Business Cycles

Executive Summary Brazil: Are Political & Macro Risks Priced-In? Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Presidential elections are due in Brazil on October 2, 2022. While the left-of-center former President Lula da Silva will likely win, the road to his victory will not be as smooth as markets expect. Incumbent President Jair Bolsonaro will make every effort to cling to power, including fiscal populism and attacks on Brazil’s institutions. These moves may roil Brazil’s equity markets as they may provide a fillip to Bolsonaro’s popularity. Bolsonaro’s institutional attacks have triggered down moves in the market before and any fiscal expansion may worry investors as it could prove to be sticky. We urge investors to take-on only selective tactical exposure in Brazil. Equities appear cheap but political and macro risks abound. To play the rally yet stave-off political risk in Brazil, we suggest a tactical pair trade: Long Brazil Financials / Short India. Tactical Recommendation Inception Date Long Brazil Financials / Short India 2022-02-10   Bottom Line: On a tactical timeframe we suggest only selective exposure to Brazil given the latent political and macro risks. On a strategic timeframe, we are neutral on Brazil given that its growth potential coexists with high debt and low proclivity to structural reform. Feature Chart 1Brazil Underperformed Through 2020-21, Is Cheap Today Brazil Underperformed Through 2020-21, Is Cheap Today Brazil Underperformed Through 2020-21, Is Cheap Today Brazil’s equity markets underperformed relative to emerging markets (EMs) for a second consecutive year in 2021 (Chart 1). But thanks to this correction, Brazilian equities now appear cheap (Chart 1). With Brazil looking cheap, China easing policy, and Lula’s return likely, is now a good time to buy into Brazil? We recommend taking on only selective exposure to Brazil on a tactical horizon for now. Brazil in our view may present a near-term value trap as markets are under-pricing political and economic risks. Lula Set For Phoenix-Like Return Luiz Inácio Lula da Silva (or popularly Lula) of the Worker’s Party (PT) appears all set to reclaim the country’s presidency in the fall of 2022. The main risk that Lula’s presidency may bring is a degree of fiscal expansion. Despite this markets may ultimately welcome his victory at the presidential elections as Lula is in alignment with the median voter, is expected to be better for Brazil’s institutions, will institute a superior pandemic-control strategy, and may also undertake badly needed structural reforms in the early part of his tenure. Despite these points we urge investors to limit exposure to Brazil for now and turn bullish only once the market corrects further. Whilst far-right President Jair Bolsonaro managed to join a political party (i.e., the center-right Liberal Party) late last year, he is yet to secure something more central to winning elections i.e., a high degree of popularity. To boost his low popularity ratings (Chart 2), we expect Bolsonaro to leverage two planks: populism and authoritarianism. These measures will bump up Bolsonaro’s popularity enough to shake up Brazil’s markets with renewed uncertainty, but not enough to win him the presidency. Chart 2Lula Is Ahead But His Lead Has Narrowed Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Lula is a clear favorite to win. After spending more than a year in jail on corruption charges, Lula is back in the fray and has maintained a lead on Bolsonaro for the first round of polling (Chart 2). Even if a second-round run-off election were to take place, Lula would prevail over Bolsonaro or other key candidates (Chart 3). By contrast, Bolsonaro’s lower popularity means that in a run-off situation he stands a chance only if pitted against center-right candidates like Sergio Moro (his former justice minister) or João Doria (i.e., the center-right Governor of São Paulo) (Chart 4). Chart 3Lula Leads Run-Off Vote Against All Potential Candidates Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 4In A Run-Off, Bolso Stands Best Chance Of Winning If Pitted Against Moro Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ What has driven the swing to the left in Brazil? After the pandemic and some stagflation, Brazil’s median voter’s priorities have changed. In specific: Brazil’s median voter’s top concerns in 2018 were centered around improving law and order (Chart 5). A right-of-center candidate with concrete law-and-order credentials like Bolsonaro was well placed to tap into this public demand. Chart 5In 2018-19, Law And Order Issues Dominated Voters’ Concerns Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Now, however, Brazil’s voters’ top concerns are focused around improving the economy and controlling the pandemic, where Bolsonaro’s record is dismal (Chart 6). Given this change of priorities, a left-of-center candidate with a solid economic record like Lula is best placed to address voters’ concerns. Lula had the fortune to preside over a global commodity bull market and Brazilian economic boom in the early 2000s (Chart 7). Regarding pandemic control, almost any challenger would be better positioned than Bolsonaro, who initially dismissed Covid-19 as “a little flu” and lacked the will or ability to set up a stable public health policy. Chart 6In 2022, Median Voter Cares Most About Economic Issues, Pandemic-Control Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 7Lula’s Presidency Overlapped With An Economic Boom Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ A left-of-center candidate like Lula, or even Ciro Gomes (Chart 8), is more in step with the median voter today for two key reasons: Inflation Surge, Few Jobs: Inflation has surged, and the increase is higher than that seen under the previous President Michael Temer (Chart 7). Transportation, food, and housing costs have all taken a toll on voter’s pocketbooks (Chart 9). The cost of electricity has also shot up. For 46% of Brazilian families, expenditure on power and natural gas is eating into more than half of their monthly income, according to Ipec. Chart 8Left-Of-Center Candidates Stand A Better Chance In Brazil In 2022 Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 9Under Bolso Inflation Has Surged Across Key Categories Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​ Distinct from inflation, unemployment too has been high under Bolsonaro (Chart 10). Chart 10Unemployment Too Has Surged Under Bolsonaro Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 11Brazil’s Per Capita Income Growth Has Lagged That Of Peers Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 12Since 2018, Brazil's Economic Miseries Have Grown More Than Those Of Peers Since 2018, Brazil's Economic Miseries Have Grown More Than Those Of Peers Since 2018, Brazil's Economic Miseries Have Grown More Than Those Of Peers Stagnant Incomes: Despite a strong post-pandemic fiscal stimulus, GDP growth in Brazil has been low (Chart 7). In a country that is structurally plagued with high inequalities, the slow growth in Brazil’s per capita income (Chart 11) under a right-wing administration is bound to trigger a leftward shift. It is against this backdrop of rising economic miseries (Chart 12) that Latin America’s largest economy is seeing its ideological pendulum swing leftwards. This phenomenon has played out before too - most notably when Lula first assumed power as the president of Brazil in 2002. Brazil’s GDP growth was low, inflation was high and per capita incomes had almost halved under the presidency of Fernando Henrique Cardoso (or popularly FHC) over 1995-2002. This economic backdrop played a key role in Lula’s landslide win in 2002. Brazil’s political differences are rooted in regional as well as socioeconomic disparities. In the 2018 presidential elections, left-of-center candidates like Fernando Haddad generated greatest traction in the economically backward northeastern region of Brazil. On the other hand, Bolsonaro enjoyed higher traction in the relatively well-off regions in southern and northern Brazil (Maps 1 & 2). Now Bolsonaro has faltered under the pandemic and Lula can reunite the dissatisfied parts of the electorate with his northeastern base. Map 1Brazil’s South, Mid-West And North Supported Bolso In 2018 Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Map 2Left-Of-Center 2018 Presidential Candidate Haddad Had Greatest Traction In Regions With Low Incomes Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Bottom Line: The stage appears set for Lula’s return to Brazil’s presidency. But will the road be smooth? We think not. Investors should gird for downside risks that Brazilian markets must contend with as President Bolsonaro fights back. Brace For Bolso’s Fightback The road to Bolsonaro’s likely loss will be paved with market volatility and potentially a correction. Interest rates have surged in Brazil as its central bank combats inflation (Chart 13). Even as BCB’s actions will lend some stability to the Brazilian Real (Chart 13), political events over the course of 2022 will spook foreign investors. Bolsonaro will leverage two planks in a desperate attempt to retain control: Plank #1: Populism Brazil’s financial markets experienced a major correction in the second half of 2021. This was partially driven by the fact that Brazilian legislators approved a rule that allows the government to breach its federal spending cap. Given Bolsonaro’s low popularity ratings today and given that his fiscal stance has been restrained off late, Bolsonaro could well drive another bout of fiscal expansion in the run up to October 2022. Such a move will bump up his popularity but at the same time worry markets given Brazil’s elevated debt levels (Chart 14). Bolsonaro can technically pass these changes in the Brazilian national assembly given that in both houses the government along with the confidence and supply parties has more than 50% of seats. Chart 13Brazil’s Central Bank Has Hiked Rates Aggressively Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 14Brazil Is One Of The Most Indebted Emerging Markets Today Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Plank #2: Institutional Attacks To rally his supporters, the former army captain could also sow seeds of doubt in Brazil’s judiciary and electoral process. Given the strong support that Bolsonaro enjoys amongst conservatives, he may even mobilize supporters to stage acts of political violence in the run up to the elections. Bolsonaro could make more dramatic attempts to stay in power than former US President Trump, whose rebellion on Capitol Hill did not go as far as it could have gone to attempt to seize power for the outgoing president. Last but not the least, there is a possibility that the Brazilian judiciary presents an unexpected roadblock to Lula’s candidacy. Given the unpredictable path of Brazil’s judicial decisions, investors should be prepared for at least some kind of official impediments to Lula’s rise. Even if Lula is ultimately allowed to run, any ruling that casts doubt on his candidacy or corruption-related track record will upset financial markets. Global financial markets rallied through the Trump rebellion on January 6 last year. But US institutions, however flawed, are more stable than Brazil’s. Brazil only emerged from military dictatorship in 1985. Bolsonaro has fired up elements of the populace that are nostalgic for that period, as we discuss below. Bottom Line: Brazil’s equities look cheap today, but political risks have not fully run their course. President Bolsonaro may launch his fightback soon, which could drive another down-leg in Brazil’s markets. His institutional attacks have triggered down moves before and any potential fiscal expansion that Bolsonaro pursues may worry investors, as this expansion could stick under the subsequent administration. In addition, there is a chance that civil-military relations undergo high strain in the run-up to or immediately after Brazil’s elections. Is A Self-Coup By Bolso Possible? “One uncomfortable fact of the dictatorship is that its most brutal period of repression overlapped with what Milton Friedman called an economic miracle.… Brazil’s economy, nineteenth largest in the world before the coup, grew into the eighth largest. Jobs abounded and the regime then was actually popular.” – Alex Cuadros, Brazillionaires: Wealth, Power, Decadence, and Hope in an American Country (Spiegel & Grau, 2016) It is extremely difficult for President Bolsonaro to win the support of a majority of the electorate. But given his open admiration for Brazil’s dictatorship, is a self-coup possible in 2022? The next nine months will be tumultuous. A coup attempt could occur. However, we allocate a low probability to a successful self-coup because: Bolsonaro’s Popularity Is Too Low: Even dictators need to have some popular appeal. Bolsonaro has lost too much support (Chart 15), he never had full control of any major institutions (including the military), and few institutional players will risk their credibility for his sake. If he somehow clung to power, his subsequent administration would face overwhelming popular resistance. Chart 15Bolsonaro’s Low Approval Ratings - A Liability Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Bolsonaro’s Economy Is Too Weak: The dictatorship in Brazil managed to hold power for more than two decades partially because this period of authoritarianism was accompanied by a degree of economic well-being. Currently the public is shifting to the left because low growth and high inflation have dented the median voter’s purchasing power. The weak economy would make an authoritarian government unsustainable from the start. Lack Of American Support: Some military personnel may be supportive of a coup and several retired military officers are occupying civilian positions in the Brazilian federal government, thanks to Bolsonaro. So why can’t Brazil slip right back into a military dictatorship led by Bolsonaro, say if the election results are narrow and hotly contested? The coup d'état in Brazil in 1964 was a success to a large extent because this regime-change was supported by America. Back then communism was a threat to the US and Washington was keen to displace left-leaning heads of states in Latin America, such as Brazilian President João Goulart. But America’s strategic concerns have now changed. America today is attempting to coalesce an axis of democracies and the Biden administration has no incentive whatsoever to muddy its credentials by supporting dictatorship in Latin America’s largest country. Even aside from ideology, any such action would encourage fearful governments in the region to seek support from America’s foreign rivals, thus inviting the kind of foreign intervention that the US most wants to prevent in Latin America. The Brazilian Military Has Not Been Suppressed Or Sidelined: History suggests that coups are often triggered by a drop in the military’s importance in a country. However, the military’s power in Brazil has remained meaningful through the twenty-first century. Brazil has maintained steady military spends at around 1.5% of GDP over the last two decades. Thus, top leaders of Brazil’s military have no reason to feel aggrieved or disempowered. Having said that, it is not impossible that an extreme faction of junior officers might try to pull off a fantastical plot, even if they have little hope of succeeding, which is why we highlight that markets can be rudely awakened by the road to Brazil’s election this year. In Turkey in July 2016, an unsuccessful coup attempt caused Turkish equities to decline by 9% over a four-day period. Bottom Line: Investors must gird for the very real possibility of civil-military relations undergoing high degrees of strain in Brazil, particularly if a contested election occurs. While Bolsonaro’s supporters and disaffected elements of the Brazilian military could resist a smooth transition of power away from Bolsonaro, the transition will eventually take place because two powerful constituencies – Brazil’s median voter and America – will not support a coup in Brazil. Will Lula Be Good For Brazil’s Markets? Looking over Bolsonaro’s presidency, from a market-perspective, some policy measures were good, some were bad, and some were downright ugly. In specific: The Good: Pension Reforms And Independent Monetary Policy In Bolsonaro’s first year in power, he delivered pension sector reforms. The law increased the minimum retirement age and also increased workers’ pension contributions thereby resulting in meaningful fiscal savings. Bolsonaro passed a law to formalise the BCB’s autonomy and the BCB has been able to pursue a relatively independent monetary policy. BCB has now lifted the benchmark Selic rate by 725bps over 2021 thereby making it one of the most hawkish central banks amongst EMs (Chart 13). This is in sharp contrast to the situation in EMs like Turkey where the central bank cut rates owing to the influence of a populist head of state. The Bad: Poor Free Market Credentials And Fiscal Expansion In early 2021, President Bolsonaro fired the head of Petrobras (the state-owned energy champion) reportedly for raising fuel prices. Bolsonaro then picked a former army general (with no relevant work experience) to head the company. Although Bolsonaro positioned himself as a supporter of privatization in the run up to his presidency, he failed to follow through. Another area where the far-right leader has disappointed markets is with respect to Brazil’s debt levels. Under his presidency, a constitutional amendment to raise a key government spending cap was passed. Shortly afterwards came the creation of the massive welfare program Auxílio Brasil. Bolsonaro embraced fiscal populism to try to save his presidency after the pandemic. Consequently Brazil’s public debt to GDP ratio ballooned from 86% in 2018 to a peak of 99% in 2020. The Ugly: Poor Pandemic Response And Institutional Attacks The darkest hour of Bolsonaro’s presidency came on September 7, 2021, i.e., Brazil’s Independence Day. During rallies with his supporters, Bolsonaro levelled attacks on the Brazilian judiciary and sowed seeds of doubt in Brazil’s electoral process. More concretely, the greatest failing of the Bolsonaro administration has been its lax response to the pandemic. Bolsonaro delayed preventive measures, and this has meant that Brazil was one of the worst hit major economies of the world. The pandemic has claimed more than 630,000 lives in Brazil i.e., the second highest in the world. In relative terms too, Brazil has experienced a high death rate of about 2,960 per million which is even higher than the US rate of 2,720 per million. President Bolsonaro’s poor handling of the pandemic will cost the President in terms of votes in 2022 as the highest Covid-19-related death rates were seen in Southern Brazil (Map 3) i.e., a region that had voted in large numbers for Bolsonaro in 2018 (see Map 1 above). Map 3The Pandemic Has Had A Devastating Impact In Brazil’s South, Mid-West And North Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Given this backdrop, a Lula presidency will be welcomed by global financial markets, potentially for three reasons: Superior Pandemic-Control: An administration headed by Lula will bring in a more scientific and cohesive pandemic-control strategy thereby saving lives and benefiting the economy. Alignment With Institutions: Lula will act in alignment with Brazil’s institutions. He stands to benefit from the existing electoral system, the civil bureaucracy, academia, and the media. He may have rougher relations with the judiciary and parts of the military, but he is a known quantity and not likely to attempt to be a Hugo Chavez. Possibility Of Some Structural Reform: Given Brazil’s unstable debt dynamics, and the “lost decade” of economic malaise in the 2010s, there is a chance that Lula could pursue some structural reforms. Lula is more popular than his Worker’s Party, which is still tainted by corruption, so his strength in Congress will not be known until after the election. But Brazilian parties tend to coalesce around the president and Lula has experience in managing the legislative process. The probability of Lula pushing through some bit of structural reform will be the greatest in 2021. Back in 2019, it is worth recounting that only 4% of the Brazilian public supported pension reforms. Despite this Bolsonaro managed the passage of painful pension reforms in 2019 because market pressure forced the parties to cooperate. Faced with inflation and low growth, Lula may be forced to push through some piecemeal structural financial sector and economic reforms. However, if commodity prices and financial markets are cheering his election, he may spend his initial political capital on policies closer to his base of support, which means that a market riot may be necessary to force action on structural reforms. This dynamic will have to be monitored in the aftermath of the election. Assuming Lula does pursue some structural reforms while he has the political capital, and therefore that his first year is positive for financial markets, there is a reason to be positive on Brazil selectively on a tactical basis. However, electoral compulsions could cause Lula to pursue left-wing populism, fiscal expansion, and to resist privatization over the remaining three years of his presidency. Given Brazil’s already elevated debt levels (Chart 14), such a policy tilt would be market negative. It is against this backdrop that we expect a pro-Lula market rally to falter after the initial excitement. Bottom Line: Once the power transition is complete, a relief rally may follow as markets factor in the prospects of institutional stability and possibly a dash of structural reform in the first year of Lula’s presidency. But given Brazil’s elevated inequalities, even a pro-Lula rally will eventually fade as the administration will be constrained to switch back to the old ways and pursue an expansionary fiscal policy when elections loom. Investment Conclusions Brazil Presents A Value Trap, Fraught with Politico-Economic Risks From a strategic perspective, we are neutral on Brazil. A decade of bad news has been priced in but there is not yet a clear and sustainable trajectory to improve the country’s productivity. History suggests that both left-wing and right-wing presidents are often forced to backtrack on structural reforms and resort to cash-handouts in the run up to elections. This tends to add to Brazil’s high debt levels, prevents the domestic growth engine from revving up, and adds to inflation. Low growth and high inflation then set the wheels rolling for another bout of fiscal expansion (Chart 16). Chart 16The Vicious Politico-Economic Cycle That Brazil Is Trapped In Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Exceptions to this politico-economic cycle occur when a commodity boom is underway or if China, which is Brazil’s key client state, is booming. China today buys a third of Brazil’s exports (Chart 17) and is Brazil’s largest export market. The other reason we remain circumspect about Brazil’s strategic prospects is because of the secular slowdown underway in China. China is not in a position today to recreate the commodity and trade boom that buoyed Lula during his first presidency. China’s policy easing is a tactical boon at best, which can coincide with a Lula relief rally, but afterwards investors will be left with Chinese deleveraging and Brazilian populism. Political Risks Are High, Selective Tactical Exposure Brazil Will Be Optimal We urge investors to buy into Brazilian assets only selectively, even as Brazilian equities appear cheap (Chart 18). Political risks and economic risks such as low growth in GDP and earnings (Chart 19) could contribute to another correction and/or volatility in Brazilian equities. Chart 17China Buys A Third Of Brazil’s Exports Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​ ​​​​​Chart 18Brazil: Are Political & Macro Risks Priced-In? Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Chart 19Brazil's EPS Growth Tracks China's Total Social Financing Growth With A Lag Brazil's EPS Growth Tracks China's Total Social Financing Growth With A Lag Brazil's EPS Growth Tracks China's Total Social Financing Growth With A Lag China’s policy easing is an important macro factor playing to Brazil’s benefit. As we highlighted in our “China Geopolitical Outlook 2022,” Beijing is focused on ensuring stability over the next 12 months. But history suggests that Brazil’s corporate earnings respond to a pick-up in China’s total social financing with a lag of more than six months (Chart 19). Thus, even from a purely macro perspective it may make sense to turn bullish on Brazil after the election turmoil concludes. Given that politically sensitive sectors account for an unusually high proportion of Brazil’s market capitalization (Chart 18), and given the political risks in the offing for Brazil, we suggest taking-on selective exposure in Brazil. To play the rally yet mitigate political risks (that can be higher for capital-heavy sectors), we suggest a pair trade: Long Brazil Financials / Short India. We remain positive on India on a strategic horizon. However, in view of India approaching the business-end of its five-year election cycle, when policy risks tend to become elevated, we reiterate our tactical sell on India. India currently trades at a 81% premium to MSCI EM on a forward P-E ratio basis versus its two year average of 56%. A Quick Note On The Nascent EM Rally Investors should gradually look more favorably on emerging markets, but tactical caution is warranted. MSCI EM and MSCI World are down YTD 1.1% and 4.6% respectively. Despite the dip, we are not yet turning bullish on EM as a whole, owing to both geopolitical and macroeconomic factors. Global geopolitical risks in the new year are high. We recently upgraded the odds of Russia re-invading Ukraine from 50% to 75%. Besides EM Europe, we also see high and underrated geopolitical risks in the Middle East in the short run. Both the Russia and Iran conflicts raise a non-negligible risk of energy shocks that undermine global growth. Once these hurdles are cleared, we will turn more positive toward risky assets. Macroeconomically, the current EM rally can be sustained only if China delivers a substantial stimulus, and the US dollar continues to weaken. The former is likely, as we have argued, but the dollar looks to be resilient and it will take several months before China’s credit impulse rebounds. Hence conditions for a sustainable EM rally do not yet exist. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The golden rule for investing in the stock market simply states: “Stay bullish on stocks unless you have good reason to think that a recession is imminent.” The catch, of course, is that it is difficult to know whether a recession is lurking around the corner. Still, we can learn a lot from past recessions. As we document in this week’s report, every major downturn was caused by the buildup of imbalances within the economy, which were then laid bare by some sort of catalyst, usually monetary tightening. Today, the US is neither suffering from an overhang of capital spending, as it did in the lead-up to the 2001 recession, nor an overhang of housing, as it did in the lead-up to the Great Recession. US inflation has risen, but unlike in the early 1980s, long-term inflation expectations remain well anchored. This gives the Fed scope to tighten monetary policy in a gradual manner. Outside the US, vulnerabilities are more pronounced, especially in China where the property market is weakening, and debt levels stand at exceptionally high levels. Fortunately, the Chinese government has enough tools to keep the economy afloat, at least for the time being. Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand Bottom Line: Equity bear markets rarely occur outside of recessions. With global growth set to remain above trend at least for the next 12 months, investors should continue to overweight equities. However, they should underweight the tech sector since tech stocks remain disproportionately vulnerable to rising rates, increased regulation, and a retrenchment in pandemic-induced spending on electronics and online services. Macro Matters Investors tend to underestimate the importance of macroeconomics for stock market outcomes. That is a pity. Charts 1, 2, and 3 show that the business cycle drives the evolution of corporate earnings; corporate earnings, in turn, drive the stock market; and as a result, the business cycle determines the path for stock prices. Chart 1The Business Cycle Drives Earnings… The Business Cycle Drives Earnings... The Business Cycle Drives Earnings... Chart 2…Earnings In Turn Drive Stock Prices… ...Earnings In Turn Drive Stock Prices... ...Earnings In Turn Drive Stock Prices... An appreciation of macro forces leads to our golden rule for investing in the stock market. It simply states: Stay bullish on stocks unless you have good reason to think that a recession is imminent. Chart 3…Hence, The Business Cycle Is The Main Driver Of Equity Returns ...Hence, The Business Cycle Is The Main Driver Of Equity Returns ...Hence, The Business Cycle Is The Main Driver Of Equity Returns Historically, stocks have peaked about six months before the onset of a recession. Thus, it usually does not pay to turn bearish on stocks if you expect the economy to grow for at least another 12 months. In fact, aside from the brief but violent 1987 stock market crash, during the past 50 years, the S&P 500 has never fallen by more than 20% outside of a recessionary environment (Chart 4). Peering Around The Corner The catch, of course, is that it is difficult to know whether a recession is lurking around the corner. Leo Tolstoy began his novel Anna Karenina with the words “Happy families are all alike; every unhappy family is unhappy in its own way.” By the same token, every economic boom seems the same, whereas every recession has its own unique features. This makes forecasting recessions difficult. Difficult, but not impossible. Even though recessions differ substantially in their magnitude and causes, they all share the following three characteristics: 1) The buildup of imbalances that make the economy vulnerable to a downturn; 2) A catalyst that exposes these imbalances; and 3) Amplifiers or dampeners that either exacerbate or mitigate the slump. Let us review six past recessions to better understand what these three characteristics reveal about the current state of the global economy. Chart 4Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand The 1980 And 1982 Recessions The double-dip recessions of 1980 and 1982 were the last in which inflation played a starring role. Throughout the 1970s, the Fed consistently overstated the degree of slack in the economy (Chart 5). This led to a prolonged period in which interest rates stayed below their equilibrium level. The resulting upward pressure on inflation from an overheated economy was compounded by a series of oil shocks, the last of which occurred in 1979 following the Iranian revolution. Chart 6The Volcker Era: It Took Massive Monetary Tightening To Bring Down Inflation The Volcker Era: It Took Massive Monetary Tightening To Bring Down Inflation The Volcker Era: It Took Massive Monetary Tightening To Bring Down Inflation Chart 5The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s In an effort to break the back of inflation, newly appointed Fed chair Paul Volcker raised rates, first to 17% in April 1980, and then following a brief interlude in which the effective fed funds rate dropped back to 9%, to a peak of 19% in July 1981 (Chart 6).   The 1990-91 Recession Overheating also contributed to the early 1990s recession. After reaching a high of 10.8% in 1982, the unemployment rate fell to 5% in 1989, about one percentage point below its equilibrium level at that time. Core inflation began to accelerate, reaching 5.5% by August 1990. The Fed initially responded to the overheating economy by hiking interest rates. The fed funds rate rose from 6.6% in March 1988 to a high of 9.8% by May 1989. By the summer of 1990, the economy had already slowed significantly. Commercial real estate, still reeling from the effects of the Savings and Loan crisis, weakened sharply. Defense outlays continued to contract following the collapse of the Soviet Union. The final straw was Saddam Hussein’s invasion of Kuwait, which caused oil prices to surge and consumer confidence to plunge (Chart 7).   The 2001 Recession An overhang of IT equipment sowed the seeds of the 2001 recession. Spending on telecommunications equipment rose almost three-fold over the course of the 1990s, which helped lift overall nonresidential capital spending from 11.2% of GDP in 1992 to 14.7% in 2000 (Chart 8). Chart 7Overheating In The Leadup To The 1990-91 Recession Overheating In The Leadup To The 1990-91 Recession Overheating In The Leadup To The 1990-91 Recession The recession itself was fairly mild. After subsequent revisions to the data, growth turned negative for just one quarter, in Q3 of 2001. However, due to the lopsided influence of the tech sector in aggregate profits – and even more so, in market capitalization – the dotcom bust had a major impact on equity prices (Chart 9). Chart 9The Dotcom Bust Dragged Down Tech Earnings The Dotcom Bust Dragged Down Tech Earnings The Dotcom Bust Dragged Down Tech Earnings Chart 8A Glut Of I.T. Equipment Sowed The Seeds Of The 2001 Recession A Glut Of I.T. Equipment Sowed The Seeds Of The 2001 Recession A Glut Of I.T. Equipment Sowed The Seeds Of The 2001 Recession Having raised rates to 6.5% in May 2000, the Fed responded to the downturn by easing monetary policy. Falling rates were effective in reviving the economy – indeed, perhaps too effective. The resulting housing boom paved the way for the Great Recession.   The Great Recession (2007-2009) The housing sector was the source of imbalances in the lead-up to the Great Recession. In the US, and in other countries such as Spain and Ireland, house prices soared as lenders doled out credit on increasingly lenient terms. Chart 10A Long House Party A Long House Party A Long House Party Rising house prices stoked a consumption boom and incentivized developers to build more homes. In the US, the personal savings rate fell to historic lows. Residential investment reached a high of 6.7% of GDP, up from an average of 4.3% of GDP in the 1990s (Chart 10). While the housing bubble would have burst at some point anyway, tighter monetary policy helped expedite the downturn. Starting in June 2004, the Fed raised rates 17 times, pushing the fed funds rate to 5.25% by June 2006. The ECB also hiked rates; it raised the refi rate from 2% in December 2005 to 4.25% in July 2008, continuing to tighten policy even after the Fed had begun to cut rates. Once global growth started to weaken, a number of accelerants kicked in. As is the case in every recession, rising unemployment led to less spending, which in turn led to even higher unemployment. To make matters worse, a vicious circle engulfed the housing market. Falling home prices eroded the collateral underlying mortgage loans, producing more defaults, tighter lending standards, and even lower home prices. The Fed responded to the crisis by cutting rates and introducing an alphabet soup of programs to support the financial system. However, the zero lower-bound constraint limited the degree to which the Fed could cut rates, forcing it to resort to unorthodox measures such as quantitative easing. While these measures arguably helped, they fell short of what was needed to resuscitate the economy. Fiscal policy could have picked up the slack, but political considerations limited the scale and scope of the 2009 Recovery Act. The result was a needlessly long and drawn-out recovery.   The Euro Crisis (2012) Chart 11The State Is Here To Mop Up The Mess The State Is Here To Mop Up The Mess The State Is Here To Mop Up The Mess A reoccurring theme in economic history is that financial crises often force governments to assume private-sector liabilities in order to avoid a full-scale economic collapse. Unlike Greece, where government debt stood at very high levels even before the GFC, debt levels in Spain and Ireland were quite modest before the crisis. However, all that changed when Spain and Ireland were forced to bail out their banks (Chart 11). Unlike the US, UK, and Japan, euro area member governments did not have access to central banks that could serve as buyers of last resort for their debts. This limitation created a feedback loop where rising bond yields made it more onerous for governments to service their debts, which led to a higher perceived likelihood of default and even higher yields (Chart 12). Chart 12Multiple Equilibria In The Debt Market Are Possible Without A Lender Of Last Resort The Golden Rule For Investing In The Stock Market The Golden Rule For Investing In The Stock Market The ECB could have short-circuited this vicious cycle. Unfortunately, under the hapless leadership of Jean-Claude Trichet, instead of providing assistance, the central bank raised rates twice in 2011. This helped spread the crisis to Italy and other parts of core Europe. It ultimately took Mario Draghi’s “whatever it takes pledge” to restore some semblance of normality to European sovereign debt markets. Lessons For Today The current environment bears some resemblance to the one preceding the recessions of the early 1980s. As was the case back then, inflation today has surged well above the Federal Reserve’s target, forcing the Fed to turn more hawkish. Oil prices have also risen, despite slowing global growth. Even Russia has returned to its status as the world’s leading geopolitical boogeyman. Yet, digging below the surface, there is a big difference between today and the early ‘80s. For one thing, long-term inflation expectations remain well anchored. While expected inflation 5-to-10 years out has risen to 3.1% in the latest University of Michigan survey, this just takes the reading back to where it was not long after the Great Recession. It is still nowhere near the double-digit levels reached in the early ‘80s (Chart 13). Market-based inflation expectations are even more subdued. In fact, the widely watched 5-year/5-year forward TIPS breakeven inflation rate is currently well below the Fed’s comfort zone (Chart 14). Chart 13Long-Term Inflation Expectations Are Inching Up But Are Still Low Long-Term Inflation Expectations Are Inching Up But Are Still Low Long-Term Inflation Expectations Are Inching Up But Are Still Low Chart 14Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Higher oil prices are unlikely to have the sting that they once did. The energy intensity of the global economy has fallen steadily over time, especially in advanced economies (Chart 15). Today, the US generates three-times as much output for every joule of energy consumed than it did in 1970. Household spending on energy has declined from a peak of 8.3% of disposable income in 1980 to 3.8% in December 2021. The US also produces over 11 million barrels of oil per day, more than Saudi Arabia (Chart 16). Chart 15The Global Economy Has Become Less Energy Intensive Over Time The Global Economy Has Become Less Energy Intensive Over Time The Global Economy Has Become Less Energy Intensive Over Time Chart 16When It Comes To Energy Production, The USA Is Now #1 When It Comes To Energy Production, The USA Is Now #1 When It Comes To Energy Production, The USA Is Now #1 Unlike in the late 1990s, advanced economies do not face a significant capex overhang. Quite the contrary. Capital spending has been fairly weak across much of the OECD. In the US, the average age of the nonresidential capital stock has risen to the highest level since the 1960s (Chart 17). Looking out, far from cratering, capital spending is set to rise, as foreshadowed by the jump in core capital goods orders (Chart 18). Chart 17The Aging Capital Stock The Aging Capital Stock The Aging Capital Stock Chart 18The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright Chart 19Need More Houses Need More Houses Need More Houses In contrast to the glut of housing that helped precipitate the Global Financial Crisis, housing remains in short supply in many developed economies. In the US, the homeowner vacancy rate has fallen to a record low. There are currently half as many new homes available for sale as there were in early 2020 (Chart 19). Even in Canada, where homebuilding has held up well, government officials have been hitting the panic button over a brewing home shortage.   The Biggest Risk Is Debt The biggest macroeconomic risk the global economy faces stems from high debt levels. While household debt has fallen by 20% of GDP in the US, it has risen in a number of other economies. Corporate debt has generally increased everywhere, in many cases to finance share buybacks and M&A activity (Chart 20). Public debt has also soared to the highest levels since during World War II. Chart 20Mo' Debt Mo' Debt Mo' Debt Among emerging markets, China’s debt burden is especially pronounced. Total private and public debt reached 285% of GDP in 2021, nearly double what it was in early 2008. The property market is also slowing, which will weigh on growth. Like many countries, China finds itself in a paradoxical situation: Any effort to pare back debt is likely to crush nominal GDP by so much that the debt-to-GDP ratio rises rather than falls. Ironically, the only solution is to adopt reflationary policies that allow the economy to run hot. In the near term, this could prove to be a favorable outcome for investors since it will mean that monetary policy stays highly accommodative. Over the long haul, however, it may lead to a stagflationary environment, which would be detrimental to equities and other risk assets. In summary, investors should remain overweight stocks for now. However, they should underweight the tech sector since tech stocks remain disproportionately vulnerable to rising rates, increased regulation, and a retrenchment in pandemic-induced spending on electronics and online services.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix The Golden Rule For Investing In The Stock Market The Golden Rule For Investing In The Stock Market Special Trade Recommendations Current MacroQuant Model Scores The Golden Rule For Investing In The Stock Market The Golden Rule For Investing In The Stock Market

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Dear Clients, On behalf of the China Investment Strategy team, I would like to wish you a very happy, healthy, and prosperous Chinese New Year of the Tiger! Gong Xi Fa Chai, Best regards, Jing Sima China Strategist Executive Summary Chinese Investable Value Stocks Earnings Growth Will Likely Stabilize By Mid-2022 Chinese Investable Value Stocks Earnings Growth Will Likely Stabilize By Mid-2022 Chinese Investable Value Stocks Earnings Growth Will Likely Stabilize By Mid-2022 Chinese investable stocks passively outperformed their global counterparts in the first month of the year. However, we do not think January’s outperformance in the aggregate MSCI China Index will be sustained beyond the next six months. On a cyclical basis, when global stocks recover, growth stocks will likely underperform value stocks. The tech-heavy MSCI China Index is therefore less attractive to investors than other EM and developed market (DM) equities that are more value centric. Chinese investable ex-tech stocks are cheaply valued versus their global peers. Even if the earnings recovery in 2H22 are modest, Chinese investable value stocks are still attractive on a risk-reward basis. For investors that look to increase exposure to China on a cyclical basis, we recommend long Chinese investable value stocks while minimizing exposure to the tech sector. CYCLICAL RECOMMENDATIONS (6 - 18 MONTHS) INITIATION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Long MSCI China Value Index /Short MSCI China Growth Index 02-02-22     Bottom Line: We expect the tech sector’s passive outperformance in January to be short lived. Value stocks in Chinese investable equities, on the other hand, offer a better risk-reward profile relative to their TMT peers and for investors with a 6- to 12-month investment horizon. Feature Chart 1Chinese Investable Stocks Passively Outperformed In January This Year Chinese Investable Stocks Passively Outperformed In January This Year Chinese Investable Stocks Passively Outperformed In January This Year Chinese investable stocks dropped by 5% in January from December last year, giving up a 3% gain in the first three weeks (Chart 1). Still, the MSCI China Index outperformed global stocks by 2%. Some media reports stated that global investors have been drawn to Chinese offshore equities for their relatively cheap valuations and China’s easier monetary policy compared with other major economies . In our January 19 report we recommended investors tactically (0 to 6 months) upgrade the MSCI China Index to overweight within a global equity portfolio, based on the notion that the MSCI China Index would passively outperform since it would fall less than global equities. We maintain this view but do not expect the outperformance in aggregate Chinese investable stocks to endure on a cyclical basis. Our judgment is that while both China’s investable TMT (technology, media, and telecommunications) and ex-TMT stocks have been deeply discounted versus global stocks, beyond the next six months the investable TMT stocks will likely be a drag on the aggregate MSCI China Index. Thus, for investors looking for trades to increase their cyclical exposure to Chinese stocks, we recommend minimize their exposure to the tech sector. Meanwhile, we continue to favor onshore stocks versus their offshore counterparts, despite cheaper relative valuations in offshore stocks. We will discuss our view of the onshore market in next week’s report. A Valuation Catch-Up A valuation catch-up, as opposed to an improvement in China’s economic fundamentals, appears to be driving the passive outperformance in Chinese investable stocks. Our assessment is based on the following observations: Chart 2Chinese Stocks Normally Fall In Risk-Off Environment Chinese Stocks Normally Fall In Risk-Off Environment Chinese Stocks Normally Fall In Risk-Off Environment The beta of Chinese investable stocks has been steadily increasing over the past few years, versus both EM and global stocks. The high beta and pro-risk nature of Chinese investable stocks suggest their prices should fall in a risk-off market. Generally investors would not favor Chinese stocks during global market selloffs. Chart 2 shows that both EM and global stock benchmarks have fallen below their 200-day moving averages. Therefore, investors have been buying Chinese stocks against a risk-off market backdrop because Chinese stocks offer better risk-reward profile either due to their favorable valuations or higher earnings growth. It is simplistic to assume that investors favor Chinese investable stocks because of the country’s easier monetary policy versus the rest of the world. Chinese A-share stocks, which valuations are neutral, have been selling off more than the offshore stocks (Chart 3). Chinese onshore tech company stocks also suffered large losses in January, similar to their US peers (Chart 3, middle and bottom panels). Therefore, the divergence in the relative performance between the Chinese onshore and offshore markets suggests that discounted valuations in offshore Chinese stocks rather than economic fundamentals have driven the relative gains in the investable bourse. The mirror image in regional equity performance this year compared with last year also suggests that factors other than monetary policy explain equity dynamics (Chart 4). While the tech-heavy US bourse was the worst performer among major indices, markets that generated the greatest returns in 2021 have suffered the biggest losses so far in 2022. This phenomenon suggests that investors may be locking in last year’s gains, which is accentuating the underperformance of 2021’s winners and the outperformance of last year’s losers. Chart 42022 Is A Mirror Image Of 2021 Chinese Investable Stocks In A Global Equity Selloff Chinese Investable Stocks In A Global Equity Selloff Chart 3Chinese Onshore Stocks Followed The Global Market Downtrend Chinese Onshore Stocks Followed The Global Market Downtrend Chinese Onshore Stocks Followed The Global Market Downtrend   Bottom Line: Chinese investable stocks ended January with a much smaller loss than their global peers. The relative outperformance in the MSCI China Index has been mainly driven by its cheaper valuations relative to its global peers. Complacency Risk And Chinese Investable Stocks We see the recent global stock market selloff as a sharp reduction in complacency in the market, particularly in the high-flying tech sector (Chart 5). The correction in global tech stock prices will likely continue for a few months while the market digests a sudden rise in bond yields. As such, the prices in Chinese offshore tech companies will also fall in absolute terms but can still passively outperform their global counterparts, given their deeply discounted relative valuations. Nonetheless, several factors make us cautious about the exposure of China's outsized tech sector beyond the next six months. Hence, our overweight stance on Chinese investable stocks (in relative terms) is limited to the short term (i.e. in the next 0 to 6 months). The growth rates of the 12-month trailing and forward earnings for global tech stocks are both above the 85th percentiles (Chart 6). This indicates that a substantial amount of profit growth has already been priced into global tech stocks, raising the risk of earnings disappointment in the next 6 to 12 months. By contrast, China's TMT-stock 12-month trailing and forward earnings have fallen to below the 25th percentiles (Chart 6, bottom panel). This suggests that the global exuberance in tech earnings is less priced in among Chinese TMT stocks. Chart 5A Sharp Complacency Reduction In The Tech Sector A Sharp Complacency Reduction In The Tech Sector A Sharp Complacency Reduction In The Tech Sector Chart 6Global Tech Earnings Growth Remains Significantly Stretched Global Tech Earnings Growth Remains Significantly Stretched Global Tech Earnings Growth Remains Significantly Stretched However, as noted in our previous reports, Chinese growth/tech companies’ price discount relative to their earnings reflects structural risks that investors are pricing in. These structural headwinds may not intensify in the near term but are not going away either. The regulatory backdrop has not improved enough to justify a sustained faster multiple expansion in China’s internet giants. Beijing continues to rein in its internet behemoths and tighten regulations related to data. It is not yet clear what impact some of the new regulations announced last year will have on the tech sector’s business models. At the very least, antitrust regulations will chip away at the competitive advantage of these tech titans. Furthermore, China's investable TMT sector appears to be a domestic consumer play and thus, likely to weaken in the coming 6 to 12 months given the poor outlook for consumption (Chart 7). Even though China has stepped up its policy support for the aggregate economy, its stringent measures to counter the domestic COVID situation will significantly weigh on its service sector and consumption. The downbeat prospect on China's housing market will also curb consumption growth based on the expectations for employment and income dynamics (Chart 8). Chart 7Outlook For Chinese Internet Sales Remains Downbeat Outlook For Chinese Internet Sales Remains Downbeat Outlook For Chinese Internet Sales Remains Downbeat Chart 8Housing Market Slump A Significant Drag On Household Consumption Housing Market Slump A Significant Drag On Household Consumption Housing Market Slump A Significant Drag On Household Consumption Chart 9Rising Rates Are A Tailwind For Value Stocks Rising Rates Are A Tailwind For Value Stocks Rising Rates Are A Tailwind For Value Stocks Lastly, we expect the pace of increases in bond yields to slow and global equities to trend higher beyond the next couple months. In this case, we are not convinced that Chinese investable stocks will continue to outperform their global peers. The reason for our skepticism is that in a climate of rising interest rates, growth stocks tend to underperform value ones (Chart 9). Given that China's TMT sector’s weight (43%) is considerably higher than the global benchmark (30%), Chinese investable stocks will underperform once valuations in China’s TMT stocks catch up to be in line with those of the global tech sector. Bottom Line: From a valuation perspective, Chinese investable stocks currently look reasonable. In the next a few months when global tech stocks continue to sell off, Chinese offshore tech companies and stocks in general will likely passively outperform their global peers. However, from a risk-reward standpoint and beyond the next six months, the MSCI China Index is at a disadvantage due to a high concentration of stocks in the tech sector. Investment Conclusions On a cyclical basis, Chinese investable stocks will not be immune from global market selloffs due to the offshore market’s high volatility and positive correlation with global stocks. In addition, the MSCI China Index will likely underperform global equities in an up market because of a higher-than-average stake in tech stocks. As such, in a global portfolio we continue to favor onshore stocks over the investable bourse, despite cheaper relative valuations in offshore market equities. Next week’s report will discuss our views on the onshore market. Meanwhile, given the risks facing stocks in China’s tech sector, we propose a new trade recommendation for investors with a cyclical time horizon: long MSCI China Value Index /Short MSCI China Growth Index. The trade will increase cyclical exposure to Chinese offshore stocks, while minimizing stake in the offshore tech sector. The MSCI's China growth index is almost entirely made up of TMT equities, meaning that a relative value play will effectively mimic an ex-TMT position. Extremely cheap valuations in Chinese ex-TMT equities versus global stocks indicate that investors have already priced in a degree of weakness in China's economy (Chart 10). We remain alert to the possibility of a more pronounced near-term slowdown in the business cycle, but we expect China’s economy to regain its footing and stabilize by mid-2022. Our model shows that earnings will decelerate sharply in 1H22 (Chart 11). However, even if the upcoming stimulus and earnings recovery in 2H22 are modest, Chinese value stocks are still attractive on a risk-reward basis given the sizeable valuation discount levied on China relative to global stocks. Chart 10Chinese Investable Value Stocks Are Trading At A Huge Discount Versus Global Chinese Investable Value Stocks Are Trading At A Huge Discount Versus Global Chinese Investable Value Stocks Are Trading At A Huge Discount Versus Global Chart 11Chinese Investable Value Stocks Earnings Growth Will Likely Stabilize By Mid-2022 Chinese Investable Value Stocks Earnings Growth Will Likely Stabilize By Mid-2022 Chinese Investable Value Stocks Earnings Growth Will Likely Stabilize By Mid-2022   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary Cyclical UST Curve Flattening, But With Unusually Low Rate Expectations Deciphering The Messages From The US Treasury Curve Deciphering The Messages From The US Treasury Curve The US Treasury curve is unusually flat given high US inflation and with the Fed not having begun to raise interest rates. The dichotomy between deeply negative real interest rates and a flattening yield curve is not only evident in the US, but in other major developed countries like Germany and the UK. A low term premium on longer-term US Treasury yields is one factor keeping the curve so flat, but the term premium will likely rise as the Fed begins to hike rates. An overly flat US Treasury curve more likely reflects a belief that the neutral real fed funds rate (r-star) is actually negative. This is consistent with markets pricing in a very low peak in the funds rate for the upcoming tightening cycle, despite the current high inflation and tight labor market. Bottom Line: The Fed will hike by less than the market expects in 2022 and longer-term Treasury yields remain too low versus even a moderate 2-2.5% peak in the fed funds rate. Stay in US curve steepeners, as the Treasury curve is already too flat and will not flatten as much as discounted in forward rates this year. Feature Last week’s FOMC meeting essentially confirmed that the Fed will begin lifting rates in March and deliver multiple rate hikes this year. This was considered a hawkish surprise as the Fed signaled imminently tighter monetary policy even with the elevated financial market volatility seen so far in 2022. Fed Chair Jerome Powell noted that the US economy was in a stronger position compared to the 2016-18 tightening cycle, justifying a faster pace of hikes – and an accelerated pace of QE tapering – this time around. Markets have responded to the increasingly hawkish guidance of the Fed by pushing up rate expectations for 2022, continuing a path dating back to last September’s FOMC meeting when the Fed first signaled that QE tapering was imminent (Chart 1). There are now 163bps of Fed rate hikes by year-end discounted in the US overnight index swap (OIS) curve. Some Wall Street investment banks are calling for the Fed to hike as much as 6 or 7 times in 2022. We see this as much too aggressive. Chart 1Fed Hawkishness Pushing Up Rate Expectations For 2022/23 - But Not Beyond That Fed Hawkishness Pushing Up Rate Expectations For 2022/23 - But Not Beyond That Fed Hawkishness Pushing Up Rate Expectations For 2022/23 - But Not Beyond That Our base case scenario calls for the Fed to lift rates “only” 3-4 times this year. The persistently high inflation that is troubling the Fed is likely to peak in the first half of 2022, taking some heat off the FOMC to move as aggressively as discounted in markets this year. Although inflation will remain high enough, and the labor market tight enough, to keep the Fed on a tightening path into 2023. The US Treasury Curve Looks Too Flat What is unique about the upcoming Fed tightening cycle is that it is starting with such a flat US Treasury curve. The spread between the 2-year and 10-year yield now sits at 61bps, the lowest level since October 2020. This dynamic is not unique to the US, as yield curves are quite flat in other major countries where policy rates are near 0% and inflation remains relatively high, like the UK and Germany (Chart 2). In the US, the modest slope of the Treasury curve is notably unusual given a growth and inflation backdrop that would be more consistent with much higher bond yields: The US unemployment rate fell to 3.9% in December, well within the range of full employment estimates from FOMC members (Chart 3, top panel) Chart 2Bond Bearish Yield Curve Flattening In The US & UK Bond Bearish Yield Curve Flattening In The US & UK Bond Bearish Yield Curve Flattening In The US & UK US labor costs are accelerating; the wages and salaries component of the Employment Cost Index for Private Industry Workers rose to a 38-year high of 5.0% on a year-over-year basis in Q4/2021 (middle panel) Chart 3Challenges To The Fed's Inflation Fighting Credibility Challenges To The Fed's Inflation Fighting Credibility Challenges To The Fed's Inflation Fighting Credibility ​​​​​​ Higher inflation is becoming more embedded in medium term consumer inflation expectations measures like the University of Michigan 5-10 year ahead series that climbed to 3.1% last month (bottom panel). Importantly, market-based measures of inflation expectations have pulled back, even with little sign of inflation pressures easing. The 5-year TIPS breakeven, 5-years forward has fallen 35bps from the October 2021 peak of 2.41%. The bulk of that decline occurred in January of this year, alongside a rising trend in real TIPS yields as markets began pricing in a faster pace of Fed rate hikes. TIPS breakevens can often be something of a “vote of confidence” by the markets in the appropriateness of the Fed’s policy stance; rising when policy appears overly stimulative and vice versa. Thus, the decline in the TIPS 5-year/5-year forward breakeven, which climbed steadily higher since the Fed introduced massive monetary easing in March 2020 in response to the pandemic, can be interpreted as a sign that markets agree with the Fed’s recent hawkish turn. However, while the move in TIPS breakevens is sensible, the flatness of the Treasury curve appears unusual. In Chart 4, where we look at the previous times since 1975 that the 2-year/10-year US Treasury spread flattened to 70bps (just above the current level). In past cycles, the Treasury curve would be flattening into such a level after the Fed had already hiked rates a few times, which is obviously not the case today. Also, US unemployment was typically approaching, or falling through, the full employment NAIRU when the 2/10 Treasury curve fell to 70bps, suggesting diminished spare economic capacity and rising inflation pressures – similar to the current backdrop. Chart 4The UST Curve Is Unusually Flat Right Now The UST Curve Is Unusually Flat Right Now The UST Curve Is Unusually Flat Right Now Chart 5UST Curve Too Flat Relative To Inflation Pressures UST Curve Too Flat Relative To Inflation Pressures UST Curve Too Flat Relative To Inflation Pressures In those past cycles, the funds rate was rising at a faster pace than that of core inflation, suggesting that the Fed was pushing up real interest rates. The backdrop looks very different today, with US realized inflation soaring and the real funds rate now deeply negative. In the top panel of Chart 5, we show a “cycle-on-cycle” chart of the 2/10 Treasury curve versus an average of the previous five instances where the curve flattened to 70bps. The green line is the median outcome of all the cycles, while the shaded region represents the range of all the outcomes. In the other panels of the chart, we show US economic variables (the Conference Board leading economic index and the ISM Manufacturing index) and US inflation variables (the wages and salaries component of the Employment Cost Index and the US Congressional Budget Office estimate of the US output gap). The panels are all lined up so that the vertical line in the middle of the chart represents the date that the 2/10 curve falls to 70bps. The conclusion from Chart 5 is that the US economic variables shown are currently at the high end of the range of past curve flattening episodes, but the inflation variables are well above the high end of the historical range. In other words, the current modest slope of the 2/10 Treasury curve is in line with US growth momentum but is too flat relative to US inflation trends. So Why Isn’t The US Treasury Curve Steeper? There are a few possible reasons why the US curve is as flat as it is before the Fed has even begun tightening amid above-trend US growth and very high US inflation: Fears of a deeper financial market selloff The Fed believes strongly in the role of financial conditions in transmitting its monetary policy into the US economy. That often means that, during tightening cycles, the Fed hikes rates “until something breaks” in the financial markets, like a major equity market downturn or a big widening in corporate credit spreads. Such moves act as a brake on US growth through negative wealth effects for investors and by raising the cost of capital for businesses – reducing the need for additional Fed tightening. If bond investors thought that a major market selloff was likely before the Fed could successfully lift rates back to neutral (or even restrictive) levels during a tightening cycle, then they would discount a lower peak level of the funds rate. This would also lower the expected peak level of longer-term Treasury yields, resulting in a flatter Treasury yield curve. Given the current elevated valuations on so many asset classes – like equities, corporate credit and housing – it is likely that the relatively flat Treasury curve incorporates some believe that the Fed will have difficulty delivering a lot of rate hikes in this cycle. However, it should be noted that the US financial conditions remain quite accommodative, even after the recent equity market turbulence (Chart 6), and represent no impediment to US growth that reduces how much tightening the Fed will need to do. Longer-term bond term premia are too low A relatively flat yield curve could reflect a lack of a term premium on longer-maturity bonds. That is certainly the case when looking at the slope of the 2/10 government yield curve in the US, as well as in the UK and Germany (Chart 7).1 Chart 6US Financial Conditions Are No Impediment To US Growth US Financial Conditions Are No Impediment To US Growth US Financial Conditions Are No Impediment To US Growth ​​​​​​ Chart 7Flatter Yield Curves? Or Just Lower Bond Term Premia? Flatter Yield Curves? Or Just Lower Bond Term Premia? Flatter Yield Curves? Or Just Lower Bond Term Premia? ​​​​​ The term premium is the defined as the extra yield that investors require to commit to own a longer-maturity bond instead of the compounded yield from a series of shorter-maturity bonds. The latter can also be expressed as the “expected path of short-term interest rates”, which is often proxied by an average expected path of the monetary policy rate over the life of the longer-maturity bond. So the term premium on a 10-year US Treasury yield is the difference between the actual 10-year Treasury yield and the expected (or average) path of the fed funds rate over the next ten years. The term premium can also be thought of as a risk premium to holding longer-term bonds. On that basis, the term premium should correlate to measures of bond risk, like bond price volatility or inflation volatility. That is definitely true in the US, where the 10-year Treasury term premium shows a strong correlation to the MOVE index of Treasury market option-implied volatility or a longer-term standard deviation of headline CPI inflation (Chart 8). Estimated term premia can also rise during periods of slowing economic growth momentum, but that is typically due to a rapid decline in the expected path of interest rates rather than a rise in bond risk premia (in this case, this is probably more accurately described as a rise in bond uncertainty). Currently, a low term premium on US Treasury yields is justified by the relatively low level of bond volatility and solid US growth momentum. However, the term premium looks far too low compared to the more volatile US inflation seen since the start of the COVID-19 pandemic. With the Fed set to respond to that higher inflation with rate hikes, rising real interest rate expectations could also give a lift to the Treasury term premium. Our favorite proxy for the market expectation of the peak/terminal real short-term interest rate for the major developed market economies is the 5-year/5-year forward OIS rate minus the 5-year/5-year forward CPI swap rate. That “real” 5-year/5-year forward rate measure is typically well correlated to our estimates of the 10-year term premium in the US, Germany and the UK (Chart 9). This correlation likely reflects the level of certainty bond investors have over the likely future path of real interest rates. When there is more uncertainty about how high rates will eventually go to in a tightening cycle, a higher term premium is required. The opposite is true during periods of very low and stable interest rates. Chart 8Drivers Of US Term Premia Pointing Upward Drivers Of US Term Premia Pointing Upward Drivers Of US Term Premia Pointing Upward ​​​​​​ Chart 9Bond Term Premia Positively Correlated To Real Rate Expectations Bond Term Premia Positively Correlated To Real Rate Expectations Bond Term Premia Positively Correlated To Real Rate Expectations ​​​​​​ Chart 10Global Yield Curves Are Too Flat Versus Real Policy Rates Global Yield Curves Are Too Flat Versus Real Policy Rates Global Yield Curves Are Too Flat Versus Real Policy Rates Currently, the estimated 10-year US term premium is increasing alongside a rising market-implied path for the real fed funds rate. We anticipate these trends will continue as the Fed lift rates over the next couple of years, boosting longer-term Treasury yields and potentially putting some steepening pressure on the US Treasury curve (or at least limiting the degree of flattening as the Fed tightens). Markets believe that the neutral real rate (r*) is negative Historically, yield curve slopes for government bonds were well correlated to the level of real interest rates, measured as the central bank policy rate minus headline inflation. That relationship has broken down in the US, with the Treasury curve flattening in the face of soaring US inflation and an unchanged fed funds rate (Chart 10). Similar dynamics can also be seen in the German and UK yield curves. The most plausible reason for such a dramatic shift in the relationship between curve slopes and real policy rates is that bond investors now believe that the neutral real interest rate, a.k.a. “r-star”, is negative … and perhaps deeply so. The New York Fed has produced estimates of the US r-star dating back to the 1960s. The gap between the real fed funds rate and that r-star estimate has typically been fairly well correlated to the slope of the Treasury curve (Chart 11). When the real fed funds rate is below r-star, indicating that the policy is accommodative, the Treasury curve is usually steepening, and vice versa. Under this framework, the recent flattening trend of the Treasury curve would indicate that policy is actually getting tighter, despite the falling, and deeply negative, real fed funds rate of -5.4% (deflated by core inflation). Chart 11UST Curve Slope Is Positively Correlated To The 'Real Policy Gap' UST Curve Slope Is Positively Correlated To The 'Real Policy Gap' UST Curve Slope Is Positively Correlated To The 'Real Policy Gap' The last known estimate of r-star from the New York Fed was 0%, but no update has been provided for almost two years. Blame the pandemic for that. The sharp lockdown-fueled collapse in US GDP growth in 2020, and the rapid recovery in growth as the economy reopened, made it impossible to estimate the the “neutral” level of real interest rates given such massive swings in demand that were not related to monetary policy. One way to try and “back out” the implicit pricing of r-star currently embedded in US Treasury yields is to estimate a model linking the gap between the real fed funds rate and r-star to the slope of the Treasury curve. We did just that, with the results presented in Chart 12. This model estimates the “Real Policy Gap”, or r-star minus the real fed funds rate, as a function of the 2/10 Treasury curve slope. In other words, the model shows the Real Policy Gap that is consistent with the current slope of the curve. Chart 12Current UST Yield Curve Makes Slope Sense ... If The Fed Followed The Taylor Rule With 7% Inflation Current UST Yield Curve Makes Slope Sense ... If The Fed Followed The Taylor Rule With 7% Inflation Current UST Yield Curve Makes Slope Sense ... If The Fed Followed The Taylor Rule With 7% Inflation The model estimates that the current 2/10 curve slope is consistent with a Real Policy Gap of 96bps. With US core CPI inflation currently at 5%, and assuming r-star is still 0% as per the last New York Fed estimate, the fed funds rate would have to rise to 4% to justify the current slope of the 2/10 curve. While that may sound like an implausibly large increase in the funds rate, similar results are produced using straightforward Taylor Rules.2 We can also use our Real Policy Gap model to infer the level of inflation that is consistent with a Gap of 96bps, for various combinations of the funds rate and r-star. Those are shown in Table 1. Assuming the funds rate rises in line with current market expectations to 1.7% and r-star remains close to 0%, the current slope of the 2/10 Treasury curve suggests a fall in US inflation to just around 3% - still above the Fed’s inflation target - from the current 5%. Table 1The UST Curve Slope Has Already Discounted A Big Drop In US Inflation Deciphering The Messages From The US Treasury Curve Deciphering The Messages From The US Treasury Curve We see this as the most plausible reason for the relatively flat level of the 2/10 US Treasury curve. Markets expect somewhat lower US inflation and a moderate rise in the funds rate over the next couple of years, making the real funds rate less negative but not pushing it above a negative r-star expectation. This would suggest upside risk for US Treasury yields, and potential bearish steepening pressure, as markets come to realize that the neutral real fed funds rate is actually positive, not negative. Fight The Forwards, Stay In US Treasury Curve Steepeners While it may sound counter-intuitive with the Fed set to begin a rate hiking cycle, we continue to see better value in tactically positioning in US Treasury curve steepening trades. Specifically, we are keeping our recommended trade in our Tactical Overlay on page 19, where we are long a 2-year Treasury bullet versus a duration-neutral barbell of cash (a 3-month US Treasury bill) and a 10-year Treasury bond. The trade is currently underwater, but we see good reasons to expect the performance to rebound over the next few months. The front end of the curve now discounts more hikes than we expect will unfold in 2022, which should limit further increases in the 2-year Treasury yield. At the same time, the 10-year yield looks too low relative to the expected cyclical peak for the fed funds rate (Chart 13). One way we can assess this is by comparing 5-year/5-year forward Treasury rates to survey estimates of the longer run, or terminal, fed funds rate. The median FOMC forecast (or “dot”) for the terminal funds rate is 2.5%, the median terminal rate forecast from the New York Fed’s Survey of Primary Dealers is 2.25% and the median terminal rate forecast from the New York Fed’s Survey of Market Participants is 2%. This sets a range of estimates of the longer-run terminal rate of 2-2.5%, in line with the current expectations of the BCA Research bond services. The current 5-year/5-year forward Treasury rate is 2.0%, at the low end of that range. We see those forwards rising to the upper part of that 2-2.5% range by the end of 2022, which will push the 10-year Treasury yield toward our year-end target of 2.25%. Chart 13The 5-Year/5-Year UST Forward Rate Is Too Low The 5-Year/5-Year UST Forward Rate Is Too Low The 5-Year/5-Year UST Forward Rate Is Too Low ​​​​​​ Chart 14Stay In UST Curve Steepeners, Even With Fed Liftoff Imminent Stay In UST Curve Steepeners, Even With Fed Liftoff Imminent Stay In UST Curve Steepeners, Even With Fed Liftoff Imminent ​​​​​​ Some of our colleagues within the BCA family see the longer-term neutral funds rate as considerably higher than survey estimates, perhaps as high as 3-4%. We are sympathetic to that view, but it will take signs of US economic resiliency in the face of rate hikes before bond investors – and more importantly, the Fed – arrive at that conclusion. This would make steepening trades more attractive on a strategic, or medium-term, basis as the market realizes that the Fed is further behind the policy curve (i.e. the funds rate even further below a higher terminal rate) than previously envisioned. For now, we do not see the US Treasury curve flattening at the pace discounted in the Treasury forward curve over the next 3-6 months (Chart 14, top panel). However, this will be more of a carry trade by betting against the forwards over time. A bearish steepening of the Treasury curve with a swift upward move in the 10-year Treasury yield is less likely with bond investor/trader positioning already quite short (bottom two panels).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com       Footnotes 1      The term premium estimates shown here are derived from our own in-house framework. For those familiar with the various term premium estimates on the 10-year US Treasury yield produced by the Fed, our estimates are currently in line with those produced by the ACM model and the Kim & Wright model. 2     A fun US Taylor Rule calculator, which can be used to generate Taylor Rules under a variety of assumptions, is available on the Atlanta Fed’s website here. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Deciphering The Messages From The US Treasury Curve Deciphering The Messages From The US Treasury Curve The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades

Highlights The selloff in equities since the start of the year marks a long overdue correction rather than the start of a bear market. Stocks often suffer a period of indigestion when bond yields rise suddenly, but usually bounce back as long as yields do not move into economically restrictive territory. BCA’s bond strategists expect the 10-year yield to rise to 2%-to-2.25% by the end of the year, which is well below the level that could trigger a recession. While valuations in the US remain stretched, they are much more favorable abroad. Investors should overweight non-US markets, value stocks, and small caps in 2022. Go long homebuilders versus the S&P 500. US homebuilders are trading at only 6.5-times forward earnings and will benefit from tight housing supply conditions and a moderation in input costs. FAQ On Recent Market Action The selloff in stocks since the start of the year has garnered a lot of attention. In this week’s report, we address some of the key questions clients are asking.   Q: What do you see as the main reasons for the equity selloff? A: At the start of the year, the S&P 500 had gone 61 straight weeks without experiencing a 6% drawdown, the third longest stretch over the past two decades. Stocks were ripe for a pullback. The backup in bond yields provided a catalyst for the sellers to come out. Not surprisingly, growth stocks fell hardest, as they are most vulnerable to changes in the long-term discount rate. At last count, the S&P 500 Growth index was down 13.7% YTD, compared to 4.1% for the Value index. Our research has found that stocks often suffer a period of indigestion when bond yields rise suddenly, but usually bounce back as long as yields do not move into economically restrictive territory (Table 1). BCA’s bond strategists expect the 10-year yield to rise to 2%-to-2.25% by the end of the year, which is well below the level that could trigger a recession. Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Should Recover A Correction Not A Bear Market A Correction Not A Bear Market Historically, equity bear markets have coincided with recessions (Chart 1). Corrections can occur outside of recessionary periods, but for stocks to go down and stay down, corporate earnings need to fall. That almost never happens unless there is a major economic downturn (Chart 2). In fact, the only time in the last 50 years the US stock market fell by more than 20% outside of a recessionary environment was in October 1987. Chart 1Recessions And Bear Markets Tend To Go Hand In Hand Recessions And Bear Markets Tend To Go Hand In Hand Recessions And Bear Markets Tend To Go Hand In Hand Chart 2Business Cycles Drive Earnings Business Cycles Drive Earnings Business Cycles Drive Earnings Chart 3The Bull-Bear Ratio Is Below Its Pandemic Lows The Bull-Bear Ratio Is Below Its Pandemic Lows The Bull-Bear Ratio Is Below Its Pandemic Lows It is impossible to know when this correction will end. However, considering that the bull-bear spread in this week’s AAII survey fell below the trough reached both in March 2020 and December 2018, our guess is that it will be sooner rather than later (Chart 3). With global growth likely to remain solid, equity prices should rise. Q: What gives you confidence that growth will hold up? A: Households are sitting on a lot of excess savings – $2.3 trillion in the US and a similar amount abroad. That is a lot of dry powder. Banks are also actively looking to expand credit, as the recent easing in lending standards demonstrates (Chart 4). Leading indicators of capital spending are at buoyant levels (Chart 5). Chart 4US Banks Are Easing Lending Standards US Banks Are Easing Lending Standards US Banks Are Easing Lending Standards Chart 5The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright It is striking how well the global economy has handled the Omicron wave. While service PMIs have come down, manufacturing PMIs have remained firm. In fact, the euro area manufacturing PMI reached 59 in January versus expectations of 57.5. It was the strongest manufacturing print for the region since August. The manufacturing PMI also ticked up slightly in Japan. The China Caixin/Markit PMI and the official PMI published by the National Bureau of Statistics also ticked higher. After dipping below zero last August, the Citi global economic surprise index has swung back into positive territory (Chart 6). Chart 6The Omicron Wave Did Not Drag Down The Global Economy The Omicron Wave Did Not Drag Down The Global Economy The Omicron Wave Did Not Drag Down The Global Economy Markets are also not pricing in much of a growth slowdown (Chart 7). Growth-sensitive industrial stocks have outperformed the overall index by 1.1% in the US so far this year. EM equities have outperformed the global benchmark by 5.9%. The Bloomberg Commodity Spot index has risen 7.2%. Credit spreads have barely increased. Chart 7Markets Are Not Discounting Much Of A Growth Slowdown Markets Are Not Discounting Much Of A Growth Slowdown Markets Are Not Discounting Much Of A Growth Slowdown   Q: What is your early read on the earnings season? A: Nothing spectacular, but certainly not bad enough to justify the steep drop in equity prices. According to Refinitiv, of the 145 S&P 500 companies that have reported Q4 earnings, 79% have beat analyst expectations while 19% reported earnings below expectations. Usually, 66% of companies report earnings above analyst estimates, while 20% miss expectations. In aggregate, the reported earnings are coming in 3.2% above estimates, slightly lower than the historic average of 4.1%. Guidance has been lackluster. However, outside of a few tech names like Netflix, earnings disappointments have generally been driven by higher-than-expected expenses, rather than weaker sales. Overall EPS estimates for 2022 have climbed 0.4% in the US and by 1.1% in foreign markets since the start of the year (Chart 8).   Q: To the extent that the Fed is trying to engineer tighter financial conditions, doesn’t this imply that stocks must continue falling? A: That would be true if the Fed really did want to tighten financial conditions, either via lower stock prices, a stronger dollar, higher bond yields, or wider credit spreads. However, we do not think that this is what the Fed wants. Despite all the chatter about inflation, the 5-year/5-year forward TIPS breakeven inflation rate has fallen to 2.05%, which is 25 basis points below the bottom end of the Fed’s comfort zone (Chart 9).1 Chart 8Earnings Expectations Have Not Been Revised Lower Earnings Expectations Have Not Been Revised Lower Earnings Expectations Have Not Been Revised Lower Chart 9Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Chart 10The Terminal Fed Funds Rate Seen At 2%-2.5% The Terminal Fed Funds Rate Seen At 2%-2.5% The Terminal Fed Funds Rate Seen At 2%-2.5% Chart 11The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% Remember that the Fed’s estimate of the neutral rate, R*, is very low. The Fed thinks it will only be able to raise rates to 2.5% during this tightening cycle, which would barely bring real rates into positive territory (Chart 10). The market does not think the Fed will be able to raise rates to even 2% (Chart 11). The last thing the Fed wants to do is inadvertently invert the yield curve. In the past, an inverted yield curve has reliably predicted a recession (Chart 12). Chart 12A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) The Fed is about to start raising rates and shrinking its balance sheet not because it wants to slow growth, but because it wants to maintain its credibility. While the Fed will never admit it, it is very much attuned to the direction in which the political winds are blowing. The rise in inflation, and the Fed’s failure to predict it, has been embarrassing for the FOMC. Doing nothing is no longer an option. However, doing “something” does not necessarily imply having to raise rates more than the market is already discounting. Contrary to the consensus view that the Fed has turned hawkish, we think that the main takeaway from this week’s FOMC meeting is that Jay Powell, aka Nimble Jay, wants more flexibility in how the Fed conducts monetary policy. This makes perfect sense, as layer upon layer of forward guidance merely served to confuse market participants while unnecessarily tying the Fed’s hands.   Q: How confident are you that inflation will fall without a meaningful tightening in financial conditions? A: If we are talking about a horizon of 2-to-3 years, not very confident. As we discussed two weeks ago in a report entitled The New Neutral, the interest rate consistent with stable inflation and full employment is substantially higher than either the Fed believes or the market is pricing in. This means that the Fed is likely to keep rates too low for too long. However, if we are talking about a 12-month horizon, there is a high probability that inflation will fall dramatically, even if monetary policy stays very accommodative. Today’s inflation is largely driven by rising durable goods prices. Durables are the one category of the CPI basket where prices usually fall over time, so this is not a sustainable source of inflation (Chart 13). As demand shifts back from goods to services and supply bottlenecks abate, durable goods inflation will wane. Chart 14 shows that the price indices for a number of prominent categories of goods – including new and used vehicles, furniture and furnishings, building supplies, and IT equipment – are well above their trendlines. Not only is inflation in these categories likely to fall, but it is apt to turn negative, as the absolute level of prices reverts back to trend. This will put significant downward pressure on inflation. Chart 13Durable Goods Prices Are The Main Driver Of Inflation Durable Goods Prices Are The Main Driver Of Inflation Durable Goods Prices Are The Main Driver Of Inflation Chart 14Some Of These Prices Will Fall Outright Some Of These Prices Will Fall Outright Some Of These Prices Will Fall Outright Chart 15Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Granted, service inflation will accelerate this year as the labor market continues to tighten. However, rising service inflation is unlikely to offset falling goods inflation. While wage growth has accelerated, wage pressures have been concentrated at the bottom end of the wage distribution (Chart 15). According to the Census Household Pulse Survey, a record 8.75 million workers – many of them in relatively low-paid service jobs – were not working in the second week of January due to pandemic-related reasons (Chart 16). As the Omicron wave fades, most of these workers will re-enter the labor force. This should help boost labor participation among low-wage workers, which has recovered much less than for higher paid workers (Chart 17).   Chart 16The Pandemic Is Still Affecting Labor Supply The Pandemic Is Still Affecting Labor Supply The Pandemic Is Still Affecting Labor Supply Chart 17Employment In Low-Wage Industries Has Not Fully Recovered Employment In Low-Wage Industries Has Not Fully Recovered Employment In Low-Wage Industries Has Not Fully Recovered Q: Tensions between Ukraine and Russia have risen to a fever pitch. Could this destabilize global markets? Chart 18Valuations Matter For Long-Term Returns Valuations Matter For Long-Term Returns Valuations Matter For Long-Term Returns A: In a note published earlier today, Matt Gertken, BCA’s Chief Geopolitical Strategist, increased his odds that Russia will invade Ukraine from 50% to 75%. However, of that 75% war risk, he gives only 10% odds to Russia invading and conquering all of Ukraine. A much more likely scenario is one where Russia invades Donbas and perhaps a few other regions in Eastern or Southern Ukraine where there are large Russian-speaking populations and/or valuable coastal territory. While such a limited incursion would still invite sanctions from the West, Matt does not think that Russia will retaliate by cutting off oil and natural gas exports to Europe. Not only would such a retaliation deprive Russia of its main source of export earnings, but it could lead to a hostile response from countries such as Germany which so far have pushed for a more measured approach than the US has championed.   Q: Valuations are still very stretched. Even if the conflict in Ukraine does not spiral out of control and the goldilocks macroeconomic scenario of above-trend global growth and falling inflation comes to pass, hasn’t much of the good news already been discounted? A: US stocks are quite pricey. Both the Shiller PE ratio and households’ allocations to equities point to near-zero total returns for stocks over a 10-year horizon (Chart 18). That said, valuations are not a useful timing tool. The business cycle, rather than valuations, tends to dictate the path of stocks over medium-term horizons of 6-to-12 months (Chart 19). Chart 19AThe Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) Chart 19BThe Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) Moreover, stocks are not expensive everywhere. While US equities trade at 20.8-times forward earnings, non-US stocks trade at a more respectable 14.1-times. The valuation gap is even more extreme based on other measures such as normalized earnings, price-to-book, and price-to-sales (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) In terms of equity styles, both small caps and value stocks trade at a substantial discount to large caps and growth stocks (Chart 21). We recommend that investors overweight these cheaper areas of the market in 2022. Trade Recommendation: Go Long US Homebuilders Versus The S&P 500 US homebuilder stocks have fallen by 19.4% since December 10th. Beyond the general market malaise, worries about rising mortgage rates and soaring input costs have weighed on the sector. Yet, current valuations more than adequately discount these risks. The sector trades at 6.5-times forward earnings, a steep discount to the S&P 500. Whereas demand for new homes is near record high levels according to the National Association of Home Builders (NAHB) survey, the homeowner vacancy rate is at a multi-decade low. The supply of recently completed new homes is half of what it was on the eve of the pandemic (Chart 22). With demand continuing to outstrip supply, home prices will maintain their upward trend. As building material prices stabilize and worries about an overly aggressive Fed recede, homebuilder stocks will rally. Chart 21Value Stocks And Small Caps Are Cheap Value Stocks And Small Caps Are Cheap Value Stocks And Small Caps Are Cheap Chart 22US Homebuilders Looking Attractive US Homebuilders Looking Attractive US Homebuilders Looking Attractive Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. Global Investment Strategy View Matrix A Correction Not A Bear Market A Correction Not A Bear Market Special Trade Recommendations Current MacroQuant Model Scores A Correction Not A Bear Market A Correction Not A Bear Market

Highlights Global equities are poised to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Non-US markets are likely to outperform. We examine the four pillars that have historically underpinned stock market performance. Pillar 1: Technically, the outlook for equities is modestly bullish, as investor sentiment is nowhere near as optimistic as it usually gets near market tops. Pillar 2: The outlook for economic growth and corporate earnings is modestly bullish as well. While global growth is slowing, it will remain solidly above trend in 2022. Pillar 3: Monetary and financial conditions are neutral. The Fed and a number of other central banks are set to raise rates and begin unwinding asset purchases this year. However, monetary policy will remain highly accommodative well into 2023. Pillar 4: Valuations are bearish in the US and neutral elsewhere. Investors should avoid tech stocks in 2022, focusing instead on banks and deep cyclicals, which are more attractively priced. The Bedrock For Equities In assessing the outlook for the stock market, our research has focused on four pillars: 1) Sentiment and other technical factors, which are most pertinent for stocks over short-term horizons of about three months; 2) cyclical fluctuations in economic growth and corporate earnings, which tend to dictate the path for stocks over medium-term horizons of about 12 months; 3) monetary and financial conditions, which are also most relevant over medium-term horizons; and finally 4) valuations, which tend to drive stocks over the long run. In this report, we examine all four pillars, concluding that global equities are likely to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Pillar 1: Sentiment And Other Technical Factors (Modestly Bullish)   Chart 1US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern Scaling The Wall Of Worry Stocks started the year on a high note, before tumbling on Wednesday following the release of the Fed minutes. Market breadth going into the year was quite poor. Even as the S&P 500 hit a record high on Tuesday, only 57% of NYSE stocks and 38% of NASDAQ stocks were trading above their 200-day moving averages compared to over 90% at the start of 2021 (Chart 1). The US stock market had become increasingly supported by a handful of mega-cap tech stocks, a potentially dangerous situation in an environment where bond yields are rising and stay-at-home restrictions are apt to ease (more on this later). That said, market tops often occur when sentiment reaches euphoric levels. That was not the case going into 2022 and it is certainly not the case after this week's sell-off. The number of bears exceeded the number of bulls in the AAII survey this week and in six of the past seven weeks (Chart 2). The share of financial advisors registering a bullish bias declined by 25 percentage points over the course of 2021 in the Investors Intelligence poll. Option pricing is far from complacent. The VIX stands at 19.6, above its post-GFC median of 16.7.  According to the Minneapolis Fed’s market-based probabilities model, the market was discounting a slightly negative 12-month return for the S&P 500 as of end-2021, with a 3.6 percentage-point larger chance of a 20% decline in the index than a 20% increase (Chart 3). Chart 3Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Chart 2Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Equities do best when sentiment is bearish but improving (Chart 4). With bulls in short supply, stocks can continue to climb the proverbial wall of worry.   Whither The January Effect? Historically, stocks have fared better between October and April than between May and September (Chart 5). One caveat is that the January effect, which often saw stocks rally at the start of the year, has disappeared. In fact, the S&P 500 has fallen in January by an average annualized rate of 5.2% since 2000 (Table 1). Other less well-known calendar effects – such as the tendency for stocks to underperform on Mondays but outperform on the first trading day of each month – have persisted, however. Chart 4 Chart 5 Table 1Calendar Effects The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Bottom Line: January trading may be choppy, but stocks should rise over the next few months as more bears join the bullish camp. Last year’s losers are likely to outperform last year’s winners. Pillar 2: Economic Growth And Corporate Earnings (Modestly Bullish)   Economic Growth And Earnings: Joined At The Hip The business cycle is the most important driver of stocks over medium-term horizons of about 12 months. The reason is evident in Chart 6: Corporate earnings tend to track key business cycle indicators such as the ISM manufacturing index, industrial production, business sales, and global trade. Chart 6The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons Chart 7PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth Global growth peaked in 2021 but should stay solidly above trend in 2022. Both the service and manufacturing PMIs remain in expansionary territory (Chart 7). The forward-looking new orders component of the ISM exceeded 60 for the second straight month in December. The Bloomberg consensus is for real GDP to rise by 3.9% in the G7 in 2022, well above the OECD’s estimate of trend G7 growth of 1.4% (Chart 8). Global earnings are expected to increase by 7.1%, rising 7.5% in the US and 6.7% abroad (Chart 9). Our sense is that both economic growth and earnings will surprise to the upside in 2022. Chart 9Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Chart 8 Plenty Of Pent-Up Demand For Both Consumer And Capital Goods US households are sitting on $2.3 trillion in excess savings (Chart 10). Around half of these savings will be spent over the next few years, helping to drive demand. Households in the other major advanced economies have also buttressed their balance sheets. Chart 10Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand After two decades of subdued corporate investment, capital goods orders have soared. This bodes well for capex in 2022. Inventories remain at rock-bottom levels, which implies that output will need to exceed spending for the foreseeable future (Chart 11). On the residential housing side, both the US homeowner vacancy rate and the inventory of homes for sale are near multi-decade lows. Building permits are 11% above pre-pandemic levels (Chart 12). Chart 11Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Chart 12Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Chart 13China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed Chinese Growth To Rebound, Europe To Benefit From Lower Natural Gas Prices Chinese credit growth decelerated last year. However, the 6-month credit impulse has bottomed, and the 12-month impulse is sure to follow (Chart 13). Chinese coal prices have collapsed following the government’s decision to instruct 170 mines to expand capacity (Chart 14). China generates 63% of its electricity from coal. Lower energy prices and increased stimulus should support Chinese industrial activity in 2022. Like China, Europe will benefit from lower energy costs. Natural gas prices have fallen by nearly 50% from their peak on December 21st. A shrinking energy bill will support the euro (Chart 15). Chart 14Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Chart 15A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro Chart 16 Omicron Or Omicold? While the Omicron wave has led to an unprecedented spike in new cases across many countries, the economic fallout will be limited. The new variant is more contagious but significantly less lethal than previous ones. In South Africa, it blew through the population without triggering a major increase in mortality (Chart 16). Preliminary data suggest that exposure to Omicron confers at least partial immunity against Delta. The general tendency is for viral strains to become less lethal over time. After all, a virus that kills its host also kills itself. Given that Omicron is crowding out more dangerous strains such as Delta, any future variant is likely to emanate from Omicron; and odds are this new variant will be even milder than Omicron. Meanwhile, new antiviral drugs are starting to hit the market. Pfizer claims that its new drug, Paxlovid, cuts the risk of hospitalization by almost 90% if taken within five days from the onset of symptoms. Bottom Line: While global growth has peaked and the pandemic remains a risk, growth should stay well above trend in the major economies in 2022, fueling further gains in corporate earnings and equity prices.   Pillar 3: Monetary And Financial Factors (Neutral)   Chart 17The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months Tighter But Not Tight Monetary and financial factors help govern the direction of equity prices both because they influence economic growth and also because they affect the earnings multiple at which stocks trade. There is little doubt that a number of central banks, including the Federal Reserve, are looking to dial back monetary stimulus. However, there is a big difference between tighter monetary policy and tight policy. Even if the FOMC were to raise rates three times in 2022, as the market is currently discounting, the fed funds rate would still be half of what it was on the eve of the pandemic (Chart 17). Likewise, even if the Fed were to allow maturing assets to run off in the middle of this year, as the minutes of the December FOMC meeting suggest is likely, the size of the Fed’s balance sheet will probably not return to pre-pandemic levels until the second half of this decade.   A Higher Neutral Rate We have argued in the past that the neutral rate of interest in the US is higher than widely believed. This implies that the overall stance of monetary policy remains exceptionally stimulative. Historically, stocks have shrugged off rising bond yields, as long as yields did not increase to prohibitively high levels (Table 2). Table 2As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market If the neutral rate ends up being higher than the Fed supposes, the danger is that monetary policy will stay too loose for too long. The question is one of timing. The good news is that inflation should recede in the US in 2022, as supply-chain bottlenecks ease and spending shifts back from goods to services. The bad news is that the respite from inflation will not last. As discussed in Section II of our recently-published 2022 Strategy Outlook, inflation will resume its upward trajectory in mid-2023 on the back of a tightening labor market and a budding price-wage spiral. This second inflationary wave could force the Fed to turn much more aggressive, spelling the end of the equity bull market. Bottom Line: While the Fed is gearing up to raise rates and trim the size of its balance sheet, monetary policy in the US and in other major economies will remain highly accommodative in 2022. US policy could turn more restrictive in 2023 as a second wave of inflation forces a more aggressive response from the Fed.   Pillar 4: Valuations (Bearish In The US; Neutral Elsewhere)   US Stocks Are Looking Pricey… While valuations are a poor timing tool in the short run, they are an excellent forecaster of stock prices in the long run. Chart 18 shows that the Shiller PE ratio has reliably predicted the 10-year return on equities. Today, the Shiller PE is consistent with total real returns of close to zero over the next decade. Chart 18 Investors’ allocation to stocks has also predicted the direction of equity prices (Chart 19). According to the Federal Reserve, US households held a record high 41% of their financial assets in equities as of the third quarter of 2021. If history is any guide, this would also correspond to near-zero long-term returns on stocks. Chart 19Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II)   … But There Is More Value Abroad Valuations outside the US are more reasonable. Whereas US stocks trade at a Shiller PE ratio of 37, non-US stocks trade at 20-times their 10-year average earnings. Other valuation measures such as price-to-book, price-to-sales, and dividend yield tell a similar story (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) Cyclicals And Banks Overrepresented Abroad Our preferred sector skew for 2022 favors non-US equities. Increased capital spending in developed economies and incremental Chinese stimulus should boost industrial stocks and other deep cyclicals, which are overrepresented outside the US (Table 3). Banks are also heavily weighted in overseas markets; they should also do well in response to faster-than-expected growth and rising bond yields (Chart 21). Table 3Deep Cyclicals And Financials Are Overrepresented Outside The US The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Chart 21Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Bottom Line: Valuations are more appealing outside the US, and with deep cyclicals and banks set to outperform tech over the coming months, overseas markets are the place to be in 2022. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Highlights Indian stocks need more time to digest and consolidate the significant gains from earlier this year. However, the country’s medium and long-term growth outlook remains positive. Indian firms’ profit margins will likely settle at a higher level than usual. That will also put a floor on its equity multiples. With an imminent topline recovery, the main driver of Indian stocks next year will be profits, in contrast with multiple expansions during the last year and a half. India is beginning a cyclical expansion with a cheap rupee. Stay neutral Indian stocks in an EM equity basket for now. Investors should overweight India in an EM domestic bond portfolio. Feature Chart 1Indian Stocks Are Overbought Indian Stocks Are Overbought Indian Stocks Are Overbought We tactically downgraded Indian stocks from overweight to neutral in EM and emerging Asian equity portfolios in early October this year. This call has worked out well so far as India’s absolute and relative share prices seem to have peaked. The primary reason for our tactical “neutral” call on Indian equities was this market’s vertical rise earlier this year, both in absolute and relative terms. Similar spikes – in terms of magnitude and duration back in 2007 and in 2014 – were followed by a period of underperformance (Chart 1). Yet, we recommended downgrading to only a neutral allocation. The reason is that the country’s cyclical outlook remains constructive, and the profit expansion cycle has further to run. That forbade us from turning too bearish on this bourse. A neutral stance on India also makes sense for the next several months as this bourse digests and consolidates its previous gains. In this report, we detail the various nuances of our analysis. Meanwhile, the Indian currency is cheap versus the greenback and will likely be one of the best performing currencies in the EM world over the next year. A positive currency outlook also makes Indian government bonds attractive for foreign investors, as Indian bonds also offer a high yield amid a benign domestic inflation backdrop. Dedicated EM domestic bond portfolios should stay overweight India. Equity Multiple Compression Ahead? Chart 2India's Profit Margin Expansion Has Led To Its Equity Re-Rating India's Profit Margin Expansion Has Led To Its Equity Re-Rating India's Profit Margin Expansion Has Led To Its Equity Re-Rating An upshot to the steep equity rally earlier this year has been India’s stretched valuations. That made many investors question the sustainability of the outperformance. A pertinent question, therefore, is how overvalued have Indian stocks become? And how much multiple compression can investors expect in this bourse? Before we answer this question, it’s useful to understand what drove the cyclical re-rating of Indian markets in the first place. The solid black line in Chart 2 shows the gross profit margins of all Indian listed non-financial firms. They have risen substantially since spring 2020 to reach decade-high levels. Margin expansions of this magnitude are indicative of material efficiency gains; and are usually rewarded with an equity re-rating. This is indeed what happened since spring 2020: stock multiples rose following the expanding margins. The same can be said if we only consider the major non-financial corporations’ EBITDA margins (Chart 2, bottom panel). If one looks at the cyclically adjusted P/E ratio (CAPE) instead, we see a very similar thing: the CAPE ratio has also risen in line with rising profit margins (Chart 3). Chart 3Profit Margins Have A Bearing On Equity Valuations Profit Margins Have A Bearing On Equity Valuations Profit Margins Have A Bearing On Equity Valuations Charts 2 and 3 show that the positive correlations between profit margins and stock multiples held steady over past several cycles. Hence, it will be reasonable to expect that should Indian firms hold on to wide margins, they will not suffer a significant de-rating going forward. Can Margins Stay Wide? Chart 4Indian Firms' Borrowing Costs Will Likely Stay Low Indian Firms' Borrowing Costs Will Likely Stay Low Indian Firms' Borrowing Costs Will Likely Stay Low Before we delve into the question of whether margins can stay wide, we need to understand what caused such a margin expansion in the first place. That cause is cost cutting: wage bills have gone down as businesses slashed employees. Data from Oxford economics show that there had been 9% fewer workers in India as of September 2021 compared to March 2020, just before the pandemic. Interest expense has also gone down – both relative to sales and profits (Chart 4) – as interest rates were cut aggressively. In our view, the latest rollover in profit margins will likely be temporary and limited. It is probably due to hiring back of some employees. Beyond a near-term limited drop in margins, the more relevant question to ask is, can Indian corporations maintain high margins? Our bias is that, to a large extent, they can. The main reason is that firms’ costs are slated to stay under control: Chart 5Indian Companies Do Not Face Any Wage Pressures Indian Companies Do Not Face Any Wage Pressures Firms' Costs Will Likely Stay Low As Wage Pressures Are Muted... Indian Companies Do Not Face Any Wage Pressures Firms' Costs Will Likely Stay Low As Wage Pressures Are Muted... Wage expectations are low. Going forward, as millions of new job seekers and workers temporarily discouraged by the pandemic enter the job market, wages have little chance of much of an increase. The top panel of Chart 5 shows salary expectations from an industrial survey by RBI. Both the assessment for the current quarter and expectations for the next quarter have been a net negative for a while. Rural wages are also similarly timid (Chart 5, bottom panel). Notably, companies’ hiring back of employees is slow. It seems they prefer to substitute labor by capital by investing in new machines and equipment. This will boost productivity and cap wages. Overall, high productivity growth will keep companies’ profit margins wide and excess labor will suppress wages. Higher margins and low inflation are bullish for the stock market. Critically, headline inflation is within the central bank target bands, and our model shows that it will likely remain as such (Chart 6, top panel). Core inflation is also likely to stay flattish (Chart 6, bottom panel). This means the odds are that the central bank will not raise rates anytime soon. Flattish inflation and policy rates mean firms’ borrowing costs, in both nominal and real terms, are slated to stay approximately as low as they are now. Low real borrowing costs are usually a tailwind for stocks (Chart 7). Chart 6 Chart 7Low Borrowing Costs Are Bullish For Stocks Low Borrowing Costs Are Bullish For Stocks Low Borrowing Costs Are Bullish For Stocks     All put together, Indian companies will likely see their costs largely under control. That, in turn, should keep profit margins wider than usual. Wide profit margins should limit multiple compression. Can The Topline Rise Further? Wider margins will boost total profits if and once the topline (revenues) recovers. So, the next question is, how much topline recovery is in the cards? Chart 8Indian Economy Is In A Rapid Expansion Mode Indian Economy Is In A Rapid Expansion Mode Indian Economy Is In A Rapid Expansion Mode There are already signs that sales will likely accelerate in the months to come: PMI indexes for both the manufacturing and services sectors have recovered strongly since the Delta variant-induced lockdowns in spring. They are now hovering around a very high level of close to 60. This indicates that the economy is in a rapid expansion mode (Chart 8). The Industrial Outlook survey (conducted by the RBI) shows that the order books for the September quarter was already at a decade-high level. The expectation for the next few quarters is even more elevated – indicating strong momentum (Chart 9, top panel). In other surveys, such as the PMI and Business Expectation survey (from Dun & Bradstreet), we see similar strong order books (Chart 9, bottom panel). While orders are strong, inventory of finished goods is low. Not surprisingly, businesses are expecting very high-capacity utilization in the next few quarters (Chart 10, top two panels). Chart 9Firms' Order Books Are Quite Robust Firms' Order Books Are Quite Robust Firms' Order Books Are Quite Robust Chart 10Low Inventories Mean Stronger Economic Activity Ahead Low Inventories Mean Stronger Economic Activity Ahead Low Inventories Mean Stronger Economic Activity Ahead They are expecting to hire more people. Companies also believe consumer demand will revive which will enable wider profit margins. In sum, firms are optimistic about accelerating economic activity (Chart 10, bottom two panels). Chart 11A Positive Bank Credit Impulse Is Bullish For Industrial Activity A Positive Bank Credit Impulse Is Bullish For Industrial Activity A Positive Bank Credit Impulse Is Bullish For Industrial Activity This, in turn, is encouraging them to make capital investments. Finally, the commercial banks’ credit impulse has also turned positive. Rising bank credit impulses usually signal stronger industrial production (Chart 11). To summarize, chances are that firms’ top lines are set to rise materially. Coupled with high margins, this will translate into strong profit acceleration in the next several quarters. Put differently, over the past year and a half, Indian firms witnessed rising margins. Going forward, they will likely see rising profits. Higher profits, in turn, will propel Indian share prices cyclically beyond any short-term consolidation. A Sustainable Expansion? In a notable departure from most developed countries, India’s recovery from the pandemic-induced recession has been more capex-led, rather than consumption-led (Chart 12). One reason for that is the Indian government did not supplement the lost household incomes during the lockdowns nearly as much as developed countries did. That, in turn, kept household demand low. And it also contributed to keeping inflation in check – even though India’s supply side was also paralyzed due to strict lockdown measures. On the other hand, firms’ profits soared owing to rigorous cost-cutting. Higher profits in turn have encouraged firms to expand their production capacity. Companies are ramping up capital spending as they expect sales to accelerate in the future (Chart 13). Chart 12A Capex-Led Recovery Will Prolong The Economic Expansion A Capex-Led Recovery Will Prolong The Economic Expansion A Capex-Led Recovery Will Prolong The Economic Expansion Chart 13Strong Profits Are Encouraging Firms To Ramp Up Capital Spending Strong Profits Are Encouraging Firms To Ramp Up Capital Spending Strong Profits Are Encouraging Firms To Ramp Up Capital Spending Notably, the combination of curtailed household demand and robust capital expenditure has set India’s inflation dynamics apart from many other countries in Latin America and EMEA. While India’s inflation remains largely contained, countries in those regions are witnessing accelerating inflation.  Also, over a cyclical horizon, a capex-led expansion is very crucial for India as this will determine the duration and magnitude of the cycle. Strong investment expenditures do not only boost firms’ competitiveness and profitability, but they also help keep inflationary pressures at bay. Lower inflation for a longer period means the central bank need not raise rates as soon and/or as much as otherwise would be the case. That in turn allows the economic and profit expansion to continue for longer. An extended period of expansion is also positive for multiples as investors extrapolate profit growth over many years ahead. India’s current dynamics are a case in point. Given the country is facing no imminent interest rate hikes, stock multiples can stay higher for longer. This is because multiple de-rating commences only after meaningful rate hikes have already been accorded (Chart 14). Since that is quite far off, valuations are not facing any immediate and considerable headwinds. Finally, India is beginning the new cycle with a rather inexpensive currency. Chart 15 shows that the rupee is currently cheaper by about 10% than what would be its “fair value” vis-à-vis the US dollar. The fair value has been derived from a regression analysis of the exchange rate on the relative manufacturing producer prices of India and the US. Chart 14It Takes Several Rate Hikes Before It Hurts Stock Multiples It Takes Several Rate Hikes Before It Hurts Stock Multiples It Takes Several Rate Hikes Before It Hurts Stock Multiples Chart 15India's Cyclical Expansion Has A Tailwind From Cheap Currency India's Cyclical Expansion Has A Tailwind From Cheap Currency India's Cyclical Expansion Has A Tailwind From Cheap Currency   Investment Conclusions Equities: Given the vertical rise earlier this year, Indian stocks would likely need a few more months to digest previous gains and consolidate. Hence, even though the country’s cyclical outlook remains constructive, we recommend that dedicated EM and Asian equity portfolios stay neutral on this market for now. Absolute return investors should stay on the sidelines and wait for a better entry point. Currency and Bonds: The rupee is cheap and could be one of the best performers within the EM world over a cyclical horizon. Indian government bonds also offer a good value with a rather high yield (6.4% for 10-year securities) amid a benign inflation outlook. A positive rupee outlook also makes Indian bonds more appealing for foreign investors. Investors should stay overweight India in an EM local currency bond portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes

Highlights Indonesian domestic demand is struggling to recover in the face of a very tight policy settings. Exceptionally high real borrowing costs continue to hurt non-financial sectors. This will hurt banks too as credit is stymied and NPLs rise. Equity investors should fade the rebound and stay underweight Indonesia in an EM equity portfolio. Indonesia’s external accounts will deteriorate, as the Chinese slowdown weighs on resource prices. Softening commodity prices will herald a weakness in the rupiah. Currency investors should consider going short the rupiah versus the US dollar. Domestic bond investors should tactically downgrade Indonesia from neutral to underweight within an EM bond portfolio. Sovereign EM credit investors, however, should stay overweight Indonesia. Feature Chart 1Indonesian Stock Rebound Will Be Short-Lived Indonesian Stock Rebound Will Be Short-Lived Indonesian Stock Rebound Will Be Short-Lived After years of underperformance, Indonesian stocks have rebounded in absolute terms and inched up relative to the EM benchmark (Chart 1). Could this be the beginning of a sustainable outperformance? Our research indicates that the answer is no. The Indonesian economy is still struggling. Domestic demand remains lackluster, hamstrung as it is by very high real interest rates and a tight fiscal stance. A flexing export sector, the sole source of strength so far, is set to dissipate as well. Weaker exports will weigh on the nation's financial markets. A budding softness in EM financial markets – emanating from a slowing China and rising US bond yields – will be yet another headwind for Indonesian assets over the next several months. Investors therefore should fade the current rebound and remain underweight this bourse in EM equity portfolios. EM domestic bond portfolios should consider downgrading this market from neutral to underweight relative to its EM peers. Currency investors may consider shorting the rupiah versus the US dollar. Sovereign EM credit investors, however, should stay overweight Indonesia in an EM US dollar bond portfolio. Straightjacketed The main drag to Indonesia’s economic recovery is coming from prohibitively high interest rates in the country. Real borrowing costs for the private sector, of the order of 10% (Chart 2, top panel), are extremely restrictive for any economy to handle, let alone one trying to recover from a debilitating recession. The real rates in Indonesia are also much higher than anywhere else in Asia – for both the private sector as well as for the government (Chart 2, bottom panel). Chart 2The Economy Is Struggling In the Face Of Very High Real Interest Rates The Economy Is Struggling In the Face Of Very High Real Interest Rates The Economy Is Struggling In the Face Of Very High Real Interest Rates Chart 3Absence Of Fiscal Support Is Making The Recovery Harder Absence Of Fiscal Support Is Making The Recovery Harder Absence Of Fiscal Support Is Making The Recovery Harder The fiscal stance does not appear to be very supportive either. The government is planning to rein in the fiscal deficit next year to 4.8% of GDP from an expected 5.7% this year. The IMF projects that the cyclically- adjusted fiscal thrust in 2022 will be a negative 0.8% of potential GDP, and a further negative 1.5% in 2023 (Chart 3). The consequence of such restrictive settings is that domestic consumption and consumer confidence are languishing well below pre-pandemic levels (Chart 4). Consistently, loan demand is also very weak. Bank credit for both consumption and production purposes (both working capital and term loans) have barely risen after having shrunk outright last year (Chart 5). Chart 4Domestic Demand Is Soft As Consumer Confidence Remains Low Domestic Demand Is Soft As Consumer Confidence Remains Low Domestic Demand Is Soft As Consumer Confidence Remains Low Chart 5All Types Of Bank Credit Are Weak All Types Of Bank Credit Are Weak All Types Of Bank Credit Are Weak Chart 6Disinflationary Pressures Are Entrenched In The Economy Disinflationary Pressures Are Entrenched In The Economy Disinflationary Pressures Are Entrenched In The Economy Weak domestic demand is reinforcing deflationary forces. Inflation has been undershooting the lower band of the central bank target for almost two years now. Core and trimmed mean CPI measures have been averaging below 1% over the past year. Headline CPI is below the lower target band despite high oil and food prices (Chart 6, top panel). At the same time, nominal wages are barely rising (Chart 6, bottom panel). Hence, household income growth is subdued, which is sapping consumer demand. Notably, the very high real interest rates in Indonesia today are an outcome of monetary policy falling behind the disinflation curve. In the 2000s, the country’s consumer price inflation would often flare up to double digits, and the central bank used to keep interest rates consistently high. Over the past 10 years or so, however, inflationary pressures have gradually given way to deflationary forces. Even though the central bank has reduced its policy rate, it has not reduced it sufficiently enough to offset the drop in inflation. As a result, real interest rates have risen. Banks, on their part, also refused to fully pass along the rate cuts accorded by the central bank. As such, banks’ lending rates to the private sector, in both nominal and real terms, remained much higher compared to their peers elsewhere in Asia (Chart 2, above).  Part of the reason why the central bank has fallen behind the disinflation curve has to do with the exchange rate stability and Indonesia’s dependence on foreign debt capital inflows. The country needs to offer high real rates to continue to attract enough foreign capital so that it can finance the current account deficit. As long as the central bank has rupiah stability (as a means for price stability) as its mandate, it will not reduce real interest rates. Incidentally, a bill to include economic growth and employment within the central bank’s mandate was submitted to Parliament earlier this year. Discussion over the bill, however, has been delayed. This means that elevated real interest rates will prevail for now in Indonesia, hampering economic growth. Fading Bright Spot Chart 7The Surge In Exports Has Been All About Commodity Prices, Not Increasing Volumes The Surge In Exports Has Been All About Commodity Prices, Not Increasing Volumes The Surge In Exports Has Been All About Commodity Prices, Not Increasing Volumes In contrast to domestic demand, Indonesia’s exports did phenomenally well over the past few quarters. That said, there are signs that those heady days are coming to an end: The main reason exports did so well is that commodity prices went vertically up. Export volumes, on the other hand, stayed quite low. This is also evident in the case of coal and palm oil – Indonesia’s two main export items (Chart 7). Since it’s not the volume that drove up the export revenues, the latter is vulnerable to the whims of global commodity prices – of which Indonesia is a price-taker. And commodity prices, in general, have already begun to soften. China is by far the largest destination for Indonesian exports (22% of total), and demand in the Middle Kingdom has been among main reasons behind the recent surge in Indonesian exports. Yet, the fact that China’s credit and money impulses have turned negative is a major concern for Indonesian exports going forward. If history is of any guide, negative impulses will cause a contraction in Indonesian exports over the next year or so (Chart 8). Odds are therefore that the country’s trade surplus will roll over and the current account balance will slip back to a deficit (Chart 9, top panel). Chart 8Negative Chinese Credit And Money Impulses Will Cause Indonesian Exports To Shrink Negative Chinese Credit And Money Impulses Will Cause Indonesian Exports To Shrink Negative Chinese Credit And Money Impulses Will Cause Indonesian Exports To Shrink Chart 9Indonesia's Trade And Current Account Balances Have Peaked Indonesia's Trade And Current Account Balances Have Peaked Indonesia's Trade And Current Account Balances Have Peaked Chart 10A Slowing Chinese Credit & Fiscal Impulse Is Always A Bad Omen For The Rupiah A Slowing Chinese Credit & Fiscal Impulse Is Always A Bad Omen For The Rupiah A Slowing Chinese Credit & Fiscal Impulse Is Always A Bad Omen For The Rupiah Meanwhile, Indonesia’s financial account is struggling to stay in surplus as capital inflows have dwindled significantly over the past couple of years (Chart 9, middle panel). FDI inflows are also showing few signs of revival (Chart 9, bottom panel). This indicates that Indonesia’s envisioned reforms, under the ‘Omnibus bill’, are yet to gain much traction and produce meaningful improvements in the economy’s structural backdrop. All in all, the outlook for the country’s external accounts is much less sanguine in the months ahead. That will not bode well for the rupiah, which has benefitted from robust external accounts so far. A material drop in Chinese credit and fiscal impulse has never been positive for the Indonesian currency. In the months ahead, therefore, the path of least resistance for the rupiah appears to be down (Chart 10, top panel). The link is via commodity prices (Chart 10, bottom panel). Notably, most capital inflows into Indonesia are in the form of debt capital inflows. Equity inflows are paltry. The reason is straightforward: foreign bond investors like the extremely high real rates that the country has been offering, whereas the equity investors do not. Yet, in the past couple of years, even debt capital inflows have subsided (Chart 9, middle panel). Should foreign investors turn nervous about the rupiah outlook due to falling commodity prices and/or rising US interest rates, those debt inflows would further subside. Deteriorating capital inflows would cause further weakness in the rupiah in a self-fulfilling prophecy. Domestic Bonds Chart 11Indonesian Domestic Bonds' Outperformance Is Late Indonesian Domestic Bonds' Outperformance Is Late Indonesian Domestic Bonds' Outperformance Is Late Indonesian local currency bonds have significantly outperformed their EM counterparts over the past several months (Chart 11, top panel). We have been positive on Indonesian domestic bonds. Going forward, however, the nation’s local bonds will find it difficult to rally in absolute terms and will likely underperform their EM peers. One reason for this is that, given Indonesian yields are already close to post-pandemic lows, it will be harder for them to fall much more. The relative performance of domestic bonds versus their EM peers will also be beset by a vulnerable rupiah – as explained above. The bottom panel of Chart 11 shows that periods of a weaker rupiah are usually associated with Indonesia underperforming overall EM domestic bonds. This is because foreign investors (who hold 21% of Indonesian local bonds) usually head for the exit once the rupiah begins to depreciate. Finally, as was explained in our report last week, various EM assets classes are in for a period of volatility – prompted by a deepening slowdown in China and rising US bond yields. Periods of EM stress do not augur well for Indonesian local bonds’ relative performance vis-à-vis their EM brethren. This is because the relative yield differential of Indonesia with that of EM widens in such periods – as occurred during the 2013 taper tantrum, the 2015 EM slowdown, and the 2020 pandemic (Chart 11, bottom panel). Since another EM risk-off period is around the corner, investors will be well advised to book profits on Indonesian domestic bonds’ recent outperformance and tactically downgrade this market to underweight in an EM domestic bond portfolio. Sovereign Credit Unlike the case of local currency bonds, Indonesia's sovereign credit has metamorphosed into a defensive market over the past several years. Investors now consider Indonesian sovereign credit to be among the safest within EM. This is an upshot of low public debt, including very low foreign currency public indebtedness, and years of orthodox fiscal and monetary policies. Chart 12Indonesian Sovereign Bonds Now Outperform During Risk-Off Periods Indonesian Sovereign Bonds Now Outperform During Risk-Off Periods Indonesian Sovereign Bonds Now Outperform During Risk-Off Periods In previous risk-off periods (such as the GFC in 2008 and the taper tantrum in 2013), Indonesian sovereign credit would typically underperform their EM counterparts. Yet, in more recent episodes (such as the EM slowdown in 2015 and the COVID-19 pandemic in 2020), Indonesian sovereign credit massively outperformed the EM benchmark. These recent instances suggest that during the oncoming risk-off period investors should stay overweight Indonesian sovereign credit in an EM basket.  Notably, the regime change in Indonesia’s sovereign credit characteristics has led to its relative performance (versus overall EM) being decoupled from the rupiah (Chart 12). While the rupiah remains a cyclical currency, the significant improvement in sovereign creditworthiness has turned Indonesian credit markets into a defensive play within EM. Therefore, a weakness in the rupiah in the months ahead will not jeopardize its relative performance. Share Prices Chart 13Indonesian Bank Stocks Failed To Break Out, While Non-Banks Keep Falling Indonesian Bank Stocks Failed To Break Out, While Non-Banks Keep Falling Indonesian Bank Stocks Failed To Break Out, While Non-Banks Keep Falling The Indonesian equity market is structurally beset by an uneven playing field, where the country’s banking sector has benefitted at the expense of all others. This is a consequence of banks maintaining high real lending rates as well as very wide net interest rate margins for far too long. The outcome is evident in financial and non-financial sectors’ diverging performance over the past decade (Chart 13). Given that the bull market in bank stocks has been contingent on banks’ net interest margins (NIM), any reduction therein will hurt bank stocks (Chart 14). At the same time, maintaining current lending rates and net interest margins will continue to hurt non-financial sectors (i.e., borrowers). In other words, for non-financial sectors to benefit, it will have to come at the expense of banking sector. Since banks and the rest of the stock market have very similar weights in this bourse, this dynamic will make it hard for this market to rally overall in a sustainable manner. Notably, bank stocks have failed to breach their pre-pandemic highs. This is despite net interest margins being quite elevated. The reason is that high real borrowing costs in a weak economy not only discourage credit off-take, but also threaten to raise NPLs further. Indonesian bank stocks are quite expensive as well: their ‘price/book value’ ratio is 2.6 while that of their EM counterparts is 1.1. As such, they will be hard pressed to have another sustainable rally. The other half of Indonesian equity markets, non-financials, are expectedly doing worse in the face of persistently high borrowing costs. So are the small cap stocks – where non-financial firms make up 85% of the market cap (Chart 13, bottom two panels). Notably, since Indonesia is a commodity producer, Indonesian stock prices usually do well during periods of rising commodity prices. Yet, headwinds emanating from weak domestic demand prevented Indonesia from benefitting much from high commodity prices this past year (Chart 15). Going forward, with the dissipating commodity tailwind, the Indonesian market will likely falter anew. Chart 14Any Fall In The Elevated Net Interest Margins Will Hurt Bank Stocks Any Fall In The Elevated Net Interest Margins Will Hurt Bank Stocks Any Fall In The Elevated Net Interest Margins Will Hurt Bank Stocks Chart 15Extremely Restrictive Real Rates Prevented Indonesia From Benefitting From High Commodity Prices Extremely Restrictive Real Rates Prevented Indonesia From Benefitting From High Commodity Prices Extremely Restrictive Real Rates Prevented Indonesia From Benefitting From High Commodity Prices Furthermore, a period of overall EM volatility is also a negative for Indonesian stocks’ absolute and relative performances. Investment Conclusions An impending relapse in commodity prices will herald a weakness in the rupiah. Currency investors should consider going short the rupiah versus the US dollar. In view of the likely weakness in the rupiah, dedicated EM local currency bond portfolios should pare back their exposure to Indonesia and tactically downgrade this market from neutral to underweight. Expected softness in domestic demand in the face of high real rates, faltering commodity prices and an impending volatility in EM assets - all entail that investors should stay underweight this bourse in an EM equity portfolio.   Finally, given the new defensive stature of Indonesian sovereign credit, asset allocators should stay overweight Indonesia in dedicated EM US dollar bond portfolios. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes

Highlights China’s slowdown will deepen, and US bond yields will likely rise. This augurs well for the US dollar but will produce a toxic cocktail for EM. The recent weakness in the commodity complex will continue. EM markets are at risk in absolute terms and will continue to underperform their DM counterparts. From a global macro perspective, the US dollar’s appreciation will be a re-balancing act. In a world where China is exporting economic weakness/deflation and the US is experiencing genuine inflation, a strong US dollar is desirable. The latter will redistribute inflation away from the US to the rest of the world and will redirect disinflationary pressures from the rest of the world to the US. Feature Chart 1DXY Breakout, EM FX Breakdown DXY Breakout, EM FX Breakdown DXY Breakout, EM FX Breakdown The US dollar is breaking out and EM currencies are breaking down (Chart 1). This will set in motion a number of responses in global financial markets. These include but are not limited to selloffs in EM equities, domestic bonds and EM credit markets and a setback in the commodity complex. Hence, we reiterate our negative stance on EM stocks and fixed-income markets. We continue to recommend shorting a basket of EM currencies versus the US dollar. Please refer to the end of this report for detailed investment recommendations. Why The Greenback Is Set To Strengthen Since early in the year, our investment strategy has been based on two macro themes: China’s slowdown and rising US inflation. We concluded early on that these dynamics are positive for the US dollar. Both macro themes have played out fairly well, yet until recently the broad trade-weighted US dollar’s advance has been hesitant. Odds are that the rally in the greenback is about to accelerate. Chart 2China's Slowdown = US Dollar Rally China's Slowdown = US Dollar Rally China's Slowdown = US Dollar Rally The fundamental case for the US dollar rally remains as follows: China’s slowdown will weigh more on emerging Asia, Japan, Europe, and/or commodity producing, developing and developed economies than it will on the US. The basis is that US exports to China make up only 0.7% of its GDP. The same ratio is much higher for the rest of the world. Hence, the US economy will outperform many advanced and emerging economies. Chart 2 illustrates that, historically, whenever China has slowed down, the US dollar has rallied. The mainland’s property construction is shrinking, and traditional infrastructure investment is also extremely weak (Chart 3). Beijing is easing its regulatory and macro policies but only by degrees. For now, policy support will be insufficient to reverse the business cycle downturn. In the meantime, the US economy is overheating. Specifically, all core type inflation measures have surged to well above 2% (Chart 4). Critically, nominal wages are rising at the fastest rate seen in the past 35 years (Chart 5). Chart 3China: Infrastructure Investment Is Very Weak China: Infrastructure Investment Is Very Weak China: Infrastructure Investment Is Very Weak Chart 4US Core Inflation Is Broad-Based And High US Core Inflation Is Broad-Based And High US Core Inflation Is Broad-Based And High Given that the employee quit rate is very high, employers will have to grant notable wage increases to both new and current employees. Thus, wage growth will accelerate further. Recent wage gains have not been offset by productivity growth. As a result, unit labor costs are rising (Chart 6). This will push businesses to raise their selling prices. So long as household income and consumption remain robust, businesses will likely succeed in raising their prices. In short, US inflation is acute and genuine, and, hence, it will persist unless the economy slows considerably. Chart 5US Nominal Wage Growth Is At Its Fastest In 35 Years US Nominal Wage Growth Is At Its Fastest In 35 Years US Nominal Wage Growth Is At Its Fastest In 35 Years Chart 6US Unit Labor Costs Are Rising Fast US Unit Labor Costs Are Rising Fast US Unit Labor Costs Are Rising Fast The rise in US inflation will initially be bullish for the US dollar. The reason is that fixed-income markets will move to price in higher Fed funds rates and the Fed will also acknowledge the need to hike rates given that core inflation is well above its target range. At some point in future, however, high inflation will start hurting the US dollar. This will happen when the Fed eschews rate hikes and falls behind the inflation curve. We believe we are still in a window where US bond yields could rise further. Rising US interest rates will support the dollar. Finally, the US economy, but not necessarily its equity and credit markets, is better positioned to handle central bank tightening than are other DM and EM economies. American consumers have substantially deleveraged and there are shortages in US housing and cars. Even as US borrowing costs rise, interest rate sensitive sectors like housing and autos will still do well because of pent-up demand. In particular, the US housing market is sensitive to long-term (30-year) mortgage rates and not the front end of curve. On the contrary, many EM and other DM economies and their housing sectors are sensitive to domestic short-term rates. In percentage terms, the rise in US mortgage rates will likely be smaller than those in DM and EM economies. In short, the US economy will not slow sharply in the response to rates while EM and other DM economies will. This augurs well for the dollar. The key US vulnerability from higher interest rates stems from its equity and credit markets, not the real economy. US equities and credit markets are very richly priced, so the rising cost of capital could trigger a major selloff. In turn, wealth effects and tightening financial conditions will pose a risk to the real economy. However, even in this case, the US dollar will initially appreciate because it always rallies during risk-off phases. The greenback’s depreciation will resume when the Fed turns dovish again. From a big picture macro perspective, the US dollar’s appreciation will be a re-balancing act. In a world where China is exporting economic weakness/deflation and the US is experiencing genuine inflation, a strong US dollar is desirable. The latter will redistribute inflation away from the US to the rest of the world and will redirect disinflationary pressures from the rest of the world to the US. In this period of US dollar strength, EM financial markets will be hurt because foreign investors always flee EM when their currencies depreciate. Bottom Line: China’s slowdown will deepen, and US bond yields will likely rise. This will produce a toxic cocktail for EM. Watch Out Commodity Prices Chart 7Reduced Financing For Property Developers = Less Construction Reduced Financing For Property Developers = Less Construction Reduced Financing For Property Developers = Less Construction The downturns in China’s property construction and traditional infrastructure spending are bad for raw material prices. The following points offer an explanation as to why commodity prices will relapse in spite of the fact that they have thus far resisted China’s slowdown. Although Chinese property sales and starts have been shrinking, floor area completed (construction work) has been very strong. However, the liquidity crunch that many real estate developers are experiencing will lead them to halt or cut back on their construction work (Chart 7, top panel). The latter will weigh on raw material prices (Chart 7, bottom panel). Taiwan’s new export orders PMI for the basic materials sector has dropped below 50, indicating plunging regional demand for raw materials (Chart 8). Ongoing weakness in Chinese demand is the culprit behind this drop. Due to electricity shortages, mainland production of industrial metals has plunged (Chart 9, top panel). Yet, the prices of these metals have recently corrected (Chart 9, bottom panel). Falling prices amid shrinking supply are a sign of major demand relapse. Chart 8Greater China: Orders For Basic Materials Are Already Shrinking Greater China: Orders For Basic Materials Are Already Shrinking Greater China: Orders For Basic Materials Are Already Shrinking Chart 9Base Metal Price Falling Despite Production Shutdowns In China Base Metal Price Falling Despite Production Shutdowns In China Base Metal Price Falling Despite Production Shutdowns In China   The Baltic Dry index – the price of shipping bulk commodities – has rolled over decisively. It has reasonable correlation with industrial metal prices. Oil is much less exposed than base metals to China’s property and infrastructure contraction. In the case of crude, the key risks are the US and China releasing their strategic reserves and the US dollar strength. Bottom Line: The recent weakness in the commodity complex will continue. Other Considerations Chart 10China's Onshore Stock-to_Bond Ratio Is Breaking Down China's Onshore Stock-to_Bond Ratio Is Breaking Down China's Onshore Stock-to_Bond Ratio Is Breaking Down There are a number of other considerations and indicators that lead us to maintain a negative stance on EM financial markets: China’s onshore stock-to-bond ratio has broken below its 200-day moving average (Chart 10). This signifies a deepening growth slump in China. EM equity underperformance has been broad-based. Both the market cap-weighted and equal-weighted EM equity indexes have been underperforming their respective DM indexes. Further, not only have TMT (technology, media and telecom) stocks been underperforming their DM peers, but non-TMT stocks have also lagged their counterparts substantially (Chart 11). Last but not least, EM TMT stocks remain at risk. First, share prices of Chinese internet companies will continue derating due to structurally lower profitability going forward as the government exercises more control over them. We have discussed this in previous reports. In addition, consumer spending online has slowed sharply while smartphone sales are plunging (Chart 12). Chart 11EM Equity Underperformance Is Broad-Based EM Equity Underperformance Is Broad-Based EM Equity Underperformance Is Broad-Based Chart 12China: Online Spending Is Very Weak China: Online Spending Is Very Weak China: Online Spending Is Very Weak Second, DRAM (memory chip) prices are deflating and the value of DRAM sales is shrinking (Chart 13). This is weighing on Korean semiconductor share prices like Samsung and SK Hynix. These stocks have a large market cap in the KOSPI index. Finally, demand for semiconductors produced by Taiwanese companies has been booming but it is presently showing signs of moderation (Chart 14). Chart 13Falling DRAM Prices Are Weighing On Korean Semi Stocks Falling DRAM Prices Are Weighing On Korean Semi Stocks Falling DRAM Prices Are Weighing On Korean Semi Stocks Chart 14Taiwanese Semiconductor Industry: Moderating Orders Taiwanese Semiconductor Industry: Moderating Orders Taiwanese Semiconductor Industry: Moderating Orders Importantly, geopolitical risks around Taiwan in general and TSMC in particularly are enormous. The latter is literally at the center of the US-China confrontation. The timing of a diplomatic or even military crisis is uncertain but our Geopolitical Strategy team expects geopolitical risks over Taiwan to escalate substantially. The recent summit between Presidents Joe Biden and Xi Jinping does not change this assessment.  Investment Recommendations Chart 15EM Credit Markets: Prepare For A Broad Selloff EM Credit Markets: Prepare For A Broad Selloff EM Credit Markets: Prepare For A Broad Selloff Continue underweighting EM equities in a global equity portfolio. Within the EM space, our overweights are Korea, Singapore, China (favoring A shares over investable stocks), Vietnam, Russia, central Europe and Mexico. Concerning EM equity sectors, we reiterate the short EM banks / long DM banks and short EM banks / long EM consumer staples positions. In line with our US dollar breakout thesis, we continue to recommend a short position in a basket of the following EM currencies versus the US dollar: BRL, CLP, COP, PEN, ZAR, TRY, THB, PHP and KRW. EM exchange rate depreciation is bad for EM domestic bonds. Currency weakness could lead central banks in Latin America to hike rates further. In brief, the risk-reward of EM local currency bonds is still unattractive. In this space, we recommend the following positions: bet on yield curve flattening in Mexico and Russia (pay 1-year/receive 10-year swap rates); pay Czech 10-year swap rates; receive Chinese and Malaysian 10-year swap rates. We reiterate our underweight in EM credit (both sovereign and corporate) markets versus US corporate credit, quality adjusted. As EM exchange rates depreciate, EM credit spreads will widen (Chart 15). Chinese high-yield corporate US dollar bonds are not yet a buy because the mainland property market’s travails are far from over, as was discussed in our recent Special Report. For a complete list of our recommendations across all asset classes and country strategy within each asset class, please see below or visit our web site. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations