suggests that when the mid-sized firms’ ecosystem weakens, the pipeline of future potential mega-cap companies get affected. In Japan, the proportion of core firms (Chart 12), as well as their revenue share (Chart 13), has not been growing as is the case, say, in China. And this is perhaps why, despite being the third-largest economy in the world today, Japan is home to only one listed mega-sized corporation with revenues of over $200 billion (Toyota). Chart 13The Revenue Share Of Japanese Mid-Sized Firms Has Plateaued The US May Have Hit Peak Oligopolization The fact that ten Big Shot firms (i.e., firms with annual revenues of over $200 billion) exist in the US today is remarkable. After all, the number of Big Shot firms in the US today exceeds the total number of Big Shots in the next four largest economies of the world combined (Chart 14). Chart 14The US Today Is The Global Hub For Mega-Sized Companies So why will the US’s leadership in this area come under pressure going forward? One reason is that the large size of American firms could itself become a liability. Specifically: Public Backlash Against The US’s Big Shots: The ten Big Shot firms of the US today account for more than a fifth of the revenue generated by all firms that constitute the MSCI US index (Chart 15). Also, the number of Big Shot firms, as a share of total firms, is high in the US (Chart 16). Chart 15Big Shots Account For More Than A Fifth Of Revenues Generated By The US Listed Space Chart 16A Large Proportion Of Firms In The US Are Very Big Notably, market leaders across a range of key sectors in the US account for an unusually large chunk of the sector’s revenues. Financials, Information Technology, and Consumer Discretionary together account for about half of the US equity market index’s weight. The dominant firm in each of these three sectors (as defined by MSCI) accounts for 15%-to-25% of that sector’s revenue (Chart 17). Market power usually benefits investors. But too much market power can be a problem. The growing oligopolization of the US economy has caused public dissatisfaction over the influence of corporations in the US to hit a multi-year high (Chart 18). Over 60% of Americans want major US corporations to have less influence. It is for this reason that the record scale acquired by American firms could prove to be an issue. American mega-scaled firms’ high market shares will provide them with pricing power, but this very power will end up baiting regulatory attention and anti-trust lawsuits which, in turn, will restrict their future growth rates. The fact that the US Federal Trade Commission (FTC) today is headed by a leader who wants to return the FTC to its trust-busting origins, and made her name by writing a paper arguing for Amazon to be broken up,2 is indicative of which way the wind is blowing. Chart 17Market Leaders In The US Are Too Big Chart 18Public Dissatisfaction With US Big Shot Firms Is High And Rising Interestingly, the speed at which the US restricts the market power of big firms will determine how quickly the US’s mid-sized firms begin to flourish again, thereby setting the stage for the US to spawn a new generation of big firms. Besides the growing regulatory risks for the US’s big firms, three other technical factors will end up slowing the pace at which the US can generate large firms, namely: Slowing GDP Growth: Since the US is a large and mature economy, the pace of its growth is bound to slow (Chart 19). Besides the deceleration in the US’s growth rate relative to its own past, it is projected to end up being lower than that of major economies like China. Chart 19US GDP Growth Is Set To Slow Big Business ≠ Big GDP Growth: While GDP growth receives a fillip when small firms grow, the high pricing power that very large firms command can end up constraining an economy’s growth rate. This is because large firms can charge monopolistic prices, thereby restraining demand. Secondly, mega-sized firms may actively invest in manipulating institutions to block upstarts,3 a dynamic that can restrict productivity growth as well. Chart 20The Revenue-To-Nominal GDP Ratio Is Already Elevated In The US Approaching Revenue Saturation: A cross-country comparison suggests that the revenue-to-nominal GDP ratio in the US is high1 (Chart 20). Only Japan has a superior ratio, which is likely to be an aberration rather than the norm (owing to Japanese firms’ unique tendency to prioritize revenues over profitability). Given that the US revenue-to-nominal GDP ratio is already elevated, it is likely that even as the US’s nominal GDP keeps growing, the pace of conversion of this GDP into revenues will stay the same or may even diminish over the coming decade.   Prepare For A Brave New World “German judges…first read a description of a woman who had been caught shoplifting, then rolled a pair of dice that were loaded so every roll resulted in either a 3 or a 9. As soon as the dice came to a stop, the judges were asked whether they would sentence the woman to a term in prison greater or lesser, in months, than the number showing on the dice…On average, those who had rolled a 9 said they would sentence her to 8 months; those who rolled a 3 said they would sentence her to 5 months; the anchoring effect was 50%.” – Daniel Kahneman, Thinking, Fast and Slow (Farrar, Straus and Giroux, 2011)   The US has been the largest economy in the world and has also been able to nurture some of the largest mega-scaled companies of today. Such is the might and size of these firms that it is impossible to imagine a world where American firms’ leadership could be disrupted. Moreover, it is mentally easier to extrapolate the US’s lead today into the future. It may even seem like there is no other alternative to the US since Japan’s economy has been stagnating, Europe lacks innovation, and the political environment in China is contentious. Also, it is true that the US today is the undisputed leader when it comes to qualitative factors such as the ability to attract top global talent, its education system, and its legal system. However, the case can be made that this belief (that the US’s lead on mega-sized companies will spill into the next decade) runs the risk of becoming a Kahneman-esque anchoring bias. This is because: History Suggests That Upsets Are The Norm: History suggests that the evolution of the top 20 global firms (by revenue) has been a story of upsets. For instance, Europe’s hold over this list in the 2000s was striking by all accounts (Chart 21). Back then, it would have been almost blasphemous to question Europe’s lead (Chart 22). But today firms from three Asian island-countries account for more companies on this list than all of pre-Brexit Europe put together. Chart 21In The 2000s, Europe Was The Epicenter Of Global Mega-Sized Firms Chart 22How The Mighty Can, And Do, Fall ​​​​​​​China’s Disadvantages < Its Competitive Advantages: Despite its political baggage, China has the most formidable capability today to displace the US’s leadership position on the league tables of top 20 global firms by revenue. This is because China has a thriving ecosystem of core firms (Chart 11) and is set to grow at a faster clip than the US over the next five years (Chart 19). Moreover, while the Chinese government’s tolerance for large tech giants could remain low, the establishment could be keen to grow firms in the industrials as well as financials space for the sake of common prosperity. EM Listed Space Can Catch Up: The listed space in the US has developed at an exceptionally fast pace relative to its peers. The gap between US nominal GDP and listed space parameters is low (Chart 20), while the gap is wider for countries like Germany, China, and several other EMs. Even in a ceteris paribus situation where nominal GDPs were to stay static, an increase in the size of the listed universe in other countries can adversely affect the US’s current footprint. So, what can investors do to prepare for this coming tectonic shift? We recommend reducing allocations to US equities since the US’s weight in global indices will peak soon. It is worth noting that this strategic investment recommendation dovetails nicely with our earlier view that strategic investors should rotate out of US stocks. Currently, about half of the 20 largest firms globally by revenue are American (Map 1). Owing to the dynamics listed above, the number of American firms in the global league of top 20 could fall from this high level to 7 or 8 over the coming decade. Given that this change is indicative of things to come, we would urge investors to reduce allocations to US equities in a global portfolio over a strategic horizon. A confluence of micro and macro factors is likely to result in the US’s weight in global indices to crest sooner rather than later. Map 1Could The Global Epicenter Of Big Firms Drift Eastwards Over The Next Decade? In fact, US equities’ weight in a global index like the MSCI ACWI could have already peaked (Chart 23) and could fall by 500-to-600bps over the next decade if the last year’s trend is extrapolated into the future. As regards to sectors, health care appears to be the key industry where the US’s footprint could weaken (Table 2). Chart 23Loss Of US Influence Will Create Space For Underrepresented Markets To Grow Table 2China’s Weight In Top 20 Firms Is Set To Grow As the US cedes its leadership position, we expect the global epicenter of mega-sized listed corporates to drift eastwards (Map 1). Specifically: China: Currently, less than a quarter of the 20 largest firms globally by revenue are Chinese (Map 1). It is highly likely that the number of Chinese firms in the global list of top 20 firms will increase. China should be able to spawn more mega-sized companies since it already has a cache of promising large and mid-sized companies. Chinese companies will also benefit from the high growth rate of China’s domestic economy. From a sectoral perspective, financials and industrials appear to be two sectors where China’s footprint could grow the most (Table 2). Asia Ex-China: Asian countries like Korea, Taiwan, and Japan could potentially end up growing their weight in global equity indices by becoming home to more than one company that makes it to the global league tables of large companies. Besides the high GDP growth rate on offer in their domestic markets (Chart 20), firms in these countries could increase scale by feeding a stimulus-fueled industrial boom in the US. Additionally, these Asian countries have a competitive advantage when it comes to high-tech manufacturing capabilities (Chart 24). This will ensure that they will accrue any offshore opportunities that arise. Taiwan has the potential to grow its presence in the Information Technology space, given its innate competitive advantages (Chart 24) and the positive structural outlook for global semiconductor demand. In the case of India, it is worth noting that the country’s influence in the world economy will be ascendant over the next decade as its growing middle class flexes its muscles. Despite this, the probability of an Indian firm making an appearance among the largest firms of the world is low given the unusually small size of Indian companies today. Europe: Distinct from the Asian countries listed above, Germany could benefit from the industrial boom in the US given its capabilities when it comes to high-end manufacturing (Chart 24). ​​​​​​​Even as we believe that oil faces a bleak future on a structural basis, if a commodities supercycle were to take hold over the next decade, then the UK and France could improve their presence in global equity benchmarks given that Europe is home to some large firms in the energy sector. A commodities supercycle will also end up benefiting China and the US, since some large energy producers are also located in these countries. Chart 24Korea, Japan, And Germany Have An Edge In Manufacturing, While Taiwan, Japan, And China Have An Edge In Semiconductors ​​​​​​​Appendix The Methodology The starting point for most country-level economic analyses tends to be a country’s nominal GDP. But as market economists we realized that some key advantages could be unlocked by focusing on ‘revenues’ generated by the listed universe of a country. These advantages include: Investment Focus: As compared to nominal GDP which ends up picking up signals about the health of the listed ‘and’ unlisted firms in any country, focusing on listed firms’ revenues allows us to home-in on the health of the listed space. This is a valuable merit since the listed space is what public equity investors can buy into. For example, India is the fifth largest economy of the world and is also one of the fastest growing economies globally. But India is also characterized by a listed space where the largest companies have revenues of only around $100 billion. This makes India less investable than countries like Taiwan or South Korea that have far smaller nominal GDPs as compared to India but are home to firms with revenue of around $200 billion. Taking note of this difference - between the size of a country’s nominal GDP and the size of investable firms in a country - is key for our clients. Focus On Cause, Not Effect: It is fashionable today in the financial press to focus on the daily changes in market capitalization of assets (and non-assets too). But it is critical to note that the market cap of a stock or the price of a security is a dependent variable. Revenue, on the other hand, is a key independent variable that influences prices. So, a focus on forecasting movement in revenues of companies in a country ten years down the line, can be a more fruitful exercise for strategic investors. Steady And Stable: Revenue generated by a firm, is also a superior measure as compared to the market capitalization of a firm because the latter can be volatile. Whilst it could be argued that earnings of a company as a variable also offer stability and influence prices, earnings suffer from one drawback which is that it is a function of revenues as well as costs. Revenues of companies on the other hand have a direct theoretical link to the nominal GDP of a country. So, to rephrase a popular adage - market cap is vanity, nominal GDP is sanity, but revenue is king. This is the reason why in this Special Report, we analyze investment opportunities through the lens of revenues generated by listed firms in some of the largest economies of the world. We do so by focusing on the constituents of MSCI Country Indices (Equity) for major world economies in 2021. ​​​​​​​ Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Footnotes 1  Based on MSCI ACWI data for 2021. 2  Kiran Stacey, “Washington vs Big Tech: Lina Khan’s battle to transform US antitrust,” ft.com, August 2021. 3  Kathy Fogel, Randall Morck, and Bernard Yeung, “Big Business Stability And Economic Growth: Is What’s Good For General Motors Good For US?”, NBER Working Paper No. 12394, nber.org, July 2006.

The Global Investment Strategy service tactically downgraded equities in February but then upgraded them in May. The decision to upgrade equities to overweight in May was clearly premature, as stocks fell significantly in June. However, the rally in July has brought stocks back above the level where we upgraded them. Hence, we are using this opportunity to shift our recommended equity allocation back to neutral. While our base case forecast still foresees no recession in the US over the next 12 months, the risks to this view have increased. In Europe, we see a recession as more likely than not. China’s economy will remain under pressure due to Covid lockdowns, a shift in global spending away from manufactured goods, and a weakening property market. Even if the US avoids a recession, this could prove to be a bittersweet outcome for stocks: While earnings will hold up, the Fed is unlikely to cut rates next year, as markets are currently discounting. Real bond yields, which have already risen steeply this year, will rise further, weighing on equity valuations.  Time to Take Some Chips Off the Table The consensus view among investors these days seems to be that the US is heading into a recession (or may already be in one), which will cause stocks to fall during the remainder of the year as earnings estimates are slashed. Looking out to 2023, most investors expect stocks to recover as the Fed begins to cut rates. I have the opposite view. While the risks to growth have increased, the US will probably avoid a recession over the next 12 months. This will allow stocks to rise modestly from current levels into year-end. However, as we enter 2023, it will become obvious that the Fed has no reason to cut rates. This could cause stocks to give up some of their gains, thus producing a fairly flat profile for equities over a 12-month horizon. In past reports, we have argued that the neutral rate of interest – the interest rate consistent with full employment and stable inflation – is higher than widely believed in the US. The nice thing about a high neutral rate is that it insulates the economy from tighter monetary policy: Even if the Fed raises rates to 3.8% next year, as the dots are currently forecasting, that will only put rates in the middle of our fair value range of 3.5%-to-4% for the US neutral rate. The downside of a high neutral rate is that eventually, investors will need to value stocks using a higher discount rate. The 10-year TIPS yield has already increased from -0.97% at the start of the year to +0.36% today. It will rise to 1%-to-1.5% by the middle of 2023. A higher-than-expected neutral rate also raises inflation risks because it could cause the Fed to inadvertently keep monetary policy too loose. Inflation is likely to fall significantly over the coming months as supply-chain bottlenecks ease. However, this decline in inflation could sow the seeds of its own demise: As inflation falls, real wage growth – which is now negative – will turn positive. Rising real wages will booster consumer confidence and spending. A reacceleration in inflation in the second half of next year could prompt the Fed to start hiking rates again in late 2023, thus producing a recession not in 2022 but in 2024. Outside the US, the outlook is more challenging. In Europe, a recession is more likely than not in the second half of the year. We expect the recession to be fairly short-lived, with European governments moving aggressively to mitigate the fallout from gas shortages through various income support schemes for the private sector. Chinese growth should rebound in the second half of the year. However, the specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening property sector will continue to weigh on activity. We will have much more to say about this view change early next week. In the meantime, please review our report from last week entitled “The Downside Of A Soft Landing” for further color on some of the points made in this short bulletin. Tomorrow, my colleague Ritika Mankar will be sending you a Special Report making the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter.

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