Developed Countries

Highlights Chart 1Stick With Steepeners The new year promises to be one of Fed tightening. The minutes from the December FOMC meeting reinforced the notion that rate hikes will begin as early as March and the market is now priced for 85 bps of rate increases (between 3 and 4 hikes) by the end of 2022. The long-end of the curve has responded to the hawkishness with the 10-year Treasury yield moving above its previous post-pandemic high of 1.74%. Just as interesting, however, is that the 5-year/5-year forward Treasury yield has only just climbed back to the lower-end of the range of neutral fed funds rate estimates (Chart 1). This has implications for our preferred yield curve positioning. With the 5-year/5-year forward yield still below our target, it makes sense to position for a bear-steepening of the Treasury curve. A shift from steepeners to flatteners will be warranted once the 5-year/5-year is more consistent with survey estimates of the neutral rate. For now, we recommend keeping portfolio duration low and owning 2/10 Treasury curve steepeners (long 2-year, short cash/10 barbell). Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in December and by 162 bps in 2021. The index option-adjusted spread tightened 7 bps on the month and our quality-adjusted 12-month breakeven spread ticked down to its 6th percentile since 1995 (Chart 2). This indicates that corporate bonds remain expensive, despite the Fed’s pivot toward tightening. The slope of the yield curve is a critical indicator for our corporate bond call. We are very comfortable holding corporate bonds when the 3-year/10-year Treasury slope is above 50 bps, but our work suggests that returns to credit risk take a significant step down once the slope flattens into a range of 0 bps to 50 bps.1 The 3-year/10-year Treasury slope recently bounced off the 50 bps level and it currently sits at 59 bps. However, our fair value estimates for the 3/10 slope suggest that it won’t stay above 50 bps for long (bottom panel). The three scenarios we consider all suggest that the 3/10 slope will break below 50 bps within the next six months.2 We will turn more defensive on corporate bonds once that occurs. High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 216 bps in December and by 669 bps in 2021. The index option-adjusted spread tightened 54 bps on the month, ending the year at 283 bps. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – also fell back to 3.3% (Chart 3). The odds are good that defaults will come in below 3.3% in 2021, which should coincide with the outperformance of high-yield bonds versus duration-matched Treasuries. For context, the high-yield default rate came in at 1.8% for the 12 months ending in November and we showed in a recent report that corporate balance sheets are in excellent shape.3 Specifically, we noted that the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). We recommend that investors favor high-yield over investment grade corporate bonds. While, as noted on page 3, we will turn more defensive on credit risk (including high-yield) once the 3/10 Treasury slope moves sustainably below 50 bps, we will likely retain a preference for high-yield over investment grade based on relative valuations.      MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 21 basis points in December but lagged by 69 bps in 2021. The zero-volatility spread for conventional 30-year agency MBS tightened 6 bps on the month, evenly split between 3 bps of option-adjusted spread (OAS) tightening and a 3 bps drop in the compensation for prepayment risk (option cost) (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021, despite the back-up in yields.4 The robust pace of home price appreciation has been an important factor boosting refis, as homeowners have been increasingly incentivized to tap the equity in their homes. With no indication that cash-out refi activity is about to slow, we expect refinancings to remain stubbornly high in 2022. This will put upward pressure on MBS spreads. We recommend an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel). Government-Related: Overweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 34 basis points in December and by 68 bps in 2021. Sovereign debt outperformed duration-equivalent Treasuries by 216 bps in December but lagged by 10 bps in 2021. Foreign Agencies outperformed the Treasury benchmark by 6 bps on the month and by 41 bps in 2021. Local Authority bonds underperformed by 37 bps in December but beat duration-matched Treasuries by 368 bps in 2021. Domestic Agency bonds underperformed by 1 bp in December and were flat versus Treasuries on the year. Supranationals outperformed Treasuries by 2 bps in December and by 20 bps in 2021. The investment grade Emerging Market Sovereign bond index outperformed the duration-equivalent US corporate bond index by 109 bps in December. The Emerging Market Corporate & Quasi-Sovereign index outperformed duration-matched US corporates by 16 bps (Chart 5). Both EM indexes continue to offer significant yield advantages versus US corporate bonds with the same credit rating and duration. We continue to recommend overweighting USD-denominated EM sovereigns and corporates versus investment grade US corporates with the same credit rating and duration.5  Within EM sovereigns, attractive countries include: Philippines, Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar. Municipal Bonds: Maximum  Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 43 basis points in December and by 416 bps in 2021 (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuations.6 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue munis offer a breakeven tax rate of 19% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 25% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in December but reversed some of that flattening in the first week of January. All in all, the 2-year/10-year Treasury slope has flattened 2 bps since the end of November, bringing it to 89 bps. As noted on the front page of this report, the 5-year/5-year forward Treasury yield is rising but it is still only at the low-end of survey estimates of the long-run neutral fed funds rate. This argues for continuing to hold curve steepeners in the near term. It will make sense to shift into flatteners once the 5-year/5-year forward yield rises to the middle of the range of survey estimates. We also observe that the 2/5/10 butterfly spread is extremely high, both in absolute terms and relative to our model’s fair value (Chart 7). This signals that a 2/10 curve steepening position (long 5-year bullet, short 2/10 barbell) is incredibly cheap. Indeed, the 2/10 slope has already flattened to below the levels that were witnessed on the last two Fed liftoff dates in 2015 and 2004 (panel 4) and the Fed has still not raised rates off the zero bound. A trade long the 5-year bullet and short a duration-matched 2/10 barbell looks attractive in this environment. However, we note that the 2/5 Treasury slope has also flattened to below levels seen on the prior two Fed liftoff dates (bottom panel). In other words, the 2/5 slope also has room to steepen. For that reason, we prefer to focus our long positions on the 2-year Treasury note rather than the 5-year. We recommend buying the 2-year bullet versus a duration-matched cash/10 barbell. We also advise investors to own a position long the 20-year bond versus a duration-matched 10/30 barbell. This latter position offers a very attractive duration-neutral yield advantage of 20 bps. TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 85 basis points in December and by 830 bps in 2021. The 10-year TIPS breakeven inflation rate rose 8 bps on the month while the 2-year TIPS breakeven inflation rate fell by 2 bps. The 10-year and 2-year rates currently sit at 2.52% and 3.17%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps on the month. It currently sits at 2.19%, somewhat below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. All three trades will profit from falling short-maturity inflation expectations. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in December and by 31 bps in 2021. Aaa-rated ABS outperformed by 4 bps in December and by 17 bps in 2021. Non-Aaa ABS outperformed Treasuries by 9 bps in December and by 103 bps in 2021. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth is starting to rebound, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones.       Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in December and by 180 bps in 2021. Aaa Non-Agency CMBS outperformed Treasuries by 17 bps in December and by 80 bps in 2021. Non-Aaa Non-Agency CMBS outperformed Treasuries by 42 bps in December and by 513 bps in 2021 (Chart 10). Though returns have been strong and spreads remain relatively high, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 12 basis points in December and by 70 bps in 2021. The average index option-adjusted spread tightened 1 bp on the month. It currently sits at 36 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.   Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet.   Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of December 31st, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of December 31st, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -58 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 58 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2  We consider three scenarios for the fed funds rate. (1) March liftoff, 100 bps per year hike pace, 2.08% terminal rate. (2) March liftoff, 75 bps per year hike pace, 2.08% terminal rate. (3) March liftoff, 75 bps per year hike pace, 2.33% terminal rate. 3  Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 4  Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 5  Please see US Bond Strategy Special Report, “2022 Key Views: US Fixed Income”, dated December 14, 2021. 6  Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021.  

Highlights The markets are already looking past Omicron. Now they have new worries – the Fed battling inflation. In the past, the Fed moved because of confidence that strong economic growth can withstand rates normalization. This time around, the Fed’s hand is forced by inflation, which is no longer deemed “transitory”.  So far, fear of an inflation-induced tightening cycle manifests in expectations of a steeper trajectory for rates, and violent and indiscriminate rotation out of the tech names. Companies have set aside record amounts of cash for wage increases. This is sure to cut into corporate profitability and validates our thesis that peak margins are in the rear-view window. Supply bottlenecks are easing, so is the ISM activity index, which we interpret as a normalization. When it comes to our style recommendations, we continue preferring small caps over large caps on the back of attractive valuations and favorable economic backdrop. Today, we also upgrade Value / Growth from neutral to OW - rising rates are a tailwind for Value. Recommended Allocation Feature December was a good month for equities (Chart 1). While the beginning of the month was marred by turbulence, induced by the arrival of Omicron, and the Fed shifting to a more hawkish stance, Santa Claus did deliver a rally to close the month, with the S&P 500 rising by 6% and lifting its 2021 gains to an impressive 27%. But 2021 was a wild year for active investors, as only 15% of funds and strategies outperformed the S&P 500. Hence, many investors had to watch the S&P 500 gains from the sidelines: The year was characterized by rotation across sectors and styles. December brought about a sell-off in the most speculative names in the equity market (EEM, IWM, ARKK, BTC, IPO), which has continued unabated into January: The Fed’s imminent monetary tightening is a culprit. Capital has also rotated away from Cyclicals and towards Defensives (the MSCI Cyclicals / Defensive ratio was down 7% in December). However, Cyclicals are starting to rebound from the Omicron slump. Overarching Macroeconomic Themes Omicron or “Omicold”? Either Way, The US Market Is Looking Past It… Little was known about the Omicron variant when it took us all by surprise at the end of November. Fortunately, an expectation that this variant is more contagious but less virulent has come to pass: While the number of cases has surged (nearly, every family I know in the tri-state area has had it by now), the number of hospitalizations has remained contained (Chart 2). The economic damage, at least in the US, has been minor, and mostly due to people being away from work sick or quarantined. It also appears that this COVID wave is close to a peak, which explains the recent outperformance of Cyclicals (Chart 3): The markets are already looking past Omicron. Now they have new worries – the Fed battling inflation. Chart 2Omicron Wave Is Close To A Peak... Chart 3...And Cyclicals Are Rebounding Inflation Is Forcing The Fed’s Hand Into An Aggressive Tightening Cycle Fed rate hikes are now all but certain: The market is pricing in four rate hikes in 2022 with a probability of nearly 90% (Chart 4), a noticeable increase from the three rate hikes expected in December 2021. The Fed’s December meeting minutes indicate that the first rate hike may come as soon as March. What is different this time is the inflation backdrop: In the past, the Fed moved because of confidence that strong economic growth can withstand rates normalization. This time around, the Fed’s hand is forced by inflation, which is no longer deemed “transitory”. The Fed is raising rates to squish growth to tame inflation, giving rate rises a different context: The Fed is behind the curve, and while in the past the stock market took rate hikes in its stride (after a short-lived slump in performance), now market reaction may be much more negative. So far, fear of an inflation-induced tightening cycle manifests in expectations of a steeper trajectory for rates (Chart 5), and violent and indiscriminate rotation out of the tech names. Chart 4Market Is Expecting Four Hikes In 2022 Chart 5Rates Made A Vertical Move More Wage Raises Are On The Way – A Headwind To Corporate Profitability According to the NIPA, wages constitute about 50% of sales of US companies. Over the past year, nominal wages increased by 5.8% but still could not keep up with rising prices – real wage growth is running at -2.3% (Chart 6). Considering that in 2021 only a minor share of workers got raises – those rejoining the workforce, starting a new job, or members of a few labor unions, the majority of Americans have had no change in income and have been bewildered by prices in the supermarkets. As the new calendar year rolls on, many of these workers will negotiate their salaries to get inflation adjustments (Chart 7). In fact, according to the WSJ, companies have set aside record amounts of cash for wage increases. This is sure to cut into corporate profitability and validates our thesis that peak margins are in the rearview window. Chart 6Wages Are Not Keeping Up With Inflation Chart 7Wage-Price Spiral? Another concern is a wage-price spiral, leading to rampant inflation, making the Fed’s job harder, and calling for more aggressive monetary tightening, striking a blow to the stock market. Supply Bottlenecks Are Easing, So Is The ISM Activity Index The ISM Manufacturing index has turned from 64.7 to 58.7 (Chart 8A). Part of the decline in the top-line numbers is due to the resolution of supply-chain bottlenecks: The ISM Supplier Index has fallen from 78.6 to 64.9 (Chart 8B), indicating a reduction in delivery times. On the other hand, the New Orders index has also declined from 68 to 60.4, suggesting that bottlenecks are clearing thanks to the reduction in business activity, which we interpret as a normalization. Of course, zero-tolerance to COVID policy in China and other countries may lead to new production and shipping delays, and another leg up for the inflation readings. Chart 8AISM PMI Has Turned... Chart 8BAnd Not Only Because Of Shorter Delivery Times Styles Comments Small Vs. Large Cap: Sticking To Our Overweight In Small Valuations: Small caps are cheap and unloved, trading at 16x forward earnings with a 25% discount to Large. The BCA Valuation Indicator for Small vs. Large is standing more than two standard deviations below its long-term average. Profitability: Since 2019, Small has delivered 47% annualized profit growth compared to 14% from Large. The small companies have demonstrated resilience and successfully navigated the economic landscape, plagued with supply bottlenecks, labor shortages, and surging prices (Chart 9A). Small-cap margins have exceeded the historical average and have likely peaked, just like the margins of their larger brethren. According to the NFIB Small Business Survey, a core concern is inflation, but 54% of small companies intend to raise prices, passing on costs to customers. Like all other American companies, they experience labor shortages and are planning to raise wages too. On balance, we believe that small caps will remain profitable and their earnings will continue to grow, albeit at a slower pace, i.e., at 15% (Chart 9B), which is significantly less than 88% in 2021, but more than the 10% growth expected of larger companies. Chart 9ASmall Businesses Are Worried About Inflation And Are Raising Prices Chart 9BEarnings Growth Expectations Have Normalized Macroeconomic Backdrop: Historically, small caps have outperformed large caps in the environment of rising rates (Chart 10), because of higher allocations to Cyclicals, such as Financials and Industrials. Also, while rising rates take the froth off the high-flying growth stocks, smaller companies are cheap and have moderate growth expectations. Overweight Small vs. Large: Attractive valuations and fundamentals, and a high likelihood to perform well when rates are rising, make overweighting Small vs Large an attractive proposition. Risks: While we stay with the call, there are a few caveats: Small caps’ margins are narrow, and continued cost pressures, especially surging labor costs, have the potential to dent their profitability. Further, while empirical analysis indicates that Small outperforms during the rate-hiking cycle, we are concerned that surging inflation may render this analysis less useful – can this time really be different? Growth Vs. Value: Shifting Towards Value Valuations: Over the course of 2021, Growth outperformed Value by 23% (trough to peak), and by 5% over just the last 26 weeks. As a result of such a strong run, Growth has become very expensive, trading at 29x forward multiples, which is which is a 70% premium to Value (which is trading at 17x). The Growth/Value BCA Valuation Indicator corrected below the 2 standard deviation mark and is mean reverting. Profitability: Despite significant valuation discrepancy between Growth and Value, both asset classes are set to deliver roughly the same earnings growth over the next year, suggesting that the premium for Quality and Growth may be excessive (Chart 11A). Macroeconomic Backdrop: Since the beginning of the pandemic, performance of Value vs. Growth has been strongly linked to the direction of change in yields (Chart 11B). Growth is overweight long-duration Technology stocks, while Value is highly exposed to Financials, which appear to thrive in the environment of rising rates. Chart 11AGrowth Expectation Are Similar, But Value Is Cheaper Chart 11BRising Rates Are A Tailwind For Value Overweight Value: As we stated in our 2022 Outlook, “Our neutral position [in Growth vs. Value] will be a great launching pad towards overweighting value stocks at the first whiff of rising long rates.” Now, with rate hikes drawing nearer and Omicron peaking, we are changing our neutral allocation to a cyclical overweight in Value, and underweight in Growth. Valuations and the macroeconomic backdrop are at the core of the call. Risks: We may be early with our presumption that Omicron is just an uber-contagious “Omicold” – hospitalizations may still surge, while global lockdowns may cause much economic damage. In that case, rates may remain range-bound, while the Fed may delay rate hikes. Then Growth would be bound to outperform Value.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   S&P 500 Chart 12Macroeconomic Backdrop Chart 13Profitability Chart 14Valuations And Technicals Chart 15Uses Of Cash Cyclicals Vs Defensives Chart 16Macroeconomic Backdrop Chart 17Profitability Chart 18Valuation And Technicals Chart 19Uses Of Cash Growth Vs Value Chart 20Macroeconomic Backdrop Chart 21Profitability Chart 22Valuations And Technicals Chart 23Uses Of Cash Small Vs Large Chart 24Macroeconomic Backdrop Chart 25Profitability Chart 26Valuations and Technicals Chart 27Uses Of Cash Recommended Allocation Footnotes  .   

Highlights European economic activity will suffer in Q1 from both the Omicron wave and elevated natural gas prices. The Omicron wave will fade quickly and its impact on growth will be short lived. The biggest economic risk related to Omicron is inflation. Inflation is being caused by supply disruptions, a function of China’s zero-tolerance policy toward COVID. An ebbing of COVID will allow cyclicals to breakout relative to defensive equities in the second quarter. Buy banks / sell tech. For the remainder of the winter, European electricity will remain expensive because of elevated natural gas prices. This process creates a drag on growth and prevents the euro from recovering. European PMIs have not yet bottomed; however, they will do so in Q2. While French and UK economic activity has led Europe in recent months, Germany and the Netherlands are likely to continue to lag as the Omicron variant is only starting there. Italian and Spanish spreads have limited upside under these circumstances. Feature At the end of 2021, the European economy was hit by a spike in COVID-19 infections and another surge in natural gas prices. These shocks will continue to affect activity in the first few months of 2022. Understanding the evolution of these shocks will help investors find attractive entry points for the dominant trend that will play out for the remainder of the year. Omicron Spikes Chart 1Omicron Is Different COVID-19 cases are once again spiking across Europe because of the highly contagious Omicron variant. As Chart 1 shows, cases in the UK, France, Spain, and Italy have now eclipsed previous peaks. Cases in Germany and the Netherlands have declined recently, but this improvement reflects the ebbing Delta wave. These two countries are likely to follow the path of their European neighbors in relation to the Omicron variant. The Omicron wave will not have a lasting impact on European economic activity despite its frightening scale. Hospitalizations are rising, but they remain far from levels implied by the number of active cases in France, the UK, and Spain (Chart 1, third panel). Additionally, hospitalizations spans are shorter because the infection seems to be less virulent. Recent data out of France indicates that COVID-induced admissions in ICU are now around 18% with a median length of stay of three days, compared to roughly 30% and seven days in the previous waves. This more positive health outcome also reflects the benefit of elevated vaccination rates in the region. The evolution of the Omicron wave in South Africa also points toward a rapid turnaround of the COVID situation in Europe. Gauteng Province, where Omicron first became dominant, witnessed a sharp rise in new cases that declined less than four weeks after the outbreak began (Chart 1, bottom panel). The number of cases there thus seems to have reached its apex already. There are limited reasons to expect a different trajectory for the Omicron wave in Europe. This wave is also affecting individual behavior. Rules are now being developed to impose vaccinations on swath of the recalcitrant population in Italy and Austria, and the French president is openly defying anti-vaxxers by further limiting their daily lives. Vaccination rates are increasing and booster campaigns have rolled out successfully, as the UK illustrates. Finally, anti-viral drugs such as Pfizer Paxlovid will further limit the severity of infections of contaminated individuals. This background implies that the likelihood is low for long-lasting, severe lockdowns, such as those that prevailed in 2020 and in early 2021. As a result, the impact of the Omicron wave on economic activity and the labor market will be temporary and will wane before the end of Q1 2022. Chart 2Cyclicals Will Breakout... Eventually Financial markets have already adopted this view, as evidenced by European equities that rallied smartly through December—until the release of the Fed’s minutes last week spooked investors. We are inclined to agree with investors and look beyond the impact of COVID at the index level. Nonetheless, as long as the wave remains in place and economic activity bears its footprint, cyclicals will not break out relative to defensives (Chart 2). Omicron, however, is not without risks. China’s commitment to its zero-tolerance policy toward COVID-19 remains firmly in place, which may prove inflationary for the global economy. Entire cities such as Xi’an and Yuzhou have been pushed into lockdowns, and, if Omicron spreads further, more cities will suffer the same fate. If it is sufficiently widespread, then this process will produce global supply-chain bottlenecks again and renew pricing pressures, especially if it expands to Chinese port cities.  Investment Implications The first relevant market implication of a transitory Omicron shock is that, despite its violence and breadth, global markets will avoid a severe sell-off caused by plunging economic activity. As a corollary, cyclical stocks may continue to consolidate in the near-term against their defensive counterparts, but a breakout by the middle of 2022 remains highly likely. Chart 3Utilities Hate Ebbing Waves Tactical traders will also soon benefit from a short-term investment opportunity. Utilities have been outperforming in recent weeks as investors bid up defensive plays. However, the pattern of previous waves indicates that, as soon as this wave of cases peaks, utilities stocks will suffer a significant period of underperformance (Chart 3). Thus, short-term investors should sell European utilities once the seven days moving average of new cases peaks in the UK. Chart 4Banks To Outperform Tech The environment is also likely to remain favorable for banks relative to tech stocks in Europe. The recently released Fed minutes revealed that the FOMC has a strong hawkish bias and that the March meeting will be a live one. It also showed that, if Omicron proved to be inflationary because of its impact on supply chains, the Fed might be even more inclined to raise interest rates and cut its balance sheet size. Thus, a transitory Omicron shock to growth that is likely to have inflationary effects will contribute to higher yields. This will hurt tech stocks relative to banks, especially as European banks forward earnings are rising relative to the tech sector and their relative valuations are extremely favorable (Chart 4). Bottom Line: The number of COVID-19 cases in Europe is spiking rapidly, but we do not expect lengthy lockdowns to become the norm. As a result, the shock to growth caused by the Omicron variant will be ephemeral. Nonetheless, China’s health policy response points to some inflationary risks caused by supply bottlenecks. Investors should expect European markets to continue to take Omicron in stride and cyclicals to breakout later this year. Utilities are soon to be sold relative to the broad market and European banks will benefit at the expense of tech stocks. Natural Gas Remains The Euro’s Foe Chart 5Natural Gas Prices Are High And Volatile Dynamics in the European natural gas market remain a major risk for European economic activity and European currencies over the course of the first quarter of 2022. Natural gas prices on the Title Transfer Facility in the Netherlands spiked to a record close of EUR181/MWh on December 21, 2021, as tensions with Russia rose in Ukraine. Since then, Dutch natural gas prices—the continental European benchmark—have declined by 46% (Chart 5). The following combination of factors explains this sharp retrenchment: Europe, France, and Germany in particular have enjoyed exceptionally clement weather in recent days, stifling demand for heat and electricity. 11 LNG tankers from the US have been rerouted toward Europe, accounting for 800,000 tonnes of natural gas. Tensions between Russia and the West have eased somewhat. Despite this recent decline in the price of natural gas, it remains at elevated levels. BCA’s commodity and energy strategy team expects its volatility to stay high over the remaining winter months. First, Asia is not sitting on its hands as LNG shipments shift toward Europe. Instead, a bidding war is starting in order to attract liquefied gas to the East. Second, Europe’s winter is far from over, which means that demand-boosting cold fronts are still likely. Finally, Russia is sending gas back to its territory to fulfil its own domestic needs (and probably to continue to put pressure on European nations). Chart 6European Electricity Is Dear The continuation of elevated European natural gas prices and the potential for further upsides of volatility remain headwinds to European economic activity this winter, ones we deem comparable to Omicron. The main impact is via electricity prices. As Chart 6 highlights, they are still extremely high in France, Germany, and Spain. The continued surge in the price of CO2 emission quotas is increasing the pressure on electricity prices, as will the upcoming maintenance of many nuclear power plants in France. Gas consumption is contracting on a year-on-year basis in major European markets (Chart 7). This development indicates that elevated natural gas prices are already creating a supply shock to activity and sapping discretionary disposable income from households. The recent decline in European consumer confidence, despite strong employment numbers and growing net worth, confirms that households are feeling the pinch from elevated electricity and natural gas prices (Chart 8). Chart 8Consumers Feel The Pinch Chart 7Gap Consumption Is Slowing High natural gas and electricity prices also create further inflation risks for Europe. The recent spikes to 23.7% in PPI inflation and to 5% for headline CPI inflation show the effect of high-energy costs. Instead, a genuine threat would emerge if household inflation expectations followed energy prices, which could in turn trigger a wage-price spiral in Europe. We are not there yet, but the longer natural gas and electricity prices rise, the greater the likelihood of this scenario. Investment Implications The principal consequence of the strength of the European natural gas market is its euro-bearish impact. The tax on European growth is high, which delays the willingness of the ECB to remove monetary accommodation in a meaningful way. On the western shore of the Atlantic, the Fed is poised to pull the trigger soon and is now discussing a decrease in the size of its balance sheet, something the ECB is nowhere near ready to do. Consequently, although EUR/USD may be cheap and oversold on a cyclical basis, a turnaround is unlikely as long as electricity prices remain this elevated. Chart 9EUR/USD near An Existential Level Bottom Line: European natural gas prices may have come off their Christmas boil, but they remain elevated and will likely experience major bouts of upside volatility over the remainder of the winter. Hence, the drag on growth stemming from demanding electricity prices remains intact, which negatively affects consumer confidence. The euro cannot rally meaningfully until natural gas prices mean-revert, especially as the Fed ramps up its hawkishness. A re-test of EUR/USD long-term trendline around 1.10 is likely before the end of Q1 (Chart 9). The Evolution Of European PMIs European manufacturing activity remains below its June peak, but it has surprised many observers by how well it is withstanding the various shocks hitting the continent. Despite this encouraging behavior, it may take a few more months before the PMIs find a floor. The following three factors best explain why European manufacturing activity will decelerate further: The Chinese economic slowdown is not over. Credit growth is improving, but much of this comes from increasing purchases of banker’s acceptances by financial institutions, which does not in turn provide credit to the economy. Thus, European exports to China and EM will remain on the backfoot. The Omicron crisis remains intact and natural gas remains a drag, as previously discussed. Chart 10Manufacturing Deceleration Will End In Q2 The evolution of the Sentix Global Investor Survey and the ZEW survey, which are a very reliable forecaster of the Manufacturing PMI, points to more economic weakness in Q1 2022 (Chart 10). While these forces will hurt growth in the near term, they also suggest that this deceleration is long in the tooth and that activity will firm anew during the second quarter of the year. The gap between the expectation and current activity components of the Sentix Global Index Survey and the ZEW survey have already bottomed. Moreover, both Omicron and natural gas crises will ebb as winter passes. Finally, Chinese authorities will not let growth collapse and will likely generate a small pickup in activity after the Chinese New Year. Already, the PBoC has ramped up its liquidity injections and Premier Li Keqiang recently highlighted potential tax cuts and support for the corporate sector to help Q1 and Q2 domestic activity. Looking at European countries individually shows that current economic conditions are disparate and largely reflect the different impacts of both Omicron and natural gas prices. To judge economic conditions, we expand the Rotation Methodology introduced two months ago.1 Instead of analyzing financial assets, we examine manufacturing PMIs through this lens, looking at the evolution of the level and momentum of each country’s manufacturing PMIs compared to the overall European level. This approach reveals the following over the past six months (Chart 11): France experienced the greatest relative improvement, moving from a Lagging economy to the Leading economy in Europe. France benefits from limited lockdowns, from the large role of nuclear power in electricity generation, and from its diminished exposure to China’s slowdown compared to Germany. This economic performance explains why French equities have recently performed so much better than sectoral biases would have justified. The UK economy remains in the Leading quadrant despite the ferocity with which the Omicron wave has overtaken the nation. This paradox reflects the health policy chosen by Downing Street, emphasizing voluntary isolation and investing heavily in booster shots. Relative to that of the rest of Europe, Italy’s and Spain’s PMIs are still elevated, but they are losing momentum, which is pulling these two countries into the Weakening quadrant. The Netherlands suffered the greatest decrease in activity, dropping from the Leading quadrant to the Lagging one. The Netherlands is under a severe lockdown to combat the Delta wave. The situation is unlikely to improve meaningfully any time soon as the Omicron wave is starting there. Germany is trying to stage a recovery, moving from the Lagging quadrant into the Improving one. However, we worry that this will not work out and that Germany will shift back into the Lagging quadrant as the government prepares to crackdown further on COVID because the Omicron variant is starting to hit the country. Investment Implications Chart 12Peripheral Spreads To Stay Contained The continuation of the weakness observed in Germany and the Netherlands will force the ECB to remain more dovish than implied by the inflation rate. As a result, Spanish and Italian bond spreads are unlikely to move anywhere close to the levels recorded in the spring of 2020 (Chart 12), especially as their respective economies outperform those of Germany and the Netherlands.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com     Footnotes 1     The “Leading” (“Lagging”) quadrant denotes countries with PMIs performing better (worse) than the benchmark, the European manufacturing PMI, with strengthening (weakening) momentum. The “Improving” (“Weakening”) quadrant denotes countries with PMIs that are performing worse (better) than the benchmark, with strengthening (weakening) momentum. Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights The prospect of Fed rate hikes seems to be weighing on 2022 equity return expectations, … : Financial media outlets have been sounding the alarm about the impact of rate hikes on equity returns.  … but we think concerned investors are getting ahead of themselves, because monetary policy works with a lag, … : It takes time for changes in the fed funds rate to work their way through the economy. Even if the FOMC initiates a rate hike campaign in March, its effects may not begin to be felt until September or next March.  … and the fed funds rate is miles away from becoming restrictive: In inflation-adjusted terms, the entire interest rate structure is incredibly supportive of economic activity. Assuming 4% inflation, the real fed funds rate will still be well below the bottom of its 2013-19 range even if all of the rate hikes investors are currently discounting occur in 2022. We continue to believe that it is too soon to turn defensive in multi-asset portfolios: The bull markets in equities and credit will eventually end, but not while the FOMC is only beginning to unwind maximum monetary accommodation. Feature The release of the minutes from the FOMC’s December meeting momentarily roiled financial markets last week. The minutes had a distinctly hawkish tone, pointing to a mid-March liftoff date and raising the specter of a shrinking Fed balance sheet. The ensuing sell-off dovetailed with rising anxiety in the financial media about the potentially adverse equity market impacts of impending rate hikes. The opening two paragraphs of “The Big Uneasy” article that filled the front page of The New York Times’ Business section on New Year’s Day captured the prevailing tone:1 For two years, the stock market has been largely able to ignore the lived reality of Americans during the pandemic … because of underlying policies that kept it buoyant. Investors can now say goodbye to all that. The body of the article was much more measured, pointing out that a series of rate hikes would eventually slow the economy and could diminish investors’ near-term appetite for equities, before wrapping up with a wildly sensationalist quote. “The nightmare scenario is: The Fed tightens and it doesn’t help,” said Aaron Brown, a former risk manager of AQR Capital Management who now manages his own money and teaches math at [NYU]. Mr. Brown said that if the Fed could not orchestrate a “soft landing” for the economy, things could start to get ugly – fast. And then, he said, the Fed may have to take “very aggressive action like a rate hike to 15 percent, or wage and price controls, like we tried in the ‘70s.” By an equal measure, the Fed’s moves, even if they are moderate, could also cause a sell-off in stocks, corporate bonds and other riskier assets, if investors panic when they realize that the free money that drove their risk-taking to ever greater extremes over the past several years is definitely going away. Dennis Gartman, the longtime writer of a daily newsletter for traders and institutional investors, echoed the theme in an interview with Bloomberg Radio last Monday. The Bloomberg story summarizing the interview was headlined “Gartman Sees Stocks Falling 15% in 2022 on Aggressive Fed Hikes” and hewed to the higher-rates/lower-stocks mantra. “Gartman said … that stocks could trade 10% to 15% lower this year. While [he] has long been calling for a bear market, he said the catalyst for the decline could be the central bank raising interest rates amid a continued rise in inflation. … ‘The advent of a bear market will come when the Fed begins to tighten monetary policy, and that will be later this year. No question.’” We admired The Gartman Letter and subscribe to the Times, but fed funds rate concerns have gotten overdone. In our view, anxiety about the effect of rate hikes on equity returns in 2022 is misplaced on two counts. First, it ignores that monetary policy only impacts the economy with a lag. Second, it fails to distinguish between the level of the fed funds rate and its direction. The economy and the S&P 500 have historically thrived in the early stages of rate-hiking campaigns, meeting their Waterloo only after the level of the fed funds rate becomes restrictive. The Fed Funds Rate Cycle We formulate investment strategy based on our analysis of the cycles that exert the strongest pull on financial markets: the business cycle, the credit cycle and the monetary policy cycle. As applied to US markets, we have found that the monetary policy cycle has the most reliably meaningful impact. As shown in Figure 1, we decompose the cycle into four phases based on whether the FOMC is hiking (the left half of the curve) or cutting (the right half) rates and the position of the fed funds rate relative to our estimate of its equilibrium level (the dashed horizontal line). We deem policy to be accommodative when the funds rate is below equilibrium and restrictive when it is above equilibrium. We like to describe equilibrium as the fed funds rate that neither encourages nor discourages economic activity. The equilibrium rate is a concept and cannot be directly observed; though our estimate represents our best efforts, we recognize that no one can always pinpoint it in real time. We nonetheless take heart from the sharp divide in S&P 500 returns across periods that we have designated as easy or tight. As we show for the first time in this report, growth in key economic indicators aligns consistently with the progression of the funds rate cycle, supporting the investment conclusion that the approaching rate-hiking phase will be favorable for risk assets. Monetary Policy Works With A Lag The idea that monetary policy affects the economy with long and variable lags, first advanced by Milton Friedman in the late fifties, is universally accepted. To test the proposition within our policy cycle framework, we mapped growth in nonfarm payrolls, aggregate bank lending, consumption and GDP across rate cycle phases over the last 60 years. All series grew at their fastest rate in Phase I, when the Fed is tightening policy but has not yet made it tight. They continued to grow faster than their through-the-cycle pace, even when adjusted for inflation, in Phase II, when the Fed continues to hike the funds rate beyond its equilibrium level. Growth in Phases III and IV, when the Fed is easing policy to stimulate the economy, is markedly slower across all metrics than it is when the Fed is tightening. Chart 1 shows each indicator’s phase-by-phase performance in its own panel, with growth in early tightening Phase I (the solid black line) and late tightening Phase II (the dashed green line) easily surpassing early easing Phase III (the solid gray line) and late easing Phase IV (the dashed red line). Chart 1It Takes A While To Turn A Battleship, Especially When The Rudder Moves With Long And Variable Lags Table 1 fleshes out the results, reporting each metric’s compound annual growth rate (CAGR) across the phases and compiling the CAGRs when the Fed is hiking rates and when it's cutting them. It also presents the nominal growth rates for lending, consumption and GDP, which are not shown in the chart. We view the results as forcefully supporting the long-and-variable view, especially as the FOMC deliberately moves at an incremental pace so as not to act like Friedman’s fool in the shower.2 Given that Phase II growth is comfortably above trend for every metric, it appears that Phase I would have to move at hyperspeed to hobble the economy at any point over the next year-plus. Table 1Phase I Is The Economy's Growth Sweet Spot The Starting Point Matters, Too The economy should also be insulated from the adverse effects of reduced accommodation by virtue of its current level of support. The real fed funds rate is way below its financial crisis lows (Chart 2, top panel), along with the real 10-year Treasury yield (Chart 2, bottom panel). Both rates have steadily declined over the last 40 years' complete peak-to-peak cycles, in line with the US economy’s declining potential growth. Falling inflation has further contributed to a decline in the nominal equilibrium rate, as per the actual fed funds rate and our in-house estimate (Chart 3). Chart 2Real Rates Have A Long, Long Way To Go To Become Restrictive Chart 3Interest Rates May Have More Headroom Than Markets Think Our estimate bottomed well before the onset of the pandemic, however, and we would argue that the economy currently has far less need for monetary policy support than it did in the aftermath of the crisis. While the financial system reeled, Congress provided stingy fiscal support before taking it back like Lucy pulling the football away from Charlie Brown. In contrast, the US now has a surfeit of fiscal support and even WeWork founder Adam Neumann has ready access to capital. The upshot is that the rates tipping point is miles away and we doubt the Fed can cover that much ground in the space of one year. For Equities, Level Trumps Direction The level, not the direction, of the fed funds rate has driven US equity performance over the 60-year period covered by our equilibrium estimate. The S&P 500 has eked out a 0.4% nominal annualized return across the aggregate 19 years that policy has been tight, by our reckoning, while advancing 10.6% annually over the accumulated 41 years when it has been easy (Table 2). Easy policy’s ten-percentage-point advantage over tight policy leaves cutting rates’ four-point edge over hiking rates in the dust. Table 2Easy Policy Settings Yield An Extra 10 Percentage Points Of Nominal Returns, ...​​​​​​ Table 3... And An Extra 11.5 After Adjusting For Inflation​​​​​​ The easy/tight disparity widens to eleven-and-a-half percentage points when nominal returns are adjusted for inflation. In Phases I and IV, when the fed funds rate is below our estimate of equilibrium, the S&P 500 has generated robust 7.1% real annualized returns while shedding 4.4% in Phases II and III, when the funds rate exceeds our equilibrium estimate (Table 3). Stocks do better on a real basis when the Fed is cutting rates, just as they do on a nominal basis, but the spread is narrower. The level of rates is the key dividing line, not their direction. Investment Implications The empirical record overwhelmingly supports the idea that early-stage rate hikes will not stifle growth or prevent equities from generating ample positive excess returns over Treasuries and cash. Against a backdrop of high and soaring inflation that the economy has only faced twice in the last 50 years (Chart 4), however, it is worth considering whether this time could be different. Whereas most recent rate hike campaigns have patiently aimed to prevent potential inflation pressures from taking root in a robust economy, this one might require the Fed to move urgently to get the genie back in the bottle. Chart 4Be Careful What You Wish For, Central Bankers The potential for urgent rather than incremental action could turn the prevailing positive correlation between stock prices and interest rates negative, as our Chief Emerging Markets Strategist Arthur Budaghyan has warned. If inflation worries choke off animal spirits, multiple de-rating could more than offset typical Phase I earnings gains, sending stocks lower. Although we do not expect multiple contraction in 2022 given the dearth of asset classes with positive expected real returns, we see it as one of the major threats to our risk-friendly positioning. We will be watching out for it, along with adverse pandemic surprises and the possibility that consumption could disappoint, though we will stick with our constructive positioning in the meantime.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      "Fed’s Moves in 2022 Could End the Stock Market’s Pandemic Run", The New York Times (nytimes.com). Accessed January 3, 2022. 2     Friedman likened central banks to a person who excessively turns the hot or the cold tap in the shower when the water temperature does not change immediately, only to shock him/herself once the lag between action and effect closes.