Consumer

As the FOMC explicitly acknowledged this week, monetary policy operates with substantial lags. We see the risks to stocks as tilted to the upside over the next 6 months but are neutral on global equities over a 12-month horizon.

Falling inflation will allow bond yields to decline in the major economies over the next few quarters. As such, we recommend that investors shift their duration stance from underweight to neutral over a 12 month-and-longer horizon and to overweight over a 6-month horizon. Structurally, however, a depletion of the global savings glut could put upward pressure on yields.

The September CPI report was disappointing, but we still see several signs pointing to a rapid decline in inflation. Our constructive near-term view on stocks and the economy remains intact.

Long-after-the-fact revisions to reported income, spending and savings data do not alter our assessment that a flush consumer will continue to support the US economy and allow S&P 500 earnings to surprise the bearish investor consensus.

We share our thoughts about some of the less-discussed topics that came up across three weeks of face-to-face discussions with investors. We retain our conviction that the American consumer’s demise has been greatly exaggerated, and it continues to underpin our constructive near-term view on the US economy.

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

Executive Summary We hold to our view that households are in better shape than widely perceived, nourished by a robust labor market and a formidable supply of pandemic savings. We do not believe that the equity bear market will derail our base-case scenario that consumption will keep the economy afloat over the next several quarters. Empirically, changes in equity wealth have exerted little to no impact on consumption. Housing does have a discernible wealth effect, and consumption may be more sensitive to falling home prices than rising ones. The sharp decline in home prices feared by many investors could prompt homeowners to retrench, realizing the number-one risk to our constructive view. Although home price appreciation is in the process of decelerating, housing remains undersupplied and home prices will not fall precipitously. Housing bubble chatter is unfounded. Consumption Declines Are Few And Far Between Consumption Declines Are Few And Far Between Consumption Declines Are Few And Far Between Bottom Line: Neither the equity bear market nor a softening housing market will stifle consumption. The Fed’s anti-inflation campaign will eventually induce a recession, but wealth effect concerns are overblown. Feature Flush consumers drawing down the mountain of excess savings they accumulated across 2020 and 2021 provide the foundation for our constructive near-term view on risk assets and the economy. Consumer retrenchment is one of the two principal risks to our stance1 and we would abandon it if a meaningful share of households began to cut back. We do not know that households will dip into their savings to keep consuming at something close to their trend pace – the scale of the fiscal transfers that fattened their bank accounts was unprecedented – but we view the low and declining savings rate as providing ongoing validation for our thesis. Households can sustainably dis-save relative to their post-crisis trend (Chart 1), as a 5% savings rate whittles down their remaining $2.1 trillion stash by just $150 billion per quarter. Chart 1An Extended Period Of Dis-saving Is Sustainable An Extended Period Of Dis-saving Is Sustainable An Extended Period Of Dis-saving Is Sustainable The wealth effect is real – household spending fluctuates with wealth – and one may question whether consumers will continue to spend amidst an equity bear market while the 3-percentage-point surge in mortgage rates pressures home values. As counterintuitive as it may seem, however, changes in equity wealth have had a modest and inconsistent effect on consumption. Changes in housing wealth have exerted greater influence, and one study by prominent researchers suggests that the effect is stronger when home prices decline. We consider the empirical evidence regarding equity and housing wealth effects, along with the prospects for a sharp decline in home prices, in this report. What Drives Spending? For all the talk of the wealth effect, consumer spending is predominantly a function of income. Every multi-factor regression we performed (Box 1) indicated that changes in nominal income account for the lion’s share of changes in nominal consumption, with estimates ranging up to 75%. When we regressed real consumption with real income and real measures of equity and housing wealth, the estimates of income’s effect were sharply lower – typically between 10 and 25% – but the modeled results were dramatically less robust. We accordingly focus on the nominal relationships in the rest of this report, though we note that the real regressions reinforced the nominal regressions’ pointed implication that changes in equity wealth are largely irrelevant for explaining changes in consumption. Box 1: A Regression Refresher Multi-factor linear regression is a statistical method for determining which independent variables influence the movements of a dependent variable. Regression analysis reveals the statistical significance of independent variables based on their empirical relationship with the dependent variable. If the relationship is robust enough that it is unlikely to have occurred randomly, the independent variable is deemed to be significant. The regression equation describes a best-fit line that minimizes the individual observations’ aggregate deviation from the line. It includes a constant term, b, marking the point where the best-fit line intersects the y-axis, and an x term that denotes each of the independent variables, paired with a coefficient, a. Each coefficient describes the sensitivity of the dependent variable to changes in the value of each independent variable. For dependent variable y, and independent variables x1, x2, …, xn, the equation is written as: y = a1x1 + a2x2 + … + anxn + b. The robustness of the regression is indicated by its r-squared value, ranging from 0 to 1, which quantifies the share of the dependent variable's movement that is explained by movement in the independent variables. In our research, we used Personal Consumption Expenditures and Personal Income from the National Income Accounts as our measures of consumption and income, respectively. We used the measure of corporate equities held by households and nonprofit organizations from the Fed’s quarterly Financial Accounts of the United States (report Z.1) to measure equity wealth and followed the methodology of Case, Quigley and Shiller (2005 and 2013)2 to calculate housing wealth.3 We also followed Case, Quigley and Shiller’s methodology in regressing the year-over-year percentage change in the natural log of the variables’ values. Homes Trump Stocks Simple regressions, measuring the empirical impact of a single independent variable upon a dependent variable, indicate that changes in equity wealth exert considerably less influence over changes in consumption than changes in housing wealth. With a two-quarter lag, year-over-year consumption has changed by nearly three cents for every dollar move in equity wealth (Chart 2). Three cents are in line with rule-of-thumb estimates, but we note that the regression’s r-squared is less than 3%. An unlagged year-over-year regression posits a 0.6-cent consumption change for every dollar move in equity wealth with a microscopic r-squared of 0.1%. Chart 2Equities' Relationship With Consumption Is Weak And Unreliable, ... The Wealth Of Households The Wealth Of Households The housing wealth regression indicates that every dollar of changes in housing wealth leads to a 38-cent change in consumption. With a 38% r-squared, the housing wealth regression generates a visibly tighter fit (Chart 3), inspiring more confidence in the posited relationship, though it is incomplete without considering any other variables’ role in influencing consumption. The housing wealth relationship is also considerably stronger on an unlagged basis (Table 1). Chart 3... Contrasting With Housing's Stronger, More Consistent Pull The Wealth Of Households The Wealth Of Households Table 1Simple Regression Output The Wealth Of Households The Wealth Of Households Chart 4Equities Are Owned By Low MPC Households The Wealth Of Households The Wealth Of Households It may seem surprising that relatively opaque changes in housing wealth exert a much stronger influence over consumption than immediately observable changes in equity wealth. We think the result is a function of the greater breadth of home ownership; nearly two-thirds of households own their home, and it is far and away the largest asset for all but the wealthiest of families. Stock ownership, on the other hand, is highly concentrated, with the top 1% of households by wealth owning over 50% of equities, and the top 10% owning nearly 90% of them (Chart 4). Fluctuations in the stock market mostly impact households with a low marginal propensity to consume but changes in home prices effect a much fuller sweep of Americans. The simple regressions set the stage for what we discovered when we performed multi-factor regressions, confirming previous researchers’ findings. Income is the primary driver of consumption, with a one-dollar change in nominal income provoking a 65-to-72-cent change in nominal spending, and its statistical significance in the models is beyond question (Table 2). Table 2Multiple Regression Output The Wealth Of Households The Wealth Of Households Equities’ wealth effect is not statistically significant in the unlagged model at a 5% significance level (it’s not even statistically significant at the more forgiving 10% significance level) and it is modest (about 1.5 cents on the dollar) in any event. The model would be better off without including equity wealth as an independent variable. In the model lagging consumption by two quarters, which produces a slightly better fit and accords more easily with our own intuition that wealth effects are not felt instantaneously, consumption moves inversely with equity wealth, falling 3 cents for every one-dollar increase in equity wealth and rising 3 cents for every one-dollar decrease. That result is statistically significant, albeit hard to wrap one’s head around. The housing wealth variable is comfortably significant even at a 1% significance level and its impact is quite large in both the unlagged (14.5 cents on the dollar) and the two-quarter-lagged (11.75 cents on the dollar) specifications. Both model specifications generate high r-squareds, explaining 58% and 60% of the variability in consumption, respectively, and the modeled values fit the actual values extremely well before the pandemic scrambled the relationship between consumption and its drivers (Chart 5). Chart 5A Tight Fit Before The Pandemic A Tight Fit Before The Pandemic A Tight Fit Before The Pandemic We also ran a version of the model that substituted Disposable Income for Personal Income, but it slightly weakened its explanatory power and we judge that the broader Personal Income series is a better input. We also ran a version of the model that used household real estate holdings and mortgage balances from the Fed’s quarterly Z.1 report to calculate a factor that translates gross housing wealth to net housing wealth to reflect that all households do not own their homes free and clear.4 Substituting net housing wealth reduced the model’s explanatory power by about two percentage points but left the individual variables’ significance largely intact while cutting housing’s unlagged and two-quarter lagged wealth effect to 7 and 5 cents, respectively (Table 3). Net housing wealth is more intellectually satisfying than gross housing wealth and the smaller wealth effect estimates are more in line with the peer-reviewed literature. Table 3Multiple Regression Output With Net Housing Wealth The Wealth Of Households The Wealth Of Households Whither Home Prices? Investors appear to be braced for a sizable decline in home prices even though nominal price declines are unusual in the five-decade history of the leading repeat sales price indexes. The Case-Shiller National Index has declined just 19% of the time on a sequential basis and 14% of the time on a year-over-year basis (Chart 6). Excepting the 21 consecutive quarters of year-over-year declines from 1Q07 through 1Q12, the Case-Shiller National Index has declined in just five quarters over 41 years, all during the 1990-91 recession that featured tax law changes sharply curtailing individuals’ ability to benefit from losses on real estate investments. The FHFA (née OFHEO) House Price Index has declined on a year-over-year basis just 11% of the time, with only one decline occurring outside of 2007 to 2012 (Chart 7). Chart 6Ex-The Crisis, Declines Are Rare, ... Ex-The Crisis, Declines Are Rare, ... Ex-The Crisis, Declines Are Rare, ... ​​​​​​ Chart 7... In Both Major Series ... In Both Major Series ... In Both Major Series ​​​​​​ Investors expecting a decline therefore appear to be anchoring to an extreme outlier. We cringe whenever we hear the term “housing bubble” used to liken today’s backdrop to the one that preceded the financial crisis. Make no mistake: it is not 2007 in the housing finance market in any way, shape or form. Residential mortgage originations have been made to vastly better borrowers than they were in the run-up to the crisis (Chart 8) and they’ve been made on far more solid terms, as the loan-to-value ratio for residential mortgages has shrunk by 25 percentage points in the immediate aftermath of the bust to its easily sustainable levels of the early ‘80s (Chart 9). Chart 8Mortgages Have Been Extended To Better Borrowers ... The Wealth Of Households The Wealth Of Households Chart 9... On Better Terms Than Before The Crisis ... On Better Terms Than Before The Crisis ... On Better Terms Than Before The Crisis Chart 10Housing Supply Is Tight Housing Supply Is Tight Housing Supply Is Tight Housing is broadly undersupplied, as evidenced by the record-low home vacancy rate (Chart 10). Higher mortgage rates have surely put monthly payments out of the reach of some aspiring buyers, sending them to the sidelines, but supply remains constrained and home prices fall slowly. Kahneman and Tversky demonstrated that people are quick to take gains by selling appreciated assets but slow to part with assets that are under water. Even if we are underestimating the eventual magnitude of a decline in home prices, we are confident that the decline will not be sudden. Homeowners with discretion over when they sell will wait to exercise it; turnover will slow as pricing softens and the reduced supply will help to mitigate the declines. Investment Implications We were inspired to explore the housing wealth effect by a striking assertion featured in a leading market periodical two weeks ago. An independent strategist stated that the wealth effect from a one dollar decline in home prices was a whopping 40 cents, while the effect of a like decline in equity prices was 10 cents. The assertion was passed on without comment or criticism by the publication, which has long touted its skepticism and unwillingness to accept bullish statements at face value. Alas for its readers, the standard apparently does not apply to bearish claims, no matter how far off the beam they may be. (Based on our results, we suspect these wealth effect estimates are based on simple regressions.) Divergent views are what make a market, but nothing in the body of peer-reviewed research supports the idea that the $6.5 trillion decline in directly owned equities and a hypothetical 10% decline in home equity from its nearly $30 trillion June 30th level will extinguish $650 billion and $1.2 trillion of consumption, respectively. That nearly $2 trillion hit would be punishing, given consumption's current $17 trillion annualized pace. It would also be unprecedented: since the Personal Consumption Expenditures series began in 1950, nominal consumption has only ever declined by a margin that can be seen by the naked eye during the Great Recession and the COVID pandemic (Chart 11). Those historic declines amounted to 3.5% from the 3Q08 peak to the 2Q09 trough and 11.4% from the 4Q20 peak to the lockdown 2Q21 trough. Chart 11Visible Declines In Nominal Spending Are Rare Visible Declines In Nominal Spending Are Rare Visible Declines In Nominal Spending Are Rare We are only too happy to take the other side of the view that another 11% decline could be in store, assuming the absence of nuclear war or another pandemic. We think the 3.5% Great Recession decline will likely remain out of reach, as well, given that the financial crisis emerged from a concatenation of events that cannot repeat now that regulators have so thoroughly clipped the banking system’s wings. Not every investor subscribes to Chicken Little warnings about the housing market, but the promiscuity with which the term bubble is thrown around strongly suggests to us that the consensus view overestimates the probability of a dire economic outcome. When subsequent events reveal that the shock probability has been overstated, the consensus economic and S&P 500 earnings views will have to be revised upward and we believe the eventual revisions will provide risk assets with a path to recover some of the ground they’ve lost this year. We continue to believe that it would be premature to implement full-on defensive asset allocation measures before they do.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      A breakout in long-run inflation expectations is the other. 2      Case, Karl E., John M. Quigley, and Robert J. Shiller, “Comparing Wealth Effects: the Stock Market versus the Housing Market,” Advances in Microeconomics, 5(1),2005: 1-32.  Case, Karl E., John M. Quigley, and Robert J. Shiller, “Wealth Effects Revisited: 1975-2012,” NBER Working Paper 18667, January 2013. 3      Case, Quigley and Shiller calculate housing wealth in time t, HWt, as the product of the number of US households, Nt, the homeownership rate, ORt, the average price of a single-family home in the base period (1Q75 in our study), AVGBASE, and a weighted repeat sales price index relative to its base period value, (PIt/PIBASE). We used the National Association of Realtors’ average existing home price series and the Case-Shiller National Index for variables AVG and PI, respectively, as per the following equation: HWt = Nt × ORt × AVG1Q75 × (PIt/PI1Q75) 4     HWt, described in the second footnote, is a gross measure of housing wealth. We divided outstanding mortgage debt by the value of households’ real estate holdings to calculate the aggregate residential mortgage loan-to-value ratio, LTV. We subtracted LTV from 1 to calculate the share of housing value that represented households’ aggregate home equity and multiplied it by HWt to produce an estimate of net housing wealth, NHW: NHWt = HWt × (1 – LTVt)

Executive Summary Turbulence remains the signal feature of 2022 as worries about inflation and the Fed’s reaction to it continue to haunt investors and plague financial markets. Despite four-decade highs in measured inflation, long-run inflation expectations have held fast, keeping an inflation vicious circle from taking hold. As the diminishing threat from COVID helps unsnarl supply and transportation bottlenecks, it will also reduce the potential for expectations to become unmoored. The labor market has been sending encouraging signals for the economy and corporate profit margins. Although payrolls continue to expand at a robust pace and job openings remain near record highs, upward wage pressures appear to be losing momentum. Households have proven willing to spend their excess pandemic savings and maintain a sizable cushion to keep the economy growing near its long-run trend pace.  All Is Not Yet Lost All Is Not Yet Lost All Is Not Yet Lost Bottom Line: Markets remain volatile, subject to sharp swings upon any data points that portend a shift in the Fed’s tightening campaign. The August CPI report did not change our view that the consensus is underestimating the potential for positive earnings surprises in the next two quarters and we continue to recommend overweighting equities over the next three to six months. Feature Will the real inflation trend please stand up? Financial markets were emboldened by July’s CPI release, which reported a 0.1% month-over-month decline in inflation, 10 basis points below expectations, and demoralized by August’s edition, which reported a 0.1% month-over-month increase, 20 basis points above expectations. Core inflation, which backs out changes in volatile food and energy prices, came in at 0.6% in August after a 0.3% reading in July. In the harsh light of the August release, the July data point looked anomalous to the naked eye after holding between 0.6 and 0.7% in the three previous months. Related Report  US Investment StrategyChartbook Equities swooned after the release, but policymakers and economic participants should focus on data trends rather than data points. Though we share in the general disappointment that inflation remains elevated, we continue to expect that headline CPI growth will abate to around 4% over the coming months. The supply of goods and services will increase as COVID’s threat continues to recede, while demand will slacken as the Fed and other major central banks continue to tighten monetary policy. The end of COVID restrictions will help to facilitate the ongoing shift in demand from goods to services. All in all, the underlying trend toward decelerating inflation will not be upended by noisy one-off data points. Stubbornly high inflation prints increase the risk that inflation expectations will become unmoored, feeding a self-reinforcing cycle in which high prices beget even higher prices, but there is no sign yet that they are poised to break out. Persistent inflation also increases the risk that the Fed will overdo the tightening and induce a deeper recession than would otherwise occur. We remain vigilant on both fronts, but believe markets are overestimating the probability of each risk. The charts that follow – tracking COVID’s course, inflation expectations, the labor market, household balance sheets and the outlook for S&P 500 earnings – show the data underpinning our stance. We will abandon our sanguine tactical view if consumers show signs of retrenching, which would torpedo our better-than-consensus growth outlook, or if inflation expectations show signs of becoming unmoored, which would force the Fed to move to throttle the economy immediately. Neither condition has yet been met, however, and we continue to believe that the consensus is underestimating the potential for upside earnings surprises. Chart 1Omicron Has Come And Gone ... Omicron Has Come And Gone ... Omicron Has Come And Gone ... Chart 2... With Much Less Of An Impact Than Delta ... With Much Less Of An Impact Than Delta ... With Much Less Of An Impact Than Delta Chart 3The Picture Looks Even Better Outside The US ... The Picture Looks Even Better Outside The US ... The Picture Looks Even Better Outside The US ... Chart 4... Though Ancillary Counts May Not Be So Rigorously Maintained ... Though Ancillary Counts May Not Be So Rigorously Maintained ... Though Ancillary Counts May Not Be So Rigorously Maintained Chart 5Watch This Space Watch This Space Watch This Space Chart 6Consumers Are Still Not Chasing Big-Ticket Items Consumers Are Still Not Chasing Big-Ticket Items Consumers Are Still Not Chasing Big-Ticket Items Chart 7Near-Term Expectations Are Way Down ... Near-Term Expectations Are Way Down ... Near-Term Expectations Are Way Down ... Chart 8... And Long-Term Expectations Remain Contained ... And Long-Term Expectations Remain Contained ... And Long-Term Expectations Remain Contained Chart 9Steady As She Goes Steady As She Goes Steady As She Goes Chart 10We're All Doomed! We're All Doomed! We're All Doomed! Chart 11Oh, Wait, Never Mind Oh, Wait, Never Mind Oh, Wait, Never Mind Chart 12Initial Claims Are Nearly 20% Below Their Mid-July Peak ... Initial Claims Are Nearly 20% Below Their Mid-July Peak ... Initial Claims Are Nearly 20% Below Their Mid-July Peak ... Chart 13... And Openings Have Come Only Slightly Off Of Theirs ... And Openings Have Come Only Slightly Off Of Theirs ... And Openings Have Come Only Slightly Off Of Theirs Chart 14Ready, Willing And Able To Keep The Economy Going Ready, Willing And Able To Keep The Economy Going Ready, Willing And Able To Keep The Economy Going Chart 15Down, But Not Out Down, But Not Out Down, But Not Out Chart 16Margins Remain Elevated ... Margins Remain Elevated ... Margins Remain Elevated ... Chart 17... And Profit Warnings Are Few And Far Between ... And Profit Warnings Are Few And Far Between ... And Profit Warnings Are Few And Far Between Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

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

Executive Summary Chair Powell’s Jackson Hole speech did not change our fundamental take on the economy; we still think the expansion will survive through the first half of 2023 at a minimum. Financial markets’ reaction to Powell’s remarks highlighted that volatility will likely remain elevated but we continue to expect that equities will generate meaningful excess returns over Treasuries and cash over the rest of the year. The flow of data continues to send mixed signals about the outlook for financial markets and the economy, but the biggest risks to our view are no closer to occurring today than they were when we laid them out last month. An Eventful Intermeeting Period An Eventful Intermeeting Period An Eventful Intermeeting Period Bottom Line: We remain more optimistic than the consensus and continue to recommend a risk-friendly tilt in multi-asset portfolios over the next six months. We are still on high alert, however, and remain open to changing our views if incoming data begin to hint at an approaching inflection. Feature At the outset of a Zoom call last week, a US-based client asked if Chair Powell’s Jackson Hole speech had changed our view. The short answer is no, though it certainly roiled financial markets, providing the latest reminder that investors’ conviction levels should be lower than normal. This week’s report offers a longer answer, analyzing Powell’s comments while revisiting the risks to our view that we laid out in August. The principal risks have not gotten any closer to fruition and we therefore stand by our glass-half-full view, though we reiterate that it is contingent on incoming data flows – if they point to a worse outcome than our current base case, we may yet join the bearish chorus. The Fed Bigwigs Went To Grand Teton National Park … Chair Powell opened his speech by promising brevity, focus and directness and he delivered on all three counts. He used less than a third of his allotted 30 minutes to hammer home the Fed’s commitment to bringing inflation back to its 2% target and he didn’t mince words. The speech was short enough to allow the following close reading of it in which we excerpt a key line from nearly every paragraph, followed by our italicized takeaways. Powell: “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance.” US Investment Strategy: We are prepared to accept a lengthy stretch of subpar growth as the cost of getting inflation under control. Until further notice, fighting inflation takes precedence over encouraging growth. “The labor market … is clearly out of balance, with demand … substantially exceeding … supply[.]” The rip-roaring labor market is so strong that we have no choice but to lean against it given the inflation backdrop. “In current circumstances, … [the dots’] estimates of [the] longer-run neutral [fed funds rate] are not a place to stop or pause.” It will take a good bit more monetary tightening to get inflation back to the 2% target. “I said [in July] that another unusually large increase could be appropriate at our next meeting.” Another 75-basis point hike is on the table in September. The pace of increases will eventually slow, but we don’t yet know when. “Restoring price stability will likely require maintaining a restrictive policy stance for some time.” Don’t count on rate cuts any time soon. “[C]entral banks can and should take responsibility for delivering low and stable inflation.” The Fed is obligated to combat high inflation, even if some of its causes are beyond our control. Though we can’t relieve supply constraints, we can bring demand into better balance with supply. Related Report  US Investment StrategyRisks To Our View (Again) “If the public expects that inflation will remain low and stable over time, absent major shocks, it likely will. Unfortunately, the same is true of expectations of high and volatile inflation.” High inflation expectations can be self-fulfilling and we cannot allow them to become entrenched à la the 1970s. “The longer the current bout of high inflation continues, the greater the chance that expectations of higher inflation will become entrenched.” We cannot take it for granted that inflation expectations will remain well anchored despite high inflation prints. The public’s focus on inflation threatens future price stability and future growth and we would be playing with fire if we didn’t address it now. “[W]e must keep at it until the job is done.” If we do not act forcefully now, the cost of getting inflation back to the 2% target will be much greater. “We will keep at it until we are confident the job is done.” In case you missed my first reference to Paul Volcker’s memoir, Keeping At It, a moment ago, or the two times I spoke his name, understand that we’re willing to do whatever it takes to getting the inflation genie back in the bottle. … And All Investors Got Was A Lousy Selloff Our italicized translations should have sent a chill down the spines of equity investors and the S&P 500 duly plunged 3.4% after Powell’s speech, then followed up by sliding as much as another 3.8% in last week's sessions. BCA has always viewed 2023 rate cuts as something of a pipe dream, and we have been relieved to see the money market raise its terminal fed funds rate estimate while pushing out the date it will be reached. As Chart 1 shows, the expected terminal rate has risen by about 75 basis points and rate cuts have been pushed back since the July FOMC meeting, but even Jackson Hole didn’t get investors to give up on them entirely. Our best guess is that they still question the Fed’s commitment in the face of a slowdown. Chart 1A Lot Can Change In Five Weeks A Lot Can Change In Five Weeks A Lot Can Change In Five Weeks That interpretation offers a ready answer for why the glass-half-full view has taken a beating over the last six sessions but suggests that the glass-half-empty view could be at risk before too long. A higher terminal fed funds rate implies lower near-term earnings as well as a reduced willingness to pay for those earnings, so stocks have suffered as investors revised their expectations to better align with the Fed’s guidance. But the need to hike more and faster than investors expected underscores aggregate demand’s surprising resilience. If the labor market, consumption and corporate earnings all continue to hold up better than expected, equities have a path to move higher once the terminal rate outlook fully discounts the Jackson Hole rhetoric. Risks To Our View: Unanchored Inflation Expectations If it takes longer than markets expect for rate hikes to bite, and corporate earnings and economic growth surprise to the upside while inflation intrinsically recedes along with COVID's threat, underweight investors are likely to find themselves pulled back into equities. That scenario remains our base case, but it would become highly improbable if inflation expectations were to become unmoored, forcing the Fed to race to get the fed funds rate above 4% and keep it there. We therefore deem a breakout in inflation expectations to be an existential threat to our view. One month’s flat headline CPI reading certainly does not meet the Fed’s “clear and consistent” standard for falling inflation but various indications that consumer prices have peaked have begun to provide some near-term expectations relief. Two-year TIPS breakevens fell 35 basis points in two weeks, to 2.3%, their lowest level since January 2021 (Chart 2, top panel). Two-year CPI swap rates dipped 15 basis points in that stretch and are at their lowest level since last October (Chart 3, top panel). Intermediate- (Charts 2 and 3, middle panel) and long-term (Charts 2 and 3, bottom panel) expectations have ticked slightly higher in the last two weeks but reduced near-term expectations will take some of the pressure off them. Consumers see it the same way, with one-year inflation coming down sharply in the University of Michigan’s August survey (Chart 4, top panel) while long-term inflation expectations held steady at the bottom of the 2.9-3.1% range that has been in place for a year (Chart 4, bottom panel). Chart 2Way Lower Near-Term And ... Way Lower Near-Term And ... Way Lower Near-Term And ... ​​​​​ Chart 3... Range-Bound Longer-Term Expectations ... Range-Bound Longer-Term Expectations ... Range-Bound Longer-Term Expectations ​​​​​ Chart 4No Vicious Inflation Expectations Cycle Yet No Vicious Inflation Expectations Cycle Yet No Vicious Inflation Expectations Cycle Yet Risks To Our View: Consumer Retrenchment Our sanguine take on economic growth and corporate earnings will be in trouble if consumers begin to hoard their excess savings. The Personal Income report released the morning of Powell’s Jackson Hole speech indicated that the aggregate household savings rate was just 5% in July, matching June’s downwardly revised number. We view the steadily declining trend (Chart 5) as ongoing validation of our thesis that consumers will deploy their excess savings to keep consumption and the US economy growing at trend, despite uncomfortably high inflation. Chart 5Staying Out Of The Paradox-Of-Thrift Trap Staying Out Of The Paradox-Of-Thrift Trap Staying Out Of The Paradox-Of-Thrift Trap Risks To Our View: A Softening Labor Market The major labor market datapoints that have arrived over the last two weeks have been consistently robust. Job openings, which had appeared to have entered a steady decline, turned out to be in a holding pattern following a significant July beat and an upward revision to June’s reading. Before the release, job openings were projected to be 12.5% below their March peak; instead, they’ve only shrunk by 5%, or about 100,000 more than July’s net payroll additions (Chart 6, top panel). Meanwhile, job quits data softened a little more, falling for the fourth straight month (Chart 7, top panel) and pushing the quits rate to its lowest level since May 2021 (Chart 7, bottom panel). Taken together, the openings and quits data hint that a Goldilocks outcome – labor demand remains strong but not so strong that employees are able to command higher wages simply by walking to the competitor across the street – is not impossible. Chart 6Job Openings Have Gotten A Second Wind ... Job Openings Have Gotten A Second Wind ... Job Openings Have Gotten A Second Wind ... ​​​​​ Chart 7... While Quits Are Slowing ... While Quits Are Slowing ... While Quits Are Slowing ​​​​​ The four-week moving average of initial unemployment claims extended its modest decline after a smaller-than-expected number last week and a downward revision in the previous week’s estimate (Chart 8). Markets let out a sigh of relief after the August employment situation report managed to thread the needle,1 showing that net payrolls robust growth is gently moderating (Chart 9). The numbers below the headline were also encouraging; average hourly earnings increased just 0.3% from July and the labor force participation rate rose by 30 basis points to match the post-COVID high set in March (Chart 10). The part rate remains a full percentage point below its pre-COVID level, amounting to 2.75 million missing workers – if they were to return, payrolls would have room to expand even as the unemployment rate ticks higher. Chart 8Jobless Claims Have Been Falling Since Mid-July Jobless Claims Have Been Falling Since Mid-July Jobless Claims Have Been Falling Since Mid-July Chart 9Payrolls Are Still Growing At A Healthy Clip Payrolls Are Still Growing At A Healthy Clip Payrolls Are Still Growing At A Healthy Clip ​​​​​​ Chart 10Yet Another Supply Constraint Yet Another Supply Constraint Yet Another Supply Constraint ​​​​​ Investment Implications The data received over the last two weeks suggest that the economy retains considerable momentum. Solid nonfarm payrolls gains, the month-and-a-half interruption in initial unemployment claims’ uptrend and the job openings and job quits data paint a picture of a labor market that is still humming even as upward pressure on wages may be moderating. We continue to be heartened by the low and slightly declining savings rate, which lends support to our thesis that excess pandemic savings will provide households with a cushion to keep spending despite painful increases in the price of necessities. Finally, despite eye-popping inflation readings, household, business and investor inflation expectations have remained well anchored. Though the fundamentals have been good since we elaborated on the key risks to our view two weeks ago, the technical picture turned against us with a vengeance. The S&P 500 support at 4,175 folded like a cheap lawn chair after Chair Powell took to the podium at Jackson Hole. We are CFAs, not CMTs, though we posit that technical analysis has a place in fundamental practitioners’ processes as a means of identifying advantageous entry and exit points. Going forward, however, we will not float ideas about technical levels without explicitly defining stops to exit a position if the technical level fails to hold. The stock swoon that ensued after Jackson Hole underlines how much investors are hanging on the Fed. Any perceived change of emphasis or direction has the potential to scramble financial markets and we continue to advise that investors carefully manage their holding periods and benchmark deviations. Although we think the Fed will eventually force a sober reckoning for risk assets, we believe equities can outperform over the next three to six months and therefore recommend overweighting equities in multi-asset portfolios through the end of the year. If inflation decelerates over the rest of the year as we expect, the Fed’s rhetoric should become less frightening and risk assets should see renewed inflows as the gloomy scenarios take longer to arrive than the consensus currently expects.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      As we went to press, however, equities were selling off sharply, apparently on reports of an extended Gazprom pipeline shutdown.