Economy

Highlights Chart 1Past Peak Inflation The Fed is all set to deliver a 50 basis point rate hike when it meets this week and with inflation still well above target Chair Powell will be keen to re-affirm the Fed’s commitment to tighter policy. However, with the market already priced for a 3% fed funds rate by the end of this year – 267 bps above the current level – we don’t see much scope for further hawkish surprises during the next eight months. Core PCE inflation posted a monthly growth rate of 0.29% in March. This is consistent with an annual rate of 3.6%, below the Fed’s median 4.1% forecast for 2022. Slowing economic activity between now and the end of the year will also weigh on inflation going forward (Chart 1). All in all, we see the Fed delivering close to (or slightly less) than the amount of tightening that is already priced into the curve for 2022. US bond investors should keep portfolio duration close to benchmark. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 140 basis points in April, dragging year-to-date excess returns down to -292 bps. The average index option-adjusted spread widened 19 bps on the month to reach 135 bps, and our quality-adjusted 12-month breakeven spread moved up to its 48th percentile since 1995 (Chart 2). In a recent report we made the case for why investors should underweight investment grade corporate bonds on a 6-12 month horizon.1 First, we noted that while investment grade spreads had jumped off their 2021 lows, they remained close to the average level from 2017-19 (panel 2). Spreads have widened even further during the past two weeks, but they are not sufficiently attractive to entice us back into the market given the stage of the economic cycle. The 2-year/10-year Treasury slope has un-inverted, but it remains very flat at 19 bps. The flat curve tells us that we are in the mid-to-late stages of the economic cycle. Corporate bond performance tends to be weak during such periods unless spreads start from very high levels. Finally, we noted in our recent Special Report that corporate balance sheets are in excellent shape. In fact, total debt to net worth for the nonfinancial corporate sector has fallen to its lowest level since 2008 (bottom panel). Strong corporate balance sheets will prevent spreads from rising dramatically during the next 6-12 months, but with profit growth past its cyclical peak, balance sheets will look considerably worse by this time next year. Table 3A Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 187 basis points in April, dragging year-to-date excess returns down to -281 bps. The average index option-adjusted spread widened 54 bps on the month to reach 379 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 – shifted up to 4.7% (Chart 3). As we discussed in our recent Special Report, a very flat yield curve sends the same negative signal for high-yield returns as it does for investment grade.2 However, we maintain a neutral allocation to high-yield bonds compared to an underweight allocation to investment grade bonds for three reasons. First, relative valuation remains favorable for high-yield. The spread advantage in Ba-rated bonds over Baa-rated bonds continues to trade significantly above its pre-COVID low (panel 3). Second, there are historical precedents for high-yield bonds outperforming investment grade during periods when the yield curve is very flat but when corporate balance sheet health is strong. The 2006-07 period is a prime example. Finally, we calculate that the junk index spread embeds an expected 12-month default rate of 4.7%. Given our macroeconomic outlook, we expect the high-yield default rate to be in the neighborhood of 3% during the next 12 months. This would be consistent with high-yield outperforming duration-matched Treasuries.     MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 105 basis points in April, dragging year-to-date excess returns down to -178 bps. We discussed the incredibly poor performance of Agency MBS in last week’s report.3 We noted that MBS’ poor performance has been driven by duration extension. Fewer homeowners refinanced their loans as mortgage rates rose, and the MBS index’s average duration increased (Chart 4). But now, the index’s duration extension is at its end. The average convexity of the MBS index is close to zero (panel 3), meaning that duration is now insensitive to changes in rates. This is because hardly any homeowners have the incentive to refinance at current mortgage rates (panel 4). The implication is that excess MBS returns will be stronger going forward. That said, we still don’t see enough value in MBS spreads to increase our recommended allocation. The average index spread for conventional 30-year Agency MBS remains close to its lowest level since 2000 (bottom panel). At the coupon level, we observe that low-coupon MBS have much higher duration than high-coupon MBS and that convexity is close to zero for the entire coupon stack. This makes the relative coupon trade a direct play on bond yields. Given that we see potential for yields to fall somewhat during the next six months, we recommend favoring low-coupon MBS (1.5%-2.5%) within an overall underweight allocation to the sector. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Market (EM) bonds underperformed the duration-equivalent Treasury index by 92 basis points in April, dragging year-to-date excess returns down to -592 bps. EM Sovereigns underperformed the Treasury benchmark by 181 bps on the month, dragging year-to-date excess returns down to -779 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 37 bps, dragging year-to-date excess returns down to -474 bps. The EM Sovereign Index underperformed duration-equivalent US corporate bonds by 2 bps in April. The yield differential between EM sovereigns and duration-matched US corporates remains negative. As such, we continue to recommend a maximum underweight allocation (1 out of 5) to EM sovereigns. The EM Corporate & Quasi-Sovereign Index outperformed duration-matched US corporates by 79 bps in April (Chart 5). This index continues to offer a significant yield advantage versus US corporates (panel 4). As such, it makes sense to maintain a neutral allocation (3 out of 5) to the sector. The EM manufacturing PMI fell into contractionary territory in March (bottom panel). The wide divergence between US and EM PMIs will pressure the US dollar higher relative to EM currencies. This argues for the continued underperformance of hard currency EM assets. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 17 basis points in April, dragging year-to-date excess returns down to -139 bps (before adjusting for the tax advantage). We view the municipal bond sector as better placed than most to cope with the recent bout of spread product volatility. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and it will take some time to deplete those coffers even as economic growth slows and federal fiscal thrust turns into drag. On the valuation front, munis have cheapened up relative to both Treasuries and corporates during the past few months. The 10-year Aaa Muni/Treasury yield ratio is currently 94%, up significantly from its 2021 trough of 55%. The yield ratio between 12-17 year munis and duration-matched corporate bonds is also up significantly off its lows (panel 2).    We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation Municipal bonds and duration-matched corporates is 94%. The same measure for 17-year+ Revenue bonds stands at 99%, just below parity even without considering municipal debt’s tax advantage. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve rose dramatically and steepened in April. The 2-year/10-year Treasury slope steepened 15 bps, from 4 bps to 19 bps. Meanwhile, the 5-year/30-year slope steepened 2 bps, from 2 bps to 4 bps. In a recent Special Report we noted the unusually large divergence between flat slopes at the long end of the curve and steep slopes at the front end.4 For example, the 5-year/10-year Treasury slope is -3 bps while the 3-month/5-year slope is 209 bps. This divergence is happening because the market has moved quickly to price-in a rapid near-term pace of rate hikes that will end in roughly one year. However, so far, the Fed has only delivered 25 bps of those hikes (with another 50 bps due tomorrow) and this is holding down the very front-end of the curve. The oddly shaped curve presents us with an excellent trading opportunity. Specifically, we recommend buying the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. This trade looks attractive on our model (Chart 7) and will profit if the rate hike cycle moves more slowly than what is currently priced but lasts longer, as is our expectation. We also continue to recommend a position long the 20-year bullet versus a duration-matched 10/30 barbell as an attractive carry trade. TIPS: Underweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 113 basis points in April, bringing year-to-date excess returns up to +387 bps. The 10-year TIPS breakeven inflation rate rose 3 bps on the month to reach 2.90% and the 5-year/5-year forward TIPS breakeven inflation rate rose 12 bps to reach 2.47%. The 10-year TIPS breakeven inflation has moved up to well above the Fed’s 2.3%-2.5% comfort zone (Chart 8) and the 5-year/5-year forward breakeven rate is at the top-end of that range. Concurrently, our TIPS Breakeven Valuation Indicator has shifted into “expensive” territory (panel 2). In a recent report we made the case for why inflation has already peaked for the year.5  Given that outlook and the message from our valuation indicator, it makes sense to underweight TIPS versus nominal Treasuries on a 6-12 month horizon. In addition to trending down, we expect the TIPS breakeven inflation curve to steepen as inflation heads lower between now and the end of the year. This is because short-maturity inflation expectations are more tightly linked to the incoming inflation data than long-maturity expectations. Investors can position for this outcome by entering inflation curve steepeners or real (TIPS) yield curve flatteners. We also continue to recommend holding an outright short position in 2-year TIPS. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 7 basis points in April, dragging year-to-date excess returns down to -38 bps. Aaa-rated ABS underperformed by 5 bps on the month, dragging year-to-date excess returns down to -32 bps. Non-Aaa ABS underperformed by 16 bps on the month, dragging year-to-date excess returns down to -67 bps. 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 has rebounded, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. This also indicates that while surging gasoline prices will weigh on consumer activity in the coming months, household balance sheets are starting from such a good place that we don’t expect a meaningful increase in consumer credit delinquencies. 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: Overweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in April, dragging year-to-date excess returns down to -84 bps. Aaa Non-Agency CMBS underperformed Treasuries by 2 bps on the month, dragging year-to-date excess returns down to -69 bps. Non-Aaa Non-Agency CMBS underperformed by 18 bps on the month, dragging year-to-date excess returns down to -128 bps. CMBS spreads remain wide compared to other similarly risky spread products. Further, last week’s Q1 GDP report confirmed that commercial real estate (CRE) investment remains weak (Chart 10, panel 4). Weak investment will continue to support CRE price appreciation (panel 3) which will benefit CMBS spreads. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 4 basis points in April, dragging year-to-date excess returns down to -43 bps. The average index option-adjusted spread widened 2 bps on the month. It currently sits at 50 bps, not that far from its average pre-COVID level (bottom panel). Agency CMBS spreads also continue to look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 296 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: 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 April 29, 2022) 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 April 29, 2022) 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 -56 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 56 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 C: 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. Chart 12Excess Return Bond Map (As Of April 29, 2022)   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 2 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 3 Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 4 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. 5 Please see US Bond Strategy Weekly Report, “Peak Inflation”, dated April 19, 2022. Recommended Portfolio Specification Other Recommendations   Treasury Index Returns Spread Product Returns

Special Report

Executive Summary Rampant talk of a wage-price spiral is premature, ginned up by media reports about union organizing successes and union negotiators’ wins. Recent agreements negotiated by unions have not lit an inflationary fuse, as all major compensation series are contracting in real terms. The full sweep of US labor market history, buttressed by the history of the last four decades, suggests that labor has a steep hill to climb to reverse its fortunes. The president has a bully pulpit and the executive branch has a lot of enforcement levers at its disposal, but the judicial and legislative branches are powerful counterweights and the state-level climate is decidedly unfriendly to workers. Labor could regain the upper hand but we’ve been underwhelmed by its victories thus far in the pandemic. We will not believe that it’s turned the tide until we see definitive evidence. The Labor Tide Is Out Bottom Line: Investors assume that a wage-price spiral is inevitable, or has already begun, at their own peril. The playing field is still heavily tilted in employers’ favor and mainstream media has exaggerated labor’s pandemic gains. Feature Dear Client, This Special Report, updating and elaborating upon our view of the likelihood of a US wage-price spiral, will be our last written output until Monday, May 23rd. We are vacationing this week and we will be holding our quarterly webcast on May 16th in lieu of a publication. Please join us with your questions on the 16th to make it a fully interactive event. Best regards, Doug Peta The term “wage-price spiral” is being increasingly bandied about by the media, broker-dealers and independent strategists and economists. The talk has been prevalent enough that a significant proportion of investors seem to believe a spiral is inevitable if it hasn’t already begun. There is more to the history of US labor market relations than the stagflation seventies and early eighties, however, and we are tempted to see the early-thirties-to-late-seventies New Deal era as the anomaly and the Reagan era that began in 1981 as the rule. Much may hinge on just how much the administration of the “most pro-union president you’ve ever seen” will be able to accomplish when it faces the prospect of the loss of its Congressional majorities in six months. After restating our framework for thinking about the origins and outcomes of strikes and lockouts, we examine the outcomes of the pandemic-era work stoppages tracked by the Bureau of Labor Statistics (BLS). The BLS’ database only covers strikes involving at least 1,000 workers, effectively limiting its scope to strikes involving large union locals. Though the database is not comprehensive, we strongly believe that the incidence of large strikes and their outcomes offer meaningful insight into the evolving balance of power between employees and employers. Our conclusion is that management retains the upper hand; it will take more than a pandemic and one friendly administration’s term to turn the tables. Strikes Occur When One Side Overplays Its Hand Chart 1The Strike-Slack Link Has Been Shattered Strikes (and lockouts) occur when labor and management cannot reach a mutually acceptable settlement, often because at least one side overestimates its bargaining power. It is easy to agree when labor and management hold similar views about each side’s relative position, as when both perceive that one of them is considerably stronger. In that case, a settlement favoring the stronger side can be reached quickly, especially if the stronger side exercises some restraint and does not seek to impose terms that the weaker side can scarcely abide. Restraint is rational in repeated games like employer-employee bargaining, especially if the stronger party recognizes that its advantage is not permanent. 40 years of waxing management power, however, may have imbued both sides with a sense that employers have insurmountable structural advantages. Since the early eighties, private sector union membership has withered, taboos against hiring strikebreakers have disappeared, the Federal bench has been filled with judges disposed to see things from management’s perspective, and state legislatures have increasingly weakened union protections to attract businesses. Since the Reagan administration took office, the incidence of major work stoppages (Chart 1, top panel) has ceased to correlate with the state of labor market slack (Chart 1, bottom panel). With the JOLTS, consumer confidence and NFIB surveys indicating that the pandemic has made it as easy as it has ever been to find a job (and extremely difficult to fill one), it is notable that so few unionized employees are playing their trump card of withholding their labor to extract concessions from their employers. Related Report  US Investment StrategyLabor Strikes Back, Part 2: Where Strikes Come From And Who Wins Them With the link between labor market tightness and strikes severed, game theory offers the best insight into the origin of strikes. We posit a simple framework in which each side can hold any of five perceptions of its own bargaining power, resulting in a total of 25 possible joint perceptions. Labor (L) can believe it is way stronger than Management (M), L >> M; stronger than Management, L > M; roughly equal, L ≈ M; weaker than Management, L < M; or way weaker than Management, L << M. Management also holds one of these five perceptions, and the interaction of the two sides’ perceptions establishes the path negotiations will follow. Limiting our focus to today’s prevailing conditions, Figure 1 displays only the outcomes consistent with labor’s belief that it has the upper hand. For completeness, the exhibit lists all of management’s potential perceptions, but we deem the three away from the extremes to be most likely. Record job openings and quits rates (Chart 2) should convince even the most cocksure management negotiators that the landscape has tilted at least a little in labor’s favor. On the other hand, four consecutive decades of victories will make it hard for all but the most objective management negotiators to believe that the tables have completely turned. Figure 1Lots Of Room For Disagreement Chart 2It's A(Labor)Seller's Market... The Availability Of Substitutes Chart 3... And Mothballed Supply Is Coming Back On Line Ultimately, leverage derives from the availability of substitutes. If employees can easily switch jobs and obtain better terms because employers are actively competing for scarce labor inputs, they should be able to extract concessions simply by threatening to strike. If employers can replace union members with cheaper non-union workers, substitute cheaper foreign labor for domestic labor while meeting less onerous working standards, or invest in automation to reduce the need for human inputs, employees will have little recourse but to accept whatever terms management dictates. The prevailing view is that there are precious few substitutes for domestic labor. The pandemic has exposed global supply chains' inherent vulnerability, forcing businesses to consider onshoring some functions. The labor market is exceedingly tight, as early retirements and the Great Resignation will suppress labor availability into the intermediate term. Quickening increases in labor force participation among those aged 55 to 59 (Chart 3, top panel) and 60 and 64 (Chart 3, bottom panel), however, are casting doubt on the narrative. We additionally expect that younger workers will not be able to hold themselves aloof from the work force indefinitely in the absence of new fiscal transfers. The explosion in nominal wage growth lends credence to the prevailing view (Chart 4). But none of the three main series, average hourly earnings (Chart 5, top panel), the Atlanta Fed wage tracker (Chart 5, middle panel) or the Employment Cost Index (Chart 5, bottom panel) is keeping pace with inflation. A wage-price spiral, as commonly understood, results when wages and consumer prices chase each other higher in something like a game of tag. Average hourly earnings got the game going in 2020, when essential workers received hazard pay for braving infection risks, but they’ve lagged consumer prices ever since. Chart 4Nominal Wages Are Surging ...​​​​​​ Chart 5... But They're Not Keeping Up With Inflation​​​​​​ This Is Not The Sixties And Seventies The wage-price spiral gained momentum when the unemployment rate spent eleven consecutive years (1964 through 1974) below or just barely above the CBO’s estimate of its natural rate (Chart 6, bottom panel). That helped feed consistently positive real wage gains through the seventies whenever the economy was expanding (Chart 6, top panel). Upward price pressures were stoked by profligate government spending (funding the war in Vietnam concurrently with Great Society programs) and a complacent Fed. The pandemic fiscal and monetary backdrop may look uncomfortably familiar, but today’s workers are far less equipped to turn it to its advantage. Chart 6The Wage-Price Spiral Of The Seventies Was A Long Time In The Making Union membership is way down from the mid-to-late sixties (Chart 7), leaving unions with far fewer resources and much less of a corner on available labor. They also have less public support, less likelihood of benefiting from sympathy strikes or other support from unionized workers elsewhere in the chain and little to no lived experience with striking. They confront better organized and more determined opposition, as business concentration has reduced competition for their services to the point of establishing near-monopsonies in localized labor markets. The only way to confront the monopsony power of very few buyers is to organize a monopoly of suppliers, but private-sector union membership is mired at post-Depression lows despite The New York Times’ and other outlets’ relentless cheerleading. Chart 7It's Hard To Be An Influencer When You're Hemorrhaging Followers I Walked A Picket Line For Four Weeks And All I Got Was This Lousy T-Shirt If workers are to change their fortunes (Chart 8), they need to achieve large-scale victories that win national attention, inspiring other workers to challenge management and laying out a roadmap for their own success. With that in mind, we examined the BLS’ detailed compilation of work stoppages since the beginning of 2020 to see what strikes were able to achieve. If striking reveals that labor truly has the whip hand, employers should accede en masse to employees’ demands, signaling that a broad compensation reset is afoot. Chart 8The Hazard-Pay Pop Was Short Lived After backing out graduate student attempts to escape indentured servitude as sub-minimum-wage instructors, we examined the outcomes of the 22 large-scale strikes since 2020 (Table 1). In terms of base wage and salary gains, the results were decidedly underwhelming. Two of the union walkouts produced nothing (Swedish Medical Centers, 2020, and Kaiser Permanente Oakland sympathy strike, 2021) and prospects are not favorable for the United Mine Workers’ strike against Warrior Met Coal (2021) that is entering its fourteenth month. Public workers’ walkouts generally yielded nothing more than compensation increases around the Fed’s 2% annual inflation target. Teachers and front-line healthcare workers touted agreements to reduce class sizes, increase support staffs, formalize hazard pay and stockpile personal protective equipment but they’ve fallen further behind economically. Table 1Large-Scale Pandemic-Era Strikes Private-sector workers have fared better, though one must often squint to see it. Kellogg’s cereal plant workers hit a home run, gaining cost-of-living adjustments on top of nominal salary increases, better retirement benefits and an accelerated path for new employees to transition to the more remunerative legacy employee tier, all without making a single concession. Seattle’s unionized carpenters also did well for themselves, gaining three 4.5% annual raises and a 50% increase in hourly parking reimbursements (no small matter in a full-to-bursting coastal city). Their fellows got some cash in their pockets via one-time bonuses for ratifying their deals, but whether they’ll be better off on an inflation-adjusted basis by the time they expire is an open question. In reading about the walkouts, negotiations and settlements, we were struck by how long it had been since many of these union locals had walked off the job. Minneapolis teachers last struck in 1970; the last nationwide Kellogg’s strike was in 1972; the UAW hadn’t struck John Deere since 1986; aside from a one-day 2017 walkout, Sacramento teachers hadn’t struck since 1989; and United Steelworkers hadn’t walked out from Allegheny Technologies in 30 years. Perhaps an unfamiliarity with striking among union leadership and rank-and-file made the unions timid and inclined to settle a little sooner than may have been optimal. Perhaps they were starting on the back foot and anchoring to that position, as many of the unions trumpeted that they refused management's concession demands. Workers in this round of negotiations may have been more concerned about working conditions than money and simply wanted to be heard and seen after running the COVID infection gauntlet. There’s no guarantee that will last, but it’s a good sign for corporate margins and municipal budgets in the near term. Management showed little inclination to cede its advantages: hospitals brought in temporary replacements like pricey traveling nurses at a cost far exceeding the raises unions sought, the two-tier compensation system for legacy and newer workers largely remains intact and companies preferred one-time bonuses to salary increases to pacify employees. It’s possible that workers simply lack much leverage; after securing 2% annual raises for 2020 and 2021 that woefully failed to keep pace with inflation, St. Paul teachers agreed to an eleventh-hour deal for 2022-23 that will provide another two years of 2% raises, though they also won $3,000 retention bonuses/recognition awards for their trouble. Looking Ahead When watching future negotiations between employers and unions, we will be looking out for the fate of the two-tier compensation model and the balance between salary/wage increases and one-time bonuses. Two-tier compensation has allowed employers to drive a wedge between senior employees and their successors. The model incents grandfathered employees to ratify deals that preserve their above-market compensation and benefits at the expense of less senior employees. “We can’t afford to pay all of you like UAW workers in the ‘70s and ‘80s, but we want to reward those who’ve demonstrated their loyalty to the company …” (and will disappear by attrition over the next ten years or so, bending our cost curve way down in real terms). We are also watching the mix of base salary and wage increases and bonus payments. We think of the former as akin to a public company’s dividends and the latter to their stock buybacks. Dividend payments (and wages) are sticky on the downside, as companies don’t want to signal financial weakness by cutting them and employees are loath to see their nominal pay decline. Once dividends and base salaries are raised, it’s hard to cut them. Buybacks, on the other hand, are purely discretionary and shareholders don’t count on them year after year. The same goes with bonuses – future base wages and salaries are a rigid function of previous base wages and salaries, but bonus payments are a one-off that don’t get directly factored into ongoing compensation. We thought John Deere’s agreement with the UAW preserved the status quo to management’s benefit. Per the terms of the new six-year contract, workers got splashy odd-year raises of 10%, 5% and 5%, interspersed with even-year bonuses. The compounded annual growth rate of their base pay is therefore 3.3% over the life of the contract [(1.1*1.05*1.05)^(1/6) – 1]. We’d bet the 3.3% growth will yield very close to zero real gains, and it seems like the 8.5% signing bonus workers received for ratifying the contract was a reasonable up-front price for Deere to pay to lock in six years of nearly flat real increases. The company must pay bonuses in years 2, 4 and 6 as well, but that might be a small price to pay to preserve the divide between workers hired before and after 1997. By the time the deal is up, the least senior of the expensive legacy employees will have been punching the clock for 30 years and their numbers will be thinning at a rapid rate. Ruth Milkman, a sociologist of labor and labor movements who has written or collaborated on over a dozen books in her half-century career, was recently asked when she last felt hopeful about workers’ outlook. After laughing, she said, “I remember when Obama was elected and I made a fool of myself predicting a big labor resurgence.”1 In a pattern reminiscent of Lucy pulling the football away from Charlie Brown, labor hopes pinned on the Obama administration failed to be realized. The Biden administration can direct the Department of Justice, Department of Labor, National Labor Relations Board and OSHA to enforce the laws on the books more vigorously, but it can’t write new ones without both houses of Congress and the Senate lacks the president's appetite to do so. “It’s a story of endless disappointments,” according to Milkman, “and it seems like that’s where we are now, too.” We will believe in labor’s renaissance only after we see it. The course of labor negotiations since the pandemic in no way suggests that a wage-price spiral is inevitable, nor that it is probable. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      https://www.nytimes.com/2022/02/17/magazine/unions-amazon.html. Accessed 4/27/22.

Executive Summary Three Problems For European EPS The Chinese economic slowdown in response to COVID lockdowns represents a major headwind for European profits in 2022. Weaker global growth creates another hurdle. The energy crisis is the third major problem for European profit growth this year. European profits must be revised downward for 2022, but the impact on 2023 EPS will be small. Cyclical sectors are particularly exposed to these three headwinds, which will hurt profitability this year. The recent relative strength in industrials and materials earnings is likely to buckle in response to weaker global growth, while the defensive characteristics of healthcare and communication services will shine. Within defensive sectors, favor healthcare and communication services versus utilities and consumer staples. Bottom Line: A downward revision of European profits will constrain the ability of European equities to rally in the coming quarters; however, it does not portend another major down leg in European stocks. Nonetheless, the downward revision still points to further underperformance of cyclical equities. Within the defensive sectors, healthcare and communication services are more appealing than utilities and consumer staples shares.     The earnings season has begun. According to the MSCI index, Eurozone profit margins are at a 14-year high following a sharp rebound in profits after the pandemic-induced collapse of 2020. Faced with a war in Ukraine and surging inflation, investors worry that this robust profit picture will not last. We share these worries. The near-term outlook for European profits has deteriorated significantly. While the inflation surge amplified by the Ukrainian crisis is an important problem for European firms, it is not the only one. European businesses must also cope with the effect of a growth slowdown in the US goods sector. Moreover, Chinese growth is likely to plunge in response to the tightening lockdowns across the country. As a result, we fear that current earnings estimates for 2022 are too optimistic. Nonetheless, European stocks are unlikely to collapse further. The valuation cushion amassed during the first quarter market shake-out already embeds some downside for 2022 earnings. Additionally, 2023 earnings have much more limited downside than this year’s EPS. Three Problems For European EPS Chart 1European Earnings Profile Three major problems indicate that the current European earnings estimates for 2022 are too optimistic: namely, China’s economic slowdown, a global economic deterioration, and the consequences of the Ukrainian war on the European economy (Chart 1). China’s Slowdown This publication has regularly highlighted that, even if the Chinese credit impulse is already trying to bottom, the lagged effect of the previous slowdown in credit flows would continue to hurt European growth in the first half of 2022. China’s COVID outbreak and Beijing’s severe policy response only accentuate this headwind. European profits are even more sensitive to Chinese economic fluctuation than European economic activity, which points to a meaningful drag on profitability. Many relationships highlight our concerns: So far, the weakness in the Chinese credit impulse is still consistent with a rapid deterioration of forward earnings growth and could lead to a contraction in forward EPS (Chart 2, top panel). The Chinese new orders index is falling rapidly. The elevated likelihood that China endures even more lockdowns in the coming months implies a sharper drop in orders and further weakness in European EPS (Chart 2, second panel). The CNY is depreciating again, which often coincides with a deflationary shock in global industrial goods that Europe produces. Unsurprisingly, a weaker RMB correlates well with narrowing operating profit margins in the Eurozone (Chart 2, bottom panel). Korean business conditions are deteriorating in response to the softening of the Chinese economy. A weaker RMB will further hurt business sentiment in the peninsula, especially if Chinese lockdowns broaden. The Korean economy is a key barometer of global business conditions because of its high cyclicality. BCA’s EM strategy team anticipates an additional softening in Korea,  which portends weaker European profits and margins (Chart 3). Chart 2China's Troubles Trouble Europe Profits Chart 3Listen to Korea Global Economic Weakness The global growth weakness goes beyond China’s troubles. US economic activity is slowing down in response to higher yields, higher inflation, and the disappearance of pent-up demand following a splurge on goods by consumers during the pandemic. As a result, Q1 GDP growth fell to -1.4% from a quarterly annualized rate of 5.5% in Q4 2021. The weakness in the ISM New Orders-to-Inventory ratio points to continued softness through Q2. EM are not immune to these vulnerabilities either. EM consumers are suffering greatly from surging food and fuel costs. Moreover, EM interest rates continue to rise briskly and the ensuing liquidity removal points to fainter growth ahead. Chart 4The Weaker ISM NOI Is Worrisome The impact of weaker global economic activity on European earnings is straightforward: A falling US ISM New Orders-To-Inventories ratio is a prelude both to slower earnings growth and to narrower profit margins in the Eurozone (Chart 4). Global exports growth has collapsed to 5.5% from more than 20% prior year and is likely to deteriorate further. Historically, weaker global shipments are associated with a slowdown in European forward earnings growth (Chart 4, third panel). Global economic surprises have rebounded this year, but, as we showed two weeks ago, they are likely to move back below zero in the near future. This is a noisy series, but negative surprises often prompt downward revisions to earnings estimates. The Energy Shock Europe is facing an exceptional energy shock that is hurting the region’s growth prospects. Now that Russia is curtailing gas shipments to Poland and Bulgaria, more energy disruptions are likely, which will further hamper domestic growth prospects across the region, while simultaneously elevating the cost of goods sold for firms. However, not all countries will be hit equally by a Russian energy embargo among the major economies. Germany and Italy have the most to lose, while France and the UK are the least at risk (Chart 5). The impact of an oil supply shock on European earnings is negative. When oil prices rise because of strong global aggregate demand, European earnings handle rising energy prices well because the increasing sales volume creates a powerful offset. However, our simple model that accounts for the evolution of oil demand and global policy uncertainty highlights that we do not face a demand shock, but rather a supply shock (Chart 6), which implies that most sectors will suffer from higher energy prices. Chart 5Varying Vulnerabilities To Russia’s Energy Showdown Chart 6Oil's Rally Is Supply-Driven Chart 7European Margins Under Pressure The inflation passthrough from energy to everything else is not strong enough to protect profit margins. Yes, HICP is elevated, but European PPIs are rising much more rapidly. Historically, such an inability to pass on higher production costs results in slower European profits growth and contracting operating profit margins (Chart 7). The current weakness in consumer confidence and the expected drag on business confidence underscore that pricing power will likely deteriorate from here, which will accentuate the negative impact on profits from the current energy shock. Wage Costs: Not A Problem For Now Wage costs are the one bright spot for European profit margins. European negotiated wages are expanding at a very low rate of 1.6%. Unit labor costs are only expanding at 2.4%, a rate similar to last decade when European core inflation averaged 1%. Chart 8Wages Do Not Hurt Margins Historically, rising wage rates correlate with rising profitability, not declining margins (Chart 8). This relationship seems paradoxical, but European wages only increase when global aggregate demand is very strong. Due to the degree of operating leverage of European equities, the impact of robust aggregate demand on revenues swamps the impact of accelerating wage growth on production costs. Hence, it will probably take a wage growth rate much higher than the experience of the past 20 years for salaries to start hurting margins. While this is possible, we are many quarters away from this risk becoming reality. Bottom Line: European forward earnings estimates for 2022 are far too elevated in view of the headwinds European businesses are currently facing. The combination of weaker Chinese economic activity, slowing global growth, and a supply-driven energy shock will force significant downward revisions to this year’s EPS. Related Report  European Investment StrategyPlenty Of Risks For Cyclical Stocks 2023 EPS should fare better. Chinese authorities are increasingly supporting their economy and this stimulus will impact activity when the lockdowns end. This process will prompt a boom later this year. Global growth will recover once the energy shock recedes. Decelerating European PPI will also help profit margins recover. Following their severe decline in the first quarter, European equities have already embedded a significant valuation cushion to compensate for the transitory shock to earnings. European stocks will not be able to advance meaningfully while 2022 earnings estimates weaken, but they are unlikely to make new lows either. Three Problems For Cyclicals vs Defensives The same three factors that hurt the outlook for European profits for 2022 also confirm that cyclical equities should underperform defensives in the near term. China’s Slowdown Cyclicals are extremely sensitive to a Chinese economic slowdown: The past weakness in the Chinese credit impulse is consistent with a further downgrade of the profit expectations for European cyclicals stocks compared to that of their defensive peers (Chart 9). A deterioration in China’s PMI New Orders heralds a period of weakness in the earnings of cyclical equities. A weak Chinese yuan leads to poor relative earnings (Chart 9). The deterioration in Korean business confidence and the poor performance of Korean equities also leads to weakness in both the earnings and profit margins of cyclical equities relative to those of defensive stocks (Chart 9). Global Growth Weakness The earnings outlook for cyclical sectors relative to defensives is negatively affected by slowing global economic activity: A deterioration in global economic surprises often results in a period of anemic cyclicals’ earnings (Chart 10). The rapidly declining ISM New Orders-to-Inventories ratio is synonymous with underperforming cyclicals’ earnings as well as a contraction in their relative profit margins because of their heightened degree of operating leverage (Chart 10). Weaker global exports confirm the continued risks to cyclicals’ earnings. Chart 9China Is A Threat To Cyclical Equities Chart 10Global Growth Threatens Cyclical Stocks The Energy Shock There is no clear relationship between energy prices and the outlook for the profits of cyclical equities relative to those of defensive stocks. Nonetheless, we may deduce that, if elevated energy prices hurt aggregate profits, they will also hurt cyclical profits, since the latter exacerbate the fluctuation of the former. Moreover, Europe’s elevated stagflation risk is consistent with sagging profits for cyclicals relative to those of defensives, because cyclicals experience greater pain from deteriorating economic activity than the benefit they enjoy from higher inflation. Bottom Line: The problems faced by the Chinese economy as well as the risks to global growth are consistent with an underperformance of the profits of cyclical stocks compared to those of defensive equities. Moreover, while higher energy prices are not necessarily a problem for cyclical equities, the elevated perceived stagflation risk is consistent with downward revisions for the relative earnings of cyclicals. This picture indicates that cyclical equities are still vulnerable to some downside relative to the broad market in the near term. A Look at Individual Sectors Chart 11Sectoral Degrees Of Operating Leverage We may distill the impact of China’s problems, the global economic slowdown, and the energy shock on sectoral earnings. A simple starting point is to look at their degree of operating leverage. Based on this observation, financials and consumer discretionary stocks are the sectors most at risk from weaker revenue growth, while utilities are the least exposed (Chart 11). A more complete picture may be gleaned from each sector’s pricing power. Energy Chart 12Improving Energy Margins The energy sector enjoys a significant margin tailwind from the oil supply shock (Chart 12). Nonetheless, this boost is long in the tooth and a pullback is likely if Brent falls toward the $94/bbl level expected by BCA’s Commodity & Energy team in the second half of 2022, and $88/bbl level in 2023. Hence, it is likely that the near-term benefits for the energy sector’s profits are already fully discounted and that the sector could suffer a significant setback in the coming quarters. Industrials The pricing power of industrials (as approximated by the gap between CPI and PPI) is still strong, which creates a tailwind for relative earnings (Chart 13). However, this robustness is under threat in the current environment in which global industrial production, global trade, and global capital goods orders are decelerating (Chart 14). Hence, a period of downgrade for the earnings of industrials relative to the broad market is likely in the coming months. Chart 13Robust Pricing Power For Industrials... Chart 14...But For How Long? Financials Chart 15Financials Are Under Siege The relative pricing power1 of financials is rapidly deteriorating, despite the recent increase in German yields (Chart 15). Moreover, it is likely to remain weak in a context in which core CPI has yet to decrease. Finally, the potential for a European recession in 2022, or at least, a severe growth slowdown, should lift non-performing loans. As a result, this sector’s earnings could experience a significant downgrade in the near term. Tech The sector’s pricing power was in an uptrend, but it has started to deteriorate in recent quarters (Chart 16). This evolution indicates that that tech earnings and profit margins are likely to suffer relative to the broad market, especially in light of the sector’s high degree of operating leverage. Consumer Discretionary Stocks This sector is suffering from a complete collapse of its pricing power (Chart 17). Additionally, tumbling consumer confidence in Europe and around the world is a significant drag on near-term sales. Consequently, earnings growth as well as profit margins are likely to lag the overall market. Chart 16Crucial Tech Tailwind Dwindling Chart 17A Problem For Consumer Discretionary Stocks Materials European materials sector’s profit margins stand at a 19-year high compared to that of the broad market. However, relative profit growth has collapsed. The bad news for the sector is that its pricing power is rapidly deteriorating because of surging input costs. It suggests that relative profit growth will become negative as relative profit margins contract (Chart 18). Utilities The pricing power of utilities is plunging because retail electricity prices are not rising as fast as input costs. The negative impact of this adverse pricing on profit margins is consequential (Chart 19). Governments around Europe are likely to continue to pressure this sector to limit the increase in electricity prices to households, which means that utilities are likely to lag other defensive sectors. Chart 18Materials' Outlook Deteriorating Materially Chart 19Crunch Time For Utilities Consumer Staples Chart 20Staples Under Duress The consumer staples sector is facing a similar pricing power problem to that of consumer discretionary stocks: input costs are rising rapidly relative to selling prices (Chart 20). Nonetheless, the earnings of staples will prove more resilient than that of their discretionary counterparts because the staples’ sales volumes are less sensitive to both deteriorating global consumer confidence and falling household real incomes. However, consumer staples equities have already greatly outperformed consumer discretionary stocks. Thus, much of the good news in terms of relative earnings is well discounted and the additional outperformance will be limited. Healthcare Chart 21Healthcare Stocks Still Have Pricing Power The pricing power of the healthcare sector remains positive, but it is not as strong as it was ten years ago. Hence, profits growth has scope to improve further compared to the rest of the market (Chart 21). Beyond favorable pricing power dynamics, the industry is insulated from weaker global growth relative to the rest of the broad market. Importantly, the healthcare sector sports one of the lowest degrees of operating leverage in Europe, which will also boost its relative profitability in the current environment. Healthcare is our top defensive sector right now, despite its valuation premium. Communication Services Chart 22Telecom Will Prove Resilient The profit growth and profit margins of the European communication services sectors are already under duress because pricing power remains negative. Nonetheless, the contraction in relative growth rates of earnings is extended (Chart 22). Telecom revenues did not benefit from a boost when the economy rebounded after the economic contraction in 2020. This stability is now an asset because the sector will not struggle from slowing global economic activity. In this context, the cheap communication services sector remains an attractive defensive play in Europe. Bottom Line: Looking at sectors individually confirms that the outlook for profit growth is worse for cyclicals than it is for defensive stocks. The recent relative strength in industrials and materials earnings is likely to buckle in response to weaker global growth, while the defensive characteristics of healthcare and communication services will shine. Utilities are under stress, as they stand at the confluence of higher energy prices and the explicit desire of politicians to limit the impact of these higher energy costs on households. Favor healthcare and communication services versus utilities and consumer staples.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes   1     In the case of financials, we use core CPI as a proxy for the sector’s costs. Eurostat does not publish a PPI for the sector and the main costs are related to labor costs.   Tactical Recommendations Cyclical Recommendations Structural Recommendations

Listen to a short summary of this report.       Executive Summary Second Fastest Hiking Cycle Ever? Can the Fed achieve a soft landing, bringing inflation back to its 2% target without causing growth to slow significantly below trend? It has managed this only once in the past (in 2004). Every other cycle triggered a recession or, at best, a fall in the PMI to below 50. Recession is not a certainty. A higher neutral rate than in the past – partly due to the build-up of household savings – means the economy may be unusually robust this time. But the risk is high. We recommend a neutral weighting in equities, with a tilt to more defensive positioning: Overweight the US, and a focus on quality and defensive growth sectors. China’s slowdown is particularly worrying. We expect the RMB to fall, which will put downward pressure on other Emerging Markets. Bottom Line: Investors should maintain low-risk portfolio positioning until the outcome of the sharp tightening of financial conditions is clearer.     Recommended Allocation The key to the performance of financial markets over the next year is whether the Fed and other central banks can kill inflation without killing economic growth. This is not impossible. But the risk that aggressive tightening of monetary policy triggers a recession – or at best a sharp slowdown – is high. Investors should maintain relatively low-risk portfolio positioning. If the Fed raises rates in line with what the futures market is projecting – by 286 basis points over the next 12 months – it will be the second fastest tightening on record, after only the “full Volcker” of 1980-1981 (Chart 1). Other central banks, even in countries and regions with much weaker growth than the US, are predicted to tighten almost as aggressively (Table 1). At the same time, the Fed will start to run down its balance-sheet rapidly; we estimate its holdings of US Treasurys will fall by more than $1 trillion by end-2023 (Chart 2). What was the impact on the economy of previous Fed hiking cycles? It varied, but on only one occasion in the past 50 years (2004) was there neither a recession nor a fall of the Manufacturing ISM to below 50 in the two years or so following the first hike (Table 2).1 The ISM (and other global PMIs) falling to below 50 is important because that is typically the dividing line between equities outperforming bonds and vice versa (Chart 3). Chart 1Second Fastest Hiking Cycle Ever? Table 1Futures Projected Interest Rate Hikes Chart 2Fed Balance-Sheet Will Shrink Rapidly Too Table 2What Happened To The Economy In Fed Hiking Cycles Chart 3Will PMIs Fall Below 50?  A recent paper by Alex Domash and Larry Summers showed that, since 1955, when US inflation was above 4% and unemployment below 5%, there was a 73% probability of recession over the next four quarters, and 100% over the next eight quarters (Table 3). On each of the three occasions when inflation was above 5% and unemployment below 4% (as is the case now), recession followed within a year. How could the Fed avoid a hard landing? Inflation could come down quickly, which would allow the Fed to ease back on tightening. As consumption switches back to services from durables, and the supply side succeeds in increasing production, the price of manufactured goods could fall (Chart 4). There were signs of this happening already in March, when US durables prices fell by 0.9% month-on-month. The problem, however, is that because of rising energy costs and lockdowns in China, the supply-side response has been delayed. The fall in semiconductor and shipping costs, which we previously argued would happen this year, is not yet clearly coming through (Chart 5). There are also signs of a price-wage spiral, with US wages rising (with a lag) in line with prices (Chart 6). Table 3This Level of Inflation And Unemployment Usually Leads To Recession Chart 4Can The Price Of Durables Now Fall? Chart 5Supply-Side Recovery Delayed? The economy could be more robust than in the past, leaving it unscathed by higher rates. Our model of the equilibrium level of short-term rates is 3.2%, well above the Fed’s estimate of 2.4% (Chart 7). Our colleague Peter Berezin has argued that the neutral rate could be as high as 4%.2 In particular, the $2 trillion-plus of excess US household savings (equal to 10% of GDP) could support consumption for some years even if real wage growth is negative (Chart 8). However, there are already signs that higher rates are hurting the housing market, the most interest-rate sensitive part of the economy. The average US 30-year fixed-rate mortgage rate has risen to 5.1% from 3.2% since the start of the year. This is negatively impacting home sales and mortgage applications (Chart 9). Moreover, even if the Fed can succeed in raising rates without killing the expansion, the markets – for a while – will worry that it cannot. Chart 6A Price-Wage Spiral? Chart 7Rates Are Still A Long Way Below Neutral Chart 8Excess Savings Could Support The Economy Chart 9Higher Rates Already Impacting Home Sales There are clear signs of a slowdown in the global economy. Europe may already be in recession, with sentiment indicators collapsing to recessionary levels (Chart 10). More esoteric indicators, which have historically signaled slowing growth ahead, such as the Swedish new orders/inventories ratio, are also flashing a warning signal (Chart 11). Global financial conditions have tightened at the fastest pace since 2008 (Chart 12). Corporate earnings forecasts have started to be revised down for the first time in this cycle (Chart 13). Chart 10Is Europe Already In Recession? Chart 1111. Signs Of Trouble Ahead Chart 12Financial Conditions Have Tightened Significantly Chart 13Corporate Earnings Forecasts Being Revised Down But what of the argument that investors have already turned ultra-pessimistic and that all the bad news is in the price? Global equities are down only 14% from their historic peak, barely in correction territory. It is true that sentiment (historically a contrarian indicator) is very poor, with twice as many respondents to the American Association of Individual Investors’ weekly survey expecting the stock market to fall over the next six months as expect it to rise (Chart 14). But, despite investor pessimism, there are few signs that investors have made their portfolios more defensive. The same AAII survey shows little decline in equity weightings, and no big shift into cash (Chart 15). Chart 14Investors Are Very Pessimistic... Chart 15...But Haven't Moved More Defensive Equities: The US is the best house on a tough street. Growth is likely to remain more robust than in the euro area or Japan. The US stock market has a lower beta (Chart 16). And, while the US is more expensive, valuations do not drive the 12-month relative performance of stocks and, anyway, the US premium valuation can be justified by higher ROE and the lower volatility of profits (Chart 17). Emerging markets continue to look vulnerable to the slowdown in China and tighter US financial conditions (Chart 18). We remain underweight. Chart 16US Stocks Are Lower Risk Chart 17US Premium Valuation Is Justified Chart 18Tightening Financial Conditions Are Bad For EM Chart 19Consumer Staples Are Defensive Chart 20IT Earnings Will Continue To Grow Strongly Within sectors, our preference remains for quality and defensive growth. Consumer staples tend to outperform when PMIs are falling (Chart 19) and are supported by attractive dividend yields. Information Technology is a more controversial overweight, given that it is expensive and sensitive to rising rates. Nevertheless, investment in tech hardware and software is likely to continue, giving the sector strong structural earnings growth in coming years (Chart 20). Currencies: The dollar has risen by 7.3% year-to-date driven by interest-rate differentials and the Fed being expected to be more aggressive than other central banks. But we are only neutral, since the Fed will probably not raise rates by as much as the market is pricing in, and because the dollar looks very overvalued (Chart 21). We lower our recommendation on the Chinese yuan to underweight. Interest-rate differentials with the US clearly point to it falling further – also the outcome desired by the authorities to help bolster growth (Chart 22). The likely CNY weakness will put further downward pressure on other EM currencies, particularly in Asia, given their high correlation to the Chinese currency (Chart 23). Chart 21The Dollar Is Very Overvalued Chart 22Rate Differentials Point To A Weaker RMB... Chart 23...Which Is Bad News For Other EM Currencies Fixed Income: With the 10-year US Treasury yield at 2.9% and that in Germany at 0.9%, there is a stronger argument for marginally raising weightings in government bonds. We are neutral on government bonds within the (underweight) fixed-income category. Remember, though, that real yields are still negative: -0.1% in the US and -2.1% in Germany. We do not expect long-term rates to rise much over the next 6-9 months, and so remain neutral on duration. The “golden rule of bond investing” says that government bond returns are driven by whether the central bank is more or less hawkish than expected over the next 12 months (Chart 24). We would expect the Fed to be slightly less hawkish than currently forecast. US high-yield bonds offer an attractive yield pick-up – as long as US growth does not collapse. In a way, HY bonds are like defensive equities, given their high correlation with equities but beta only one-third that of equities (Chart 25). Chart 24Will The Fed Be More Or Less Hawkish Than Expected? Chart 25High Yield Bonds Are Like MinVol Equities Chart 26Russian Oil Is Going Cheap Commodities: Oil prices are likely to fall back to around $90 a barrel by year-end, as demand softens and increased supply (from Saudi Arabia, UAE, and North American shale, and maybe from Venezuela and Iran) enters the market. But the risk is to the upside if this extra supply does not emerge. In particular, possible bans on Russian oil and gas into the European Union (or Russia blocking sales) could disturb the market. It will take time for Russia’s 11 million b/d of oil production, which used to go mainly to Europe, to be rerouted to Asia. This is why the Urals benchmark is at a 30% discount to Brent (Chart 26). The long-term story for industrial commodities remains good, but there is downside risk – especially for iron ore and steel – from China’s slowdown (Chart 27). Gold is an obvious hedge against geopolitical risks and high inflation. But over the past 20 years, it has been negatively correlated to real interest rates and the US dollar, suggesting upside is capped. There is a chance, however, that the relationship between rates and gold breaks down, as it did in the 1970s and 1980s (Chart 28). We, therefore, remain neutral on gold, believing that a moderate holding is a good diversifier for portfolios. Chart 27Chinese Slowdown Is Negative For Commodities Chart 28Will Gold Start To Behave As It Did Before 1990? Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1         In 2015, the ISM was already below 50 when the Fed hiked in December. 2         Please see Global Investment Strategy Report, “Is A Higher Neutral Rate Good Or Bad For Stocks?” dated March  18, 2022. Recommended Asset Allocation Model Portfolio (USD Terms)