Asset Allocation

This week’s <i>Global Investment Strategy</i> report titled Fourth Quarter 2022 Strategy Outlook: A Three-Act Play discusses the outlook for the global economy and financial markets for the rest of 2022 and beyond.

Executive Summary Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues In this report, we discuss our move last week to shift to a below-benchmark overall global duration stance in more detail. Our strongest conviction view on developed market government bonds is underweighting US Treasuries. The outcome of last week’s FOMC meeting, where the Fed committed to a rapid shift to restrictive US monetary policy, supports that position. Our strongest conviction overweight is on Japan, with the Bank of Japan both willing and able to maintain its cap on longer-term JGB yields. We are also overweight countries where it will be difficult for central banks to lift rates as much as markets expect – core Europe, Australia and Canada. The explosion in UK bond yields, and collapse of the British pound, seen after last week’s UK “mini-budget” shows that investors have not lost the power to punish fiscal and monetary policies that are non-credible - like a massive debt-financed tax cut at a time of high inflation. As a result, the Bank of England will now be forced to raise rates much more than we had been expecting, and Gilts will remain extremely volatile in the near-term. Bottom Line: Maintain a below-benchmark overall duration stance in global bond portfolios. Stay underweight US Treasuries. Upgrade exposure to government bonds in Japan and Canada to overweight, but tactically downgrade UK Gilts to underweight until a more market-friendly policy mix leads to greater stability of the British pound. Feature We shifted our recommended stance on overall global portfolio duration to below-benchmark in a Special Alert published last week. In this report, we go into the rationale for that move in more detail, and present specific details of that shift in terms of allocations by country across the various yield curves. Related Report  Global Fixed Income StrategyReduce Global Portfolio Duration To Below-Benchmark The global inflation and monetary policy backdrops remain toxic for bond markets. Last week saw interest rate increases from multiple developed economy central banks, including the Fed and Bank of England (BoE). The magnitudes of the rate hikes unnerved bond investors, with even the likes of perennial low yielders like the Swiss National Bank and Riksbank lifting rates by 75bps and 100bps, respectively. The Fed followed up its own 75bp hike by digging in its heels on the need for additional policy tightening after the 300bps of hikes already delivered this year (Chart 1). Fed Chair Jerome Powell strongly hinted that a policy-induced US recession is likely the only way to return overshooting US inflation back to the Fed’s 2% target. This triggered a breakout of the benchmark US 10-year Treasury yield above 3.5%. But the real fireworks in global bond markets occurred after the UK government announced its “mini-budget” last Friday that included massive tax cuts to be funded by debt issuance, triggering a sharp decline in the British Pound and spike in UK Gilt yields – a move that spilled over into other bond markets, pushing government bond yields to cyclical highs in the US and euro area. Chart 1Central Banks Keep Trying To “Out-Hawk” Each Other The Global Bond Bear Market Continues The Global Bond Bear Market Continues Chart 2Yields Are Now Driven By Rate Hike Expectations, Not Inflation Yields Are Now Driven By Rate Hike Expectations, Not Inflation Yields Are Now Driven By Rate Hike Expectations, Not Inflation We had been anticipating another move upward in global bond yields for this cycle, and we shifted to a below-benchmark overall global duration stance in advance of the Fed and BoE meetings last week. We see this next move higher in yields as being driven not by rising inflation expectations but by an upward repricing of interest rate expectations, leading to additional increases in real bond yields (Chart 2). Trying to pick a top in bond yields has now become a game of forecasting the level to which policy rates must rise in the current global monetary tightening cycle. On that front, there is still scope for rate expectations, and bond yields, to move higher in most developed market countries, justifying our downgrade of our recommended overall duration exposure to below-benchmark. Shifting rate expectations also lead to the changes in country bond allocations we announced last week. Rate Expectations And Country Bond Allocations Our proxy for medium-term nominal terminal rate expectations in developed market countries, the 5-year/5-year forward overnight index swap (OIS) rate, has been tracking 10-year bond yields very closely in the US and UK and, to a lesser extent, Europe (Chart 3). In those regions, the OIS curves are pricing in an increasing medium-term level of policy rates, leading to markets repricing government bond yields higher. In the US, the OIS curve is pricing in a 2023 peak for the fed funds rate of 4.67%, but with only a modest path of rate cuts in 2024 and 2025, leading to a 5-year/5-year OIS projection of 3.36% as of Monday’s market close. After the Gilt market rout, the UK OIS curve is now pricing in a 2023 peak Bank Rate over 6%, with our medium-term nominal rate proxy settling at 3.69%. In the euro area, the OIS curve is discounting a 2023 peak in the ECB policy rate of 3.22%, with a 5-year/5-year forward OIS rate of 2.7%. For all three of those regions, the market is now pricing in the highest peak in rates for the current tightening cycle. That is not the case in Canada or Australia, where rate expectations and longer-term bond yields are still below cyclical peaks (Chart 4). Japan remains the outlier, with the Bank of Japan’s yield curve control keeping 10-year JGB yields capped at 0.25%, even with the Japan OIS curve pricing in a medium-term terminal rate of 0.75%. Chart 3Rising Yields Reflect Higher Terminal Rate Expectations Rising Yields Reflect Higher Terminal Rate Expectations Rising Yields Reflect Higher Terminal Rate Expectations Chart 4Our High-Conviction Government Bond Overweights Our High-Conviction Government Bond Overweights Our High-Conviction Government Bond Overweights After looking at all the repricing of interest rate expectations and bond yields, we can determine our preferred government bond allocations within our strategic model bond portfolio framework. The US Remains Our Favorite Government Bond Underweight The new set of interest rate forecasts (“the dots”) presented at last week’s Fed meeting showed that the median FOMC member was forecasting the fed funds rate to rise to 4.4% by the end of 2022 and 4.6% by the end of 2023, before falling to 3.9% and 2.9% and the end of 2024 and 2025, respectively. Those are all significant increases from the June dots, where the expectations called for the funds rate to hit 3.4% by end-2022 and 3.8% by end-2023. The median Fed forecasts are now broadly in line with the pricing in the US OIS curve for 2022-2024, although the market expects higher rates than the FOMC in 2025 (Chart 5). Chart 5USTs Still Vulnerable To Additional Fed Hawkish Surprises The Global Bond Bear Market Continues The Global Bond Bear Market Continues There has been a lot of back and forth between the Fed and the markets this year, but the market has generally lagged the Fed interest rate projections for 2023 and 2024 before last week. Market pricing is now in line with the Fed dots, as investors have adjusted to the increasingly hawkish message from Fed officials that are focused solely on slowing growth, and tightening financial conditions, in an effort to bring US inflation down. We see the US Treasury curve as still vulnerable to additional hawkish messaging from the Fed, and a potentially higher-than-anticipated peak in the funds rate versus the FOMC dots. The US consumer is facing a lot of headwinds from higher interest rates and rising food and gasoline prices. However, the latter has fallen 26% from the June 13/2022 peak and is acting as a “tax cut” that also helps reduce US inflation expectations (Chart 6). Consumer confidence measures like the University of Michigan expectations survey have already shown improvement alongside the fall in gas prices, which has boosted real income expectations according to the New York Fed’s Consumer Survey (bottom panel). Even a subtle improvement in consumer confidence due to some easing of inflation expectations can help support a somewhat faster pace of consumer spending at a time of robust labor demand and accelerating wage growth. The Atlanta Fed Wage Tracker is now growing at a year-over-year pace of 5.7%, while the ratio of US job openings to unemployed workers remains near a record high (Chart 7). Fed Chair Powell has noted that the Fed must see significant weakening of the US jobs market for the Fed to consider pausing on its current rate hike path. So far, there is little evidence pointing to a loosening of US labor market conditions that would ease domestically-generated inflation pressures. Chart 6Lower Gas Prices Can Provide A Lift To US Consumer Spending Lower Gas Prices Can Provide A Lift To US Consumer Spending Lower Gas Prices Can Provide A Lift To US Consumer Spending Chart 7A Tight US Labor Market Will Keep The Fed Hawkish A Tight US Labor Market Will Keep The Fed Hawkish A Tight US Labor Market Will Keep The Fed Hawkish Chart 8Stay Underweight US Treasuries Stay Underweight US Treasuries Stay Underweight US Treasuries We expect overall US inflation to decelerate next year on the back of additional slowing of goods inflation, but will likely settle in the 3-4% range in 2023 given stubbornly sticky services inflation and wage growth. The Fed should follow through on its current interest rate projections, with a good chance that rates will need to be pushed up even higher in response to resilient labor market conditions in the first half of 2023. The risk/reward still favors higher US Treasury yields over at least the next 3-6 months, particularly with an improving flow of US data surprises and with bond investor duration positioning now much closer to neutral according to the JPMorgan client survey (Chart 8). Bottom Line: The US remains our highest conviction strategic government bond underweight in the developed markets. Recommended Allocations In Other Countries The path for monetary policy rates outside the US shows a similar profile as in the US, with a “front loading” of rate hikes to mid-2023 followed by modest rate cuts over the subsequent two years (Chart 9). The OIS-implied path for the level of rates is nearly identical in the US, Australia and Canada. On the other hand, markets are discounting much lower of levels of policy rates in Europe and Japan compared to the US, and a considerably higher path for rates in the UK (more on that in the next section). Chart 9Markets Priced For Global 'Front-Loaded' Rate Hikes Markets Priced For Global 'Front-Loaded' Rate Hikes Markets Priced For Global 'Front-Loaded' Rate Hikes We would lean against the US-like pricing of interest rates in Australia and Canada. Based on work we published in a recent Special Report along with our colleagues at BCA Research European Investment Strategy, the neutral real interest rate (“r-star”) is estimated to be deeply negative in Australia and Canada after adjusting for the high level of non-financial debt in those countries (Table 1). That financial fragility makes it much less likely that the Bank of Canada and Reserve Bank of Australia can raise rates as much as the Fed. Table 1Some Big Swings In Our R* Estimates When Including Debt The Global Bond Bear Market Continues The Global Bond Bear Market Continues US-like interest rates would almost certainly trigger a major downturn in house prices and household wealth given the inflated housing values in those two countries – the growth of which is already slowing rapidly in response to rate hikes delivered in 2022. We are maintaining our overweight recommendation on Australian government bonds, while we upgraded Canada to overweight from neutral after last week’s duration downgrade. Chart 10Move To Overweight Japan Move To Overweight Japan Move To Overweight Japan We are also staying overweight on German and French government bonds, as the ECB is unlikely to deliver the full extent of rate increases discounted in the European OIS curve. Our estimated debt-adjusted r-star is also quite negative in the euro area, suggesting that financial fragility issues (due to high government debt in Italy and high corporate debt in France) will likely limit the ECB’s ability to continue with recent chunky rate increases for much longer. In Japan, we continue to view JGBs as an “anti-duration” instrument, given the Bank of Japan’s persistence in maintaining negative interest rates and yield curve control. That makes JGBs a good overweight when global bond yields are rising and a good underweight when global bond yields are falling (Chart 10). Given our decision to reduce our recommended duration exposure to below-benchmark, the logical follow through decision is to upgrade JGBs to overweight. The only remaining country to consider is our view on UK Gilts, which has now become more complicated. Anarchy In The UK The selloff in the UK Gilt market has been stunning in its ferocity. Dating back to last Thursday’s 50bp rate hike by the BoE, the 10-year UK Gilt yield has jumped 120bps and now sits at 4.52%. The increase in yields was identical at the front-end of the Gilt curve, with the 2-year yield jumping 120bps to 4.68%.  The surge in longer-term Gilt yields stands out to the rise in bond yields seen outside the UK, as it also incorporates an increase in our estimate of the UK term premium – a move that was not matched in other countries (Chart 11). The rise in Gilt yields was also much more concentrated in real yields compared to inflation expectations (Chart 12), as markets aggressively repriced the path for UK policy rates after the UK government’s announced debt-financed fiscal package, including £45bn of tax cuts. Chart 11Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues Chart 12The Gilt Market Becomes Unhinged The Gilt Market Becomes Unhinged The Gilt Market Becomes Unhinged The UK’s National Institute for Economic And Social Research (NIESR) estimates that the combined impact of the tax cuts and additional spending measures would increase the UK government deficit by a whopping £150bn, or 5% of GDP. The NIESR also estimated that the fiscal measures, including the previously-announced plan for the UK government to cap energy price increases, would result in positive UK GDP growth in the 4th quarter and also lift annual real GDP growth to 2% over 2023-24. The UK government now faces a major credibility issue with markets on its announced fiscal plans. The sheer size of the package, coming at a time when the US economy was already operating at full employment with high inflation, invites a greater than expected monetary policy tightening response from the BoE. The UK OIS curve now forecasts a peak in rates of 6.3% in October 2023, up from the current 2.25%. That would be a massive move in rates in just one year from a central bank that has been relatively gun shy in lifting rates since the 2008 financial crisis, even during the current inflation overshoot. New UK Prime Minister Liz Truss, and her new Chancellor of the Exchequer Kwasi Kwarteng, have both noted they would prefer a mix of looser fiscal policy (aimed at boosting the supply side of the economy to lift potential growth) with tighter monetary policy that would prevent asset bubbles and inflation overshoots. While there is certainly merit in any plan designed to boost medium-term growth by lifting anemic UK productivity through supply-side reforms, the timing of the announcement could not have been worse. Just one day earlier, the BoE announced a plan to go forward with the sale of Gilts from its balance sheet accumulated during quantitative easing. The Truss government needs to find buyers for all the Gilts that must be issued to pay for the tax cuts and stimulus, but the BoE will not be one of them. In the end, however, the BoE’s expected path for interest rates matters more than the increase in Gilt supply in determining the level of Gilt yields and the slope of the Gilt curve. The NIESR estimates that the UK public debt/GDP ratio will rise to 92% by 2024-25, versus its pre-budget forecast of 88%. While that is a meaningful increase, the correlation between the debt/GDP ratio and the slope of the Gilt curve has been negative for the past few years (Chart 13, top panel). The stronger relationship is between the slope of the curve and the level of the BoE base rate (bottom panel), which is pointing to an inversion of the 2-year/30-year curve if the BoE follows market pricing and lifts rates to 6%. Our view dating back to the early summer was that a low neutral interest rate would prevent the BoE from lifting rates as much as markets were discounting without causing a deep recession, lower inflation and, eventually, a quick reversal of rate hikes. The huge UK fiscal stimulus package changes that calculus, as the nominal neutral rate that will be needed to bring UK inflation back to target is likely now much higher. We have always believed that when a thesis underlying an investment recommendation is challenged by new information, it is best to adjust the recommendation to reflect the new facts. Thus, this week, we are tactically downgrading UK Gilts to underweight in our model bond portfolio framework. We still see a significant medium-term opportunity to go overweight Gilts, as UK policy rates pushing into the 4-6% range are not sustainable. However, the BoE will likely have no choice to begin lifting rates at a much more aggressive pace to restore UK policy credibility, especially with the British pound under immense selling pressure (Chart 14). Despite rumors of an inter-meeting rate hike by the BoE this week to try and support the pound, that is likely too risky a step for the BoE to take as it would invite a battle with investors and currency speculators. Such a battle would be difficult to win without a more credible and market-friendly medium-term fiscal policy from the Truss government. Chart 13The BoE Matters More Than Debt Levels For Gilts The BoE Matters More Than Debt Levels For Gilts The BoE Matters More Than Debt Levels For Gilts Chart 14Tactically Move To Underweight UK Gilts Tactically Move To Underweight UK Gilts Tactically Move To Underweight UK Gilts   Bottom Line: We will review our UK Gilt stance once there are more clear signals of stability in the pound, but for now, we will step aside and limit our recommended exposure to Gilts – even after the huge selloff seen to date, which likely has more to go. Summarizing All The Changes In Our Model Bond Portfolio All the changes to our recommended duration exposure and country allocations after the past week, including the new weightings in our model bond portfolio, are shown in the tables on pages 14-16. To summarize: We moved the overall recommended global duration exposure to below-benchmark, and shifted the model bond portfolio duration to 0.9 years below that of the custom benchmark index. We increased the size of the US Treasury underweight, and moved Canada and Japan to overweight. We moved the UK to underweight, on top of the reduction in UK duration exposure that was part of last week’s move to reduce overall portfolio duration. We are also cutting exposure to UK investment grade corporates to underweight, as part of an overall move to reduce UK risk in the portfolio. We slightly increased the overweight in Germany. In next week’s report, we will present the quarterly performance review of our model bond portfolio and, more importantly, we will present out scenario-based return expectations after all the changes made this week. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com     GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The Global Bond Bear Market Continues The Global Bond Bear Market Continues The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) The Global Bond Bear Market Continues The Global Bond Bear Market Continues

Listen to a short summary of this report     Executive Summary On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall without much loss in production or employment. Skeptics will argue that such benign disinflations rarely occur, pointing to the 1982 recession. But long-term inflation expectations were close to 10% back then. Today, they are broadly in line with the Fed’s target. Equities will recover from their recent correction as headline inflation continues to fall and the risks of a US recession diminish. Go long EUR/USD on any break below 0.99. Contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? Bottom Line: The US economy is entering a temporary Goldilocks period of falling inflation and stronger growth. The latest correction in stocks will end soon. Investors should overweight global equities over the next six months but look to turn more defensive thereafter.   Dear Client, I will be attending BCA’s annual conference in New York City next week. Instead of our regular report, we will be sending you a Special Report written by Mathieu Savary, BCA’s Chief European Strategist, and Robert Robis, BCA’s Chief Fixed Income Strategist, on Monday, September 12. Their report will discuss estimates of global neutral interest rates. We will resume our regular publication schedule on September 16. Best Regards, Peter Berezin, Chief Global Strategist The Hawks Descend On Jackson Hole Chart 1Markets Still Think The Fed Will Start Cutting Rates Next Year Markets Still Think The Fed Will Start Cutting Rates Next Year Markets Still Think The Fed Will Start Cutting Rates Next Year Jay Powell’s Jackson Hole address jolted the stock market last week. Citing the historical danger of allowing inflation to remain above target for too long, the Fed chair stressed the need for “maintaining a restrictive policy stance for some time.” Powell’s comments were consistent with the Fed’s dot plot, which expects rates to remain above 3% right through to the end of 2024. However, with the markets pricing in rate cuts starting in mid 2023, his remarks came across as decidedly hawkish (Chart 1). While Fedspeak can clearly influence markets in the near term, our view is that the economy calls the shots over the medium-to-long term. The Fed sees the same data as everyone else. If inflation comes down rapidly over the coming months, the FOMC will ratchet down its hawkish rhetoric, opting instead for a wait-and-see approach. The Slope of Hope Could inflation fall quickly in the absence of a deep recession? The answer depends on a seemingly esoteric concept: the slope of the aggregate supply curve. Economists tend to depict the aggregate supply curve as being convex in nature – fairly flat (or “elastic”) when there is significant spare capacity and becoming increasingly steep (or “inelastic”) as spare capacity is exhausted (Chart 2). The basic idea is that firms do not require substantially higher prices to produce more output when they have a lot of spare capacity, but do require increasingly high prices to produce more output when spare capacity is low. Chart 2The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? When the aggregate supply curve is very elastic, an increase in aggregate demand will mainly lead to higher output rather than higher prices. In contrast, when the aggregate supply curve is inelastic, rising demand will primarily translate into higher prices rather than increased output. In early 2020, most of the developed world found itself on the steep side of the aggregate supply curve. The unemployment rate in the OECD stood at 5.3%, the lowest in 40 years (Chart 3). In the US, the unemployment rate had reached a 50-year low of 3.5%. Thus, not surprisingly, as fiscal and monetary policy turned simulative, inflation moved materially higher. Goods inflation, in particular, accelerated during the pandemic (Chart 4). Perhaps most notably, the exodus of people to the suburbs, combined with the reluctance to use mass transit, led to a surge in both new and used car prices (Chart 5). The upward pressure on auto prices was exacerbated by a shortage of semiconductors, itself a consequence of the spike in the demand for electronic goods. Chart 3The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low Chart 4With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic The supply curve for labor also became increasingly inelastic over the course of the pandemic. Once the US unemployment rate fell back below 4%, wages began to accelerate sharply. The kink in the Phillips curve had been reached (Chart 6). Chart 5Car Prices Went On Quite A Ride During The Pandemic Car Prices Went On Quite A Ride During The Pandemic Car Prices Went On Quite A Ride During The Pandemic Chart 6Wage Growth Soared When The Economy Moved Beyond Full Employment Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? Chart 7Job Switchers Usually See Faster Wage Growth Job Switchers Usually See Faster Wage Growth Job Switchers Usually See Faster Wage Growth Faster labor market churn further turbocharged wage growth. Both the quits rate and the hiring rate rose during the pandemic. Typically, workers who switch jobs experience faster wage growth than those who do not (Chart 7). This wage premium for job switching increased during the pandemic, helping to lift overall wage growth. A Symmetric Relationship? All this raises a critical question: If an increase in aggregate demand along the inelastic side of the aggregate supply curve mainly leads to higher prices rather than increased output and employment, is the inverse also true – that is, would a comparable decrease in aggregate demand simply lead to much lower inflation without much of a loss in output or employment? If so, this would greatly increase the odds of a soft landing. Skeptics would argue that disinflations are rarely painless. They would point to the 1982 recession which, until the housing bubble burst, was the deepest recession in the post-war era. The problem with that comparison is that long-term inflation expectations were extremely high in the early 1980s. Both consumers and professional forecasters expected inflation to average nearly 10% over the remainder of the decade (Chart 8). To bring down long-term inflation expectations, Paul Volcker had to engineer a deep recession. Chart 8Long-Term Inflation Expectations Are Much Better Anchored Now Than In The Early 1980s Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? Chart 9Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Jay Powell does not face such a problem. Both survey-based and market-based long-term inflation expectations are well anchored. Whereas real long-term bond yields reached 8% in 1982, the 30-year TIPS yield today is still less than 1% (Chart 9). The Impact of Lower Home Prices Chart 10Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices While falling consumer prices would boost real incomes, helping to keep the economy out of recession, a drop in home prices would have the opposite effect on consumer spending. As occurred with other durable goods, a shortage of building materials and qualified workers prevented US homebuilders from constructing as many new homes as they would have liked during the pandemic. The producer price index for construction materials soared by over 50% between May 2020 and May 2022 (Chart 10). As a result, rising demand for homes largely translated into higher home prices rather than increased homebuilding.  Real home prices, as measured by the Case-Shiller index, have increased by 25% since February 2020, rising above their housing bubble peak. As we discussed last week, US home prices will almost certainly fall in real terms and probably in nominal terms as well over the coming years. Chart 11Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs How much of a toll will falling home prices have on the economy? It took six years for home prices to bottom following the bursting of the housing bubble. It will probably take even longer this time around, given that the homeowner vacancy rate is at a record low and reasonably prudent mortgage lending standards will limit foreclosure sales. Thus, while there will be a negative wealth effect from falling home prices, it probably will not become pronounced until 2024 or so. Moreover, unlike during the housing boom, US households have not been tapping the equity in their homes to finance consumption (Chart 11). This also suggests that the impact of falling home prices on consumption will be far smaller than during the Great Recession. Inelastic Commodity Supply While inelastic supply curves had the redeeming feature of preventing a glut of, say, new autos or homes from emerging, they also limited the output of many commodities that face structural shortages. Compounding this problem is the fact that the demand for many commodities is very inelastic in the short run. When you combine a very steep supply curve with a very steep demand curve, small shifts in either curve can produce wild swings in prices.  Nowhere is this problem more evident than in Europe, where a rapid reduction in oil and gas flows has caused energy prices to soar, forcing policymakers to scramble to find new sources of supply.  Europe’s Energy Squeeze At this point, it looks like both the UK and the euro area will enter a recession. In continental Europe, the near-term outlook is grimmer in Germany and Italy than it is in France or Spain. The latter two countries are less vulnerable to an energy crunch (Spain imports a lot of LNG while France has access to nuclear energy). Both countries also have fairly resilient service sectors (Spain, in particular, is benefiting from a boom in tourism). The good news is that even in the most troubled European economies, the bottom for growth is probably closer at hand than widely feared. Despite the fact that imports of Russian gas have fallen by more than 60%, Europe has been able to rebuild gas inventories to about 80% of capacity, roughly in line with prior years (Chart 12). It has been able to achieve this feat by aggressively buying gas on the open market, no matter the price. While this has caused gas prices to soar, it sets the stage for a possible retreat in prices in 2023, something that the futures market is already discounting (Chart 13). Chart 12Europe: Squirrelling Away Gas For The Winter Europe: Squirrelling Away Gas For The Winter Europe: Squirrelling Away Gas For The Winter Chart 13Natural Gas Prices In Europe Will Come Back Down To Earth Natural Gas Prices In Europe Will Come Back Down To Earth Natural Gas Prices In Europe Will Come Back Down To Earth Europe is also moving with uncharacteristic haste to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG. A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. In the meantime, Germany is building two “floating” LNG terminals. Germany has also postponed plans to mothball its nuclear power plants and has approved increased use of coal-fired electricity generators. Chart 14The Euro Is Undervalued The Euro Is Undervalued The Euro Is Undervalued France is seeking to boost nuclear capacity. As of August 29, 57% of nuclear generation capacity was offline. Electricité de France expects daily production to rise to around 50 gigawatts (GW) by December from around 27 GW at present. For its part, the Dutch government is likely to raise output from the massive Groningen natural gas field. All this suggests that contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The euro, which is 30% undervalued against the US dollar on a purchasing power parity basis, will rally (Chart 14). Go long EUR/USD on any break below 0.99. Investment Conclusions Chart 15Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall with little loss in production or employment. Will this be the end of the story? Probably not. As inflation falls, US real wage growth, which is currently negative, will turn positive. Consumer confidence will improve, boosting consumer spending in the process (Chart 15). The aggregate demand curve will shift outwards again, triggering a “second wave” of inflation in the back half of 2023. Rather than cutting rates next year, as the market still expects, the Fed will raise rates to 5%. This will set the stage for a recession in 2024. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on            LinkedIn & Twitter   Global Investment Strategy View Matrix Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? Special Trade Recommendations Current MacroQuant Model Scores Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing?      

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 Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year 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 In The Past, Two Consecutive Quarters Of Negative Growth Have Always Coincided With A Recession In 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 Shifting Into Neutral: A Q&A Shifting Into Neutral: A Q&A 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 Recessions And Spikes In The Unemployment Rate Go Hand-In-Hand Recessions And Spikes In The Unemployment Rate Go Hand-In-Hand Chart 4A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market   Chart 5Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy 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 Falling Inflation Will Boost Real Wages And Consumer Confidence Falling Inflation Will Boost Real Wages And Consumer Confidence Chart 7The Futures Market Points To Further Declines In Gasoline Prices The Futures Market Points To Further Declines In Gasoline Prices The 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 Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Investors 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 Housing Activity Should Recover Now That Mortgage Rates Have Stabilized Housing 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 Macro Forces Are An Important Driver Of Equity Returns On Cyclical Horizons (I) Macro Forces Are An Important Driver Of Equity Returns On Cyclical Horizons (I) Chart 11Equity Bear Markets And Recessions Go Hand-In-Hand Equity Bear Markets And Recessions Go Hand-In-Hand Equity Bear Markets And Recessions Go Hand-In-Hand   Chart 12Soaring Energy Prices Have Boosted Earnings Estimates This Year Soaring Energy Prices Have Boosted Earnings Estimates This Year Soaring 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 Real Yields Have Scope To Rise Further Real 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 Shifting Into Neutral: A Q&A Shifting Into Neutral: A Q&A 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 High-Yield Bonds Are Pricing In Higher Default Rates High-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 High Energy Prices Are Weighing On The European Economy High 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 The Zero-Covid Policy And Slumping Property Market Are Weighing On Chinese Economic Activity The Zero-Covid Policy And Slumping Property Market Are Weighing On Chinese Economic Activity Chart 18China Faces A Structural Decline In The Demand For Housing China Faces A Structural Decline In The Demand For Housing China 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 Image Special Trade Recommendations Current MacroQuant Model Scores Shifting Into Neutral: A Q&A Shifting Into Neutral: A Q&A

Listen to a short summary of this report.     Executive Summary US Lead On Mega-Sized Firms: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: 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 America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 2The Listed Universe In The US Has Grown From Strength To Strength America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 3Growing Sales In The US Have Powered Its Outperformance Over The Past Decade Growing Sales In The US Have Powered Its Outperformance Over The Past Decade Growing 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? America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: 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 America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? 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 America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 6The Revenues Of US Big Shot Firms Are Comparable To India’s Nominal GDP! America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? 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 America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? 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 America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 9The Revenue Share Of US Mid-Sized Firms Is Also Falling America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 10Share Of Mid-Sized Firms In China Is Expanding America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 11The Revenue Share Of Chinese Mid-Sized Firms Is Rising America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? 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). Image Chart 13The Revenue Share Of Japanese Mid-Sized Firms Has Plateaued America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? 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 America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? 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 America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 16A Large Proportion Of Firms In The US Are Very Big America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? 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 America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 18Public Dissatisfaction With US Big Shot Firms Is High And Rising America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? 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 America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? 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 America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? 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 America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 22How The Mighty Can, And Do, Fall America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? ​​​​​​​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? America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? 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 America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Table 2China’s Weight In Top 20 Firms Is Set To Grow America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? 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 America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? ​​​​​​​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 The Downside Of A Soft Landing The Downside Of A Soft Landing Bottom Line: We recommend a modest overweight on global equities for now but would turn neutral if the S&P 500 were to rise above 4,050.   Dear Client, I am delighted to announce that Ritika Mankar, CFA, has joined the Global Investment Strategy team. Ritika will be writing occasional special reports on a variety of topical issues. Next week, she will make the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade. Best regards, Peter Berezin, Chief Global Strategist The Case for a Soft Landing in the US Chart 1Cyclicals Underperformed Defensives As Recession Risks Intensified Cyclicals Underperformed Defensives As Recession Risks Intensified Cyclicals Underperformed Defensives As Recession Risks Intensified Over the last few months, investors have become concerned that the Fed and many other central banks will need to engineer a recession in order to bring inflation down to more comfortable levels. While these fears have abated over the past trading week, they still continue to dominate market action (Chart 1). We place the odds of a US recession at about 40%. This is arguably more optimistic than the consensus view. According to Bank of America, the majority of fund managers saw recession as likely in this month’s survey. Not surprisingly, investors consider recession to be a major risk for equities over the next 12 months (Chart 2). Chart 2Many Investors Now See Recession As Baked In The Cake The Downside Of A Soft Landing The Downside Of A Soft Landing Even if a recession does occur, we have contended that it will likely be a mild one, perhaps so mild that it will be difficult to distinguish it from a soft landing. A number of things make a soft landing in the US more probable than in the past: Labor supply has scope to increase. The labor participation rate is still 1.2 percentage points below its pre-pandemic level, two-thirds of which is due to decreased participation among workers under the age of 55 (Chart 3). The share of workers holding multiple jobs is also below its pre-pandemic level (Chart 4). The number of multiple job holders has been rising briskly lately. That is one reason why job growth in the payroll survey – which double counts workers if they hold more than one job – has been stronger than job growth in the household survey. Increased labor supply would obviate the need for the Fed to take drastic actions to curtail labor demand in its effort to restore balance to the labor market. Chart 3Labor Supply Has Scope To Rise Labor Supply Has Scope To Rise Labor Supply Has Scope To Rise Chart 4The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels A high level of job openings creates a moat around the labor market. There are almost two times as many job openings as there are unemployed workers in the US (Chart 5). Many firms are likely to pull job openings before they cut jobs in response to a slowing economy. A high level of job openings will also allow workers who lose their jobs to find employment more quickly than usual, thus limiting the rise in so-called frictional unemployment. It is worth noting that the job openings rate has declined from a record 7.3% in March to a still-high 6.9% in May, with no change in the unemployment rate over this period. Chart 5A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A steep Phillips curve implies that only a modest increase in unemployment may be necessary to knock down inflation towards the Fed’s target. Just as was the case in the 1960s, the Phillips curve has proven to be kinked near full employment (Chart 6). Unlike in the late 1960s, however, when rising realized inflation caused long-term inflation expectations to reset higher, expectations have remained well anchored this time around (Chart 7). Chart 6The Phillips Curve Is Kinked At Very Low Levels Of Unemployment The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 7Long-Term Inflation Expectations Are Well Anchored Long-Term Inflation Expectations Are Well Anchored Long-Term Inflation Expectations Are Well Anchored   The unwinding of pandemic and war-related dislocations should push down inflation. A recent study by the San Francisco Fed estimates that about half of May’s PCE inflation print was the result of supply-side disturbances (Chart 8). While the ongoing war in Ukraine and the threat of another Covid wave in China will continue to unsettle global supply chains, these problems should fade over time. Falling inflation would allow real wages to start rising again. This would bolster confidence, making a soft landing more likely (Chart 9). Chart 8Supply Factors Explain Half Of The Increase In Prices Over The Past Year The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 9Positive Real Wage Growth Will Bolster Consumer Confidence Positive Real Wage Growth Will Bolster Consumer Confidence Positive Real Wage Growth Will Bolster Consumer Confidence A lack of major financial imbalances makes the US economy more resilient to economic shocks. As a share of disposable income, US household debt is 34 percentage points below its 2008 peak (Chart 10). Relative to net worth, household debt is at multi-decade lows. About two-thirds of mortgages carry a FICO score above 760 compared to only one-third during the housing bubble (Chart 11). Non-mortgage consumer credit also remains in good shape, as my colleague Doug Peta elaborated in this week’s US Investment Strategy report. While corporate debt has risen over the past decade, the ratio of corporate debt-to-assets today is still below where it was during the 1990s. Moreover, thanks to stronger corporate profitability, the interest coverage ratio is near an all-time high (Chart 12).   Chart 10AUS Household Debt Is Not Especially High Anymore (I) US Household Debt Is Not Especially High Anymore (I) US Household Debt Is Not Especially High Anymore (I) Chart 10BUS Household Debt Is Not Especially High Anymore (II) US Household Debt Is Not Especially High Anymore (II) US Household Debt Is Not Especially High Anymore (II) Chart 11FICO Scores For Residential Mortgages Have Improved Considerably Since The Pre-GFC Housing Bubble The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 12Corporate Balance Sheets Are In Decent Shape Corporate Balance Sheets Are In Decent Shape Corporate Balance Sheets Are In Decent Shape Chart 13Tight Supply Limits The Downside Risks To Housing Tight Supply Limits The Downside Risks To Housing Tight Supply Limits The Downside Risks To Housing Just like the US does not suffer from major financial imbalances, it does not suffer from any major economic imbalances either. The homeowner vacancy rate is near a record low, which should put a floor under residential investment (Chart 13). Outside of investment in intellectual property, which is not especially sensitive to the business cycle, nonresidential investment is still below pre-pandemic levels and not much above where it was as a share of GDP during the Great Recession (Chart 14). Spending on consumer durable goods has retraced four-fifths of its pandemic surge, with little ill-effect on aggregate employment (Chart 15). Chart 14Outside Of IP, Nonresidential Investment Is Still Low Outside Of IP, Nonresidential Investment Is Still Low Outside Of IP, Nonresidential Investment Is Still Low Chart 15Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Europe: A Deep Freeze Will Likely Be Avoided Chart 16Russia Can Potentially Cause Significant Economic Damage In The EU If It Closes The Taps The Downside Of A Soft Landing The Downside Of A Soft Landing The macroeconomic picture is less benign outside the US. Four years ago, German diplomats laughed off warnings that their country had become dangerously dependent on Russian energy. They are not laughing anymore. German industry, just like industry across much of Europe, is facing a major energy crunch. The IMF estimates that output losses associated with a full Russian gas shutoff over the next 12 months could amount to as much as 2.7% of GDP in the EU (Chart 16). In Central and Eastern Europe, output could shrink by 6%. Among the major economies, Germany and Italy are the most at risk. Fortunately, Europe is finally stepping up to the challenge. The highly ambitious REPowerEU plan seeks to displace two-thirds of Russian gas by the end of 2022. The plan does not include any additional energy that could be generated by increased usage of coal-fired power plants, a strategy that the European political establishment (including the German Green Party!) has only recently begun to champion. It is possible that EU leaders felt the need to generate a crisis mentality to justify the decision to burn more coal. Dire warnings about how Europe is prepared to ration gas also send a message to Russia that the EU is ready to suffer in order to thwart Putin’s despotic regime. Whether Europe actually follows through is a different story. It is worth noting that the Nord Stream 1 pipeline resumed operations this week after Germany received, over Ukrainian objections, a repaired turbine from Canada. The resumption of partial flows through the pipeline, along with increased fiscal support for households and firms, reduces the risks of a “deep freeze” recession in Europe. The unveiling of the ECB’s new Transmission Protection Instrument (TPI) this week should also help anchor sovereign credit spreads across the euro area. While the exact conditions under which the TPI will be engaged have yet to be fleshed out, we expect the terms to be fairly liberal, reflecting not only the lessons learned from last decade’s euro debt crisis, but also to serve as a powerful bulwark against Putin’s efforts to destabilize the EU economy. China: Government’s Growth Target Looks Increasingly Unrealistic Stronger growth in China would help European exporters (Chart 17). Chinese real GDP grew by just 0.4% in the second quarter from a year earlier as the economy was battered by Covid lockdowns. Activity should pick up in the second half of the year, but at this point, the government’s 5.5% growth target looks completely unachievable. The specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening Chinese property sector are all weighing on the economy (Chart 18). Chart 17European Exporters Would Welcome A Stronger Chinese Economy European Exporters Would Welcome A Stronger Chinese Economy European Exporters Would Welcome A Stronger Chinese Economy The authorities will likely seek to stimulate the economy by allowing local governments to bring forward $220 billion in bond issuance that had been originally slated for 2023. The problem is that land sales – the main source of local government revenue – have collapsed. Worried about the ability of local governments to service their obligations, both retail investors and banks have shied away from buying local government debt. Chart 18A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy Meanwhile, the inability of property developers to secure adequate financing to complete construction projects has left a growing number of home buyers in the lurch. In most cases, these properties were purchased off-the-plan. Understandably, home buyers have balked at the prospect of having to make mortgage payments on properties that they do not possess.  With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus, including increased assistance for property developers and banks, as well as income-support measures for households. While such measures will not address China’s myriad structural problems, they will help keep the economy afloat. Equity Valuations in a Soft-Landing Scenario A few weeks ago, the consensus view was that stocks would tumble in the second half of the year as the global economy fell into recession but would then rally in 2023 as central banks began lowering rates. We argued the opposite, namely that stocks would likely rebound in the second half of the year as the economy outperformed expectations but would then face renewed pressure in 2023 as it became clear that the Fed and several other central banks had no reason to cut rates (Chart 19). Chart 19After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 20Real Rates Have Jumped This Year Real Rates Have Jumped This Year Real Rates Have Jumped This Year In a baseline scenario where a recession is averted, we argued that the S&P 500 could rise to 4,500 (60% odds). In contrast, we noted that the S&P 500 could fall to 3,500 in a mild recession scenario (30% odds) and to 2,900 in a deep recession scenario (10% odds). It is worth stressing that even at 4,500, the S&P 500 would still be 11% lower in real terms than it was on January 4th. At the stock market’s peak in January, the 10-year TIPS yield stood at -0.91%, while the 30-year TIPS yield stood at -0.27%. Today, they stand at 0.58% and 0.93%, respectively (Chart 20). If real rates do not return to their prior lows, it is unlikely that equity valuations will return to their prior highs. This limits the upside for stocks, even in a soft-landing scenario. The sharp rally in stocks over the past week has priced out some of this recession risk, moving equity valuations closer towards what we regard as fair value. As we noted last week, we will turn neutral on equities if the S&P 500 were to rise above 4,050. As we go to press, we are only 1.3% from that level.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on         LinkedIn & Twitter Global Investment Strategy View Matrix The Downside Of A Soft Landing The Downside Of A Soft Landing Special Trade Recommendations Current MacroQuant Model Scores The Downside Of A Soft Landing The Downside Of A Soft Landing    

Listen to a short summary of this report.     Executive Summary The TIPS Market Foresees A Sharp Deceleration In Inflation What If The TIPS Are Right? What If The TIPS Are Right? TIPS breakevens are pointing to a rapid decline in US inflation over the next two years. If the TIPS are right, the Fed will not need to raise rates faster than what is already discounted over the next six months. Falling inflation will allow real wages to start rising again. This will bolster consumer confidence, making a recession less likely. The surprising increase in analyst EPS estimates this year partly reflects the contribution of increased energy profits and the fact that earnings are expressed in nominal terms while economic growth is usually expressed in real terms. Nevertheless, even a mild recession would probably knock down operating earnings by 15%-to-20%. While a recession in the US is not our base case, it is for Europe. A European recession is likely to be short-lived with the initial shock from lower Russian gas flows counterbalanced by income-support measures and ramped-up spending on energy infrastructure and defense. We are setting a limit order to buy EUR/USD at 0.981. Bottom Line: Stocks lack an immediate macro driver to move higher, but that driver should come in the form of lower inflation prints starting as early as next month. Investors should maintain a modest overweight to global equities. That said, barring any material developments, we would turn neutral on stocks if the S&P 500 were to rise above 4,050. US CPI Surprises to the Upside… Again        Investors hoping for some relief on the inflation front were disappointed once again this week. The US headline CPI rose 1.32% month-over-month in June, above the consensus of 1.1%. Core inflation increased to 0.71%, surpassing consensus estimates of 0.5%. The key question is how much of June’s report is “water under the bridge” and how much is a harbinger of things to come. Since the CPI data for June was collected, oil prices have dropped to below $100/bbl. Nationwide gasoline prices have fallen for four straight weeks, with the futures market pointing to further declines in the months ahead. Agriculture and metals prices have swooned. Used car prices are heading south. Wage growth has slowed to about 4% from around 6.5% in the second half of last year. The rate of change in the Zillow rent index has rolled over, albeit from high levels (Chart 1). The Zumper National Rent index is sending a similar message as the Zillow data.  All this suggests that inflation may be peaking. The TIPS market certainly agrees. It is discounting a rapid decline in US inflation over the next few years. This week’s inflation report did little to change that fact (Chart 2). Chart 1Some Signs That Inflation Has Peaked Some Signs That Inflation Has Peaked Some Signs That Inflation Has Peaked Chart 2Investors Expect Inflation To Fall Rapidly Over The Next Few Years What If The TIPS Are Right? What If The TIPS Are Right? TIPS Still Siding with Team Transitory If the TIPS market is right, this would have two important implications. First, the Fed would not need to raise rates more quickly over the next six months than the OIS curve is currently discounting (although it probably would not need to cut rates in 2023 either, given our higher-than-consensus view of where the US neutral rate lies) (Chart 3). The second implication is that real wages, which have declined over the past year, will start rising again as inflation heads lower. Falling real wages have sapped consumer confidence. As real wage growth turns positive, confidence will improve, helping to bolster consumer spending (Chart 4). To the extent that consumption accounts for nearly 70% of the US economy – and other components of GDP such as investment generally take their cues from consumer spending – this would significantly raise the odds of a soft landing.  Chart 3The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 Chart 4Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Chart 5Long-Term Inflation Expectations Remain Well Anchored Long-Term Inflation Expectations Remain Well Anchored Long-Term Inflation Expectations Remain Well Anchored Of course, the TIPS market could be wrong. Bond traders do not set prices and wages. Businesses and workers, interacting with each other, ultimately determine the direction of inflation. Yet, the view of the TIPS market is broadly in sync with the view of most households and businesses. Expected inflation 5-to-10 years out in the University of Michigan survey has risen since the pandemic began, but at about 3%, it is close to where it was for most of the period between 1995 and 2015 (Chart 5). As we pointed out in our recently published Third Quarter Strategy Outlook, and as I discussed in last week’s webcast, the fact that long-term inflation expectations are well anchored implies that the sacrifice ratio – the amount of output that must be forgone to bring down inflation by a given amount — may be quite low. This also raises the odds of a soft landing. Investors Now See Recession as the Base Case Our relatively sanguine view of the US economy leaves us in the minority camp. According to recent polling, more than 70% of US adults expect the economy to be in recession by year-end. Within the investment community, nearly half of retail traders and three-quarters of high-level asset allocators expect a recession within the next 12 months (Chart 6). Chart 6Many Investors Now See Recession As Baked In The Cake What If The TIPS Are Right? What If The TIPS Are Right? Reflecting the downbeat mood among investors, bears exceeded bulls by 20 points in the most recent weekly poll by the American Association of Individual Investors (Chart 7). A record low percentage of respondents in the New York Fed’s Survey of Consumer Expectations believes stocks will rise over the next year (Chart 8). Chart 7Bears Exceed The Bulls By A Wide Margin Bears Exceed The Bulls By A Wide Margin Bears Exceed The Bulls By A Wide Margin Chart 8Households Are Pessimistic On Stocks Households Are Pessimistic On Stocks Households Are Pessimistic On Stocks Resilient Earnings Estimates Admittedly, while sentiment on the economy and the stock market has soured, analyst earnings estimates have yet to decline significantly. In fact, in both the US and the euro area, EPS estimates for 2022 and 2023 are higher today than they were at the start of the year (Chart 9). What’s going on? Part of the explanation reflects the sectoral composition of earnings. In the US, earnings estimates for 2022 are up 2.4% so far this year. Outside of the energy sector, however, 2022 earnings estimates are down 2.2% year-to-date and down 2.9% from their peak in February (Chart 10). Chart 9US And European EPS Estimates Are Up Year-To-Date US And European EPS Estimates Are Up Year-To-Date US And European EPS Estimates Are Up Year-To-Date Another explanation centers on the fact that earnings estimates are expressed in nominal terms while GDP growth is usually expressed in real terms. When inflation is elevated, the difference between real and nominal variables can be important. For example, while US real GDP contracted by 1.6% in Q1, nominal GDP rose by 6.6%. Gross Domestic Income (GDI), which conceptually should equal GDP but can differ due to measurement issues, rose by 1.8% in real terms and by a whopping 10.2% in nominal terms in Q1. Chart 10Soaring Energy Prices Have Boosted Earnings Estimates Soaring Energy Prices Have Boosted Earnings Estimates Soaring Energy Prices Have Boosted Earnings Estimates How Much Bad News Has Been Discounted? Historically, stocks have peaked at approximately the same time as forward earnings estimates have reached their apex. This time around, stocks have swooned well in advance of any cut to earnings estimates (Chart 11). At the time of writing, the S&P 500 was down 25% in real terms from its peak on January 3. Chart 11Unlike In Past Cycles, Stocks Peaked Well Before Earnings What If The TIPS Are Right? What If The TIPS Are Right? This suggests that investors have already discounted some earnings cuts, even if analysts have yet to pencil them in. Consistent with this observation, two-thirds of investors in a recent Bloomberg poll agreed that analysts were “behind the curve” in responding to the deteriorating macro backdrop (Chart 12). Chart 12Most Investors Expect Analyst Earnings Estimates To Come Down What If The TIPS Are Right? What If The TIPS Are Right? Nevertheless, it is likely that stocks would fall further if the economy were to enter a recession. Even in mild recessions, operating profits have fallen by about 15%-to-20% (Chart 13). That is probably a more severe outcome than the market is currently discounting. Chart 13Even A Mild Recession Could Significantly Knock Down Earnings Estimates Even A Mild Recession Could Significantly Knock Down Earnings Estimates Even A Mild Recession Could Significantly Knock Down Earnings Estimates Subjectively, we would expect the S&P 500 to drop to 3,500 over the next 12 months in a mild recession scenario where growth falls into negative territory for a few quarters (30% odds) and to 2,900 in a deep recession scenario where the unemployment rate rises by more than four percentage points from current levels (10% odds). On the flipside, we would expect the S&P 500 to rebound to 4,500 in a scenario where a recession is completely averted (60% odds). A probability-weighted average of these three scenarios produces an expected total return of 8.3% (Table 1). This is enough to warrant a modest overweight to stocks, but just barely. Barring any material developments, we would turn neutral on stocks if the S&P 500 were to rise above 4,050. Table 1A Scenario Analysis For The S&P 500 What If The TIPS Are Right? What If The TIPS Are Right? What’s the Right Framework for Thinking About a European Recession? Whereas we would assign 40% odds to a recession in the US over the next 12 months, we would put the odds of a recession in Europe at around 60%. With a recession in Europe looking increasingly probable, a key question is what the nature of this recession would be. The pandemic may provide a useful framework for answering that question. Just as the pandemic represented an external shock to the global economy, the disruption to energy supplies, stemming from Russia’s invasion of Ukraine, represents an external shock to the European economy. In the initial phase of the pandemic, economic activity in developed economies collapsed as millions of workers were forced to isolate at home. Over the following months, however, the proliferation of work-from-home practices, the easing of lockdown measures, and ample fiscal support permitted growth to recover. Eventually, vaccines became available, which allowed for a further shift to normal life. Just as it took about two years for vaccines to become widely deployed, it will take time for Europe to wean itself off its dependence on Russian natural gas. Earlier this year, the IEA reckoned that the EU could displace more than a third of Russian gas imports within a year. The more ambitious REPowerEU plan foresees two-thirds of Russian gas being displaced by the end of 2022. In the meantime, some Russian gas will be necessary. Canada’s decision over Ukrainian objections to return a repaired turbine to Germany for use in the Nord Stream 1 gas pipeline suggests that a full cutoff of Russian gas flows is unlikely. Chart 14The Euro Is 26% Undervalued Against The Dollar Based On PPP The Euro Is 26% Undervalued Against The Dollar Based On PPP The Euro Is 26% Undervalued Against The Dollar Based On PPP During the pandemic, governments wasted little time in passing legislation to ease the burden on households and businesses. The European energy crunch will elicit a similar response. Back when I worked at the IMF, a common mantra in designing lending programs was that one should “finance temporary shocks but adjust to permanent ones.” The current situation Europe is a textbook example for the merits of providing income support to the private sector, financed by temporarily larger public deficits. The ECB’s soon-to-be-launched “anti-fragmentation” program will allow the central bank to buy the government debt of Italy and other at-risk sovereign borrowers without the need for a formal European Stability Mechanism (ESM) program, provided that the long-term debt profile of the borrowers remains sustainable. Get Ready to Buy the Euro All this suggests that Europe could see a fairly brisk rebound after the energy crunch abates. If the euro area recovers quickly, the euro – which is now about as undervalued against the dollar as anytime in its history (Chart 14) – will soar. With that in mind, we are setting a limit order to buy EUR/USD at 0.981.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn & Twitter   Global Investment Strategy View Matrix What If The TIPS Are Right? What If The TIPS Are Right? Special Trade Recommendations Current MacroQuant Model Scores What If The TIPS Are Right? What If The TIPS Are Right?

Executive Summary Our recommended model bond portfolio outperformed its custom benchmark index by +24bps in Q2/2022, improving the year-to-date outperformance to a solid +72bps. The Q2 outperformance came entirely from the credit side of the portfolio (+35bps), led by underweights to US investment grade corporates (+28bps) and EM hard currency debt (+24bps). The rates side of the portfolio was down slightly (-11bps), with gains from underweights in US and UK inflation-linked bonds (a combined +24bps) helping offset the hit from overweights to German and French government bonds (a combined -30bps). Looking ahead, we continue to see more defensive positioning in growth-sensitive credit sectors like US investment grade corporate bonds and EM hard currency debt, rather than duration management, as providing the better opportunity to generate alpha in bond portfolios over the latter half of 2022. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Bottom Line: In our model bond portfolio, we are maintaining an overall neutral duration stance and a moderate underweight of spread product versus developed market sovereign bonds. We are, however, reducing the recommended tilts in inflation-linked bonds by upgrading US TIPS to neutral and downgrading Canadian linkers to neutral. Feature Dear Client, We are about to take a mid-summer publishing break, as this humble bond strategist moves his family into a new home in a new city. Next week, you will be receiving a report written by BCA Research’s Chief US Bond Strategist, Ryan Swift. The following week, there will be no Global Fixed Income Strategy report published. Our next report will be published on July 26, 2022. Regards, Rob Robis Bond investors are running out of places to hide to avoid losses in 2022. The total return on the Bloomberg Global Aggregate index (hedged into USD) in the second quarter of this year was -4%, nearly matching the -6% loss seen in Q1. No sector, from government bonds to corporate debt to emerging market credit, could avoid the damage caused by hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report  Global Fixed Income StrategyGFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Global inflation rates will soon peak, led by slowing growth of goods prices and commodity prices. However, inflation will remain well above central bank targets across the bulk of the developed world, supported by more domestic sources like services prices, housing costs and wages. This will limit the ability for important central banks like the Fed and ECB to quickly pivot in a more dovish direction to support weakening growth – and bail out foundering bond markets. With that backdrop in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the second quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2022 Model Bond Portfolio Performance: All About Credit Chart 1Q2/2022 Performance: Gains From Defensive Credit Positioning Q2/2022 Performance: Gains From Defensive Credit Positioning Q2/2022 Performance: Gains From Defensive Credit Positioning The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was -4.3%, outperforming the custom benchmark index by +24bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -11bps of underperformance versus our custom benchmark index while the latter outperformed by +35bps. In our previous quarterly portfolio performance review in April, we noted that the greater opportunities to generate outperformance for fixed income investors would come from more defensive allocations to spread product, rather than big directional moves in government bond yields. That forecast largely panned out, as global credit markets moved to price in the growing risk of a deep economic downturn. Declining nominal government bond yields provided some modest relief at the end of June, with markets modestly pricing out some of the rate hikes discounted over the next year amid deepening global recession fears. While we maintained a neutral stance on overall portfolio duration during the quarter, we did benefit from the fact that the decline in global bond yields in late June was concentrated more in lower inflation expectations than falling real yields. Thus, our underweight positioning in inflation-linked bonds, focused on the US and UK, helped add a combined +25bps of outperformance versus the benchmark (Table 1). Table 1GFIS Model Bond Portfolio Q2/2022 Overall Return Attribution GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2022 Government Bond Performance Attribution GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 3GFIS Model Bond Portfolio Q2/2022 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Biggest Outperformers: Underweight US investment grade Industrials (+19bps) Underweight UK index-linked Gilts (+15bps) Underweight US TIPS (+9bps) Underweight US investment grade Financials (+7bps) Underweight US MBS (+6bps) Underweight US Treasuries with maturities beyond ten years (+6bps) Biggest Underperformers: Overweight euro area investment grade corporates (-19bps) Overweight German government bonds with maturities beyond ten years (-14bps) Overweight French government bonds with maturities beyond ten years (-8bps) Overweight UK Gilts with maturities beyond ten years (-6bps) Overweight US CMBS (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2022 GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q2/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers within the credit side of the benchmark portfolio universe. Notably, we were underweight EM USD-denominated Sovereigns (-1099bps), EM USD-denominated corporates (-816bps) and US investment grade corporates (-686bps) on the extreme right side of the chart. Some of our key overweight positions did relatively well, led by overweights in US CMBS (-148bps), Australian government bonds (-288bps) and euro area investment grade corporates (-378bps), all of which were on the left side of Chart 4. One of our key recommendations throughout the first half of 2022 - overweighting German government bonds (-517bps) and French government bonds (-657bps) versus underweighting US Treasuries (-283bps) - performed poorly in Q2. This was due to investors rapidly pricing in a far more aggressive series of ECB rate hikes than we expected, resulting in some convergence of US-European bond yield differentials. Importantly, core European bond yields have pulled back substantially over the last month, and by much more than US yields have declined. Most notably, the 2-year German yield, which began Q2 at minus-7bps and hit a peak of 1.2% on June 14, has now fallen all the way back to 0.4% as this report went to press. The 2-year US-Germany yield differential has already widened by 35bps in the first week of July, suggesting that our overweight core Europe/underweight US allocation is already contributing positively to the model bond portfolio returns for Q3. Bottom Line: Our model bond portfolio outperformed its benchmark index in the second quarter of the year by +24bps – a positive result coming largely from underweight positions in US corporate bonds, EM spread product and inflation-linked bonds in the US and UK. Future Drivers Of Model Bond Portfolio Returns Just as in Q2/2022, the performance of the model bond portfolio in Q3/2022 will be driven more by relative allocations between countries and spread product sectors, rather than big directional moves in bond yields or credit spreads. Overall Duration Exposure Chart 5A More Stable Backdrop For Global Bond Yields A More Stable Backdrop For Global Bond Yields A More Stable Backdrop For Global Bond Yields In terms of portfolio duration, we still see a stronger case for global bond yields to be more rangebound than trending, especially in the US. There has already been a major downward adjustment to global bond yields via lower inflation expectations and reduced rate hike expectations. A GDP-weighted average of major developed market 10-year inflation breakevens has already fallen from an April 2022 peak of 281bps to 216bps (Chart 5). That aggregate breakeven is now back to the levels that began 2022, before the Russian invasion of Ukraine that triggered a surge in global energy prices. We anticipate that additional declines in global inflation expectations – and the associated reductions in central bank rate hike expectations – will be harder to achieve over the latter half of 2022. “Stickier” inflation from services, housing costs and wages will remain strong enough to keep overall inflation rates above central bank targets, even as decelerating goods and commodity price inflation act to slow headline inflation rates. Our Global Duration Indicator, which is comprised of growth indicators like the ZEW expectations index for the US and Europe as well as our own global leading economic indicator, has fallen substantially and is signaling a decline in global bond yield momentum once realized inflation rates peak (Chart 6). Chart 6Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum ​​​​​​ Chart 7Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral We see that as signaling more of a sideways action in bond yields over the next six months, rather than a big downward move, especially in the US. Thus, we are keeping the duration of the model bond portfolio close to that of the benchmark index (Chart 7). Government Bond Country Allocation We are sticking with our view that, for countries with active central banks (i.e. everyone but Japan), favoring markets where interest rate expectations are above plausible estimates of neutral policy rates should lead to outperformance from country allocation. In Chart 8, we show 10-year bond yields and 2-years-forward 1-month Overnight Index Swap (OIS) rates for the US, euro area, UK, Canada and Australia. The shaded regions in the chart represent estimates of the range of neutral policy rates. In the case of the US, rate expectations and Treasury yields are now below the upper level of the range of neutral fed funds rates estimates, between 2-3%, taken from the latest set of FOMC economic projections. Hence, we are sticking with an underweight stance on US Treasuries with yields offering less protection against the Fed following through on its current guidance and lifting the funds rate into restrictive territory above 3%. In the other countries, rate expectations are above the range of neutral rate estimates, which suggests that bond yields have a bit more protection against hawkish central bank actions. That leads us to stay overweight core Europe, the UK and Australia in the government bond portion of the model bond portfolio. We are only keeping Canada at neutral, however, as we suspect that the Bank of Canada is more willing than other central banks to follow the Fed’s lead on taking rates to a restrictive level to help bring down elevated Canadian inflation. For other countries, we are staying neutral on Italian government bond exposure, for now, and underweight Japan (Chart 9). Chart 8Favor Countries Where Markets Expect Above-Neutral Rates Favor Countries Where Markets Expect Above-Neutral Rates Favor Countries Where Markets Expect Above-Neutral Rates ​​​​​​ Chart 9Underweight JGBs, Stay Neutral Italy (For Now) Underweight JGBs, Stay Neutral Italy (For Now) Underweight JGBs, Stay Neutral Italy (For Now) ​​​​​​ For Italy, we await news from the July 21 ECB meeting on the details of a proposal to help support Italian bond markets in the event of additional yield increases or spread widening versus Germany. It is clear from the history of the past decade that Italian bond returns suffer when the ECB is either hiking rates or slowing the growth of its balance sheet (top panel). In other words, it is difficult to recommend overweighting Italian bonds without the support of easy ECB monetary policy. Chart 10Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations For Japan, our recommendation is strictly related to our view on the move in overall global bond yields. The Bank of Japan is bucking the worldwide trend to tighten monetary policy because core Japanese inflation remains weak. This makes Japanese government bonds (JGBs) a good place for bond investors to “hide out” in when global bond yields are rising. Given our view that global bond yield momentum will slow – in line with the signal from our Global Duration Indicator – we do not see a strong cyclical case for overweighting low-yielding JGBs. On inflation-linked bonds, we are maintaining a cautious overall stance, with commodity prices decelerating, realized inflation momentum set to soon peak and central banks signaling more tightening ahead (Chart 10). This week, we are closing out our lone overweight recommendation on inflation-linked bonds in Canada, where we downgrading to neutral (3 out of 5, see the model bond portfolio table on page 24).2 At the same time, we are neutralizing our underweight stance on US TIPS, moving the allocation to neutral. We still see shorter-term TIPS breakevens as having downside from here, but longer-maturity breakevens have already made enough of a downward adjustment, in our view. Global Spread Product Turning to credit markets, we are maintaining our moderately cautious view on the overall allocation to credit versus government bonds. Slowing global growth momentum and tightening global monetary policy is not an environment where credit spreads can narrow, especially for growth-sensitive credit like corporate bonds and high-yield (Chart 11). Having said that – the spread widening seen in US and European corporate bond markets has introduced a better valuation cushion into spreads. Our preferred measure of spread product valuation – the historical percentile ranking of the 12-month breakeven spread – shows that investment grade spreads in the euro area are now in the top quartile (85%) of its history on a risk-adjusted basis (Chart 12). US investment grade spreads are now up into the second quartile (64%), which is a big improvement from the start of 2022 but not as much as seen in Europe. Chart 11Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit ​​​​​ Chart 12Corporate Spread Valuations Have Improved In The US & Europe Corporate Spread Valuations Have Improved In The US & Europe Corporate Spread Valuations Have Improved In The US & Europe ​​​​​ European credit spreads likely need to be wide as a risk premium against the numerous risks the region is facing right now – slowing growth, an increasingly hawkish ECB, soaring energy prices and the lingering uncertainties stemming from the Ukraine war. However, a lot of bad news is now discounted in European spreads and, as a result, we are maintaining our overweight stance on European investment grade corporates, especially versus US investment grade where we remain underweight. High-yield spreads on both sides of the Atlantic look more attractive on a 12-month breakeven spread basis, but also on a default-adjusted spread basis (Chart 13). Assuming a moderate increase in the high-yield default rates in the US and Europe - consistent with a sharp slowing of economic growth but no deep recession - the current level of high-yield spreads net of expected default losses over the next year is above long-run averages. It is too soon to move to an overweight stance on high-yield, with the Fed and ECB set to tighten more amid ongoing growth uncertainty, but given the improved valuation cushion we see a neutral allocation to junk in both the US and Europe as appropriate in our model portfolio. Chart 13Junk Spreads Offer Value If Recession Can Be Avoided Junk Spreads Offer Value If Recession Can Be Avoided Junk Spreads Offer Value If Recession Can Be Avoided Finally, we remain comfortably underweight emerging market USD-denominated sovereign and corporate debt. The backdrop is poor for emerging market bond returns, given slowing global growth, softening commodity prices, a tightening Fed and a strengthening US dollar (Chart 14). Chart 14Staying Cautious On EM Debt Exposure Staying Cautious On EM Debt Exposure Staying Cautious On EM Debt Exposure ​​​​​​ Summing It All Up The full list of our recommended portfolio allocations can be seen in Table 2. The portfolio enters the second half of 2022 with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 15Overall Portfolio Allocation: Underweight Spread Product Vs Governments GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has an underweight allocation to overall spread products versus government bonds, equal to four percentage points of the portfolio (Chart 15) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 77bps – below our self-imposed 100bps tracking error limit (Chart 16) the portfolio now has a yield below that of the custom benchmark index, equal to -31bps on a currency-unhedged basis but a more modest “carry gap” of -10bps on a USD-hedged basis given the gains from hedging into USD (Chart 17). Chart 16Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate ​​​​​​ Chart 17Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark ​​​​​​ Bottom Line: Looking ahead, our model bond portfolio performance will continue to be driven by the same factors in Q3/2022 as in the previous quarter: the relative performance of US bonds versus European equivalents for both government debt and corporate bonds, and the path for emerging market credit spreads. Portfolio Scenario Analysis For The Next Six Months After making the modest changes to our inflation-linked bond allocations in the US and Canada, which can be seen in the tables on pages 23-24, we now turn to our regularly quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Table 3BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around the pace of global growth. Base Case (Slow Global Growth) Global growth momentum slows substantially, with firms cutting back on hiring and investing activity due to slowing corporate profit growth. An outright recession is avoided because softening energy prices help ease the drag on real spending power for consumers. China introduces more monetary and fiscal stimulus measures to boost growth. Global inflation peaks and eases on the back of slowing growth of goods prices and commodity prices, but the floor on inflation in the US and other developed markets is higher than central bank inflation targets due to sticky domestic price pressures. The Fed continues to hike at every policy meeting in H2/2022. There is a very mild bear flattening of the US Treasury curve, but with longer-term yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 28 and the fed funds rate reaches 3.25% by year-end. Resilient Growth Scenario Consumer spending surprises to the upside in the US and even Europe, as softer momentum of energy prices eases the relentless downward pressure on real incomes. Labor demand remains sold across the developed world, particularly with firms reluctant to do mass layoffs because of a perceived scarcity of quality labor. China enacts more policy stimulus with growth likely to fall below 2022 government targets. The Fed is forced to be more aggressive on rate hikes, given resilient US growth and inflation staying well above the Fed’s 2% target. The US Treasury curve bear-flattens into outright inversion, but with Treasury yields rising across the curve. The Brent oil price rises +20%, the VIX index climbs to 30, the US dollar appreciates by +3% thanks to a more aggressive Fed that lifts the funds rate to 3.75% by year-end. Recession Scenario A toxic combination of contracting corporate profits and negative real income growth drags the major developed economies into outright recession. Global inflation rates slow rapidly from current elevated levels, fueled by a rapid decline in commodity prices, but remain above central bank targets making it hard for the Fed and other major central banks to pivot dovishly to support growth. Chinese policymakers belatedly act to ease monetary and fiscal policy, but not by enough to offset the slow response from developed market policymakers. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is relatively modest as the Fed will not pivot quickly to signaling policy easing with inflation still likely to remain above 2%. The Brent oil price falls -20%, the VIX index soars to 35, the US dollar depreciates by -3% (as lower US rates win out over slowing global growth) and the Fed pushes the funds rate to 2.75% before pausing after September. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 18 and Chart 19, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 18Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis ​​​​​ Chart 19US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis ​​​​​​ Given our neutral overall duration stance, the return scenarios will be driven by mostly by the credit side of the portfolio. In the recession scenario where Treasury yields decline, there is a modest projected outperformance from the rates side of the portfolio coming through the underweight to low-beta JGBs. In all scenarios, financial market volatility is expected to stay at, or above, current levels as central banks will be unable to ease policy, even in the event of an actual recession, because of lingering high inflation. Thus, the return on the credit side of the model portfolio will be the main driver of performance, delivering a range of excess return outcomes between +47bps and +60bps. Bottom Line: The model bond portfolio should benefit in H2/2022 from the ongoing cautious stance on global spread product, focused on underweights to US investment grade corporates and EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     We are also closing out our Canadian breakeven widening trade in our Tactical Overlay portfolio. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense

Highlights We now recommend that investors maintain a neutral stance towards stocks versus bonds in a global multi-asset portfolio. We also recommend that investors increase their allocation to government bonds within a global fixed income portfolio (to overweight), at the expense of corporate bonds. We still believe that the US will likely avoid a recession over the coming year, but we are less convinced that this is true than we were a few months ago. The fact that mortgage rates have risen to neutral territory means it is possible that the usual ingredients for a recession – tight monetary policy plus a shock to aggregate demand in the form of a sharp decline in real wages – are currently present or soon will be. In addition, the Fed is now very concerned that long-term household inflation expectations may become unanchored to the upside. Headline inflation has seemingly been a more impactful driver of long-term inflation expectations than core measures, implying that the Fed may have to crowd out demand for goods and services that are comparatively less affected by supply-side constraints in order to contain rising inflation expectations. That would be clearly negative for economic growth and is potentially recessionary in nature. We see no compelling signs of an acceleration in European or Chinese growth that could act as a ballast to support the global economy. The European energy situation is worsening, China’s post-lockdown rebound has so far been tepid, and market-based indicators of Chinese economic growth are deteriorating. The US equity market is not priced for a typical “income-statement” recession induced by monetary policy. We expect the S&P 500 to fall to 3100 in a recession scenario, driven mostly by declining earnings. In a recession scenario, we do not expect long-maturity government bond yields to fall enough to offset a likely increase in the equity risk premium. Financial markets rarely trend sideways over 6-to-12 month periods. We regard a neutral global asset allocation stance as a temporary stepping stone to either a further downgrade of risky assets to underweight, or an increase in risky asset exposure back to a high-conviction overweight. The latter is still possible, especially if we soon see a substantial slowdown in the US headline inflation rate. Thus, additional changes to our recommended cyclical allocation may occur over the coming few months, in response to the incoming data and our assessment of the likely implications for monetary policy. Downgrading Risky Assets To Neutral Every month, BCA strategists hold a house view meeting to discuss the most important issues driving the macroeconomy and financial markets. As highlighted in a recent Special Alert from our Global Investment Strategy service,1 BCA strategists voted at our June meeting to change our House View to a neutral asset allocation stance towards equities, with a slight plurality favoring an outright underweight. Table I-1We Now Recommend More Conservative Positioning Than We Did In May July 2022 July 2022 The view of the Bank Credit Analyst service is in line with the consensus of BCA strategists on this issue, and we consequently recommend a neutral stance towards stocks versus bonds in a global multi-asset portfolio. We also recommend that investors increase their allocation to government bonds within a global fixed income portfolio (to overweight), at the expense of corporate bonds (Table I-1). We noted in our April report2 – when the S&P 500 index stood at 4530 – that the outlook for equities had deteriorated meaningfully since the beginning of the year and that investors should maintain at most a very modest overweight toward equities in a global multi-asset portfolio. A formal downgrade to neutral is thus not a large change in our recommended positioning, but it reflects what we view as a legitimate increase in the odds of a US recession over the coming year. It is not yet our view that a US recession is a probable outcome, but it is important to distinguish between one’s forecast of the economic outlook and the appropriate investment strategy. The unique inflationary pressure created by the COVID-19 pandemic has created a large confidence interval around our forecast, underscoring that an aggressive stance towards risky assets is not warranted. Financial markets rarely trend sideways over 6-to-12 month periods. We regard a neutral stance as a temporary stepping stone to either a further downgrade of risky assets to underweight or an increase in risky asset exposure back to a high-conviction overweight. The latter is still possible, especially if we see a substantial slowdown in the US headline inflation rate. But as we will discuss below, that slowdown will have to materialize soon in order for us to recommend an overweight risky asset stance. Reviewing Our Previously Constructive View On US Economic Growth Chart I-1Recessionary Concerns Have Escalated Significantly Since The 2-10 Yield Curve Inverted Recessionary Concerns Have Escalated Significantly Since The 2-10 Yield Curve Inverted Recessionary Concerns Have Escalated Significantly Since The 2-10 Yield Curve Inverted Concerns about a potential US recession have been growing since the Fed’s hawkish pivot in November, especially following Russia’s invasion of Ukraine. Previously, these concerns centered around two core issues: the aggressive pace at which the Fed communicated it would raise the policy rate, and the fact that the 2-10 yield curve flattened sharply in the first quarter and finally inverted (based on closing prices) on April 1st (Chart I-1). We had pushed back against those concerns, for several reasons. Our deeply-held view is that recessions typically occur when a significant shock to aggregate demand emerges against the backdrop of tight monetary policy. Sometimes the debt-service and credit demand impact of high interest rates itself is the shock. In other cases, recessions have been triggered in an environment of restrictive monetary policy by a sudden change in key input costs (such as oil prices), the bursting of a financial asset bubble, or a major shift in fiscal spending (typically following a period of war). But the core point is that recessions rarely occur when monetary policy is easy, even when shocks to aggregate demand occur. We abstract here from special cases such as the recession that occurred during the early phase of the COVID-19 pandemic. That event saw the introduction of government policies that purposely arrested economic activity, which in our view would have caused a recession under any conceivable fiscal and/or monetary policy alignment. As a business cycle indicator, the yield curve is significant for investors because it essentially represents the bond market’s assessment of the monetary policy stance. The 2-10 yield curve inversion in early April occurred, in part, because of the speed at which the Fed signaled it would raise interest rates, but also because the 10-year Treasury yield stood just under 2.4% at the point of inversion. This level of long-maturity bond yields reflected the view of both the Fed and most investors that the neutral rate of interest permanently fell following the 2008/2009 global financial crisis (GFC), a view that we have argued against in several previous reports.3 As such, the first reason we pushed back against earlier recessionary concerns is that we believe that the natural/neutral rate of interest is higher than the Fed and investors believe (even though we warned that a recessionary scare was quite likely). Chart I-2A Large Portion Of Currently Elevated Inflation Is Due To Supply-Side And Pandemic-Related Factors July 2022 July 2022 The second reason that we had pushed back against recessionary concerns was our view that a meaningful portion of currently elevated US inflation is a function of supply-side and pandemic-related factors that will eventually abate. Chart I-2 highlights credible estimates showing that roughly half of the year-over-year change in the headline PCE deflator is the result of supply-side factors, versus 40-50% for core inflation. It has been and remains our view that a substantial portion of these supply-side and pandemic-related factors will dissipate as the pandemic continues to recede in importance, with several price categories likely to deflate outright. Chart I-3Excess Savings Should Still Support Higher Services Spending Excess Savings Should Still Support Higher Services Spending Excess Savings Should Still Support Higher Services Spending Finally, we have argued in several reports that US goods spending has been well above-trend and is likely to slow, but also that services spending is far too low and is likely to rise. Chart I-3 highlights that close to $3 trillion in excess savings have accrued during the pandemic, which formed because of a combination of rising disposable income and falling services spending. We noted that the continued transition of the US and global economies towards a post-pandemic state would boost services spending, providing (an admittedly atypical) source of support for overall aggregate demand.   Why The Odds Of A US Recession Have Increased We still believe that the US will more likely than not avoid a recession over the coming year, but it is true that the strength of all three of the arguments presented above has weakened. Regarding the stance of monetary policy, Charts I-4 and I-5 highlight that it is still true that the Fed funds rate and 5-year/5-year forward Treasury yields remain below our estimate of the neutral rate (nominal potential GDP growth). However, Chart I-6 highlights that the sharp rise in consumer price inflation has caused a substantial reduction in real wage growth, which certainly constitutes a non-monetary aggregate demand shock. Chart I-4The Policy Rate Is Not Yet At Neutral, But Mortgage Rates Are The Policy Rate Is Not Yet At Neutral, But Mortgage Rates Are The Policy Rate Is Not Yet At Neutral, But Mortgage Rates Are Chart I-5Long-Maturity Government Bond Yields Would Have Room To Move A Lot Higher Absent Any Shocks To Demand... Long-Maturity Government Bond Yields Would Have Room To Move A Lot Higher Absent Any Shocks To Demand... Long-Maturity Government Bond Yields Would Have Room To Move A Lot Higher Absent Any Shocks To Demand...       Chart I-6...Unfortunately, US Consumers Are Clearly Experiencing A Shock In The Form Of Sharply Lower Real Wages ...Unfortunately, US Consumers Are Clearly Experiencing A Shock In The Form Of Sharply Lower Real Wages ...Unfortunately, US Consumers Are Clearly Experiencing A Shock In The Form Of Sharply Lower Real Wages Panel 2 of Chart I-4 also shows that the 30-year mortgage rate in the US is now at neutral levels, in contrast to government bond yields and the US policy rate. Chart I-7 highlights that our models for US home sales and starts, featured in last month’s report,4 are still not pointing to a severe slowdown in the housing market. However, the fact that mortgage rates have risen to neutral territory means that it is possible that the usual ingredients for a recession – tight monetary policy plus a shock to aggregate demand – are currently present or soon will be. On the question of services spending acting as a support for US economic growth as goods spending slows, we continue to believe that services spending will recover back towards its pre-pandemic trend – funded by excess savings that accrued during the pandemic. However, Chart I-8, presented by my colleague Arthur Budaghyan in a recent Emerging Markets Strategy report,5 underscores the extent of the wealth destruction that has occurred because of the joint effect of falling stock and bond prices. At least some of the services-boosting effect of excess savings will likely be blunted by a negative wealth effect stemming from these financial market losses, especially since the remaining excess savings in the US are likely held by middle-to-upper income households – who are the disproportionate holders of publicly-traded financial assets. Chart I-7No Sign Yet Of A Sharp Slowdown In The Housing Market, But The Ingredients Of A Typical Recession May Be Present No Sign Yet Of A Sharp Slowdown In The Housing Market, But The Ingredients Of A Typical Recession May Be Present No Sign Yet Of A Sharp Slowdown In The Housing Market, But The Ingredients Of A Typical Recession May Be Present Chart I-8A Significant Wealth Shock May Blunt The Deployment Of The Excess Savings Accrued During The Pandemic A Significant Wealth Shock May Blunt The Deployment Of The Excess Savings Accrued During The Pandemic A Significant Wealth Shock May Blunt The Deployment Of The Excess Savings Accrued During The Pandemic   On the inflation front, the May CPI release – and the Fed’s reaction to it – underscores that the US economy is at risk of a recession unless supply-side inflation dissipates quickly. Chart I-9 highlights that the May CPI release directly contradicted the view that the monthly rate of change in inflation has peaked. In addition, Chart I-10 presents a breakdown of the percent change in May’s headline consumer price index, with each bar in the chart representing the contribution of that category to headline CPI rising faster than 4% (annualized). The note next to each bar highlights our view of the main driver of that price category, and the color of the bars denotes how probable it is that we will soon see a significant easing in price pressure. Chart I-9The May CPI Report Was Clearly Inconsistent With A Peak Inflation Narrative The May CPI Report Was Clearly Inconsistent With A Peak Inflation Narrative The May CPI Report Was Clearly Inconsistent With A Peak Inflation Narrative Chart I-10Some Elements Of Outsized CPI Will Dissipate Soon. Others May Not. July 2022 July 2022     The chart makes it clear that certain price categories that have been strongly contributing to outsized headline inflation are likely to peak or even turn deflationary over the next few months. Gasoline and fuel oil inflation is clearly being driven by the trend in crude oil prices, which in our view will likely be flat for the rest of the year. In addition, motor vehicles and parts inflation continues to be driven by the impact of supply-chain shortages on vehicle production. Over the past year, the volume of industrial production of motor vehicle assemblies has averaged just 83% of its pre-pandemic level, which we noted in last month’s report now finally seems to be normalizing (Chart I-11). And while airlines have experienced legitimate cost increases due to rising fuel prices and COVID-related labor shortages, panel 2 of Chart I-11 highlights that real airfares have risen well above their pre-pandemic level. This underscores that a moderation in airfares is quite likely over the coming several months. However, Chart I-10 also highlights that there are several price categories that are less likely to ease quickly. Outsized food and energy services inflation has recently been tied to natural gas prices, given that natural gas is used to generate electricity and is a key element used in the production of fertilizer. Chart I-12 highlights that food inflation has been strongly correlated with the producer price index for pesticide, fertilizer, and other agricultural chemicals, and that there is no sign yet of the latter abating. Despite the fact that global wheat prices have recently been falling, the recent increase in European natural gas prices is likely to exacerbate US food inflation, as fertilizer is used to produce all major planted crops. In addition, European energy insecurity has created an even stronger link between the US and European natural gas markets than what prevailed prior to the Ukrainian war, because of what is likely to be permanently higher LNG demand from Europe. Chart I-11Vehicle And Airfare Inflation Is Likely To Ease Soon Vehicle And Airfare Inflation Is Likely To Ease Soon Vehicle And Airfare Inflation Is Likely To Ease Soon Chart I-12Food Inflation May Remain Elevated For Some Time Food Inflation May Remain Elevated For Some Time Food Inflation May Remain Elevated For Some Time   On top of what is likely to be persistent food and energy services inflation, shelter inflation is likely to stay elevated for some time – a point highlighted by my esteemed former colleague, Martin Barnes, in Section 2 of this month’s report. The unemployment rate and house prices are the two main drivers of shelter inflation, and the effect of the latter clearly lags because owner’s equivalent rent is a surveyed measure. The fact that mortgage rates have risen so significantly points to a meaningful slowdown in house price appreciation and possibly even mild deflation, so shelter inflation will eventually slow. The Federal Reserve has made it clear, however, that they are now focused on quickly bringing down consumer prices, even at the cost of a recession. The justification for the Fed’s impatience comes straight from the Modern-Day Phillips Curve, which we discussed in great detail in our January 2021 Special Report.6 Economic theory dictates that inflation should be “normal” when the economy is in equilibrium – defined as economic growth in line with potential growth, no economic/labor market slack, and no supply-side shocks affecting prices. In the minds of many investors, “normal” inflation means the central bank’s target for inflation, but that is not necessarily the case. The experience of the 1970s highlighted that “normal” inflation is the rate that is expected by households and firms, and that the Fed will only succeed at achieving target inflation under normal economic conditions if inflation expectations are consistent with its target. The Fed’s failure to prevent inflation expectations from shifting higher on a structural basis led to two debilitating recessions in the early 1980s, and a prolonged period over which the Fed had to maintain comparatively tight monetary policy. This is a mistake that the Fed does not want to make again. Chart I-13Headline Inflation, Not Core, Is Driving Long-Term Inflation Expectations Headline Inflation, Not Core, Is Driving Long-Term Inflation Expectations Headline Inflation, Not Core, Is Driving Long-Term Inflation Expectations Consistent with that view, Jerome Powell made it clear during the June FOMC meeting press conference that the Fed is now very concerned that long-term household inflation expectations may become unanchored to the upside. Powell implicitly referenced the University of Michigan’s 5-10 year median household inflation expectations survey during the press conference, which we have described in several previous reports as one of the most important macro data series for investors to monitor. The final reading for June came in materially lower than what was suggested by the preliminary report, but they were already at risk of a breakout even before the June release. In addition, Chart I-13 highlights that it is headline inflation (not core) that appears to be the main driver of rising long-term household inflation expectations, which raises a troubling point. If the Fed decides that inflation expectations need to be quickly reined in even at the cost of a higher unemployment rate, that decision implies that it is headline inflation that needs to return rapidly towards the Fed’s target, not just core. Given that some price categories shown in Chart I-10 are likely to be sticky for some time, and that the chart accounted for deviations in headline inflation from 4% (which itself is above the Fed’s target), the implication is that the Fed may have to crowd out demand for goods and services that are comparatively less affected by supply-side constraints. That would be clearly negative for economic growth, and is potentially recessionary in nature. As a final point, it is not just the potential for future economic weakness that concerns us. The US economy was already slowing prior to the Fed’s hawkish pivot and Russia’s invasion of Ukraine, and important indicators for economic activity continue to deteriorate. Chart I-14 highlights that the S&P Global US manufacturing and services PMIs fell meaningfully in June, and Chart I-15 highlights that the Conference Board’s US leading economic indicator continues to deteriorate. In fact, the Conference Board’s LEI has now decreased for three consecutive months, and the bottom panel of Chart I-15 highlights that four consecutive month-over-month declines have all essentially been associated with a recession. 2006 seemingly stands out as an exception to this rule, but given the fact that the housing market downturn began two years before the recession officially started, we simply regard this as an early recessionary signal rather than a false one. Chart I-14The US Is Losing Economic Momentum The US Is Losing Economic Momentum The US Is Losing Economic Momentum Chart I-15The Conference Board's LEI May Soon Send A Recessionary Signal The Conference Board's LEI May Soon Send A Recessionary Signal The Conference Board's LEI May Soon Send A Recessionary Signal     No Help From Europe Or China An overweight stance towards global equities might still be warranted in the face of a significant slowdown in US economic activity if economic growth in Europe or China were accelerating. However, the European outlook has been strongly tied to natural gas flows from Russia since the invasion of Ukraine, which tightened meaningfully in June in response to Europe’s oil ban, the looming expansion of NATO, and Europe’s success at replenishing its amount of natural gas in storage. Russia has not fully weaponized its natural gas exports and its actions so far have fallen well short of a complete cutoff, but prices have risen close to 70% over the past month, forcing Germany to trigger the alert level of its emergency gas plan. Aside from the negative impact that higher natural gas prices will have on headline inflation globally, this is obviously incrementally negative for European economic activity. Chart I-16 highlights that the German IFO business climate indexes have led the S&P Global Germany PMI lower over the past few months, and that they imply further manufacturing weakness. And while the services climate index for Germany ticked higher, it remains meaningfully below the levels that prevailed last summer and implies a deterioration in German services activity over the coming few months. In China, we see no compelling signs of a sustainable pickup in economic activity that will provide a ballast to slowing growth in the DM world. We have seen a bounce back in some activity indicators following the significant easing of restrictions in Shanghai and Beijing (Chart I-17). These indicators, however, are still quite weak, and it is likely that China will experience significant further COVID outbreaks over the coming 6-12 months. Chart I-16Europe's Economy Is Likely To Slow Further Europe's Economy Is Likely To Slow Further Europe's Economy Is Likely To Slow Further Chart I-17China's Post-Lockdown 'Recovery' Remains Tepid China's Post-Lockdown 'Recovery' Remains Tepid China's Post-Lockdown 'Recovery' Remains Tepid   While Chinese stocks have been rallying in absolute terms over the past few weeks, Chart I-18 highlights that this is essentially the only positive market-based signal about the pace of economic activity in China. The chart highlights that our market-based China Growth Indicator has experienced a renewed down leg, and that the diffusion index never rose above the boom/bust line earlier this year. The recent decline in industrial metals prices is also not a positive market-based signal for Chinese economic activity (Chart 19). Some investors have argued that weak metals prices reflect growth concerns outside of China, but even if that is the case, it implies that China’s reopening will not be forceful enough to offset slowing global ex-China growth. Chart I-18Market-Based Signals Are Not Pointing To An Improvement In Chinese Economic Activity Market-Based Signals Are Not Pointing To An Improvement In Chinese Economic Activity Market-Based Signals Are Not Pointing To An Improvement In Chinese Economic Activity Chart I-19Metals Prices Are Now Falling, Highlighting Mounting Global Growth Fears Metals Prices Are Now Falling, Highlighting Mounting Global Growth Fears Metals Prices Are Now Falling, Highlighting Mounting Global Growth Fears   Has The US Equity Market Already Priced In A Recession? One very important question for investors to answer is how much further downside is likely to occur for US equities in the event of a US recession. At its worst point in mid-June, the S&P 500 fell close to 24% from its early January high, and many investors have since questioned whether the US equity market is already priced for a potential contraction in output. Chart I-20The S&P 500 Is Not Currently Priced For A US Recession July 2022 July 2022 We disagree with this perspective, and believe that the S&P 500 would fall close to 3100 in a typical recession scenario. Chart I-20 presents a range of estimates for the S&P 500 based on a Monte Carlo approach, using what we believe are feasible ranges for the US equity risk premium, real 10-year government bond yields, and the extent of the decline in 12-month forward earnings per share. The chart shows that the equity market only has a positive return at the 5th percentile, which can be interpreted as just a 5% chance that the US equity market has already priced in the impact of a recession. Charts I-21 and I-22 highlight the range of possible outcomes that we used when modeling the likely decline in stock prices in a recession scenario. We assume that the equity risk premium, defined here as the difference between the S&P 500 12-month forward earnings yield and 10-year TIPS yields, rises on average to its early-March level in the wake of Russia’s invasion of Ukraine. We assume that both 10-year nominal Treasury yields and 10-year breakeven inflation rates fall to 2%, reflecting an expectation that 10-year TIPS yields will not return to negative territory in a recessionary scenario. Finally, we expect that S&P 500 forward EPS will decline by 15% from current levels, which is in line with the historical average decline in 12-month trailing operating EPS during recessions. Chart I-21We Do Not Expect Real Bond Yields To Fall Back Into Negative Territory In A Typical Recession Scenario We Do Not Expect Real Bond Yields To Fall Back Into Negative Territory In A Typical Recession Scenario We Do Not Expect Real Bond Yields To Fall Back Into Negative Territory In A Typical Recession Scenario Chart I-22We Expect Earnings To Decline Between 10-20% In A Recession We Expect Earnings To Decline Between 10-20% In A Recession We Expect Earnings To Decline Between 10-20% In A Recession     One key takeaway from our analysis is that the likely recessionary equity market decline projected by our approach is fairly close to our estimate of the likely decline in earnings. One potential pushback against our view that earnings will fall in line with what usually occurs during recessions is the fact that nominal revenue growth may only mildly contract or may not contract at all in a recession that is occurring due to high rates of inflation (and thus higher prices charged by firms). Chart I-23 highlights that 12-month trailing S&P 500 sales per share growth never turned negative in the 1970s, even following the 1970 and 1974 recessions. Chart I-23Revenue Growth Did Not Contract In The 1970s, And May Not Contract Significantly If A Recession Occurs Today... Revenue Growth Did Not Contract In The 1970s, And May Not Contract Significantly If A Recession Occurs Today... Revenue Growth Did Not Contract In The 1970s, And May Not Contract Significantly If A Recession Occurs Today... There are two counterpoints to this argument. First, the current risk of a recession mostly stems from the Fed’s determination not to repeat the mistakes that it made during the 1970s, meaning that inflation expectations are unlikely to rise to the level that they did during that period in advance of a recession. That implies that actual inflation, and thus corporate pricing power, will come down significantly during a recession. Second, even in a scenario in which a recession occurs and S&P 500 revenue growth contracts less aggressively than it has during previous recessions, Chart I-24 highlights that the mean-reversion risks to earnings from falling profit margins are quite high. The chart shows that even if profit margins were merely to return to their pre-pandemic levels during a recession (which would actually be a comparatively mild decline given the historical behavior of margins during recessions), it would imply close to a 20% contraction in earnings if sales per share growth were flat. Given this, we feel that our assumption of a 10-20% decline in earnings per share in a recessionary scenario is reasonable. Chart I-24But Profit Margins Are At Great Risk Of A Significant Decline If The Economy Contracts But Profit Margins Are At Great Risk Of A Significant Decline If The Economy Contracts But Profit Margins Are At Great Risk Of A Significant Decline If The Economy Contracts There is another important takeaway from our analysis, which is that the decline in bond yields that will occur in a recessionary scenario will likely be more than offset by a rise in the equity risk premium. Another potential pushback against our view that the US equity market has already priced in a recession is focused on our assumption that the 10-year US Treasury yield will only fall back to 2%, and that real 10-year yields will not return to negative territory. For some investors, this assumption seems far too high, given the structural decline in long-maturity bond yields over the past decade and the fact that the 10-year yield stood below 2% at the beginning of the year when the odds of a recession were lower than they are today. In response to this, we offer three points for structurally-bullish bond investors to consider. The first is that the decline in the nominal 10-year US Treasury yield to 0.5% in 2020 was extremely irregular and it occurred because of the extent of the essentially unprecedented economic weakness wrought by the pandemic. This is absolutely the wrong yield benchmark to use in a typical recession scenario, because the Fed’s response to the recession will be much less aggressive. The second point is related to the first, in that negative real 10-year government bond yields have been heavily driven by the secular stagnation narrative and the general view that the natural/neutral rate of interest has permanently fallen. We agree that the neutral rate of interest fell for a time following the global financial crisis, but we believe strongly that it rose in the latter half of the last economic expansion as US households aggressively deleveraged their balance sheets. Academic estimates of R-star, such as that derived from the previously popular (but now discontinued) Laubach-Williams model, continued to point to a low neutral rate from 2015-2019 because of the deflationary impact of an energy-driven decline in long-term inflation expectations on actual inflation, a factor that is clearly no longer present. Chart I-25We Doubt That The Fed Will Resort To QE When The Next Recession Occurs We Doubt That The Fed Will Resort To QE When The Next Recession Occurs We Doubt That The Fed Will Resort To QE When The Next Recession Occurs Finally, we agree that the existence of the Fed’s asset purchase program has likely had some impact on the 10-year term premium over the past decade. We doubt that the Fed would resort to QE as a monetary policy tool in response to a conventional recession, implying that the term premium will not fall as low as it has over the past decade when growth slowed or contracted. Chart I-25 highlights one important reason for this. Since 2008, the Fed’s use of asset purchases has been part of a strategy to ease monetary policy further when the policy rate had already fallen to zero, to meet its dual mandate of maximum employment and price stability. The chart highlights that even just prior to the pandemic, a persistent gap existed between the headline and core PCE deflator and the level that would have prevailed if both deflators had grown at a 2% annual rate since the onset of the 2008 recession. The chart makes it clear that this gap will completely disappear within the next 12 months for both the headline and core deflator, if the recent pace of change in prices is sustained. In effect, Chart I-25 highlights that the entire post-GFC missed inflation-target era is almost over, which severely undercuts the idea that the Fed will resort to QE as a monetary policy tool in a recession scenario unless the contraction is very severe as it was in 2008 and 2020. We doubt that this will be the case if a recession does occur, implying that both a deeply negative term premium and a significant decline in the 5-year/5-year forward bond yield in a typical recession scenario is unlikely. Investment Conclusions Wayne Gretsky’s famous quotation, that he “skate[s] to where the puck is going, not where it has been” is often invoked by BCA strategists. Successful active investing requires anticipation rather than reaction, and it is legitimate for investors to ask whether downgrading risky assets at the current juncture represents the latter rather than the former. We are cognizant of that risk, but we are also mindful of the importance of capital preservation. When we wrote our annual outlook last year, we believed fairly confidently that inflation would peak and specifically that supply-side inflation would wane. We still believe that pandemic-related effects on consumer prices will eventually dissipate, and it is still possible that inflation is in the process of peaking. Recent evidence, however, about the pace of price advances, the clear impact that high inflation is having on real wage growth, and the Fed’s desire to see consumer prices fall quickly back toward its target, means that the cyclical economic outlook is now highly dependent on the speed at which prices normalize – not just whether it will occur. To us, that implies that investors need to have a high-conviction view that supply-side inflation will normalize soon in order to stay overweight risky assets, and that the Fed will look through elevated housing-related inflation that is likely to persist for several months. At least in the case of supply-side inflation, we think normalization is probable but we no longer have high conviction about the speed of adjustment. As such, we recommend that investors maintain no more than a neutral stance towards stocks versus bonds in a global multi-asset portfolio. We also recommend that investors increase their allocation to government bonds within a global fixed income portfolio (to overweight), at the expense of corporate bonds, as part of an overall shift towards more defensive positions. In terms of other important asset class allocations, we recommend the following: Within a global equity portfolio, maintain a neutral regional allocation, a neutral stance toward cyclicals versus defensives, and a neutral stance towards small-cap stocks versus their large-cap peers. Modestly favor value stocks over growth stocks, as most of the outsized outperformance of growth stocks during the pandemic has already reversed. Within a fixed-income portfolio, a modestly short stance is warranted over the coming 6- to 12-months. Extremely stretched technical and valuation conditions point to a bearish view towards the US dollar over the coming 6- to 12-months, but USD will likely remain well-bid over the nearer-term. We are only likely to upgrade our cyclical USD call in a scenario in which we recommend underweighting global equities within a multi-asset portfolio. As noted above, financial markets rarely trend sideways over 6-to-12 month periods. We regard a neutral global asset allocation stance as a temporary stepping stone to either a further downgrade of risky assets to underweight or an increase in risky asset exposure back to a high-conviction overweight. Thus, additional changes to our recommended cyclical allocation may occur over the coming few months, in response to the incoming data and our assessment of the likely implications for monetary policy. Stay tuned! Jonathan LaBerge, CFA Vice President The Bank Credit Analyst June 30, 2022 Next Report: July 28, 2022 II.  Inflation Whipsaw Ahead Dear Client, This month’s Special Report has been written by Martin Barnes, BCA’s former Chief Economist. Martin, who retired from BCA Research last year after a long and illustrious career, discusses the long-run outlook for inflation. The views expressed in this report are his, and may not be consistent with those of the Bank Credit Analyst or other BCA Research services. But Martin’s warning of future stagflation is sobering, and I trust you will find his report both interesting and insightful. Jonathan LaBerge, CFA The Bank Credit Analyst Overly stimulative policies meant that inflation was set to rise even before the disruptions caused by the pandemic and Ukraine conflict. Inflation should decline sharply over the coming year in response to weaker economic growth and an easing in supply problems. But it will be a temporary respite. Central banks will not have the stomach to keep policy tight enough for long enough to squeeze inflation out of the system. Price pressures will return as economies bottom and the environment will become one of stagflation. Financial assets will rally strongly when inflation fears subside but subsequent stagflation will not be bullish for markets. Former Federal Reserve Chairman Alan Greenspan once defined price stability as existing when “households and businesses need not factor expectations of changes in the average level of prices into their decisions”. Until recently, that state of affairs was the case for much of the past 30 years and for many, inflation was quiescent during their entire working lives. But inflation is now back as a huge issue and there is massive debate and uncertainty about whether it will be a temporary or lasting problem. I lean toward the latter view. Major changes in the economic and/or financial environment more often are identified in hindsight than in real time. It is easier to attribute large trend deviations to temporary factors than to make bold predictions about structural shifts. Obviously, the pandemic and conflict in Ukraine have had a significant impact on the near-term inflation picture via massive supply-side disruptions and represent temporary events. Thus, inflation will retreat from current elevated levels as those disruptions diminish. But the conditions for higher inflation were already in place before those two unfortunate events occurred. Specifically, central banks have been erring on the side of stimulus for several years and they will find it extremely difficult, if not impossible, to put the inflation genie back into the bottle. Inflation has moved from a non-issue to the most important factor driving markets. Over the next year, the next big surprise might be how fast inflation retreats and investors and policymakers will then breathe a big sigh of relief. However, this will prove to be a temporary respite because it will not take long for inflation to move back up and remain stubbornly above central bank targets. In other words, a whipsaw is in prospect over the next few years as inflation goes from up, to down, and to up again. The Current Inflation Problem The biggest increases in consumer prices have occurred in areas most affected by supply problems, with energy attracting the most attention. Nevertheless, in most countries, inflation has risen across the majority of goods and services. The core inflation rate (i.e. consumer prices excluding food and energy) in the G7 economies climbed from 2% to 4.8% between April 2021 and April 2022 (Chart II-1). Meanwhile, the Cleveland Fed’s trimmed mean measure of US consumer price inflation has spiked dramatically higher, consistent with a broad-based acceleration in inflation.7 The rise in underlying inflation is a bigger problem in the US, UK and Canada than in Japan or the Euro Area. Chart II-2 shows current core inflation rates relative to the target rate of 2% pursued by most central banks. That geographical divergence will be touched on later and in the meantime, the focus will be on the US situation. Chart II-1A Broad-Based Pickup In Inflation A Broad-Based Pickup in Inflation A Broad-Based Pickup in Inflation Chart II-2The US, UK And Canada Have A Bigger Inflation Problem July 2022 July 2022   The latest US inflation data for a range of goods and services is shown in Table II-1. The table shows the three- and six-month annualized changes in prices because 12-month rates can be affected by a base effect given the impact of pandemic-related shutdowns and disruptions a year ago. Also, a comparison of the three- and six-month rates shows if momentum is building or fading. The trends are not encouraging in that momentum has accelerated, not diminished in many key areas. Table II-1Selected Inflation Rates In The US CPI July 2022 July 2022 Even if the data show a moderation in core inflation in the months ahead, it is important to note that rent inflation – the CPI component with the biggest weight – is seriously underestimated. This is one of the few items where prices are collected with a lag and real estate industry reports highlight that rent inflation is running at double-digit rates in the major cities. According to one report, average rents nationally increased by more than 25% in the year to May.8 The CPI data will eventually catch up with reality, providing at least a partial offset to any inflation improvements in other areas. Another problem for inflation is the acceleration in wage growth against the backdrop of an unusually tight labor market. Currently, the number of unfilled vacancies is almost twice the number of unemployed and it is thus no surprise that wage growth has picked up sharply (Chart II-3). The Atlanta Fed’s measure of annual wage inflation has risen above 6%, its highest reading since the data began in 1997. Wage growth is unlikely to suddenly decline absent a marked rise in the unemployment rate. There is much debate about whether the US economy is on the verge of recession, but let’s not get bogged down in semantics. Regardless of whether the technical definition of recession is met (at least two consecutive quarters of negative GDP growth), the pace of activity is set to slow sharply. Plunging consumer and business confidence, contracting real incomes and a peaking in housing activity all point to a significant weakening in growth, even if the labor market stays healthy (Chart II-4). Chart II-3A Very Tight US Labor Market A Very Tight US Labor Market A Very Tight US Labor Market Chart II-4The US Economy Is In Trouble The US Economy is in Trouble The US Economy is in Trouble   Softer economic growth eventually will take the edge off inflationary pressures in many goods and services. Combined with an easing in supply-side disruptions, the inflation rate is certain to decline in the coming year, even if oil prices move higher in the short run. Currently, the Fed is talking tough about dealing with inflation and there is little doubt that further rate hikes are on the way. However, policymakers will have little stomach for inflicting enough economic pain to completely squeeze inflation out of the system. Once there are clear signs of a significant economic slowdown, the Fed will back off quickly. What Causes Inflation Anyway? Economics 101 teaches that prices are determined by the interaction of supply and demand. If the demand for a good or service exceeds supply, then prices will rise to bring things back into balance. Seems simple enough but, unfortunately, this leaves many unanswered questions. How much must prices rise and for how long in order to restore balance? What if there are structural impediments to supply? What if there are monopolies in key commodities or services? What if policy interferes with the operation of market-clearing solutions? And, finally, what measure of inflation should we be looking at? Chart II-5Inflation Is A 'Modern' Issue Inflation is a 'Modern' Issue Inflation is a 'Modern' Issue For much of economic history, deflation was just as prevalent as inflation, with the latter only being a problem during periods of war (Chart II-5). As the pre-WWII world pre-dated fiat money, automatic stabilizers (e.g. the welfare state), and counter-cyclical fiscal policy, economies were prone to regular depressions that served to wash out financial and economic excesses and any inflationary pressures. But those days are long gone and free market forces should not be expected to keep inflation under wraps. I rather like the simple explanation of inflation’s roots as being “too much money chasing too few goods”. In that sense, the control of inflation lies firmly at the door of central banks. In the “old days” (i.e. before the 1990s), it was possible to use the growth in the money supply to gauge the stance of policy because there was a fairly stable and predictable relationship between monetary and economic trends. That all ended when financial deregulation and the explosion in non-bank financial activities meant that monetary trends ceased to be a reliable indicator of economic growth and inflation. As a result, the Fed stopped setting monetary growth targets more than 20 years ago and since then, money supply data has rarely been mentioned in FOMC discussions. Chart II-6A Simple Measure Of The Monetary Stance A Simple Measure of the Monetary Stance A Simple Measure of the Monetary Stance Fortunately, all is not lost. The gap between the federal funds rate and nominal GDP growth is a reasonably good proxy for the stance of monetary policy. Conditions are easy when rates are persistently below GDP growth and vice versa when they are above. As can be seen in Chart II-6, rates were below GDP growth during most of the 1960s and 1970s, a period when inflation rose sharply. And inflation fell steadily in the 1980s into the first half of the 1990s when the Fed kept interest rates above GDP growth. And look at what has happened in the past decade: rates have been significantly below GDP growth, suggesting an aggressively easy monetary stance. It was only a matter of time before inflation picked up, even without the recent supply-side disruptions. The FOMC’s latest projections show long-run growth of 3.8% in nominal GDP while the fed funds rate is expected to average only 2.5%. That implies a continued accommodative stance, yet inflation is forecast to be in line with the 2% target. That all seems very unlikely. Fed policymakers spend a lot of time trying to figure out the level of the equilibrium real interest rate – the level consistent with steady non-inflationary economic growth. It would be very helpful to have this number but coming up with an accurate measure is a largely futile exercise. It cannot be measured empirically and its estimation requires a lot of assumptions, explaining why there is no broad agreement on what the right number is. I think there is a case for the simpler approach of using the nominal growth in GDP as a proxy for where rates should be in normal circumstances. As noted above, that suggests monetary policy was excessively accommodative for an extended period. If US Policy Was Too Easy, Why Was Inflation Low For So Long? The Fed’s preferred measure of underlying inflation is the change in the personal consumption deflator, excluding food and energy. In the 25 years to 2019, inflation by this measure averaged only 1.7%, compared to the Fed’s desired level of 2%. Thus, even though the level of interest rates implied very accommodative policy over that period, inflation remained tame. This leads to an important caveat. The stance of monetary policy plays the key role in driving inflation, but it is not everything. Offsetting forces on inflation (in both directions) can mute or even swamp the impact of policy. There were several disinflationary forces in operation during the past 25 years. Specifically: In the second half of the 1990s, the explosive growth of the internet and accompanying boom in technology spending led to a marked pickup in productivity growth. The entry of China into the World Trade Organization at the end of 2001 unleashed a wave of offshoring and downward pressure on traded goods prices. A series of deflationary shocks hit the US and global economy including the 1998 financial crisis in South-East Asia and Russia, the bursting of the tech bubble after 2000, and of course the global financial meltdown in 2007-09. Unstable economic conditions undermined labor’s bargaining power, keeping a tight lid on wage growth. This was highlighted by the dramatic decline in labor’s share of income after 2000. Importantly, the above forces are no longer in place and in some cases are reversing. The key technological advances of the past decade have not been particularly good for productivity. Indeed, one could argue that the activities of most so-called FANG stocks – especially those involved in social media - have had a negative impact on productivity. Time spent on FaceBook, Twitter and Netflix do not have obvious benefits for increased economic efficiency. Chart II-7Globalization In Retreat Globalization in Retreat Globalization in Retreat Even before the pandemic’s impact on supply chains, there were signs that globalization had peaked (Chart II-7). Indeed, BCA first suggested in 2014 that globalization was running out of steam. More recently, the interruption to supply chains has highlighted the downside of relying excessively on overseas production for key goods such as semi-conductors and pharmaceuticals. Onshoring rather than offshoring will become more common with higher prices being the cost for greater control over supply. Globalization is not dead, but, at the margin, it no longer is a powerful source of disinflation. US import prices from China are back to their highest level in a decade after falling steadily during the eight years to 2020. The inflationary impact of the pandemic and the war in Ukraine via supply-side disruptions are more than offsetting any disinflationary effects of softer economic growth. In other words, they have represented stagflationary rather than deflationary shocks. Finally, with regard to income shares, the pendulum has swung more in favor of labor. Demographic trends (e.g. slow growth in the working-age population) suggest that the labor market will remain relatively tight in the years ahead, notwithstanding short-term weakness as the economy slows. Profit margins are likely to weaken and labor’s share of income will rise. The bottom line is that easy money policies will no longer be offset by a number of powerful external forces that served to keep consumer price inflation under wraps in the pre-pandemic period. And this raises another important point. If monetary policy is too easy, then it will show up somewhere, even if consumer price inflation is under control. There Is More Than One Kind Of Inflation Inflation most commonly refers to the change in the prices of consumer goods and services. That is understandable because consumer spending accounts for more than half of GDP in the major developed economies (and almost 70% in the US). And because consumers are the ones who vote, it is the inflation rate that politicians care most about. However, there are other kinds of inflation. If there are structural impediments to increased consumer prices, then excessively easy monetary policy most likely will show up in higher asset prices. This is a very different kind of inflation because it is welcomed by the owners of assets and by politicians. Nobody is happy to face higher prices for the goods and services they buy, but asset owners love the wealth-boosting effect of higher prices for homes and shares.  Consumer inflation may have been subdued in the pre-pandemic decade, but the same is not true for asset prices. During the period that the Fed ran accommodative policies, there were several periods of rampant asset inflation such as the tech stock bubble of the late 1990s, the housing bubble of the 2000s, and the bond bubble of 2016-2020. And both equity and home prices surged in response to monetary stimulus triggered by the pandemic. Central banks may fret about the potential financial stability implications of surging asset prices, but in practice they do not act to curb them. Policymakers argue that it is hard to determine when an asset bubble exists and even when one is obvious, monetary policy is a crude tool to deal with it. If rising asset prices occur alongside an economy that is characterized by stable growth and moderate inflation, then acting to burst a bubble could inflict unnecessary economic damage. That is an understandable position, but it means ignoring the longer-term problems that occur when bubbles inevitably burst. This was highlighted by the economic and financial chaos after the US housing bubble burst in 2007. The reality is that central banks have been forced to rely more heavily on asset inflation as a source of monetary stimulus. An easing in monetary policy affects economic conditions in three primary ways: boosting credit demand and supply, raising asset prices, and lowering the exchange rate.9 Historically, the credit channel was by far the most important. BCA has written extensively about the Debt Supercycle and the role of monetary policy in fueling ever-rising levels of private sector indebtedness (see the Appendix for a brief description of the Debt Supercycle). Chart II-8No Releveraging Cycle In Household Debt No Releveraging Cycle in Household Debt No Releveraging Cycle in Household Debt The environment changed dramatically after the 2007-09 financial meltdown. The collapse of the credit-fueled housing bubble drove a stake through the heart of the household sector’s love affair with debt. The ratio of household debt to income peaked in early 2009 and ten years later it was back to the levels of 2001 (Chart II-8). Even an extended period of record low interest rates has failed to trigger a new leveraging cycle. If the Fed can’t persuade consumers and businesses to fall back in love with debt, then it must rely on the other two transmission channels for monetary policy – asset prices and the exchange rate. And the Fed really has limited control over the latter channel given that it also depends on the actions of other central banks. The deleveraging of the household sector in the post-2009 period could have been very bearish for the economy, but the Fed’s easy money policies underpinned the stock market, allowing household net worth to revive. There was an explosive rise in household net worth in 2020-21 as surging house prices added to stock market gains. Between end-2019 and end-2021, the household sector’s direct holdings of equities plus owner’s equity in real estate increased in value by around $20 trillion, equal to more than one year’s personal disposable income. The recent decline in equity prices has reversed some of the gains, but net worth remains elevated by historical standards. The bottom line is that it was wrong to suggest that the Fed’s accommodative stance did not create inflation. Consumer price inflation was tame in the pre-pandemic period, but there was lots of asset inflation and that gathered pace in 2020 and 2021. There was always going to be some leakage of this into more generalized inflation but this was accelerated by the double whammy of the supply disruptions caused by the pandemic and the Ukraine war. The Strange Case Of Japan If higher inflation in the US has seemed inevitable, how can one explain the situation in Japan? In contrast to other developed countries, Japan’s annual core inflation rate was only 0.2% in May. While this was an increase from the average -1.3% rate in the prior six months, it is impressive given the country’s continued highly stimulative monetary policy and the same exposure to supply disruptions as elsewhere. Most importantly, Japan has suffered structural deflation for so long that inflation expectations are totally dormant for both consumers and businesses. In other words, raising prices is seen as a desperate measure and something to be avoided. Japan’s poor demographics may also have played a role. A sharply declining labor force and rapidly aging population are disinflationary rather than inflationary influences and help reinforce the corporate sector’s reluctance to raise prices. While Japan seems an outlier, it is worth noting that core inflation also has remained relatively subdued in many European countries. For the overall Euro area, the latest core inflation rate is 3.8%, well below that of the US and UK. Two common features of the higher inflation countries are that they tended to have more aggressively-easy fiscal policies in recent years and greater asset inflation – especially in real estate. Unfortunately, inflation expectations and business pricing behavior in the US and other Anglo-Saxon economies have not followed Japan’s example. Employees have become more aggressive in demanding higher wages, and most companies have no problem in passing on higher costs to their customers. The UK is facing a wave of public sector strikes over pay the likes of which have not been seen for decades. The Outlook Chart II-9A Peaking In Supply Problems? A Peaking in Supply Problems? A Peaking in Supply Problems? Inflation may prove sticky over the next few months, but as noted earlier, it should move significantly lower over the coming year. Crude oil prices have risen by around 75% in the past year and that pace of rise cannot be sustained. Meanwhile, while shipping rates remain historically high, they are down sharply from earlier peaks (Chart II-9). Together with a revival in Chinese exports, this suggests some easing in supply chain problems. And as mentioned above, the pace of economic activity is set to slow sharply. But a return to pre-pandemic inflation levels is not in the cards. The Fed currently is talking tough and further rate hikes are on the way. But the tightening will end as soon as it becomes clear that the economy is heading south. A deep recession is not likely because there are not the worrying imbalances such as excessive consumer debt or inventories that typically precede serious downturns. However, policymakers will not take any risks and policy will return quickly to an accommodative stance, even though inflation is unlikely to return to the desired 2% level. On a positive note, inflation may be the highest in 40 years in many countries, but we are not facing a return to the destructive high-inflation environment of the 1970s. Inflation back then was institutionalized and a self-feeding cycle of higher wages and rising prices was deeply embedded. I was working as an economist for BP in London in the 1970s and remember receiving large quarterly pay rises just to compensate for inflation. In the absence of inflation-accounting practices, companies seriously underestimated the destruction that inflation was creating to balance sheets and profitability, making them complacent about the problem. Moreover, there were not the same global competitive pressures that exist today. Inflation in the US likely will form a new base of 3% to 4% over the medium term, with occasional fluctuations to 5% or above. An environment of stagflation is in prospect: growth will not be weak enough to suppress inflation and not strong enough to allow the Fed to maintain a restrictive stance. This puts the Fed in a difficult spot as it will be reluctant to admit defeat by raising the inflation target from its current 2%, even though that level will be out of reach in practical terms. A counter view is that I am too pessimistic by underestimating the disinflationary effects of technological advances. A sustained improvement in productivity would certainly help lower inflation but how likely is this? Technological advances are occurring all the time, but in recent years they largely have been incremental in nature and it is hard to think of any new breakthrough productivity-enhancing technologies. There is a difference between new technologies that simply represent better ways to do existing tasks (3D printing would fall into that category) and general purpose technologies that completely change the way economies operate (e.g. electricity and the internet). While businesses are still exploiting the benefits of the digital world, we await innovations that will trigger a new sustained upsurge in productivity. A game changer would be the development of unlimited cheap energy (cold fusion?) but that does not seem likely any time soon. Nevertheless, I will keep an open mind about the potential for productivity to surprise on the upside, despite my current skepticism. Chart II-10Inflation Expectations Spike Higher Inflation Expectations Spike Higher Inflation Expectations Spike Higher What does all this mean for the markets? Not surprisingly, shifts in market expectations for future inflation are highly correlated with the current rate and have thus spiked higher in recent months, hurting both bonds and stocks (Chart II-10). Obvious inflation hedges would be inflation-protected bonds and resources, but neither group currently is attractively priced. The good news is that the current panic about inflation is setting the scene for a buying opportunity in both stocks and bonds. The exact timing is tricky to predict but both stocks and bonds will rally strongly later this year when inflation expectations retreat as it becomes clear that the economy is weakening and the Fed softens its hawkish tones. The bad news is that this bullish phase will not last much more than a year because a re-emergence of inflationary pressures will bring things back to earth. The long-run outlook is one of stagflation and that will be a tough environment for financial assets. Martin H. Barnes Former Chief Economist, BCA Research mhbarnes15@gmail.com   Appendix: A Primer On The Debt Supercycle The Debt Supercycle is a description of the long-term decline in U.S. balance-sheet liquidity and rise in indebtedness during the post-WWII period. Economic expansions have always been associated with a buildup of leverage. However, prior to the introduction of automatic stabilizers such as the welfare state and deposit insurance, balance-sheet excesses tended to be fully unwound during economic downturns, albeit at the cost of severe declines in activity. The pain of the Great Depression led governments to intervene to smooth out the business cycle, and their actions were given legitimacy by the economic theories of John Maynard Keynes. Fiscal and monetary reflation, together with the introduction of automatic stabilizers such as unemployment insurance, were successful in preventing the frequent depressions that plagued the pre-WWII economy, but the downside was that balance-sheet imbalances and financial excesses built up during each expansion phase were never fully unwound. Periodic "cyclical" corrections to the buildup of debt and illiquidity occurred during recessions, but these were never enough to reverse the long-run trend. Although liquidity was rebuilt during a recession, it did not return to its previous cyclical high. Meanwhile, the liquidity rundown during the next expansion phase established new lows. These trends led to growing illiquidity, and vulnerability in the financial markets. The greater the degree of illiquidity in the economy, the greater is the threat of deflation. Thus, the bigger that balance-sheet excesses become, the more painful the corrective process would be. So, the stakes became higher in each cycle, putting ever-increasing pressure on the authorities to reflate demand, by whatever means were available. The Supercycle process was driven over time by the building tension between rising underlying deflationary risks in the economy, and the ability of policymakers to create inflation. The Supercycle reached an important inflection point in the recent economic and financial meltdown, with the authorities reaching the limit of their ability to get consumers to take on more leverage. This forced the government to leverage itself up instead, representing the Debt Supercycle's final inning. III. Indicators And Reference Charts BCA’s equity indicators paint a bearish picture for stock prices. Our monetary indicator is now at its weakest in almost three decades and our valuation indicator highlights that stocks are still overvalued, albeit less so than they were last year. Meanwhile, both our sentiment and technical indicators have now broken down very significantly, and are not yet providing a contrarian buy signal. The odds of a US recession over the next 12 months have recently risen, and we now recommend a neutral stance for stocks versus bonds over the coming year. Forward earnings are no longer being significantly revised up, but bottom-up analysts’ expectations for earnings are still too rosy. Although earnings growth is still likely to be positive over the coming year if a US recession is avoided, it will be in the mid-to-low single-digits. Within a global equity portfolio, we recommend a neutral stance on cyclicals versus defensives, small caps versus large, and a neutral stance on regional equity allocation. Within a fixed-income portfolio, investors should stay modestly short duration. The increase in commodity prices that followed Russia’s invasion of Ukraine has cooled, and prices are now rolling over significantly on the back of global growth concerns. Our composite technical indicator has dropped meaningfully, indicating that commodities are now no longer overbought. Our base-case view is that oil prices have peaked, but there some risk to that view given the current geopolitical situation. In addition, the recent rise in European natural gas prices suggests that global food inflation could remain elevated, given that natural gas is used in the production of fertilizer. We remain structurally bullish on industrial metals, but metals prices are likely to decline further until recessionary concerns abate. US and global LEIs have rolled over significantly and are now edging towards negative territory. The Conference Board’s LEI has now decreased for three consecutive months, and four consecutive month-over-month declines have historically been associated with a recession. Our global LEI diffusion index has bottomed, but we are not convinced that this heralds a major upturn in the LEI itself. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators Chart III-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Content Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop   ECONOMY: Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate Footnotes 1     Please see Global Investment Strategy Special Alert "Hard Or Soft Landing? BCA Strategists Debate The Question," dated June 21, 2022, available at gis.bcaresearch.com 2     Please see The Bank Credit Analyst "April 2022," dated March 31, 2022, available at bca.bcaresearch.com 3    Please see Global Investment Strategy "Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis," dated March 20, 2020, available at gis.bcaresearch.com; The Bank Credit Analyst "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com; The Bank Credit Analyst "Do Excess Savings Explain Low US Interest Rates?" dated March 31, 2022, available at bca.bcaresearch.com 4    Please see The Bank Credit Analyst "Is The US Housing Market Signaling An Imminent Recession?" dated May 26, 2022, available at bca.bcaresearch.com 5    Please see Emerging Markets Strategy "A Conversation With Ms. Mea: Navigating An Inflation Storm," dated June 16, 2022, available at ems.bcaresearch.com 6    Please see The Bank Credit Analyst "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated December 18, 2020, available at bca.bcaresearch.com 7     This trimmed mean measure excludes the top 8% of CPI components with the largest monthly price gains and the bottom 8% with the smallest monthly gains. 8     Rent.com, https://www.rent.com/research/average-rent-price-report/, June 2022. 9    A fourth channel can be via a psychological boost to business and consumer confidence, but this can cut both ways if an easing in policy is interpreted as a sign of worsening economic conditions rather than as a reason for optimism.