Business Cycles

Dear client, We will not be publishing the US Equity Strategy next week, as I will be participating in BCA Investment Conference. We will return to our regular publishing schedule on September 19, 2022. Kind Regards, Irene Tunkel   Executive Summary Most Thematic ETFs Are Far Off Their Pandemic Peaks Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes In today’s sector Chart I-pack report we recap our structural investment themes. EV Revolution: The EV cohort benefits from a structural transformation of the automobile industry that is further supported by favorable legislative tailwinds, and shifting consumer preferences. Generation Z: Generation Zers are coming of age and wield an increasing influence over consumer trends. Cybersecurity: The pandemic-driven shift to remote work, broad-based migration to cloud computing and increasing geopolitical tensions, are all structural forces that will ensure a healthy demand pipeline for cybersecurity companies. Green And Clean: Green energy is becoming cheaper to produce, which supports a wider adaptation of green technologies. Green tech also enjoys favorable legislative tailwinds that are coming on the back of rising geopolitical tensions, the ongoing energy crisis, and climate change action. Renewables help to diversify energy sources and offer a path towards energy security. Bottom Line: Thematic investments that capture the latest technological breakthroughs present unprecedented long-term investment opportunities for investors who can stomach short-term volatility. Feature This week we are sending you a Sector Chart I-Pack, which offers macro, fundamentals, valuations, technicals, and uses of cash charts for each sector. In the front section of this publication, we will overview recent equity performance and provide a recap of the US Equity Strategy structural investment themes. August – When The Rally Came To A Stall As we predicted in the “What Will Bring This Rally To A Halt?” report, the “inflation is turning, and the Fed will be dovish” rally has come to a screeching halt. The S&P 500 was down 8% in August as investors finally believe that Jay Powell’s Fed is hell-bound on extinguishing inflation even if it means squelching economic growth (Chart I-1). The message from Jackson Hole was very much Mario Draghi-like: “whatever it takes.” The market reaction was swift and brutal. The rally winners were in the epicenter of the sell-off that ensued on the back of Powell’s comments. Invesco QQQ Trust is already down nearly 9% off its August 16 peak, while Ark Innovation (ARKK) is down 13% (Chart I-2).  We expect that equities will continue to revert to their pre-summer lows. Chart I-1Summer Rally Winners Are At The Epicenter Of The Sell-off Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Chart I-2Most Thematic ETFs Are Far Off Their Pandemic Peaks Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes With rates on the rise again, last week we shifted our overweight of Growth and underweight of Value to a neutral allocation. The last few months have been a rollercoaster. However, long-term investors may successfully survive the grind by resolutely sticking to some of the winning structural investment themes and ignoring short-term volatility. The fact that many themes are now more than 50% off their pandemic highs may indicate an opportune entry point. EV Revolution We initiated the EV Revolution theme in June 2021. Since then, the theme has outperformed the S&P 500 by 19%. The Auto and Components industry group is in the middle of a momentous transition to electric and autonomous vehicle manufacturing, thanks to technological advances in battery storage, AI, and radars. These technological breakthroughs help overcome most of the obstacles to the wide adoption of EVs. Multiple new entrants develop charging networks. Driving ranges are also rapidly increasing – Lucid promises a 500-mile range compared to Tesla’s 350. Couple that with the rising price of gas, the aging vehicle fleet, and the expectation that EVs will approach sticker parity with gas-powered cars as soon as 2023 (Chart I-3)  and there is no turning back to gas-guzzling vehicles. LMC Automotive forecasts that by 2031, EVs will reach 17 million units. Chart I-3EVs Will Reach Price Parity With ICEs In 2023 Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes The entire EV cohort also benefits from favorable legislative tailwinds, thanks to this administration’s support of decarbonization. The Inflation Reduction Act (IRA) includes approximately $370 billion in clean energy spending, as well as EV tax credits for both new and used cars. In addition, executive action by President Biden has tightened fuel economy standards. California has mandated a complete switch to EV vehicles by 2035. The surge in EV Capex and R&D spending will boost the entire supply chain, which consists of chip manufacturers, battery and lidar R&D, part manufacturers, and charging networks. Many of these companies are still small. An ETF may be the best way to capture the theme (Table I-1). Table I-1EV/AV ETFs Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Generation Z: The Digital Natives The GenZ theme, which we identified exactly a year ago, has collapsed since the beginning of the market downturn and is down 47%. Its success was at the root of its demise – it captured overcrowded names most popular among GenZers, who are avid investors (Chart I-4). However, the theme is not “dead,” as a new cohort of Americans is coming of age, and they are not shy about it. Generation Z in the US includes 62 million people born between 1997 and 2012 (Chart I-5). With $143B in buying power in the US alone making up nearly 40% of all consumer sales, Gen Z wields increasing influence over consumer trends. This is the first generation of digital natives—they simply can’t remember the world without the internet. They are the early adopters of the new digital ways to bank, get medical treatments, and learn. Gen Z is joining the workforce and replacing retiring baby boomers. Chart I-4Gen Zers Are Avid Investors... Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Chart I-5Gen Zers Are Taking Over Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Gen Z is an umbrella theme that captures many other prominent themes, such as Fintech (Paypal & Social Finance), Crypto (COIN), Meme-investing (HOOD), Gaming and Alternative Reality (GAMR & ESPO), and Online Dating. But GenZers have a few behavioral quirks that make them different even from Millennials: Quality-Over-Price Shoppers: Gen Z was found to be less price sensitive when buying products, choosing quality over price. Lululemon (LULU) and Goose (GOOS) are among Gen Z’s favorites. Healthy Lifestyle: Gen Z is a “green” generation that deeply cares about the planet, loves the outdoors and traveling, and is crazy about pets. This is also a generation that prizes a healthy lifestyle and working out: Beyond Meat (BYND), Planet Fitness (PLNT), and Yeti (YETI). Generation Sober Chooses Cannabis: GenZers perceive hard liquor and tobacco as bad for their health. Curiously, marijuana is considered “healthy.” MSOS, CNBS, YOLO, and THCX are the biggest ETFs in this space. How To Invest In Gen Z? Gen Z is a nascent investment theme, so there are no ETFs available in the market yet. We propose that investors follow our Gen Z investment themes or replicate fully or partially our Gen Z basket. Cybersecurity: A Must-Have For Survival Despite its celebrity status, this is an industry that is still in the early innings of a growth cycle. The pandemic-driven shift to remote work, broad-based migration to cloud computing, development of the internet-of-things, and increasing geopolitical tensions create new targets for hackers who are after valuable data or just want to achieve maximum damage to the networks. Ubiquitous digitization requires increasingly more complex cyber defenses. With cybercrime costing the world nearly $600 billion each year and cyberattacks increasing in number and sophistication, the global cybersecurity market is expected to grow from $125 billion in 2020 to $175 billion by 2024. Both large and small businesses are yet to fully implement cybersecurity defenses. According to a survey by Forbes magazine, 55% of business executives plan to increase their budgets for cybersecurity in 2021 aiming to prevent malicious attacks. In response to the numerous breaches, the current US administration is placing a high priority on defensive cyber programs. Since 2017, US government departments have seen the cybersecurity share of their basic discretionary funding rise steadily from 1.38% to 1.73%. These developments are a boon for cybersecurity stocks (Chart I-6 & Chart I-7 ), the sales of which are soaring (Chart I-8). Chart I-6Cybercrime Losses Spur Demand for Cybersecurity Cybercrime Losses Spur Demand for Cybersecurity Cybercrime Losses Spur Demand for Cybersecurity Chart I-7Stepped Up Government Spending Will Lift Cybersecurity Stocks Stepped Up Government Spending Will Lift Cybersecurity Stocks Stepped Up Government Spending Will Lift Cybersecurity Stocks Chart I-8Cybersecurity Sales Are Soaring Cybersecurity Sales Are Soaring Cybersecurity Sales Are Soaring We introduced cybersecurity as a structural investment theme back in October 2021. So far, the CIBR ETF, which we use as a proxy for the performance of the theme, has underperformed the S&P 500 by 11%. Monetary tightening has weighed on the performance of these companies as they tend to be younger, smaller, and less profitable than their S&P 500 counterparts, i.e., CIBR has a strong small-cap growth bias. However, with cybersecurity stocks down 26% off their November-2021 peak and valuation premium back to earth, now may be an opportune moment to add to the theme. After all, these stocks have tremendous growth potential, warranting a long-term position in most equity portfolios. There are several highly liquid ETFs powered by the cybersecurity theme, such as CIBR, BUG, and HACK, which can be excellent investment vehicles (Table I-2). Table I-2Cybersecurity ETFs Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Green And Clean We introduced the “Green and Clean” theme back in March. Since then, it has outperformed the S&P 500 by 22%, benefiting from this administration’s focus on the mitigation of climate change. Putin’s energy stand-off with Europe has also put the industry into the global spotlight. The development of renewables will help diversify energy sources and offer a path toward energy security. Thus, renewable energy and cleantech companies are at the core of the global push to increase energy security and contain climate change. The International Renewable Energy Agency (IRENA) expects renewables to scale up from 14% of total energy today to around 40% in 2030. Global annual additions of renewable power would triple by 2030 as recommended by the Intergovernmental Panel on Climate Change (IPCC). Solar and wind power will attract the lion’s share of investments. Over the past 20 years, this country has made significant strides in shifting its energy generation toward renewable sources away from fossil fuels, increasing the share of clean energy from 3.7% in 2000 to 10% in 2020 (Chart I-9). Chart I-9A Structural Trend A Structural Trend A Structural Trend The key reason for the proliferation of green energy generation is that renewable electricity is becoming cheaper than electricity produced by fossil fuels – according to IRENA, 62% of the added renewable power generation capacity had lower electricity costs than the cheapest source of new fossil fuel-fired capacity. Costs for renewable technologies continued to fall significantly over the past year (Chart I-10). Renewables are similar to traditional utility companies: They require a massive upfront investment, but also enjoy substantial operating leverage. As production capacity increases, the cost of energy generation falls. Solar power generation is a case in point (Chart I-11). Hence, we have a positive reinforcement loop: more usage begets even more usage, bolstering the economic case for transitioning to cleaner energy resources. Chart I-10R&D Is Paying Off Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Chart I-11Capacity Is Inversely Correlated To Prices Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Increased renewables adaptation is possible thanks to several technological advancements including improved battery storage, implementation of smart grid networks, and an increase in carbon capture activities. There is a host of ETFs that offer investors a wide range of choices for access to renewable energy and cleantech themes (Table I-3). These ETFs differ in geographic span, industry focus, liquidity, and cost, but all are viable investment options. Table I-3Clean Tech ETFs Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Bottom Line Thematic investments that capture the latest technological breakthroughs present unprecedented long-term investment opportunities. However, these investments come with a warning: Technological innovation themes are intrinsically risky as they are rarely immediately profitable and require both continuous investment and technological breakthroughs to succeed. Also, most technological innovation themes carry high exposure to the small-cap growth style and are sensitive to rising rates and slowing growth. As such, they are fickle over the short term but pay off over a longer investment horizon.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     S&P 500 Chart II-1Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-2Profitability Profitability Profitability Chart II-3Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-4Uses Of Cash Uses Of Cash Uses Of Cash Communication Services Chart II-5Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-6Profitability Profitability Profitability Chart II-7Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-8Uses Of Cash Uses Of Cash Uses Of Cash Consumer Discretionary Chart II-9C Macroeconomic Backdrop C Macroeconomic Backdrop C Macroeconomic Backdrop Chart II-10Profitability Profitability Profitability Chart II-11Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-12Uses Of Cash Uses Of Cash Uses Of Cash Consumer Staples Chart II-13Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-14Profitability Profitability Profitability Chart II-15Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-16Uses Of Cash Uses Of Cash Uses Of Cash Energy Chart II-17Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-18Profitability Profitability Profitability Chart II-19Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-20Uses Of Cash Uses Of Cash Uses Of Cash Financials Chart II-21Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-22Profitability Profitability Profitability Chart II-23Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-24Uses Of Cash Uses Of Cash Uses Of Cash Health Care Chart II-25Sector vs Industry Groups Sector vs Industry Groups Sector vs Industry Groups Chart II-26Profitability Profitability Profitability Chart II-27Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-28Uses Of Cash Uses Of Cash Uses Of Cash Industrials Chart II-29Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-30Profitability Profitability Profitability Chart II-31Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-32Uses Of Cash Uses Of Cash Uses Of Cash Information Technology Chart II-33Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-34Profitability Profitability Profitability Chart II-35Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-36Uses Of Cash Uses Of Cash Uses Of Cash Materials Chart II-37Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-38Profitability Profitability Profitability Chart II-39Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-40Uses Of Cash Uses Of Cash Uses Of Cash Real Estate Chart II-41Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-42Profitability Profitability Profitability Chart II-43Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-44Uses Of Cash Uses Of Cash Uses Of Cash Utilities Chart II-45Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-46Profitability Profitability Profitability Chart II-47Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-48Uses Of Cash Uses Of Cash Uses Of Cash Recommended Allocation Recommended Allocation: Addendum What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up

Next week, on September 7-8, is the BCA New York Conference, the first in-person version since 2019. I look forward to seeing many of you there, and if you haven’t already booked your place, you still can! (a virtual version is also available). As such, the next Counterpoint report will come out on September 15. Executive Summary The 2022-23 = 1981-82 template for markets is working well. If it continues to hold, these are the major investment implications: Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential correction that lifts the yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023. Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals. Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023. Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85, though our central case is $55 in 2023.  If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Bottom Line: The 2022-23 = 1981-82 template for markets is working well, and should continue to do so. Feature History doesn’t repeat, but it does rhyme. And the period that rhymes closest with the current episode in the global economy and markets is 1981-82, a rhyming which we first highlighted four months ago in Markets Echo 1981, When Stagflation Morphed Into Recession, and then developed in More On 2022-23 = 1981-82, And The Danger Ahead. In those reports, we presented three compelling reasons why 2022-23 rhymes with 1981-82: 1981-82 is the period that rhymes closest with the current episode in the global economy and markets. First, the simultaneous sell-off in stocks, bonds, inflation protected bonds, industrial commodities, and gold in the second quarter of 2022 is uniquely linked with an identical ‘everything sell-off’ in the second quarter of 1981. It is extremely rare for stocks, bonds, inflation protected bonds, industrial commodities, and gold to sell off together. Such a simultaneous sell-off has happened in just these 2 calendar quarters out of the last 200. Meaning a ‘1-in-a-100’ event conjoins 2022 with 1981 (Chart I-1 and Chart I-2). Chart I-1A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... Chart I-2...And The 'Everything Sell-Off' In 1981 ...And The 'Everything Sell-Off' In 1981 ...And The 'Everything Sell-Off' In 1981 Second, the Jay Powell Fed equals the Paul Volcker Fed. Now just as then, the world’s central banks are obsessed with ‘breaking the back’ of inflation. And now, just as then, the central banks are desperate to repair their badly battered credibility in managing inflation. Third, the Russia/Ukraine war that started in February 2022 equals the Iraq/Iran war that started in September 1980. Now, just as then, a war between two commodity producing neighbours has unleashed a supply shock which is adding to the inflation paranoia. To repeat, it is a 1-in-a-100 event for all financial assets to sell off together. This is because it requires an extremely rare star alignment. Inflation fears first morph to stagflation fears and then to recession fears. Leaving investors with nowhere to hide, as no mainstream asset performs well in inflation, stagflation, and recession. So, the once-in-a-generation star alignment conjoining 2022 with 1981 is as follows: Inflation paranoia is worsened by a major war between commodity producing neighbours, forcing reputationally damaged central banks to become trigger-happy in their battle against inflation, dragging the world economy into a coordinated recession. September 2022 Equals August 1981 If 2022-23 = 1981-82, then where exactly are we in the analogous episode? There are two potential synchronization points. One potential synchronization is that the Russia/Ukraine war which started on February 24, 2022 equals the Iraq/Iran war which started on September 22, 1980. In which case, September 2022 equals April 1981. But given that inflation is public enemy number one, a better synchronization is the Fed’s preferred measure of underlying inflation, the US core PCE deflator. Aligning the respective peaks in core PCE inflation, we can say that February 2022 equals January 1981. Meaning that our original report in May 2022 aligned with April 1981, and September 2022 equals August 1981 (Chart I-3 and Chart I-4). Chart I-3The Peak In Core PCE Inflation In ##br##February 2022 The Peak In Core PCE Inflation In February 2022 The Peak In Core PCE Inflation In February 2022 Chart I-4...Aligns With The Peak In Core PCE Inflation In ##br##January 1981 ...Aligns With The Peak In Core PCE Inflation In January 1981 ...Aligns With The Peak In Core PCE Inflation In January 1981 In which case, how has the template worked since we introduced it on May 19th? The answer is, very well. The template predicted that the long bond price would track sideways, which it has. The template predicted that the S&P 500 would decline from 4200 to 4000, which it has. The template predicted that the copper price would decline from $9250/MT to $8500/MT. In fact, it has fallen even further to $8200/MT. In the case of oil, the better synchronization is the starts of the respective wars. This template predicted that the Brent crude price would decline sharply from a knee-jerk peak in the $120s, which it has. Not a bad set of predictions! If 2022-23 = 1981-82, Here’s What Happens Next Assuming the template continues to hold, here are the major implications for investors: Bond prices will enter a sustained rally in 2023. Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential tactical correction that takes its yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023 in which the 30-year T-bond yield will fall to sub-2.5 percent (Chart I-5). Chart I-5If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500 in the coming months. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023 (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023 (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85 (Chart I-9) though our central case is $55 in 2023.  Chart I-9If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price But What If 2022-23 Doesn’t = 1981-82? And yet, and yet…what if the Jay Powell Fed doesn’t equal the Paul Volcker Fed? What if central banks lose their nerve before inflation is slayed? Long bond yields could gap much higher, or at least not come down, causing a completely different set of investment outcomes. In this case, the correct template would not be 1981-82, but the 1970s. If central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. However, there is one huge difference between now and the 1970s, which makes that template highly unlikely. In the 1970s, the global real estate market was worth just one times world GDP, whereas today it has become a monster worth four times world GDP, and whose value is highly sensitive to the long bond yield. In the US, the mortgage rate has surged to well above the rental yield for the first time in 15 years. Simply put, it is now more expensive to buy than to rent a home, causing a disappearance of would be homebuyers, a flood of home-sellers, and an incipient reversal in home prices (Chart I-10). Chart I-10If Bond Yields Don't Come Down, Then House Prices Will Crash If Bond Yields Don't Come Down, Then House Prices Will Crash If Bond Yields Don't Come Down, Then House Prices Will Crash Hence, if long bond yields were to gap much higher, or even stay where they are, it would trigger a housing market crash whose massive deflationary impulse would swamp any inflationary impulse. The upshot is that the 2022-23 = 1981-82 template would suffer a hiatus. Ultimately though, it would come good, because a crash in the $400 trillion global housing market would obliterate inflation. In other words, if central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. Fractal Trading Watchlist As just discussed, copper’s tactical rebound is approaching exhaustion. This is confirmed by the 130-day fractal structure of copper versus tin reaching the point of extreme fragility that has consistently marked turning-points in this pair trade (Chart I-11). Chart I-11Copper's Tactical Rebound Is Exhausted Copper's Tactical Rebound Is Exhausted Copper's Tactical Rebound Is Exhausted Hence, this week’s recommendation is to short copper versus tin, setting the profit target and symmetrical stop-loss at 12 percent.   Chart 1Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Chart 2Copper Is Experiencing A Tactical Rebound Copper Is Experiencing A Tactical Rebound Copper Is Experiencing A Tactical Rebound Chart 3US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 11The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 12A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 13Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Listen to a short summary of this report.     Executive Summary A Beacon Of Hope For AUD A Beacon Of Hope For AUD A Beacon Of Hope For AUD Along with the Canadian dollar, the Aussie has been one of the best performing currencies during a broad-based dollar rally. Rising interest rates are part of the story, but there is more to Aussie strength than meets the eye. Aussie’s resilience is a conundrum worth exploring. First, it is a favorite short play for an imploding economic scenario in China, which suggests it should be a lot weaker. Second, the Aussie should be in the bottom quartile of FX returns in a risk-off currency scenario. Aussie strength can be attributed to strong commodity prices that are providing a terms-of trade-tailwind. Moreover, there is marginal evidence that demand for Australian-sourced commodities could be becoming a tad more inelastic. Chinese economic growth continues to disappoint, but upside surprises will be a welcome fillip for the AUD (Feature chart). On a terms-of-trade basis, the Australian dollar is very cheap. Falling commodity prices are a handicap, but the margin of safety on the valuation makes the AUD a safer bet. Go long AUD/USD if it touches 0.665 cents. AUD/NZD bets are also attractive. However, we will stay on the sidelines on AUD/JPY bets. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN LONG AUD/USD 0.665 2022-08-26 - Bottom Line: The Aussie dollar could go on a fire sale in the coming weeks. We would be buyers of AUD/USD at 0.665 cents. Feature The Australian dollar has been relatively resilient amidst broad-based dollar strength. Year-to-date, AUD is down 3.7% versus a 13.0% rally in the DXY (Chart 1). This is a remarkable development since historically, the AUD has been a very pro-cyclical currency, bearing the heavy lifting of any dollar rally. AUD/JPY, a key barometer for a risk-on/risk-off environment is up 13.4% year to date, despite a broad-based selloff in many risk assets. Chart 1The AUD Has Outperformed The AUD Has Outperformed The AUD Has Outperformed The Aussie’s resilience is a conundrum worth exploring. First, it is a favorite short play for an imploding economic scenario in China, which suggests it should be a lot weaker. Second, the Aussie should be in the bottom quartile of FX returns in a risk-off currency scenario. In this report, we explore base case scenarios for the Australian dollar, with recommendations for both short-term and longer-term trades, as well as plays at the crosses. Technical Indicators Technical indicators suggest the AUD could be ripe for a rebound. Our intermediate-term indicator bottomed at 5.55 and has usually been associated with non-negligible rallies in the AUD (Chart 2). This indicator is volatile and our expectation is that it could relapse in the near term. However, that will be good news for investors that have a constructive view on AUD prospects. Consistently, speculators are very short the Australian dollar. China’s zero COVID-19 policy, along with property market troubles have made the AUD a favorite short play (Chart 3). Given AUD’s resilience, this suggests that speculators are being overwhelmed by a tidal wave of fundamental currency inflows, through commodity purchases, bond market investors and Aussie equity sector bulls. Chart 2Technicals Point To A Coiled-Spring Rebound In The Coming Months Technicals Point To A Coiled-Spring Rebound In The Coming Months Technicals Point To A Coiled-Spring Rebound In The Coming Months Chart 3Investors Have Been Shorting ##br##AUD Investors Have Been Shorting AUD Investors Have Been Shorting AUD Australian Commodity Demand Chart 4A Beacon Of Hope For The AUD A Beacon Of Hope For The AUD A Beacon Of Hope For The AUD Weakness in China is well known and discounted by financial market participants. The latest selloff in the RMB is a case in point. Yet positive economic surprises in China have been improving relative to peers in the developed market (Chart 4). There are two simple reasons for this. First, the Chinese government is easing domestic financial conditions. Contrary to popular belief, lower rates and higher stimulus in China are positive for the AUD since it boosts Australian exports via higher domestic demand (Chart 5). With the Chinese bond market becoming more and more liberalized, it is also becoming a good proxy for monetary conditions in China. As such, lower bond yields in China have tended to lead imports. This is good news for Aussie exports in the coming months. Chart 5AStimulus In China Is Historically Positive For AUD Stimulus In China Is Historically Positive For AUD Stimulus In China Is Historically Positive For AUD Chart 5BStimulus In China Is Historically Positive For AUD Stimulus In China Is Historically Positive For AUD Stimulus In China Is Historically Positive For AUD Second, the Australian capital account could also be on the mend as foreigners are more willing to re-rate Aussie shares (Chart 6). The Chinese credit cycle has often led to a re-rating in Aussie shares. Our China and Emerging Market strategists argue that stimulus measures might not be sufficient to turn around Chinese domestic demand. In our view, that is well priced into the Aussie, which could potentially experience another selloff in the coming weeks. However, any upside surprises in Chinese growth will be a welcome fillip for the Australian dollar. Chart 6China And Australia Are Tied To The Hip China And Australia Are Tied To The Hip China And Australia Are Tied To The Hip A Few Moats Around The AUD Infrastructure spending is a huge chunk of Chinese fixed asset investment. So, while the housing downturn will impact commodity demand, infrastructure could provide a welcome offset. This could be a big moat that investors should pay attention to. Infrastructure is 24.5% of fixed asset investment in China and 18.0% of steel demand (Chart 7). Chart 7AStimulus In China Is Historically Positive For AUD A Small Beacon Of Optimism In Australia A Small Beacon Of Optimism In Australia Chart 7BStimulus In China Is Historically Positive For AUD A Small Beacon Of Optimism In Australia A Small Beacon Of Optimism In Australia On a relative basis, Australian terms-of-trade have outperformed other commodity-producing nations. This is some evidence that the external demand for Aussie commodities could be becoming a tad more inelastic. Among Australia’s exports, liquified natural gas has been increasing both in price and as a share of total volume (Chart 8). This is following a natural tailwind. China has an imperative to become greener, which has led to a rise in the share of renewables and natural gas electricity generation (Chart 9). Australia is in the top three biggest exporters of liquified natural gas in the world and exports world class clean coal that China depends on. The result has been a tremendous gain in terms of trade (Chart 10).  Chart 8Some Aussie Exports Could Be Relatively Demand Inelastic Some Aussie Exports Could Be Relatively Demand Inelastic Some Aussie Exports Could Be Relatively Demand Inelastic Chart 9A Tailwind For Australia A Tailwind For Australia A Tailwind For Australia Chart 10Terms Of Trade Are Favorable In Australia Terms Of Trade Are Favorable In Australia Terms Of Trade Are Favorable In Australia Amidst this moat around the AUD is also a valuation cushion. As a result of strong export prices, the Australian dollar is undervalued on a terms of trade basis. While true that the AUD is vulnerable to a correction in commodity prices, the margin of safety on the valuation is sufficient for investors willing to ride out near term volatility (Chart 11). Remarkably, the 10-year government bond yield in Australia is 56.8 basis points above that in the US. This will have two profound opposing effects. First, from an interest rate perspective, it will cushion the drawdown in the Aussie, as interest-rate differentials matter for currency returns (Chart 12). On the other hand, it puts interest-rate sensitive parts of the economy, such as housing, at risk. Chart 11AUD Is Cheap On A Terms Of Trade Basis AUD Is Cheap On A Terms Of Trade Basis AUD Is Cheap On A Terms Of Trade Basis Chart 12AUD Is Cheap On A Fundamental Basis AUD Is Cheap On A Fundamental Basis AUD Is Cheap On A Fundamental Basis The Risks For The AUD The first risk for the AUD is a downturn in commodity prices. Chinese demand is genuinely slowing. This could lead to an undershoot in the AUD, as a terms-of-trade undershoot (Chart 13). That is why our recommended entry point is lower than today’s level at 0.665 cents. Chart 13A Commodity Correction Is A Risk For AUD A Commodity Correction Is A Risk For AUD A Commodity Correction Is A Risk For AUD Chart 14Housing Is A Big Risk For Australia Housing Is A Big Risk For Australia Housing Is A Big Risk For Australia The second consideration is housing prices. Real estate is experiencing a meaningful roll over in Australia. This has been led by Sydney and Melbourne, where prices were clearly overvalued, but the phenomenon is more broad based (Chart 14). Related Report  Foreign Exchange StrategyTwo Decades After The Creation Of The Euro The impact for financial markets and the AUD is two-fold. First, if the RBA continues to tighten and as this flattens the Aussie yield curve further, it will not be a welcome development for bank net interest margins and profits (Chart 15). Second, the market has already priced in interest rates higher in Australia compared to the US (Chart 16). A slowdown in housing construction activity, that makes the Aussie consumer more cautious could temper the pace of RBA rate hikes and put pressure on the AUD. Chart 15Watch The Relative Performance Of Bank Shares Watch The Relative Performance Of Bank Shares Watch The Relative Performance Of Bank Shares Chart 16The RBA Might Be Relatively Dovish in 2023 The RBA Might Be Relatively Dovish in 2023 The RBA Might Be Relatively Dovish in 2023 A Few Trades Ideas Australia provides a lot of the commodities countries need and want in today’s paradigm. That is bullish. Yet exposure to China is a clear risk that investors need to factor into investment decisions. Our trading strategy is as follows: We would buy AUD/USD at 0.665 cents. In our view, it could undershoot this level but will be an attractive longer-term buy. The risks to the housing market are higher in New Zealand compared to Australia (Chart 17). Terms of trade also likely to favor the Aussie versus the kiwi (Chart 18). As such, bet on long AUD/NZD trades. Chart 17AUD Can Withstand Higher Rates Relative To NZD AUD/NZD Is Attractive AUD/NZD Is Attractive Chart 18Terms Of Trade Will Drive AUD Higher Relative To NZD AUD/NZD Is Attractive AUD/NZD Is Attractive AUD/JPY will benefit from a rally in risk assets but is stretched. Thus, from a sentiment perspective, we are only neutral (Chart 19). Economic surprises could also likely underwhelm in Australia relative to the unloved Japanese market (Chart 20). Chart 19AUD/JPY Is Stretched AUD/JPY Is Stretched AUD/JPY Is Stretched Chart 20AUD/JPY Is Stretched AUD/JPY Is Stretched AUD/JPY Is Stretched   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins China needs lower interest rates and a weaker currency to battle deflationary pressures. In the US, the main problem is elevated inflation. This heralds higher interest rates and a stronger currency. Hence, the Chinese yuan will depreciate against the greenback. When the RMB weakens versus the US dollar, commodity prices usually fall, and EM currencies and asset prices struggle. Faced with surging unit labor costs, US companies will continue to raise their prices to protect their profit margins and profitability. This will lead to one of the following two possible scenarios in the months ahead. Scenario 1: If customers are willing to pay considerably higher prices, nominal sales will remain robust, profits will not collapse, and a recession is unlikely. However, this also implies that the Fed will have to tighten policy by more than what is currently priced in by markets. Scenario 2: If customers push back against higher prices and curtail their purchases, then the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink, and their profits will plunge.  In both scenarios, the outlook for stocks is poor. However, one key difference is that scenario 1 is bearish for US Treasurys while scenario 2 is bond bullish. Bottom Line: On the one hand, the US has a genuine inflation problem. The upshot is that the Fed cannot pivot too early. The Fed’s hawkish rhetoric will support the US dollar. A strong greenback is bad for EM financial markets. On the other hand, the Chinese economy and global trade are experiencing deflation/recession dynamics. Cyclical assets underperform and the US dollar generally appreciates in this environment. This is also a toxic backdrop for EM financial markets.   Financial markets have been caught in contradictions. The reason is that investors cannot decide if the global economy is heading into a recession with deflationary forces prevailing, or whether a goldilocks economy or a period of inflation or stagflation will emerge in the foreseeable future. There are also plenty of contradictory data to support all the above scenarios.  As such, financial markets are volatile, swinging wildly as market participants absorb new economic data points. The S&P 500 index has rebounded from its 3-year moving average, which had previously served as a major support (Chart 1). Yet, the rebound has faltered at its 200-day moving average. Its failure to break decisively above this 200-day moving average entails that a new cyclical rally is not yet in the cards. Chart 1The S&P 500 Is Stuck Between Technical Resistance And Support Lines The S&P 500 Is Stuck Between Technical Resistance And Support Lines The S&P 500 Is Stuck Between Technical Resistance And Support Lines The S&P 500 index will remain between these resistance and support lines until investors make up their minds about the economic outlook. The EM equity index has been unable to rebound strongly alongside US stocks. A major technical support that held up in the 1998, 2001, 2002, 2008, 2015 and 2020 bear markets is about 15% below the current level (Chart 2). Hence, we recommend that investors remain on the sidelines of EM stocks. Chart 2EM Share Prices Are Still 15% Above Their Long-Term Technical Support Level EM Share Prices Are Still 15% Above Their Long-Term Technical Support Level EM Share Prices Are Still 15% Above Their Long-Term Technical Support Level BCA’s Emerging Markets Strategy team’s macro themes and views remain as follows: Related Report  Emerging Markets StrategyCharts That Matter In China, the main economic risk is deflation and the continuation of underwhelming economic growth. Core and service consumer price inflation are both below 1% and property prices are deflating. Falling prices amid high debt levels is a recipe for debt deflation. We discussed the government’s stimulus – including measures enacted for the property market – in the August 11 report. The latest announcement about the RMB 1 trillion stimulus does not change our analysis. In fact, we expected an additional RMB 1.5 trillion in local government bond issuance for the remainder of the current year. Yet, the government authorized only an additional RMB 0.5 trillion. This is substantially below what had been expected by analysts and commentators in recent months.   In Chinese and China-related financial markets, a recession/deflation framework remains appropriate. Onshore interest rates will drop further, the yuan will depreciate more, and Chinese stocks and China related plays will continue experiencing growth/profit headwinds. Meanwhile, the US economy has been experiencing stagflation this year. Chart 3 shows that even though the nominal value of final sales has expanded by 8-10%, sales and output have stagnated in real terms (close to zero growth). Hence, nominal sales and corporate profits have so far held up because companies have been able to raise prices by 8-9.5% (Chart 4). Is this bullish for the stock market? Not really. Chart 3US Stagflation: Strong Nominal Growth, But Small In Real Terms US Stagflation: Strong Nominal Growth, But Small In Real Terms US Stagflation: Strong Nominal Growth, But Small In Real Terms Chart 4US Corporate Profits Have Held Up Because Of Pricing Power/Inflation US Corporate Profits Have Held Up Because Of Pricing Power/Inflation US Corporate Profits Have Held Up Because Of Pricing Power/Inflation The fact that companies have been able to raise their selling prices at this rapid pace implies that the Fed cannot stop hiking rates. Besides, US wages and unit labor costs are surging (Chart 9 below). The implication is that inflation will be entrenched and core inflation will not drop quickly and significantly enough to allow the Fed to pivot anytime soon. Overall, US economic data releases have been consistent with our view that although real growth is slowing, the US economy is experiencing elevated inflations, i.e., a stagflationary environment. Critically, wages and inflation lag the business cycle and are also very slow moving variables. Hence, US core inflation will not drop below 4% quickly enough to provide relief for the Fed and markets. Is a US recession imminent? It depends. One thing we are certain of is that faced with surging unit labor costs, US companies will attempt to raise their prices to protect their profit margins and profitability. Our proxy for US corporate profit margins signals that they are already rolling over (Chart 5). Hence, business owners and CEOs will attempt to raise selling prices further. Chart 5US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins This will lead to one of two possible scenarios for the US economy in the months ahead. Scenario 1: If customers (households and businesses) are willing to pay considerably higher prices, nominal sales will remain very robust, and profits will not collapse, reducing the likelihood of a recession. Yet, this means that inflation will become even more entrenched, and employees will continue to demand higher wages. A wage-price spiral will persist. The Fed will have to raise rates much more than what is currently priced in financial markets. This is negative for US share prices. Scenario 2: If customers push back against higher prices and curtail their purchases, output volume will relapse, i.e., the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink (prices received will rise much less than unit labor costs) and profits will plunge.  Suffering a profit squeeze, companies will lay off employees, wage growth will decelerate, and high inflation will be extinguished. In this scenario, bond yields will drop significantly but plunging corporate profits will weigh on share prices. We are not certain which of these two scenarios will prevail: it is hard to determine the point at which US consumers will push back against rising prices. Nevertheless, it is notable that in both scenarios, the outlook for stocks is poor.   Finally, as we have repeatedly written, global trade is about to contract. Charts 10-18 below elaborate on this theme. This is disinflationary/recessionary. Investment Conclusions On the one hand, the Chinese economy and global trade are experiencing deflation/recession dynamics. Cyclical assets struggle and the US dollar does well in this environment. This constitutes a toxic backdrop for EM financial markets. On the other hand, the US has a genuine inflation problem. The upshot is that the Fed cannot pivot too early. The Fed’s hawkish rhetoric will support the US dollar. A strong greenback is also bad for EM financial markets. Thus, we do not see any reason to alter our negative view on EM equities, credit and currencies. Investors should continue underweighting EM in global equity and credit portfolios. Local currency bonds offer value, but further currency depreciation and more rate hikes remain a risk to domestic bonds. We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN and IDR. In addition, we recommend shorting HUF vs. CZK, KRW vs. JPY, and BRL vs. MXN.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Messages From Various US High-Beta / Cyclical Stock Prices US high-beta consumer discretionary, industrials, tech and early cyclical stocks have not yet broken out. The rebounds in high-beta tech and industrials have been rather muted. We are watching these and many other market signs and technical indicators to gauge if the recent rebounds can turn into a cyclical bull market. Chart 6 Messages From Various US High-Beta / Cyclical Stock Prices Messages From Various US High-Beta / Cyclical Stock Prices Chart 7 Messages From Various US High-Beta / Cyclical Stock Prices Messages From Various US High-Beta / Cyclical Stock Prices Falling Global Trade + Sticky US Inflation = US Dollar Overshot On the one hand, US household spending on goods ex-autos is already contracting and will drop further. The same is true for EU demand. The reasons are excessive consumption of goods over the past two years and shrinking household real disposable income. As a result, global trade is set to shrink, which is positive for the US dollar. On the other hand, surging US unit labor costs entail that core CPI will be very sticky at levels well above the Fed’s target. Hence, the Fed will likely maintain its hawkish bias for now, which is also bullish for the greenback. In short, the US dollar will continue overshooting.  Chart 8 Falling Global Trade + Sticky US Inflation = US Dollar Overshot Falling Global Trade + Sticky US Inflation = US Dollar Overshot Chart 9 Falling Global Trade + Sticky US Inflation = US Dollar Overshot Falling Global Trade + Sticky US Inflation = US Dollar Overshot Chinese Exports Will Contract, And Imports Will Fail To Recover Chinese export volume growth has come to a halt. Shrinking imports of inputs used for re-export (imports for processing trade) are pointing to an imminent contraction in the mainland’s exports. Further, Chinese import volumes have been contracting for the past 12 months. The value of imports has not plunged only because of high commodity prices. As commodity prices drop, import values will converge to the downside with import volumes. This is negative for economies/industries selling to China. Chart 10 Chinese Exports Will Contract, And Imports Will Fail to Recover Chinese Exports Will Contract, And Imports Will Fail to Recover Chart 11 Chinese Exports Will Contract, And Imports Will Fail to Recover Chinese Exports Will Contract, And Imports Will Fail to Recover Global Manufacturing / Trade Downtrend Is Intact China buys a lot of inputs from Taiwan that are used in its exports. That is why the mainland’s imports from Taiwan lead the global trade cycle. This is presently heralding a considerable deterioration in global trade.  In addition, falling freight rates and depreciating Emerging Asian (ex-China) currencies are all currently pointing to a further underperformance of global cyclicals versus defensive sectors. Chart 12 Global Manufacturing / Trade Downtrend Is Intact Global Manufacturing / Trade Downtrend Is Intact Chart 13 Global Manufacturing / Trade Downtrend Is Intact Global Manufacturing / Trade Downtrend Is Intact Chart 14 Global Manufacturing / Trade Downtrend Is Intact Global Manufacturing / Trade Downtrend Is Intact Taiwan Is A Canary In A Coal Mine Taiwanese manufacturing companies have seen their export orders plunge and their customer inventories surge. This has occurred in its overall manufacturing and semiconductor companies.  This corroborates our thesis that global export volumes will contract in the coming months. Chart 15 Taiwan Is A Canary In A Coal Mine Taiwan Is A Canary In A Coal Mine Chart 16 Taiwan Is A Canary In A Coal Mine Taiwan Is A Canary In A Coal Mine Korean Exporters Are Struggling Korean export companies are experience the same dynamics as their Taiwanese peers. Semiconductor prices and sales are falling hard in Korea. Export volume growth has come to a halt and will soon shrink. Chart 17 Korean Exporters Are Struggling Korean Exporters Are Struggling Chart 18 Korean Exporters Are Struggling Korean Exporters Are Struggling EM Equities: Cheap And Unloved? The EM cyclically adjusted P/E (CAPE) ratio has fallen to one standard deviation below its mean. Based on this measure, EM stocks are currently as cheap as they were at their bottoms in 2020, 2015 and 2008. EM share prices in USD deflated by US CPI are now at two standard deviations below their long-term time-trend. This is as bad as it got when EM stocks bottomed in the previous bear markets. The reason for EM stocks poor performance and such “cheapness” is corporate profits. EM EPS in USD has been flat, i.e., posting zero growth in the past 15 years. Besides, EM narrow money (M1) growth points to further EM EPS contraction in the months ahead. Chart 19 EM Equities: Cheap And Unloved? EM Equities: Cheap And Unloved? Chart 20 EM Equities: Cheap And Unloved? EM Equities: Cheap And Unloved? Chart 21 EM Equities: Cheap And Unloved? EM Equities: Cheap And Unloved? Chart 22 EM Equities: Cheap And Unloved? EM Equities: Cheap And Unloved? Commodity Prices Remain At Risk China needs lower interest rates and a weaker currency to battle deflationary pressures. In the US, the problem is inflation, which heralds higher interest rates and a stronger currency to fight rising prices. Hence, the yuan will depreciate versus the greenback. When the RMB depreciates versus the US dollar, commodity prices usually fall. Further, commodity currencies (an average of AUD, NZD and CAD) continue drafting lower. This indicator correlates with commodity prices and also presages further relapse in resource prices. Chart 23 Commodity Prices Remain At Risk Commodity Prices Remain At Risk Chart 24 Commodity Prices Remain At Risk Commodity Prices Remain At Risk Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chinese crude oil imports have been contracting for almost a year. Global (including US) demand for gasoline has relapsed. Meantime, Russia’s oil and oil product exports have fallen only by a mere 5% from their January level. This explains why oil prices have recently fallen. Oil lags business cycles: its consumption will shrink as global growth downshifts. However, geopolitics remain a wild card. Hence, we are uncertain about the near-term outlook for oil prices. That said, oil has made a major top and any rebound will fail to last much longer or push prices above recent highs. Chart 25 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chart 26 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chart 27 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chart 28 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations What Is Next For The Chinese RMB? The Chinese yuan will continue depreciating versus the US dollar. China needs lower interest rates and a weaker currency to battle deflationary pressures. While currency is moderately cheap, exchange rates tend to overshoot/undershoot and can remain cheap/expensive for a while. The CNY/USD has technically broken down. Interestingly, the periods of RMB depreciation coincide with deteriorating global US dollar liquidity and, in turn, poor performance by EM assets and commodities. Chart 29 What Is Next For The Chinese RMB? What Is Next For The Chinese RMB? Chart 30 What Is Next For The Chinese RMB? What Is Next For The Chinese RMB? Chart 31 What Is Next For The Chinese RMB? What Is Next For The Chinese RMB? Stay Put On Chinese Equities Odds are rising that Chinese platform companies will likely be delisted from the US as we have argued for some time. Hence, international investors will continue dampening US-listed Chinese stocks. The outlook for China’s economic recovery and profits is downbeat. This will weigh on non-TMT stocks and A shares. Within the Chinese equity universe, we continue to recommend the long A-shares / short Investable stocks strategy, a position we initiated on March 4, 2021. Chart 32 Stay Put On Chinese Equities Stay Put On Chinese Equities Chart 33 Stay Put On Chinese Equities Stay Put On Chinese Equities Chart 34 Stay Put On Chinese Equities Stay Put On Chinese Equities Chart 35 Stay Put On Chinese Equities Stay Put On Chinese Equities Messages For Stocks From Corporate Bonds Historically, rising US and EM corporate bond yields led to a selloff in US and EM share prices, respectively. Corporate bond yields are the cost of capital that matters for equities. Unless US and EM corporate bond yields start falling on a sustainable basis, their share prices will struggle. Corporate bond yields could increase because of either rising US Treasury yields or widening credit spreads. Chart 36 Messages For Stocks From Corporate Bonds Messages For Stocks From Corporate Bonds Chart 37 Messages For Stocks From Corporate Bonds Messages For Stocks From Corporate Bonds EM Currencies And Fixed-Income: An Unfinished Adjustment The profiles of EM FX and credit spreads suggest that their adjustment might not be complete. We expect further EM currency depreciation and renewed EM credit spread widening. EM domestic bond yields have risen significantly and offer value. However, if and as US TIPS yields rise and/or EM currencies continue to depreciate, local bond yields are unlikely to fall. To recommend buying EM local bonds aggressively, we need to change our view on the US dollar. Chart 38 EM Currencies And Fixed-Income: An Unfinished Adjustment EM Currencies And Fixed-Income: An Unfinished Adjustment Chart 39 EM Currencies And Fixed-Income: An Unfinished Adjustment EM Currencies And Fixed-Income: An Unfinished Adjustment Chart 40 EM Currencies And Fixed-Income: An Unfinished Adjustment EM Currencies And Fixed-Income: An Unfinished Adjustment Chart 41 EM Currencies And Fixed-Income: An Unfinished Adjustment EM Currencies And Fixed-Income: An Unfinished Adjustment   Footnotes Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Executive Summary Definitions Matter Definitions Matter Definitions Matter Year-to-date, cyclical stocks have underperformed their defensive counterparts. It is difficult to quantify this underperformance precisely considering the divergence in definitions of what makes a sector cyclical or defensive. We offer a novel way to classify sectors based on a combination of equity beta coefficients and correlations with global macro and financial variables. Importantly, we acknowledge the importance of granularity by looking at the GICS2 sectors. This new approach leads to a cyclicals/defensives equity performance that is superior and more in line with the global economic cycle. Bottom Line: A proper definition of what constitutes a cyclical and a defensive equity sector is essential – whether a recession is around the corner and investors adopt a more defensive portfolio tilt or markets are just responding to what might simply be a mid-cycle slowdown.   Investors around the globe are holding their breath over two questions: Has inflation peaked? And will the US and Europe enter a recession? A peak in inflation may be enough to avoid a hard landing, as it would allow the Federal Reserve and the ECB to moderate their policy tightening. However, if inflation is not peaking, central banks will be forced to engineer recessions. Related Report  European Investment StrategyPlenty Of Risks For Cyclical Stocks In turn, the answers to these questions will determine how cyclical equities perform relative to defensives. So far, the underperformance of cyclical sectors relative to defensives has mostly reflected a valuation squeeze. But if a recession takes place, relative profits will drive the next phase of this market cycle. For now, European defensive sectors are likely to retain the upper hand until EM/China economic activity recovers enough to provide a lift to cyclical sectors, and/or the US dollar rally reverses course on a sustained basis. Chart 1Definitions Matter Definitions Matter Definitions Matter Despite their recent rebound, Euro Area cyclical stocks have underperformed relative to their defensive counterparts over the past nine months. However, quantifying this underperformance depends on how one defines cyclicals and defensives (Chart 1). The aim of this Special Report is to address this issue. There is no perfect way to define a sector as a cyclical or a defensive. In this piece, we review the generally accepted definitions. We draw two conclusions from our assessment; (i) the GICS1 sectors are too broad to get an accurate representation of cyclicals/defensives, and (ii) the use of only one indicator of cyclicality, such as the OECD Composite Leading Indicator (LEI), is lacking. We propose a different approach, which looks at the GICS2 sectors and applies an average of the market beta and the correlations to a set of global macro as well as financial variables sensitive to the global economy. This novel approach leads to a cyclicals/defensives equity performance that is more properly aligned with the global economic cycle. Challenging the Accepted Approach Each of the definitions of the cyclicals/defensives split has its own merit. For example, our own preferred definition of cyclical equities excludes the tech sector, because it sports a negative correlation with interest rates.     Finance theory posits that companies (or sectors) may be categorized based on how they perform in different phases of the business cycle. Consequently, cyclical companies should perform better in the first stages of a new business cycle (especially coming out of a recession) and defensive companies should shine during downturns. Table 1Definitions Matter Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives MSCI defines cyclical and defensive sectors by measuring the correlation between sectors’ relative annual performance to the annual change in the OECD Composite Leading Indicator (LEI) of the corresponding region.1 Table 1 presents the current MSCI classification. There are two issues with this approach. First, results differ substantially depending on the sample period (Table 2). GICS1 sectors match their definitions when using the full history available (from 1995 to present). However, on shorter samples, starting for example from 2005 or 2015, the correlations do not necessarily support the current MSCI classification; the communication services sector correlates negatively with the Euro Area OECD LEI from 2005 to present,2 while the energy sector displays a positive correlation since 2015. Table 2Cyclicality Changes Over Time Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives Looking at the five-year moving correlation of the relative performance of European sectors to the annual change in OECD LEI, four things stand out (Chart 2). First, the energy sector displays a positive correlation, meaning that it behaves as a cyclical. Second, it is not clear that communication services should be labeled a cyclical sector. Third, although tech has on average displayed a five-year moving correlation with activity of around 0.5, it is increasingly behaving like a defensive sector. And fourth, over the past 20 years, all sectors have at one point or another moved from a positive (negative) correlation to a negative (positive) one. Chart 2Cyclicality Is Not Static Cyclicality Is Not Static Cyclicality Is Not Static The second issue with the MSCI approach is the use of the OECD LEIs. While the OECD LEIs are satisfactory at capturing the peaks and troughs in economic activity, we have some concerns over relying on this measure alone to label a sector as cyclical or defensive. Many of the country’s LEIs already include stock prices. Moreover, academic studies have found that the LEIs performed worse than some of their single component indicators, but displayed more accuracy – that is, fewer false signals. In particular, financial components used in some of the country’s LEIs, such as interest rates, spreads, and credit indicators, proved to be better classifiers of both growth and business cycles than the overall LEIs. Chart 3Global Growth Sensitivity Global Growth Sensitivity Global Growth Sensitivity Finally, many (if not most) of the components of the LEIs are domestic variables. As a result, they may not properly reflect how the global economic and trade cycles affect an economy such as that of the Euro Area. In fact, the correlation between the relative performance of Euro Area cyclicals versus defensives and the annual change in the US and Global LEIs is similar to the correlation between the cyclical/defensive split and the Euro Area LEI (Chart 3).3  Reclassifying Cyclicals And Defensives We may draw two conclusions from our earlier assessment; (i) the GICS1 sectors are too broad to secure an accurate definition of cyclicals/defensives, and (ii) the use of only one indicator of cyclicality, such as the OECD LEI, is insufficient. Granularity Holds The Key Many industries or sectors have experienced profound changes over the past decades. Industries evolve and new ones emerge that may disrupt the status quo. For instance, today’s tech sector shares few similarities with its past-self twenty years ago. Chart 4AMore Granularity Needed (I) More Granularity Needed (I) More Granularity Needed (I) Without getting to the company level, many GICS2 sectors already exhibit characteristics deviating substantially from those of the GICS1 sectors of which they are a part (Chart 4A & 4B). Most noticeably: Within industrials: commercial and professional services (9% weight) have a negative correlation with the LEI of -0.23 (Chart 4A, top panel). Within consumer discretionary: the correlation of the retailing sector with the LEI (15% weight) went from 0.75 in the early 2010s to -0.5 in 2018 and has since been trending toward 0 (Chart 4A, third panel). Within tech: software and services (46% weight) sport a negative moving correlation of -0.25, and highlight that this sector has effectively become akin to “digital utilities.” Meanwhile, technology hardware and equipment display a correlation close to 0 (Chart 4A, fourth panel). Chart 4BMore Granularity Needed (II) More Granularity Needed (II) More Granularity Needed (II) Within communication services: telecommunication services (78% weight) still behave like a defensive sector, and it appears that the cyclicality of the GICS1 sector is driven by media and entertainment stocks (Chart 4B, top panel). Within consumer staples: food beverage and tobacco (53% weight) now display a positive correlation of 0.1 with the LEI, whereas it used to have a -0.8 correlation until 2018 (Chart 4B, second panel). Within energy: GICS2 sectors have displayed positive correlations since 2015 (Chart 4B, third panel). For the remaining GICS1 sectors, namely materials, financials, utilities, and healthcare, except for large swings observed in the past, their respective GICS2 sub-sectors currently display correlation coefficients sharing the same sign as their broader aggregates. Thus, adding granularity by looking at the GICS2 sector level instead of the GICS1 classification when creating cyclical and defensive baskets offers a more accurate picture. Good Old Beta Is the market itself the best indicator of a stock’s cyclicality? The returns on the stocks of cyclical (defensive) sectors should reflect high (low) correlation with the market index’s returns. Table 3A presents the beta coefficients obtained from linearly regressing the monthly equity returns of European GICS1 sectors on the monthly equity returns of the All-Country World benchmark. We run into the same issue of getting different results based on the sample period. Historically, the energy sector has had a beta coefficient below 1, but, from 2005, its beta has risen to 1.12. Meanwhile, communication services has a beta coefficient below 1 across all three sample periods selected. Table 3AGICS1 Beta Coefficients Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives We perform the same exercise at the European GICS2 sector level (Table 3B). The results reify the benefit of additional granularity when defining cyclicals and defensives. Table 3BGICS2 Beta Coefficients Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives Combining Correlations With Macro And Financial Variables While stock prices are certainly anticipatory, at times they can also decouple from the business cycle. Equity markets and stock indices are becoming more concentrated, which means that measuring cyclicality through beta alone is no longer sufficient. We complement the use of the beta coefficients with a composite measure of cyclicality based on correlations with global macro and financial variables. We select the following global macro variables (Chart 5A):​​​​​​​ Global Manufacturing PMI Global Industrial Production G3 Capital New Orders Global Exports Chart 5AGlobal Macro Variables Selected Global Macro Variables Selected Global Macro Variables Selected Chart 5BFinancial Variables Selected Financial Variables Selected Financial Variables Selected And we opt for the following high-frequency financial variables (Chart 5B): Trade-weighted USD: The cyclicals-to-defensives ratio and the trade-weighted US dollar display a robust negative correlation. A strong dollar both tightens global financial conditions and indicates weaker economic growth. GS Commodity Price Index: Commodity prices reflect both global supply and demand dynamics. Strong economic activity usually lifts commodity prices, while a slowdown hurts commodity demand. US 10-year Treasury Yield: The relationship with the US 10-year Treasury yield is somewhat more complex. At the beginning of a new business cycle, higher yields reflect reflation and usually correlate with an outperformance of cyclical equities. However, if yields rise too much, they start hurting growth prospects and end up damaging cyclicals. If they fall, it usually reflects increasing growth fears, which is negative for cyclical shares. Junk Spreads: US high-yield corporate bond spreads and the cyclicals/defensives ratio have a strong negative correlation. Widening junk spreads coincide with the end of the business cycle when fears of rising default risk precede a recession. Although these financial variables are highly anticipatory, they are also prone to whipsaws. Consequently, they must be viewed in conjunction with macro variables. We also compute the five-year moving correlations between monthly equity returns of European sectors relative to the ACW benchmark and the two sets of macro and financial variables (Table 4A & 4B). The results are broadly consistent between the long-term correlations with macro and financial variables, as well as with the beta coefficients,4 which comforts us into using a simple average of the three. Table 4ACombining Coefficients For GICS1 Sectors Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives Table 4BCombining Coefficients For GICS2 Sectors Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives At the GICS1 sector level, our new approach indicates that the energy sector should be treated as a cyclical, not a defensive. In fact, it displays more cyclicality than the tech sector. Communication services should also be defined as cyclicals, although it is less of a clear cut than for the other sectors since the adjusted beta coefficient is the culprit behind the negative sign. Taking a closer look at the GICS2 sector level once again provides valuable insight. The computed mean correlation for cyclical GICS2 sectors is 0.34, with a variance of 0.04 and standard deviation of 0.2. For defensive GICS2 sectors, the computed mean correlation is -0.23, with a variance of 0.02 and a standard deviation of 0.13. Assessing This New Approach Having reclassified the GICS2 sectors as cyclicals or defensives, the next step is to assess how this approach performs compared to the MSCI definition of cyclicals/defensives. To do so, we use the average coefficients displayed on Table 4B to create a dynamic basket of cyclicals and defensives GICS2 sectors. These baskets are weighted by market capitalization and are updated monthly. Chart 6New Baskets Of Cyclicals/Defensives New Baskets Of Cyclicals/Defensives New Baskets Of Cyclicals/Defensives Chart 6 shows how the novel cyclical vs. defensives performs over time in the Euro Area relative to the other definitions. Next, we perform a simple back-testing exercise to assess the performance over time of the new cyclicals-to-defensives ratio, with the Global Manufacturing PMI as a control variable. A superior definition of cyclicals vs. defensives should lead to a better performance of cyclicals when the PMI is above its 50 boom/bust line and improving, and to a better performance of defensives when the PMI is below 50 and deteriorating. We look at coincident equity returns (Table 5A). Overall, the results indicate that our new approach is superior and more accurate, both on a 3- and 12-month time horizon. This is especially true when the global economy is deteriorating. When the PMI is below 50 and falling, our basket of defensives outperforms our basket of cyclicals on average by 20% on a 12-month horizon, compared to 14% using the MSCI definition. Table 5AAssessing The Performance (I) Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives The subsequent performance of cyclicals relative to defensives following certain thresholds for the PMI also reinforces our new approach (Table 5B). Interestingly, our new basket of defensives is the only one to outperform cyclicals twelve months after the Global Manufacturing PMI deteriorated over several months and is below 50. Table 5BAssessing The Performance (II) Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives ​​​​​​​ Bottom Line: We are introducing a new approach to defining cyclical versus defensive equities. GICS1 sectors are too broad to achieve an accurate definition of cyclicality. However, the GICS2 classification offers the necessary level of granularity to do so. Moreover, we broaden the set of variables used to determine whether a GICS2 sector is cyclical or defensive. This new approach offers tighter links with the state of the global economy when selecting cyclical or defensive portfolio biases. For now, since EM economies and China remain under duress and the USD has yet to roll over clearly, we maintain our preference for defensive stocks over their cyclical counterparts within equity portfolios.   Jeremie Peloso, Editor/Strategist JeremieP@bcaresearch.com Amr Hanafy Associate Editor AmrH@bcaresearch.com Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com     Footnotes 1     Applied Research MSCI, “Index Performance in Changing Economic Environments,” 2014, p. 4. 2     Admittedly, communications services – formerly known as telecommunication services – was removed from the list of defensive sectors and classified as a cyclical one following the 2018 GICS structure adjustment. 3    In the remainder of the report, the relative equity performance of European sectors is measured against the ACW index. 4    We normalized the beta coefficients to have a mean of zero, to be comparable with correlation coefficients.

Executive Summary Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Inflation is not about oil, food or used car prices. Looking at prices of individual components of a consumer basket is akin to missing the forest for the trees. Despite the latest drop in US headline inflation, various core CPI measures continue trending up and registered considerable month-on-month rises in July. Wages and, more specifically, unit labor costs are the true measure of genuine and persistent inflation. US wage growth is very elevated, and the pace of unit labor cost gains has surged to a 40-year high. The conditions for sustainable and persistent disinflation in the US are not yet present. US inflation will prove to be much stickier and more entrenched than many market participants presently believe. The recovery in China will be U- rather than V-shaped, with risks tilted to the downside. The mainland’s property market breakdown is structural, not cyclical. Excesses are very large, and problems are snowballing, rendering the enacted policy stimulus insufficient. Bottom Line: US core inflation lingering above 4% and easing financial conditions will compel the Fed to continue hiking rates. This will cap global risk asset prices and put a floor under the US dollar.  We continue to recommend an underweight allocation to EM in global equity and credit portfolios. Consistently, we are also reluctant to chase EM currencies higher. Feature The bullish macro narrative circulating in the investment community is that conditions for a cyclical rally in global risk assets have fallen into place. Specifically: US inflation will drop sharply as US growth has crested and commodity prices have plunged; The Fed is nearing the end of a tightening cycle; China has stimulated sufficiently, and its economy is about to recover, which will boost economic conditions among its trading partners in general and EM in particular. These assumptions along with the fact that the S&P 500 index has found support at a 3-year moving average – a proven line of defense – suggest that US share prices have likely bottomed (Chart 1). Are we witnessing déjà vu of the 2011, 2016, 2018 and 2020 market bottoms? Chart 1Déjà Vu? Is 2022 Like The 2011, 2016 And 2018 Bottoms In The S&P 500? Déjà Vu? Is 2022 Like The 2011, 2016 And 2018 Bottoms In The S&P 500? Déjà Vu? Is 2022 Like The 2011, 2016 And 2018 Bottoms In The S&P 500? We have reservations about all of the above fundamental conjectures. We elaborate on these reservations in this report. On the whole, we contend that the current environment is different, and the roadmaps of all post-2009 equity market bottoms are not necessarily currently applicable. BCA’s Emerging Markets Strategy team believes that (1) US consumer price inflation is much more entrenched and will prove stickier than is commonly believed; and (2) the Chinese property market’s breakdown is structural, not cyclical; hence, the recovery will not gain traction easily.  Is This The End Of The US Inflation Problem? Not Quite This week’s US inflation data confirmed that headline CPI inflation has probably peaked: prices in several categories plunged. However, inflation is not about oil, food or used car prices. Chart 2 reveals that historically there have been several episodes whereby core inflation remains elevated despite plunging oil prices. Chart 2US Core Inflation Does Not Always Follow Oil Prices US Core Inflation Does Not Always Follow Oil Prices US Core Inflation Does Not Always Follow Oil Prices Looking at price dynamics among the individual components of the CPI basket is akin to missing the forest for the trees. Inflation is a very inert and persistent phenomenon. Underlying inflation does not change its direction often and/or quickly. That is why we believe that it is premature to celebrate the end of the US inflation problem. A few observations on this matter: Despite the drop in US headline inflation, various core CPI measures − like trimmed-mean CPI, median CPI and core sticky CPI − all continue trending up and registered substantial month-on-month rises in July (Chart 3). The range of core inflation based on these annual and month-month annualized rates is between 4-7%. In brief, the rate of genuine/sticky inflation is well above the Fed’s 2% target. Given its unconditional commitment to bringing inflation down to 2%, the Fed will continue hiking interest rates ceteris paribus. Chart 3US Core CPI Measures Are Still Very High US Core CPI Measures Are Still Very High US Core CPI Measures Are Still Very High Chart 4US Wages Growth Has Been Surging US Wages Growth Has Been Surging US Wages Growth Has Been Surging   We continue to emphasize that wages and, more specifically, unit labor costs are the true measures of persistent and genuine inflation. We have written at length about why wages and unit labor costs are more important to inflation than oil or food prices. US wage growth is very elevated and is accelerating (Chart 4). Unit labor costs, calculated as hourly wages divided by productivity, have also been surging to a 40-year high (Chart 5, top panel). Chart 5Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation The reason for this very strong wage growth and swelling unit labor costs is the very tight labor market. The bottom panel of Chart 5 demonstrates that labor demand is still outpacing labor supply by a wide margin. Hence, wage inflation will not subside until the unemployment rate rises meaningfully. Bottom Line: Conditions for sustainable and persistent disinflation in the US are not yet present.  Inflation will prove to be much stickier and more entrenched than many market participants presently believe. Core inflation lingering above 4% and easing financial conditions will compel the Fed to continue hiking rates. This will cap risk asset prices and put a floor under the US dollar.   China: Is This Time Different? If one believes that China’s current business cycle is similar to all previous ones seen since 2009, odds are that a buying opportunity in China-related financial markets is at hand. Chart 6 illustrates that the credit and fiscal spending impulse leads the business cycle by about nine months. Given that this impulse bottomed late last year, a trough in the Chinese business cycle is due. Chart 6Is A Recovery In China's Business Cycle Imminent? Is A Recovery In China's Business Cycle Imminent? Is A Recovery In China's Business Cycle Imminent? It is always risky to suggest that this time is different. Nevertheless, at the risk of being wrong, we contend that a combination of (1) property markets woes, (2) an impending export contraction, and (3) the dynamic zero-COVID policy will reduce the multiplier effect of current stimulus measures. Hence, a meaningful recovery in economic activity will likely fail to materialize in the coming months. The challenges facing the mainland property market are now well known. Yet, excesses are very large, and problems are snowballing, making policy stimulus insufficient. In particular: Authorities are contemplating bailout funds for property developers in the range of RMB 300-400 billion to enable them to complete housing that has been pre-sold. This is not sufficient financing for overall property construction. Table 1How Large Are Property Developers Bailout Funds? Déjà Vu? Déjà Vu? Table 1 illustrates that these amounts are equal to just 3-4% of annual fixed-asset investment in real estate excluding land purchases, 1.5-2% of total financing of developers, and 3-4% of the advance payments that property developers received for pre-sold housing in 2021. Property developers will not be receiving any cash upon the completion and delivery of presold housing units because they were paid in advance. Hence, without liquidating their other assets, homebuilders cannot repay the bailout financing. Consequently, only state financing can work here because, from the viewpoint of providers of this financing, this scheme de-facto means throwing good money after bad. The property industry in China is extremely fragmented. This makes bailouts difficult to organize and execute. There are officially about 100,000 property developers in China. The overwhelming majority of them are not state-owned companies. Plus, the two largest property developers, Evergrande (before defaulting) and Country Garden, had only 3.8% and 3.3% of market share respectively in 2020. The failure of homebuilders to complete and deliver pre-sold housing units could unleash a death spiral for them. In recent years, 90% of housing units have been pre-sold, i.e., buyers made advance payments/prepayments, often taking out mortgages (Chart 7, top panel). Witnessing the inability of developers to deliver on presold units, a rising number of people may decide to wait to buy. The largest source of developers’ financing – advance payments for pre-sold housing units – might very well dry up. This source has accounted for 50% of real estate developers’ total financing in recent years (Chart 7, bottom panel). In brief, a vicious cycle is possible. The lack of financing for homebuilders bodes ill for construction activity (Chart 8). Chart 7China: Housing Presales And Pre-Payments Are Critical To Developers China: Housing Presales And Pre-Payments Are Critical To Developers China: Housing Presales And Pre-Payments Are Critical To Developers Chart 8Lack Of Homebuilder Financing = Shrinking Construction Activity Lack Of Homebuilder Financing = Shrinking Construction Activity Lack Of Homebuilder Financing = Shrinking Construction Activity Chart 9Chinese Property Developers Are Extremely Leveraged Chinese Property Developers Are Extremely Leveraged Chinese Property Developers Are Extremely Leveraged Besides, property developers are very leveraged with an assets-to-equity ratio close to nine (Chart 9). They have grown accustomed to borrowing heavily to accumulate real estate assets. They have been starting but not completing construction (Chart 10, top panel). We have been referring to this phenomenon as the biggest carry trade in the world. The bottom panel of Chart 10 shows two different measures of residential floor space inventories held by property developers. One measure subtracts completed floor space from started floor space, and another one deducts sold floor space from started floor space. On both measures, residential inventories are enormous. In theory, they could raise funds by selling their real estate assets. However, if they all try to sell simultaneously, there will not be enough buyers, and asset prices will plunge, which could lead to a full-blown debt deflation spiral. The last time the real estate market was similarly distressed in 2014-15, the central bank launched the Pledged Supplementary Lending (PSL) facility. This was effectively a QE program to monetize housing. This was the reason why housing recovered strongly in 2016-2017. There is currently no such program up for discussion. On the whole, odds are that the current property market breakdown is structural, not cyclical. Financial markets – the prices of stocks and USD bonds of property developers – convey a similar message and continue to plunge (Chart 11). Chart 10Excessive Property Inventories Excessive Property Inventories Excessive Property Inventories Chart 11No Green Light From Property Stocks And Corporate Bond Prices No Green Light From Property Stocks And Corporate Bond Prices No Green Light From Property Stocks And Corporate Bond Prices Chart 12There Has Been No Recovery In China Without A Revival in Real Estate There Has Been No Recovery In China Without A Revival in Real Estate There Has Been No Recovery In China Without A Revival in Real Estate Without an improvement in the housing market, a meaningful business cycle recovery is unlikely in China. Chart 12 illustrates that all recoveries in the Chinese broader economy since 2009 occurred alongside a revival in property sales. The importance of the property market goes beyond its size. Rising property prices lift household and business confidence, boosting aggregate spending and investment. The sluggish housing market and falling house prices will impair consumer and business confidence. This, along with uncertainty related to the dynamic zero-COVID policy, will dent consumer spending and private investments. Finally, the upcoming contraction in Chinese exports will dampen national income growth. Taken together, the multiplier effect of stimulus in the upcoming months will be lower than it has been in previous periods of stimulus. There are two areas that will see meaningful improvement in the coming months: infrastructure spending and autos. BCA’s China Investment Strategy service discussed the outlook for auto sales in a recent report. Chart 13Green Shoots In China's Infrastructure Investment Green Shoots In China's Infrastructure Investment Green Shoots In China's Infrastructure Investment On the infrastructure front, there has been mixed evidence of an improvement in activity. The top and middle panels of Chart 13 demonstrate that Komatsu machinery’s operational hours and the number of approved infrastructure projects might be bottoming. However, the installation of high-power electricity lines has fallen to a 15-year low (Chart 13, bottom panel).   As we elaborated in last month’s report, the new financing/stimulus for infrastructure development will not result in new investments. Rather, it will by and large offset the drop in local government (LG) revenues from land sales this year. In short, there is little new stimulus for infrastructure beyond what was approved in the budget plan earlier this year. Bottom Line: The recovery in China will be U- rather than V-shaped, with risks tilted to the downside. Investment Recommendations Our bias is that the rebound in global risk assets could last for a few more weeks. The basis is that investor positioning in risk assets was very light when this rebound began. Plus, falling oil prices could reinforce the idea among investors that US inflation is no longer a problem. Looking beyond the next several weeks, the outlook for global and EM risk assets is dismal. Markets will realize that the Fed cannot halt its tightening with core inflation well above 4-5%. Hawkish Fed policy and contracting global trade will boost the US dollar and weigh on cyclical assets. We continue to recommend an underweight allocation to EM in global equity and credit portfolios. Consistently, we are also reluctant to chase EM currencies higher. EM local bonds offer value, as we have argued over the past couple of months, but for now we prefer to focus on yield curve flattening trades. We continue betting on yield curve flattening/inversion in Mexico and Colombia and are long Brazilian 10-year domestic bonds while hedging the currency risk. In addition, we recommend investors continue receiving 10-year swap rates in China and Malaysia.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Listen to a short summary of this report.     Executive Summary The Dollar Rises During Recessions How Deep A Recession Is The Dollar Pricing In? How Deep A Recession Is The Dollar Pricing In? At 106.5, the dollar DXY index is certainly pricing in a recession deeper than during the Covid-19 crisis. The dollar tends to rise during recessions and only peaks when a global economic recovery is in sight (Feature Chart). One caveat: contrary to conventional wisdom, US economic data is deteriorating relative to the rest of the world. Historically, that has been a negative for the greenback. The key question facing investors is if markets are entering a riot point. That is a high probability. Historically, high volatility supports the dollar. As such, our recommended stance on the dollar is neutral over the next few months. Our highest conviction bets are short EUR/JPY and long Swiss franc trades. Valuations tend to matter when most investors least expect them to. On this basis, we are negative the dollar on a 12-to-18 month time horizon. Place a limit sell on CHF/SEK at 10.76.   TRADES* INITIATION DATE PERCENT RETURNS Short EUR/JPY 2022-07-21 2.73% Bottom Line: Stand aside on the dollar for now. Continue to opportunistically play trades at the crosses. Short EUR/JPY bets make sense as a volatility hedge.   Chart 1Any Dollar Bears Left? Any Dollar Bears Left? Any Dollar Bears Left? In our conversations with clients, it is rare to find a dollar bear these days. One barometer is price action – the dollar DXY index is up 18% from its 2021 lows. More instructively, net long speculative positions are near a multi-decade high (Chart 1). In our meetings, we sense a specter of capitulation among fundamental dollar bears, as the macroeconomic environment becomes more uncertain. For chart enthusiasts, the DXY index staged a classic breakout, and the next technical level is closer to the 2002 highs near 120. We doubt the DXY index will hit this level, as significant headwinds are building. It is true that as markets increasingly price in the probability of a recession, especially in Europe, the dollar will be bought. But as we argue below, the dollar has already priced in a recession, deeper than was the case in 2020 (or admittedly, at any time since the end of the Bretton Woods system). This suggests that investors with a relatively benign economic backdrop should be fading any strength in the dollar. In other words, if your bet on a recession is low odds, fade dollar strength relatively to your colleagues. As such, our recommended stance on the dollar is neutral over the next few months, but bearish for investors with a longer-term horizon. For today, our highest conviction bets are short EUR/JPY and long Swiss franc trades. The US Dollar And Global Growth Chart 2The Dollar Tracks Global Growth The Dollar Tracks Global Growth The Dollar Tracks Global Growth There are many important drivers of the US dollar. One is the path for global growth. If global activity is going to slow meaningfully, then as a countercyclical currency, the dollar tends to rise in that environment. The dollar has been closely correlated (inversely) to the trend in global PMIs, industrial production, and other measures of global growth (Chart 2). Across the world, global growth is slowing (Chart 3). Most manufacturing PMIs in the developed world peaked in the middle of last year. In the developing world, China’s zero Covid-19 policy has nudged many PMIs close to the 50 boom/bust level. As a rule of thumb, you do not want to be short the greenback when global industrial activity is slowing. That is the bull case. Chart 3AGlobal Growth Is Slowing In Developed Markets Global Growth Is Slowing In Developed Markets Global Growth Is Slowing In Developed Markets Chart 3BGrowth Is Also Soft In Emerging Markets Growth Is Also Soft In Emerging Markets Growth Is Also Soft In Emerging Markets The good news for dollar bears is that most of this information is already priced in. Looking back at recessions since the 1970s, the dollar is pricing in one of the most anticipated slowdowns in history (Chart 4). This alone is not a reason to turn bearish on the greenback, but it is a red flag towards the consensus view. In general, currencies are a relative game. The dollar tends to rise 10%-to-15% during recessions. We are already there, with the DXY index up 18% since the 2021 lows. It is also important to gauge how the US is faring relative to the rest of the world. Quite simply, US economy economic activity is deteriorating vis-à-vis its trading partners. This is visible in the Citigroup economic surprise indices, but also via a simple chart of relative PMIs (Chart 5). Historically, that has been a negative for the greenback outside of recessions. Chart 4The Dollar Overshoots During Recessions How Deep A Recession Is The Dollar Pricing In? How Deep A Recession Is The Dollar Pricing In? Chart 5US Economic Momentum Is Deteriorating US Economic Momentum Is Deteriorating US Economic Momentum Is Deteriorating The US Dollar And Interest Rates The Fed hiked interest rates by 75bps this week. This was as expected but given what the Bank of Canada delivered on July 13th, a 100bps hike was a whisper number in our books. More importantly, interest rate differentials (real and nominal) are increasingly moving against the US. As we go to press, 10-year bond yields are 2.67% in the US, but 2.62% in Canada, 3.41% in New Zealand, and even 3.1% in Australia. Chart 6The Euro And Relative Interest Rates The Euro And Relative Interest Rates The Euro And Relative Interest Rates The key point is that the market consensus is centered around the Fed being the most hawkish central bank. That will face a critical test in the next few months, if the world enters a recession. This is especially true in the euro area. The market is pricing that interest rates in the eurozone will be 200bps lower next year, relative to the US (Chart 6). The historical spread between US and German 2-year yields has been 83 bps. If Europe indeed enters a deep recession, then that is already priced in the euro. If we get any green shoots in economic growth, then the euro is poised for a coiled-spring rebound. The market is also pricing in that US interest rates will peak next year, relative to other G10 economies (Chart 7). This could happen in one of two ways: The Fed turns more dovish and/or non-US growth loses steam, leading to lower interest rates outside the US. It is difficult to forecast how the economic scenario will evolve, but from an investor’s standpoint, the dollar has already overshot the level implied by relative interest rates (Chart 8). Chart 7US Short Real Yields Are Attractive How Deep A Recession Is The Dollar Pricing In? How Deep A Recession Is The Dollar Pricing In? Chart 8The Dollar Has Overshot Rate Fundamentals The Dollar Has Overshot Rate Fundamentals The Dollar Has Overshot Rate Fundamentals A Short Note On USD Valuations Valuations usually get little respect, especially over the last few years. The bull market in the dollar from 2011 to 2022 coincided with higher real interest rates in the US relative to the rest of the developed world. That said, a rising trade deficit (imports > exports) requires a lower exchange rate to boost competitiveness in the manufacturing sector, or less spending to reduce the trade deficit. Therefore, the natural adjustment mechanism for countries running wide trade deficits will have to be the exchange rate. Quite simply, rising deficits are a symptom of an overvalued exchange rate. Within a broad spectrum of developed and emerging market currencies, the US dollar is overvalued on a real effective exchange rate basis (Chart 9 and 10). While valuations tend to matter less until they trigger a tipping point, such inflections usually occur with a shift in animal spirits, especially when investors start to worry about huge external imbalances. Chart 9The Dollar Is Overvalued The Dollar Is Overvalued The Dollar Is Overvalued Chart 10The Dollar Is One Of The Most Expensive Currencies How Deep A Recession Is The Dollar Pricing In? How Deep A Recession Is The Dollar Pricing In? In the US, these imbalances are already starting to spark a shift. The US trade deficit has deteriorated. The basic balance in the US (the sum of the current account and foreign direct investment) is deteriorating. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts deteriorating. It is remarkable that at a time when real rates are quite negative in the US, the dollar is the most overvalued in decades on a simple PPP model basis. This is a perfect mirror image of the dollar configuration at the start of the bull market in 2010, where the dollar was cheap and real rates were more supportive. According to economic theory, a currency should adjust to equalize returns across countries. In the early 80s, an expensive dollar was supported by very positive real rates. The subsequent dollar declines thereafter also coincided with falling real interest rates. If global growth shifts from relative strength in the US to overseas, interest rate differentials will tilt in favor of non-US markets. That will be solace for dollar bears. Conclusions In financial markets, it pays to be humble but also to be bold. Our recommended stance on the DXY (and by association, the euro and cable) is to stay on the sidelines. Our highest conviction trade is to short EUR/JPY. With the drop in commodity prices, resource-related currencies are becoming interesting, a topic we will discuss in upcoming bulletins. But momentum is your friend for now, which suggests prudence.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary   More Tightening To Come More Tightening To Come More Tightening To Come In the following report we answer the most asked questions from our recent “Bear Market 2.0” webcast. Macroeconomic backdrop and inflation: While commodity prices falling, the wage-price spiral is in full force, implying that it will take many months to reach the level of PCE inflation palatable to the Fed. The Fed will continue to tighten monetary conditions until entrenched inflation reaches its target, which may take longer than the market expects. Earnings outlook: Q2-2022 results show that an earnings slowdown has already commenced and is bound to get worse over the next couple of quarters. However, earnings forecasts are still too optimistic and a slowdown in earnings growth is not yet priced in. Investment themes: We recommend topping up allocation to Tech as it benefits from rate stabilization.  However, be judicious in your choices, staying away from the more cyclical areas, such as Hardware and Equipment, and Semiconductors.  We are overweight Software and Services, which is dominated by profitable and stable growth companies. Bottom Line: We continue to recommend that investors remain patient and prudent in range-bound markets. Earnings growth is likely to deteriorate into the year end. Feature Last Monday, July 18, I hosted a webcast called “Bear Market 2.0.” A total of 675 people dialed in, and I was honored. The webcast generated a significant number of client questions which I aim to address in this weekly publication. Broadly speaking, questions fell under each of the three rubrics of the webcast: Macroeconomic backdrop, earnings outlook, and investment themes, with the latter generating the lion’s share of questions. In today’s report, we will discuss inflation and rates, earnings season results, potential S&P 500 targets, whether the S&P 500 rally is sustainable, and if it is a good idea to top up Tech. We will address remaining questions on Energy and Materials, and Semiconductor in the near future. And as always, we are looking forward to more questions! Macroeconomic Backdrop How do you reconcile your inflation outlook with an assumption that long yields may have peaked? In the “Fat and Flat” and “Adaptive Expectations” reports, we outline our view that the market’s focus is shifting away from concerns about inflation and the hawkish Fed toward worries about growth. Indeed, the 10-year rate has stabilized at 2.78% on fears of impending slowdown (Chart 1). How does this reconcile with our view that inflation is entrenched and broadening (Chart 2), especially in light of the recent pullback in energy and commodities prices? Chart 1Yields Are Stabilizing Yields Are Stabilizing Yields Are Stabilizing Chart 2Inflation Is Entrenched Inflation Is Entrenched Inflation Is Entrenched Even if energy and commodities prices are falling, the latest wage survey from the Atlanta Fed demonstrates wage growth is not letting up, and labor costs, at over 50% of sales as per NIPA accounts, are a more important component of the US corporate cost structure than the cost of energy. Inflation is embedded as, companies pass on wage increases to customers by increasing prices – and, voilà, the wage-price spiral is becoming pervasive. This dynamic implies the following: Even if inflation peaks over the next several months, it will take many months to reach the level of PCE inflation palatable to the Fed. After having mismanaged inflation over the past 18 months, the Fed will err on the side of tighter policy. In fact, in its official statement, the Fed has asserted that its commitment to bringing inflation to its 2% target is unconditional. Therefore, we are still in the early innings of the monetary tightening cycle (Chart 3), where elevated inflation coexists with slowing growth and range-bound long rates. Bottom Line: The Fed will continue to tighten monetary conditions until entrenched inflation reaches its target, which may take longer than the market expects. Chart 3More Tightening To Come More Tightening To Come More Tightening To Come Earnings Outlook What are your takeaways from the earnings seasons so far? In the Daily Insight, which we published on July 21, we offer our initial reaction to the results. In short, so far earnings have been good, but margins are under pressure (Chart 4) from rising wages and fading pricing power (Chart 5). We have also heard quite a few negative comments from companies concerning the effects of inflation and rising costs, a strong dollar, and withdrawal from Russia. Some of the largest Technology companies announced slowdowns in hiring as they anticipate falls in demand. Forward guidance has also been concerning. Most companies talk about deteriorating economic conditions. Chart 4Margins Are Expected To Contract Margins Are Expected To Contract Margins Are Expected To Contract Chart 5Pricing Power Turning Pricing Power Turning Pricing Power Turning We are still convinced that street forecasts of earnings growing at about a 10% rate over the next 12 months and 11% into year-end (Table 1), despite ubiquitous negative corporate guidance, are unrealistically high. Even in this reporting season for Q2-22, earnings growth is -3%, excluding Energy. Table 1S&P 500 EPS: Actual And Expected What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up It is unlikely that, over the next several months, macro headwinds, such as slowing growth, the hawkish Fed, stubborn inflation, and rising wages will dissipate. There is little consensus among analysts on forecasts (Chart 6) and downgrades are likely. We take it a step further, and call an earnings recession in three to six months. Chart 6Analysts Have Little Confidence In Their Forecasts Analysts Have Little Confidence In Their Forecasts Analysts Have Little Confidence In Their Forecasts Bottom Line: Q2-2022 results show that an earnings slowdown has most likely already commenced and is bound to get worse over the next couple of quarters. However, earnings forecasts are still too optimistic and a slowdown in earnings growth is not yet priced in. Do you think that the slowdown in earnings might trigger multiple expansion? Earnings contraction, everything else equal, translates into multiple expansion, as the denominator of the fraction gets smaller. For example, according to our back-of-the-envelope estimates, earnings contracting by 10% will increase the forward multiple from the current 16x to 19x. Therefore, the key question here is how likely is it that everything else will indeed stay equal, as opposed to the market selling off in line with earnings? Multiples will expand if the market is able to see past negative earnings growth, identifying a catalyst for an imminent rebound. That was the case in 2020 as investors anticipated earnings bouncing back helped by easy monetary and fiscal policy, and COVID receding. What will be a catalyst for earnings rebound in, say, 2023? We can only speculate but one of the potential reasons for faster earnings growth is perhaps normalization of growth outside of the US: A weaker dollar, peace in Ukraine, resolution of the energy crisis, or ultra-loose monetary and fiscal policy in China. At home, the anticipation of a soft landing and a more dovish monetary policy coupled with a positive real wage growth boosting consumers’ spending power may be sufficient to reassure investors that earnings growth turning positive is imminent. However, all of these developments are probably months away. And we expect the market to sell off if earnings growth disappoints. Where do you see the S&P 500 by the end of the year? Broadly speaking, BCA Research does not provide targets but rather aims to offer insights into market trends. However, in the “Is Earnings Recession In The Cards?” report, we presented a matrix outlining different scenarios of earnings growth vs. forward multiples to arrive at a potential range of the outcomes for the index. We assume that the forward multiple stays at 16x, as the multiple contraction stage of the bear market is likely completed, but there is still no clear catalyst for earnings rebound. We will approximate CY 2022 results using the Next Twelve Months Matrix (Table 2). Table 2The S&P 500 Price Target Scenarios What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up We can distill the matrix into three likely scenarios: Earnings growth delivered by companies in line with analyst expectations of 11% over the six months; flat earnings (0% growth) broadly in line with the forecast based on our earnings model; and the worst-case scenario of a severe earnings contraction of -10% into year-end. We assign 25% to both extreme cases and about 50% to earnings staying flat for the next six months (earnings recession commencing in 2023). Best-case scenario: Earnings grow into year-end by 11%, and by 9.7% over the next 12 months. In that case, the S&P 500 will end the year at 3,837 or 3% off the current level. This is what is being priced in. Most likely scenario: Earnings growth trends to zero by the end of the year with the S&P 500 hitting 3500 or downshifting roughly 10% from here. Worst-case scenario: Earnings contract by 10%, and with the multiple staying at 16x, the S&P 500 price target will be 3287 or about 17% lower than today. With “E” falling so much, perhaps the multiple expands to 17x, in which case the market will fall “only” 11% from here. Bottom Line: We expect flagging earnings to cause another leg of the bear market, which is likely to be 5-10% into year-end, and perhaps another 5-10% in 2023. Equity Market Outlook And Key Investment Themes Are investors capitulating? Are we near or even past the bottom? The decline in oil and food prices and the easing of supply-side bottlenecks have alleviated market worries about US inflation. This, coupled with oversold risk assets, and apparent extreme pessimism in investor sentiment, has resulted in the S&P 500 rebounding 8% from its June lows. Sectors that have sold off the most over the past six months have bounced back the hardest (Chart 7). Naturally, the question that is top of mind for investors is whether this rebound is sustainable. Should they add beaten-down cyclicals to their portfolios to partake in the rally? Of course, no one can predict what Mr. Market will do with 100% certainty but here are some thoughts: Chart 7Sector Performance Overview What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up Positives Many risk assets are severely oversold, and for long-term investors, an entry point is attractive valuation-wise. So far, many investors find earnings season results somewhat encouraging: Netflix soared on what its CEO Hawkins called “less bad results.” Multiples have contracted and priced in most of the primary effects of high inflation and rising rates. Negatives The Fed is determined to extinguish inflation, and this hiking cycle may end up much longer and steeper than the market is pricing in. We do not anticipate monetary easing in the first half of 2023. Financial markets are currently underrating the risk of a seriously hawkish Fed. Economic growth is slowing, and consensus forecasts of earnings growth are still overly optimistic. Earnings contraction over the next several quarters is likely but is certainly not priced in, and disappointment may rock markets. The catalyst for this summer’s rebound is two-fold: The market is celebrating the end of inflation worries and is rebounding from severely oversold conditions. Black swan “generators” such as China and Russia, may have more surprises in stock (Table 3). We continue to stick to “fat and down” expectations for the equities outlined in the “Adaptive Expectations” report and anticipate a range-bound market where relief rallies are alternated with pullbacks, mostly triggered by growth disappointments and realizations that the Fed has dug in its heels and is unlikely to let up anytime soon. The “down” leg will ensue if earnings contract. Yet we recommend investors take a granular approach to industry selection and start tilting portfolios away from assets that benefit from rising inflation, such as Energy and Materials, towards the “growthy” assets that benefit from rate stabilization and falling growth. We picked up on the turning point and upgraded Growth to overweight in early July, funding it from Value.   Table 3Scorecard What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up   Bottom Line: We consider the recent rebound in US equities a bear market rally, and don’t believe that it is sustainable. The Fed and the stock market are on a collision course – easier financial conditions will make the Fed even more aggressive. Is it time to buy Tech? As we have highlighted in the “Are We There Yet?!” report back in January, Tech’s worst performance is two to three months prior to the first rate hike, and the rebound is two to three months after the beginning of the monetary cycle. The slump and a recent rally are perfectly in line with history (Chart 8). Rates have stabilized and “growthy” Tech has pounced (Chart 9). Another issue that was holding the sector back earlier in the year was a slowdown in demand for Tech investment (Chart 10). Recently, business demand for Tech has picked up. However, US consumer spending on Tech is falling, as demand for consumer goods, pulled forward by the pandemic, is fading (Chart 11). Therefore, we need to be judicious in our selection of technology stocks. Chart 8Tech Performance During A Hiking Cycle What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up Chart 9Technology Rebounded On The Back Of Yields Peaking Technology Rebounded On The Back Of Yields Peaking Technology Rebounded On The Back Of Yields Peaking Chart 10Corporate Demand For Tech Has Picked Up… Corporate Demand For Tech Has Picked Up… Corporate Demand For Tech Has Picked Up… We reiterate our overweight in Software and Services, which is least exposed to consumer demand. Our thesis is that this industry group represents “defensive growth” thanks to the key trends of digitization of the US economy and migration to cloud. Spending on digitization and the cloud are pervasive across non-tech companies and capture a large swath of corporate America by both size and industry. Also, software and services companies tend to have stable earnings growth throughout the cycle, as software improves productivity and cuts costs (Chart 12). Chart 11...But Consumer Spending Slowed ...But Consumer Spending Slowed ...But Consumer Spending Slowed Chart 12Software Is Defensive Growth Software Is Defensive Growth Software Is Defensive Growth We are underweight more cyclical Hardware and Equipment, and Semiconductors industry groups as they are more exposed to the slowing economy and the flagging demand for hardware and chips. We will take a close look at the Semiconductor Industry Group in the near future. Bottom Line: We recommend topping up allocation to tech as it benefits from rate stabilization. However, be judicious in your choices, staying away from the more cyclical areas, such as Hardware and Equipment, and Semiconductors. We are overweight Software and Services, which is dominated by profitable and stable growth companies.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation Recommended Allocation: Addendum What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up  

Executive Summary Investors Should Mind Surging US Wages Investors Should Mind Surging US Wages Investors Should Mind Surging US Wages Despite Western sanctions on Russia, the country’s oil exports have not collapsed. According to the International Energy Agency’s (IEA) estimates, Russia’s shipments of crude and oil products have declined by only 5% since January. The combination of relatively stable supply and downshifting global oil demand constitutes a bearish cocktail for oil prices. Odds are that oil prices will decline further and recouple with industrial and precious metal prices. Labor costs are more important than oil prices for the US core inflation outlook and, hence, for Fed policy. In the US, surging wages and easing financial conditions would make the Fed even more committed to tightening monetary policy substantially. The Fed and the stock market remain on a collision course. EM/China exports will contract, and their domestic demand will also struggle. Bottom Line: As the US dollar continues to overshoot, EM stocks will underperform DM equities, and EM credit markets will underperform US credit markets on a quality-adjusted basis. An underweight position in EM in global equity and credit portfolios is warranted. Feature The decline in oil and food prices and the easing of supply-side bottlenecks have alleviated market worries about US inflation. As a result, the S&P500 has rebounded, despite the grim inflation report last week. BCA’s Emerging Markets Strategy team expects oil and industrial metal prices to drop further. Does this mean that the worst of both US inflation and the Fed’s tightening is behind us and that it is time to buy risk assets? Not really. In this report, we discuss (1) why oil prices will drop further, (2) why the worst of US monetary tightening is not over, and (3) why emerging markets are not out of the woods. In fact, EM asset prices have so far failed to advance, despite the rebound in the S&P500. This is true for EM stocks, currencies, EM credit spreads, and domestic bonds (Charts 1 and 2). Overall, our macro themes of Fed tightening amid slowing global growth, the US dollar overshooting, and China’s disappointing recovery remain intact. These factors still warrant a defensive investment strategy, despite a possible near-term rebound in the S&P 500. EMs will lag and underperform in this rebound. Chart 1No Rebound In EM Stocks And Currencies… No Rebound In EM Stocks And Currencies... No Rebound In EM Stocks And Currencies... Chart 2…Nor In EM Credit Space And Local Bonds ...Nor In EM Credit Space And Local Bonds ...Nor In EM Credit Space And Local Bonds Oil Prices Will Drop But… Chart 3Russian Oil Export Volumes Have Dropped Only By 5% Since January Russian Oil Export Volumes Have Dropped Only By 5% Since January Russian Oil Export Volumes Have Dropped Only By 5% Since January Odds are that crude prices have peaked and face material downside: Despite the sanctions and logistical challenges that Western governments have enforced on Russia, the country’s oil exports have not collapsed. According to the International Energy Agency’s (IEA) estimates, Russia’s shipments of crude and oil products have declined by only 5% since January (Chart 3). Even though Saudi Arabia appears to be committed to its production management policy, it cannot completely ignore US demands to raise its oil output. Odds are that Saudi Arabia and the United Arab Emirates will boost their oil output in the coming months. Chart 4US And Chinese Oil Consumption Is Weak US And Chinese Oil Consumption Is Weak US And Chinese Oil Consumption Is Weak In the meantime, global oil demand is shrinking, in part due to high prices. US consumption of gasoline and other motor fuel has marginally contracted (Chart 4, top panel). In China, rolling lockdowns and weak income growth will continue to suppress the nation’s crude oil imports, which have already been depressed over the past 12 months (Chart 4, bottom panel). In the rest of EM (excluding China), high oil prices in their local currency terms are leading to demand destruction. Chart 5 illustrates that oil and food prices in local currency terms are still very elevated for EM. When various commodity prices – ranging from industrial and precious metals, to soft commodities, and oil – all drop simultaneously and precipitously, it suggests that supply is not what is dominating the price action (Chart 6). Their supply is idiosyncratic, so the concurrent fall in their prices cannot be explained by their production. Chart 5Oil And Food Prices In EM Currencies Oil And Food Prices In EM Currencies Oil And Food Prices In EM Currencies Chart 6The Simultaneous Drop In Various Commodity Prices Cannot Be Explained By Supply The Simultaneous Drop In Various Commodity Prices Cannot Be Explained By Supply The Simultaneous Drop In Various Commodity Prices Cannot Be Explained By Supply   Our interpretation for the synchronized decline in various commodity prices is as follows: the sanctions imposed on Russia initially led buyers to increase their precautionary and speculative purchases of various commodities, which was a tailwind for prices. However, these precautionary and speculative purchases have since been halted or reversed, causing commodity prices to plunge. From the perspective of business and financial cycles, oil prices are a lagging variable. Their turning points often occur after the peaks or bottoms in global cyclical stock prices (Chart 7). Chart 7Oil Prices Often Lag Global Cyclical Stocks Oil Prices Often Lag Global Cyclical Stocks Oil Prices Often Lag Global Cyclical Stocks In contrast with the downbeat investor sentiment on risk assets, investor sentiment on oil prices remains very elevated (Chart 8). In terms of market technicals, the outlook for oil prices and energy stocks is troublesome. Crude prices have lately formed a double top (see Chart 6 above). From a long-term perspective, oil prices and global energy share prices in SDR1 terms might have formed a triple top (Chart 9). Chances are that the recent top in crude prices and energy stocks is a major one and a protracted selloff is in the cards. Chart 8Investors Are Still Bullish On Oil Investors Are Still Bullish On Oil Investors Are Still Bullish On Oil Chart 9A Triple Top In Oil Prices And Global Energy Stocks A Triple Top In Oil Prices And Global Energy Stocks A Triple Top In Oil Prices And Global Energy Stocks   Bottom Line: Fears that sanctions on Russia would considerably reduce global oil supply have not yet materialized. Meanwhile, global oil demand is downshifting in response to both high fuel prices and weakening global growth. In addition, the US is leveraging its geopolitical power to push Gulf countries to boost oil production. These forces all constitute a bearish cocktail for oil prices. That said, a flare-up in geopolitical tensions in the Middle East around Iran is a potential risk to our view on oil, as it would push crude prices up again. …Surging Wages Will Keep US Core Inflation Elevated Chart 10Investors Should Mind Surging US Wages Investors Should Mind Surging US Wages Investors Should Mind Surging US Wages A drop in oil prices has brought some relief to US financial markets as US inflation expectations have dropped materially. Yet, we do not think the drop in oil or food prices – and hence in US headline inflation – will lead to a less hawkish stance from the Fed. The basis for this belief is that US inflationary pressures are genuine and have been broadening. In fact, as we have argued since late last year, the US has entered a wage-price spiral. Recent wage data from the Atlanta Fed validates this thesis – US wage growth has surged to around 7% (Chart 10). To be technically correct, unit labor costs, not wages, are key to inflation dynamics (Chart 11). Unit labor cost = (wage per hour) / (productivity). Productivity is output per hour. Chart 11Unit Labor Costs, Not Oil, Drive US Core Inflation Unit Labor Costs, Not Oil, Drive US Core Inflation Unit Labor Costs, Not Oil, Drive US Core Inflation Given that labor, not oil, is the largest cost component of US businesses, unit labor costs swell and profit margins shrink when salaries rise faster than productivity. CEOs and business owners always do their best to protect their profit margins. Thus, accelerating unit labor costs will lead them to raise their selling prices. A wage-price spiral will be unleashed if consumers accept these higher prices and go on to demand even higher wages. Chart 12US Core Inflation Is Broadening And Is Well Above The Fed's Target US Core Inflation Is Broadening And Is Well Above The Fed's Target US Core Inflation Is Broadening And Is Well Above The Fed's Target This is why wage costs, and more specifically unit labor costs, are the most important variable to monitor for the inflation outlook. If consumers facing high energy and food prices are able to successfully negotiate greater wage gains that surpass their productivity growth, then inflation will become more broad-based and genuine. This is what is presently occurring in the US, and a decline in oil prices will not halt this dynamic for now. Only higher US unemployment will lead to a meaningful deceleration in wage growth. Consistent with broadening US inflation, trimmed-mean and median CPIs have accelerated and reached 6-7%, even though core CPI has recently moderated (Chart 12). After having mismanaged inflation in the past 18 months, the Fed will err on the side of tighter policy. The rationale is that the US is already facing surging wages and a very tight labor market. Financial markets are currently underrating this risk. In fact, in its official statement the Fed has asserted that its commitment to bring inflation to its 2% target is unconditional. As we have written extensively, wages and inflation are lagging business cycle variables. Despite the ongoing slowdown in the US economy, it will take many months before the underlying core inflation rate drops below 3.5%. Bottom Line: We maintain that the Fed and the stock market remain on a collision course. In the US, surging wages and easing financial conditions would make the Fed even more committed to tightening policy substantially. The basis for this perspective is that, even if core inflation falls in the coming months, it will still be well above the Fed’s target of 2%. EM/China Growth Outlook Chart 13Global Trade Will Shrink In H2 2022 Global Trade Will Shrink In H2 2022 Global Trade Will Shrink In H2 2022 EM currencies will continue depreciating versus the US dollar as the Fed reinforces its hawkish stance and global growth/EM exports contract. Indicators from Korea and Taiwan that lead global trade suggest that global export volumes are heading into contraction (Chart 13). While lower oil prices are marginally positive for EM energy importers, share prices and currencies of these countries are often driven by their exports. The latter are set to shrink. EM ex-China domestic demand will decelerate because of (1) drastic monetary tightening by their central banks, (2) reduced household purchasing power due to the substantial rise in food and energy prices in their local currency earlier this year (see Chart 5 above), and (3) the unwinding of pandemic fiscal stimulus. Currency depreciation and slumping global and domestic growth will weigh on both EM share prices and credit markets. Chart 14 illustrates that EM sovereign bond yields have continued rising (shown inverted on the chart), which is consistent with lower EM non-TMT equity prices. Chart 14Rising EM USD Bond Yields (Shown Inverted) Point To Lower Share Prices Rising EM USD Bond Yields (Shown Inverted) Point To Lower Share Prices Rising EM USD Bond Yields (Shown Inverted) Point To Lower Share Prices With respect to China, we discussed the country’s new infrastructure stimulus in depth in last week’s report. Our assessment is that this new infrastructure funding will not result in new investments. Rather, it will largely offset the drop in local government (LG) revenues from land sales this year. As for the latest events regarding mortgage boycotts and authorities’ decision to introduce a moratorium on mortgages linked to delayed housing completions, the damage to homebuyers’ confidence has already been done. Given the ongoing turmoil in China’s property market, potential homebuyers will drag their feet. As a result, home sales will be underwhelming, real estate developers will struggle, and construction activity will contract. The top panel of Chart 15 illustrates that home sales have relapsed anew in the first two weeks of July after stabilizing in June. This implies that June’s bounce was a one-off move driven by pent-up demand after lockdowns were eased. Moreover, house prices are deflating (Chart 15, bottom panel). Consistently, Chinese property stocks and offshore corporate bond prices continue to plunge (Chart 16). Chart 15Chinese Housing: Sales And Prices Are Falling Chinese Housing: Sales And Prices Are Falling Chinese Housing: Sales And Prices Are Falling Chart 16Chinese Property Developers: Stock And Bond Prices Continue Plunging Chinese Property Developers: Stock And Bond Prices Continue Plunging Chinese Property Developers: Stock And Bond Prices Continue Plunging All of the above corroborates our thesis that housing construction in China will continue to contract, weighing on raw material demand and prices and, thereby, EM exports. Finally, rolling lockdowns in China will persist as long as the mainland’s stringent dynamic zero-COVID policy remains in place. The number of cities under mobility restrictions or some form of lockdown climbed during the second week of July. Putting it all together, China’s private sector sentiment remains in the doldrums. The willingness to spend or invest among households and enterprises will remain depressed. This will ensure that the multiplier effect of the fiscal and credit stimulus will be small. Bottom Line: Not only will EM/China exports contract but their domestic demand will also struggle. These dynamics, in combination with a hawkish Fed, are bearish for EM currencies, credit markets and equities. Investment Conclusions Chart 17EM Domestic Bonds: Do Not A Catch Falling Knife EM Domestic Bonds: Do Not A Catch Falling Knife EM Domestic Bonds: Do Not A Catch Falling Knife Global risk assets are oversold, and investor sentiment is pessimistic. In this context, a technical equity rebound cannot be ruled out. However, we do not think it will be the beginning of a major cyclical rally. As the US dollar continues to overshoot, EM will underperform DM equities, and EM credit markets will underperform US credit markets on a quality-adjusted basis. An underweight position in EM in global equity and credit portfolios is warranted. With respect to EM local currency bonds, we remain on the sidelines as near-term risks are still elevated (Chart 17). For now, we prefer to bet on yield curve flattening. Our favorite markets for flatteners are currently Mexico and Colombia. We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP, and IDR. In addition, we recommend shorting HUF vs. CZK, and KRW vs. JPY. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     Special Drawing Rights are the IMF’s synthetic currency – we use it as a proxy for the global average currency.   Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Executive Summary China's Unemployment Questions From The Road Questions From The Road Over the past week we have been visiting clients along the US west coast. In this report we hit some of the highlights from the most important and frequently asked questions. Xi Jinping is seizing absolute power just as the country’s decades-long property boom turns to bust. He will stimulate the economy but Chinese stimulus is less effective than it used to be. The US and Israel are underscoring their red line against Iranian nuclear weaponization. If Iran does not freeze its nuclear program, the Middle East will begin to unravel again. The UK’s domestic instability is returning, with Scotland threatening to leave the union. Brexit, the pandemic, and inflation make a Scottish referendum a more serious risk than in the past. Shinzo Abe’s assassination makes him a martyr for a vision of Japan as a “normal country” – i.e. one that is not pacifist but capable of defending itself. Japan’s rearmament, like Germany’s, points to the decline of the WWII peace settlement and the return of great power competition. Bottom Line: Investors need a new global balance to be achieved through US diplomacy with Russia, China, and Iran. That is not forthcoming, as the chief nations face instability at home and a stagflationary global economy. Feature The world is becoming less stable as stagflation combines with great power competition. Global uncertainty is through the roof. From a macroeconomic perspective, investors need to know whether central banks can whip inflation without triggering a recession. From a geopolitical perspective, investors need to know whether Russia’s conflict with the West will expand, whether US-China and US-Iran tensions will escalate in a damaging way, and whether domestic political rotations in the US and China this fall will lead to more stable and productive economies. China: What Will Happen At The Communist Party Reshuffle? General Secretary Xi Jinping will cement another five-to-10 years in power while promoting members of his faction into key positions on the Politburo and Politburo Standing Committee. By December Xi will roll out a pro-growth strategy for 2023 and the government will signal that it will start relaxing Covid-19 restrictions. But China’s structural problems ensure that this good news for global growth will only have a fleeting effect. China’s governance is shifting from single-party rule to single-person rule. It is also shifting from commercially focused decentralization to national security focused centralization. Xi has concentrated power in himself, in the party, and in Beijing at the expense of political opponents, the private economy, and outlying regions like Hong Kong, the South China Sea, and Xinjiang. The subordination of Taiwan is the next major project, ensuring that China will ally with Russia and that the US and China cannot repair or deepen their economic partnership. Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Xi and the Communist Party began centralizing political power and economic control shortly after the Great Recession. At that time it became clear that a painful transition away from export manufacturing and close relations with the United States was necessary. The transition would jeopardize China’s long-term economic, social, political, and geopolitical stability. The Communist Party believed it needed to revive strongman leadership (autocracy) rather than pursuing greater liberalization that would ultimately increase the odds of political revolution (democratization). The Xi administration has struggled to manage the country’s vast debt bubble, given that total debt standing has surged to 287% of GDP. The global pandemic forced the government to launch another large stimulus package, which it then attempted to contain. Corporate and household deleveraging ensued. The property and infrastructure boom of the past three decades has stalled, as the regime has imposed liquidity and capital requirements on banks and property developers to try to avoid a financial crisis. Regulatory tightening occurred in other sectors to try to steer investment into government-approved sectors and reduce the odds of technological advancement fanning social dissent. China’s draconian “zero Covid” policy sought to limit the disease’s toll, improve China’s economic self-reliance, and eliminate the threat of social protest during the year of the twentieth party congress. But it also slammed the brakes on growth. China is highly vulnerable to social instability for both structural and cyclical reasons. Chinese social unrest was our number one “Black Swan” for this year and it is now starting to take shape in the form of angry mortgage owners across the country refusing to make mortgage payments on houses that were pre-purchased but not yet built and delivered (Chart 1). Chart 1China: Mortgage Payment Boycott Questions From The Road Questions From The Road The mortgage payment boycott is important because it is stemming from the outstanding economic and financial imbalance – the property sector – and because it is a form of cross-regional social organization, which the Communist Party will disapprove. There are other social protests emerging, including low-level bank runs, which must be monitored very closely. Local authorities will act quickly to stop the spread of the mortgage boycott. But unhappy homeowners will be a persistent problem due to the decline of the property sector and industry. China’s property sector looks uncomfortably like the American property sector ahead of the 2006-08 bust. Prices for existing homes are falling while new house prices are on the verge of falling (Chart 2). While mortgages only make up 15% of bank assets, and household debt is only 62% of GDP, households are no longer taking on new debt (Chart 3). Chart 2China's Falling Property Prices China's Falling Property Prices China's Falling Property Prices ​​​​​​ Chart 3China's Property Crisis China's Property Crisis China's Property Crisis ​​​​​​ Chart 4China's Unemployment China's Unemployment China's Unemployment Most likely China’s property sector is entering the bust phase that we have long expected – if not, then the reason will be a rapid and aggressive move by authorities to expand monetary and fiscal stimulus and loosen economic restrictions. That process of broad-based easing – “letting 100 flowers bloom” – will not fully get under way until after the party congress, say in December. Unemployment is rising across China as the economy slows, another point of comparison with the United States ahead of the 2008 property collapse (Chart 4). Unemployment is a manipulated statistic so real conditions are likely worse. There is no more important indicator. China’s government will be forced to ease policy, creating a positive impact on global growth in 2023, but the impact will be fleeting. Bottom Line: The underlying debt-deflationary context will prevail before long in China, weighing on global growth and inflation expectations on a cyclical basis. Middle East: Why Did Biden Go And What Will He Get? President Biden traveled to Israel and now Saudi Arabia because he wants Saudi Arabia and the Gulf Arab members of OPEC to increase oil production to reduce gasoline prices at the pump for Americans ahead of the midterm elections (Chart 5). Chart 5Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia True, fears of recession are already weighing on prices, but Biden embarked on this mission before the growth slowdown was fully appreciated and he is not going to lightly abandon the anti-inflation fight before the midterm election. Biden also went because one of his top foreign policy priorities – the renegotiation of the 2015 nuclear deal with Iran – is falling apart. The Iranians do not want to freeze their nuclear program because they want regime survival and security. While Biden is offering a return to the 2015 deal, the conditions that produced the deal are no longer applicable: Russia and China are not cooperating with the US and EU to isolate Iran. Russia is courting Iran, oil prices are high and sanction enforcement is weak (unlike 2015). The Iranians now know, after the Trump administration, that they cannot trust the Americans to give credible security guarantees that will last across parties and administrations. The war in Ukraine also underscores the weakness of diplomatic security guarantees as opposed to a nuclear deterrent. Hence the joint US and Israeli declaration that Iran will never be allowed to obtain nuclear weapons. The good news is that this kind of joint statement is precisely what needed to occur – the underscoring of the red line – to try to change Ayatollah Ali Khamenei’s calculus regarding his drive to achieve nuclear breakout. In 2015 Khamenei gave diplomacy a chance to try to improve the economy, stave off social unrest, prepare the way for his eventual leadership succession process, and secure the Islamic Republic. The bad news is that Khamenei probably cannot make the same decision this time, as the hawkish faction now runs his government, the Americans are unreliable, and Russia and China are offering an alternative strategic orientation. The Saudis will pump more oil if necessary to save the global business cycle but not at the beck and call of a US president. The drop in oil prices reduces their urgency. The Americans can reassure the Saudis and Israel as long as the deal with Iran is not going forward. That looks to be the case. But then the US and Israel will have to undertake joint actions to underline their threat to Iran – and Iran will have to threaten to stage attacks across the region so as to deter any attack. Bottom Line: If a US-Iran deal does not materialize at the last minute, Middle Eastern instability will revive and a new source of oil supply constraint will plague the global economy. We continue to believe a US-Iran deal is unlikely, with only 40% odds of happening. Europe: Will Russia Turn Back On The Natural Gas? Russia’s objective in cutting off European natural gas is to inflict a recession on Europe. It wants a better bargaining position on strategic matters. Therefore we assume Russia will continue to squeeze supplies from now through the winter, when European demand rises and Russian leverage will peak. If Russia allows some flow to return, then it will be part of the negotiating process and will not preclude another cutoff before winter. It is possible that Russia is merely giving Europe a warning and will revert back to supplying natural gas. The problem is that Russia’s purpose is to achieve a strategic victory in Ukraine and in negotiations over NATO’s role in the Nordic countries. Russia has not achieved these goals, so natural gas cutoff will likely continue. Russia also hopes that by utilizing its energy leverage – while it still has it – it will bring forward the economic pain of Europe’s transition away from reliance on Russian energy. In that case European countries will experience recession and households will begin to change their view of the situation. European governments will be more likely to change their policies, to become more pragmatic and less confrontational toward Russia. Or European governments will be voted out of power and do the same thing. Other states could join Hungary in saying that Europe should never impose a full natural gas embargo on Russia. Russia would be able to salvage some of its energy trade with Europe over the long run, despite the war in Ukraine and the inevitable European energy diversification. In recent months we highlighted Italy as the weakest link in the European chain and the country most likely to see such a shift in policy occur. Italy’s national unity coalition had lost its reason for being, while the combination of rising bond yields and natural gas prices weighed on the economy. The Italian bond spread over German bunds has long served as our indicator of European political stress – and it is spiking now, forcing the European Central Bank to rush to plan an anti-fragmentation strategy that would theoretically enable it to tighten monetary policy while preventing an Italian debt crisis (Chart 6). The European Union remains unlikely to break up – Russian aggression was always one of our chief arguments for why the EU would stick together. But Italy will undergo a recession and an election (due by June 2023 but that could easily happen this fall), likely producing a new government that is more pragmatic with regard to Russia so as to reduce the energy strain. Chart 6Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy’s political turmoil shows that European states are feeling the energy crisis and will begin to shift policies to reduce the burden on households. Households will lose their appetite for conflict with Russia on behalf of Ukrainians, especially if Russia begins offering a ceasefire after completing its conquest of the Donetsk area. If Russia expands its invasion, then Europe will expand sanctions and the risk of further strategic instability will go up. But most likely Russia will seek to quit while it is ahead and twist Europe’s arm into foisting a ceasefire onto Ukraine. Bottom Line: A change of government in Italy will increase the odds that the EU will engage in diplomacy with Russia in the coming year, if Russia offers, so as to reach a new understanding, restore natural gas flows, and salvage the economy. This would leave NATO enlargement unresolved but a shift in favor of a ceasefire in Ukraine in 2023 would be less negative for European assets and the euro. UK: Who Will Replace Boris Johnson? Last week UK Prime Minister Boris Johnson fell from power and now the Conservative Party is engaging in a leadership competition to replace him. We gave up on Johnson after he survived his no-confidence vote and yet it became clear that he could not recover in popular opinion. The inflation outburst destroyed his premiership and wiped away whatever support he had gained from executing Brexit. In fact it reinforced the faction that believed Brexit was the wrong decision. Going forward the UK will be consumed with domestic political turmoil as the cost of stagflation mounts, and geopolitical turmoil as Scotland attempts to hold a second independence referendum, possibly by October 2023. Global investors should focus primarily on Scotland’s attempt to secede, since the breakup of the United Kingdom would be a momentous historical event and a huge negative shock for pound sterling. While only 44.7% of Scots voted for independence in 2014, now they have witnessed Brexit, Covid-19, and stagflation, producing tailwinds for the Scots nationalist vote (Chart 7). Chart 7Forget Bojo's Exit, Watch Scotland Questions From The Road Questions From The Road There are still major limitations on Scotland exiting, since its national capabilities are limited, it would need to join the European Union, and Spain and possibly others will threaten to veto its membership in the European Union for fear of feeding their own secessionist movements. But any new referendum – including one done without the approval of Westminster – should be taken very seriously by investors. Bottom Line: Johnson’s removal will only marginally improve the Tories’ ability to manage the rebellion brewing in the north. A snap election that brings the Labour Party back into power would have a greater chance of keeping Scotland in the union, although it is not clear that such a snap election will happen in time to affect any Scottish decision. The UK faces economic and political turmoil between now and any referendum and investors should steer clear of the pound. (Though we still favor GBP over eastern European currencies). Britain will remain aggressive toward Russia but its ability to affect the Russian dynamic will fall, leaving the US and EU to decide the fate of Russian relations. Japan: What Is The Significance Of Shinzo Abe’s Assassination? Former Japanese Prime Minister Shinzo Abe was assassinated by a lone fanatic with a handmade gun. The significance of the incident is that Abe will become a martyr for a certain vision of Japan – his vision of Japan, which is that Japan can become a “normal country” that moves beyond the shackles of the guilt of its imperial aggression in World War II. A normal country is one that is economically stable and militarily capable of defending itself – not a pacifist country mired in debt-deflation. Abe stood for domestic reflation and a proactive foreign policy, along with the normalization of the Japanese Self-Defense Forces (JSDF). True, economic policy can become less dovish if necessary to deal with inflation. Some changes at the Bank of Japan may usher in a less dovish shift in monetary policy in particular. But monetary policy cannot become outright hawkish like it was before Abe. And Abe’s fiscal policy was never as loose as it was made out to be, given that he executed several hikes to the consumption tax. Japan’s structural demographic decline and large debt burden will continue to weigh on economic activity whenever real rates and the yen rise. The government will be forced to reflate using monetary and fiscal policy whenever deflation threatens to return. Debt monetization will remain an option for future Japanese governments, even if it is restrained during times of high inflation. Chart 8Shinzo Abe's Legacy Questions From The Road Questions From The Road ​​​​​​​ This is not only because Japanese households will become depressed if deflation is left unchecked but also because economic growth must be maintained in order to sustain the nation’s new and growing national defense budgets. Japan’s growing need for self defense stems from China’s strategic rise, Russia’s aggression, and North Korea’s nuclearization, plus uncertainty about the future of American foreign policy. These trends will not change anytime soon. Indeed the Liberal Democratic Party’s popularity has increased under Abe’s successor, Prime Minister Fumio Kishida, who will largely sustain Abe’s vision. The Diet still has a supermajority in favor of constitutional revision so as to enshrine the self-defense forces (Chart 8). And the de facto policy of rearmament continues even without formal revision. Bottom Line: Any Japanese leader who attempts to promote a hawkish BoJ, and a dovish JSDF, will fail sooner rather than later. The revolving door of prime ministers will accelerate. As Japan’s longest-serving prime minister, Shinzo Abe opened up the reliable pathway, which is that of a dovish BoJ and a hawkish foreign policy. This is important for the world, as well as Japan, because a more hawkish Japan will increase China’s fears of strategic containment. The frozen conflicts in Asia will continue to thaw, perpetuating the secular rise in geopolitical risk. We remain long JPY-KRW, since the BoJ may adjust in the short term and Chinese stimulus is still compromised, but that trade is on downgrade watch. Investment Takeaways Russia’s energy cutoff is aimed at pushing Europe into recession so as to force policy changes or government changes in Europe that will improve Russia’s position at the negotiating table over Ukraine, NATO, and other strategic disputes. Hence Russia is unlikely to increase the natural gas flow until it believes it has achieved its strategic aims and multiple veto players in the EU will prevent the EU from ever implementing a full-blown natural gas embargo. Chinese stimulus cannot be fully effective until it relaxes Covid-19 restrictions, likely beginning in December or next year when Xi Jinping uses his renewed political capital to try to stabilize the economy. However, China’s government powers alone are insufficient to prevent the debt-deflationary tendency of the property bust. The Middle East faces rising geopolitical tensions that will take markets by surprise with additional energy supply constraints. The implication is continued oil volatility given that global growth is faltering. Once global demand stabilizes, the Middle East’s turmoil will add to existing oil supply constraints to create new price pressures. The odds are not very high of the Federal Reserve achieving a “soft landing” in the context of a global energy shock and a stagflationary Europe and China.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com ​​​​​​​ Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar