Economy

Executive Summary Indonesia’s Balance Of Payments Will Be Under Pressure Indonesian domestic demand is struggling in the face of tight policy settings. High real borrowing costs are constraining credit growth, and hurting non-financial sectors. Monetary authorities have shown little intention to reduce borrowing costs by any good measure, and remain focussed on exchange rate stability. This is a major policy dilemma that the authorities need to break free from before this bourse can embark on a sustainable bull market. Indonesia’s only bright spot since the pandemic, its external accounts, will be deteriorating. Capital inflows will dwindle at a time when the current account balance is set to slip back into deficit. This will put downward pressure on the rupiah, which in turn raises the risk of policy error as the central bank might be tempted to raise rates in a bid to stabilize the currency. Doing so would hurt economic growth and stock prices.  Bottom Line: Currency investors should stay short the rupiah versus the US dollar. Equity investors should wait for relative weaknesses before considering an upgrade in EM and Emerging Asian portfolios. Investors should stay underweight Indonesia in EM local currency bond portfolios. Sovereign EM credit investors, however, should continue to overweight Indonesia. Feature In the past few months, Indonesian stocks have rallied to a pandemic-era high. They have outperformed their emerging market peers as well, albeit from a very low level (Chart 1). Could this mean that Indonesia’s decade-long underperformance is finally coming to an end? We are not convinced. The nation’s equity index in US dollar terms will find it hard to advance to new highs anytime soon. Absolute return investors, therefore, should not chase this bourse up. In terms of relative performance, odds are that some of the recent gains might be lost. The recent outperformance had more to do with investors fleeing Chinese stocks and Indonesia has been one of the major beneficiaries of this rotation (Chart 2). Meanwhile, Indonesia’s policy setting remains quite restrictive. Its external tailwinds are receding as well, which is making the rupiah vulnerable. Chart 1Indonesian Stocks Are Still Not Geared For A Sustainable Bull Market Chart 2Much of The Indonesian Outperformance Had To Do With Investors Leaving China That said, given Indonesia’s drawn-out equity underperformance since early 2013, this bourse’s relative bear market versus the EM benchmark is late. As such, following near-term weaknesses, asset allocators should consider upgrading this bourse from underweight to neutral in EM and Emerging Asian baskets. Domestic bond investors should stay underweight Indonesian local currency bonds in EM and Emerging Asian portfolios. Sovereign credit investors, however, should remain overweight Indonesia. Persistent Domestic Headwinds The recovery in Indonesian domestic demand has been quite slow over the past two years. The top panel of Chart 3 shows that the economy is still struggling. Two years into the pandemic, consumer confidence and retail sales volume are well below pre-pandemic levels. One reason for the muted consumer sentiment is meagre growth in household income. Nominal wage growth has stalled, sapping consumer demand. Wage growth in real terms (deflated by headline CPI) is shrinking outright (Chart 3, bottom panel). Weakness is palpable on the supply side as well. The capacity utilization rate for both manufacturing and other industries remains well below pre-pandemic levels (Chart 4, top two panels), despite the fact that Indonesia’s manufacturing exports have been very strong over the past year (details to come). This underscores the extent of the weakness in domestic demand. Chart 3Consumer Confidence Is Low As Household Income Is Moribund Chart 4Low Capacity Utilization And Labor Usage Points To Poor Domestic Demand Chart 5Fiscal Support Is In Short Supply In line with low capacity utilization, labor usage has also been consistently below par since the onset of the pandemic (Chart 4, bottom panel). That means hiring has been restrained and workers have had little bargaining power, which explains why nominal wage growth has halted. The restrictive macro policy is also exerting a considerable drag on economic recovery. Indonesia’s fiscal stance is rather tight. The government is planning to rein in the fiscal deficit this year to 4.3% of GDP from a revised 4.7% deficit last year. As such, the IMF estimates that the cyclically adjusted fiscal thrust will be a negative 0.9% of potential GDP this year, and a further negative 0.6% next year (Chart 5).  Monetary policy, as we have repeatedly asserted, has remained extremely restrictive for the past six to seven years. Interest rates are prohibitively high.Banks’ lending rates, for instance, have consistently stayed above nominal GDP growth rate since 2012. That will likely be the case going forward as well given the muted growth outlook. If one looks at real bank lending rates (deflated by core CPI) vis-à-vis real GDP, the picture looks even more grim (Chart 6). Such high borrowing costs, which continued for a decade, have been a major headwind for the country’s non-financial sectors. Stock prices of non-financial firms as well as those of SMEs – which had to endure chronically high financing costs − have been in a decade-long bear market in absolute terms. By contrast, banks benefited from the high lending rates, and their share prices have rallied to their pre-pandemic highs (Chart 7). Chart 6Borrowing Costs Have Been Persistently High Relative To The Economy's Growth Rate... Chart 7...Hurting Stocks Of Non-Financial Firms And SMEs, While Benefitting Banks Chart 8Exorbitant Borrowing Costs Have Led To A Stagnation In Credit Penetration Very high real interest rates is one reason Indonesia’s credit penetration, at 34% of GDP, is unusually low for an economy at this stage of development. The ratio has not risen at all in the past 10 years. In fact, it has headed lower recently (Chart 8). This is not a sign of a healthy, recovering economy. As such, for Indonesian stocks to have a sustainable bull market, one of the macro imperatives is that the real borrowing cost needs to decline considerably. Yet, Indonesian monetary authorities have shown little intention to reduce real rates by any meaningful measure. The main reasons behind this hawkish stance on the part of the central bank has had to do with (i) the country’s persistent current account deficit over the past decade, and (ii) the central bank’s mandate of exchange rate stability. Indonesia needed to offer consistently high real rates to attract enough foreign capital so that it can finance its current account deficits, and thereby have a stable rupiah. Yet, that policy has created distortions elsewhere. Persistently high real rates have led to a steady drop in non-financial firms’ return on equity. That, in turn, discouraged foreign equity inflows but encouraged international fixed-income inflows into Indonesia. This is not surprising as equity investors dislike high real rates, while debt investors prefer it. The reliance on foreign debt inflows, in turn, incentivized the authorities to keep real interest rates persistently high − even in periods when growth was rather timid and inflation undershot the central bank’s target. This is a major distortion that the Indonesian economy needs to break free from before this bourse can embark on a sustainable bull market. Incidentally, a bill to expand the central bank’s mandate to include growth and employment was introduced to parliament last year. If passed, the bill-turned-law would allow Bank Indonesia to set interest rates more in line with domestic economic conditions, rather than just focussing on currency stability. Chart 9Inflation Is Inching Up From Very Low Levels Discussions on the bill, however, have been delayed in  Parliament, and it is not clear when, or if, it will be passed. Meanwhile, Bank Indonesia has begun to tighten policy on the margin by draining excess liquidity from the system. More worryingly, the central bank could begin to raise rates in the next couple of months as it fears inflation will creep up due to rising global commodity prices (Chart 9). Outflows from the bond market might also encourage the central bank to raise rates in an attempt to stem them (details in the next section).   Receding External Tailwinds In contrast to Indonesia’s lack of domestic recovery, the country’s external sector was the star performer over the past year or two. Yet, in the next few quarters, it’s the external sector that will likely be a threat to the nation’s growth. This is because Indonesia’s exports are set to shrink and its balance of payments is set to deteriorate. These factors could threaten the rupiah stability, which would then force the central bank to raise rates / tighten liquidity prematurely in a bid to support the rupiah. Tighter policy would be a major headwind for growth, and would hobble stock prices.  Indonesian exports grew remarkably over the past two years, which helped to push the country’s current account balance into surplus for the first time in a decade (Chart 10, top panel). A closer look, however, will reveal that much of it had to do with surging exports to China – which doubled to $55 billion in two years (Chart 11). Chart 10Indonesia's Balance Of Payments Will Be Under Pressure Chart 11Improvements In The Current Account Were Mostly Due to A Surge In Exports To China           That said, much of the improvements in the current account could unravel going forward: Some of the export windfalls accrued to Indonesia when China banned Australian coal imports in 2020 and switched to Indonesian coal instead.   But more recently, a decelerating economy in China has led to slowing electricity generation. The latter has always had a direct bearing on Indonesian coal exports volume – which is now shrinking (Chart 12, top panel). China’s electricity demand and production will slump further due to COVID lockdowns of enterprises and pending weakness in its exports. Chart 12Export Windfalls Are Ending As Chinese Growth Wanes Chinese thermal coal prices have been falling in recent months from the sky-high levels of late 2021, and could fall further by the end of the year as China keeps increasing its own coal output and its electricity generation drops (Chart 12, bottom panel). All these will weigh on Indonesian export earnings in the months to come. For its part, the Indonesian government has restricted coal exports by mandating that miners set aside 25% of their output for local sales as part of their “domestic market obligation.” The government has also banned shipments of some palm oil ingredients for an indefinite period – in an apparent attempt to check domestic food price inflation. Palm oil is the second largest Indonesian export after coal, and together they make up 22% of total export revenues. Indonesia is a large net crude and refined petroleum importer. Global crude prices will likely stay elevated due to sanctions on Russia. This will be a negative for the country’s trade balance. Chart 13Dwindling Goods Demand In The Developed World Will Hurt Indonesian Manufacturing Exports Moving beyond commodities, Indonesian manufacturing exports − which are as large as its’ commodities exports in US dollar terms − will also likely get hurt. A crucial reason for that is a slowing China. Chinese manufacturing imports are set to weaken in the next several months as that economy is entering a soft patch. That usually is an adverse development for Indonesian exports to China (Chart 13, top panel). In fact, Indonesia’s overall manufacturing exports will also likely slow. Falling household goods demand in developed countries will curtail manufacturing exports from Asia, including Indonesia. Notably, early signs of an impending slowdown in Indonesian manufacturing exports often appear in Chinese data − given the heft of the Chinese economy and its trade links in Asia and beyond (Chart 13, bottom panel). More generally, global trade will likely slow going forward, which is a negative for those economies that have relied on an export windfall over the past couple of years. Essentially, the days of boyant current account balances are numbered for Indonesia.  A slipping current account balance could spell larger problems for Indonesia as the country’s financial account surplus has been steadily eroding. From a high of $37 billion annually in 2019, it dropped to just $12 billion by the end of 2021. Much of that drop is due to a fall in net debt inflows – the type of capital inflows Indonesia strives to attract by keeping real interest rates very high (Chart 10, middle panel). Chart 14Falling Real Bond Yields In Indonesia Will Keep Foreign Debt Investors At Bay Critically, the country has not been able to attract much FDI either despite passing an Omnibus Law to boost new investments and create jobs a couple of years back (Chart 10, bottom panel). Chart 14 shows that foreign investor holdings of Indonesian government debt has shrunk materially from almost $80 billion in early 2020 to less than $60 billion now. In terms of their share in total bonds outstanding, the drop is even more remarkable: from 40% of the total to just 18%. Foreign bond purchases clearly react to the ebbs and flows of Indonesian real yields on offer (Chart 14, bottom panel). Given that Indonesian inflation will likely go up from the current very low levels − putting a downward pressure on the real yields available – foreign investors could continue to shun Indonesian bonds. Indonesian policymakers might also worry as such. That apprehension could prompt Bank Indonesia to raise rates preemptively in a bid to attract debt inflows and stabilize the currency. If so, higher real rates would add to the existing policy headwinds for the domestic economy. Growth will suffer; and markets will sell off.  Investment Conclusions The Currency: The rupiah remains vulnerable as the Indonesian balance of payments is set to deteriorate. A slipping current account balance amid receding capital inflows will be putting downward pressures on the rupiah. Stay short the rupiah versus the US dollar. Domestic Bonds: Indonesian bond yields have fallen massively relative to their EM counterparts, and are at 10-year lows in relative terms. As such, the nation’s local currency bonds have little more room to benefit from relative yield compression. The rupiah is also vulnerable. We went underweight Indonesian domestic bonds in November last year, and that recommendation remains in place (Chart 15). Sovereign Credit: Absolute return investors should reduce their exposure as the rupiah weaknesses going forward could lead to widening credit spreads, and result in negative total returns in US dollar terms (Chart 16). Chart 15Stay Underweight Indonesian Domestic Bonds In An EM Bond Portfolio Chart 16Absolute Return Investors Should Reduce Exposure To Indonesian Sovereign Credit   Asset allocators, however, should stay overweight Indonesia in an EM credit basket. This market has transitioned itself into a defensive one over the past several years – thanks to years of orthodox fiscal and monetary policies and low debt. Hence, given that a period of risk-off is around the corner – during which Indonesian credit tends to outperform as it did in 2015 and 2020 − it makes sense to stay overweight this market. Stocks: Absolute return investors should not chase this bourse up. Asset allocators should wait for relative weaknesses before considering an upgrade from underweight to neutral in EM and Emerging Asian portfolios.   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Executive Summary China's Demand Was Very Weak before Lockdowns The selloff in risk assets is not over. Stay defensive. Stagflation fears will continue gripping financial markets. Global trade volumes are set to contract, but the Fed has little maneuvering room as US core inflation is well above its target. Commodity prices are at an important juncture. The plunge in Chinese material stock prices is a warning sign for global materials because China is by far the largest consumer of raw materials (excluding oil), accounting for about 50-55% of global industrial metal demand. The rally in EM commodity plays like Latin America and South Africa is at risk of a major reversal. Bottom Line: Global equity and credit portfolios should underweight EM equities and credit, respectively. The rally in the US dollar might be the final upleg before a major downtrend sets in. However, this final rally will be considerable, and the greenback will likely overshoot. A buying opportunity in EM local currency bonds will present itself after EM currencies hit a bottom versus the US dollar. Feature Global and EM risk assets will remain under selling pressure. This Charts That Matter report contains charts that will help investors navigate treacherous financial markets by shedding light on the following key issues: How much more downside in stocks? Chart 1 displays EM share prices in USD terms alongside their long-term moving averages. If EM equities break below the current technical support line, the next one implies that there is 20-25% further downside in EM stocks. For the S&P500, the next technical support is at 3650-3750. Our Equity Capitulation Indicators for both the S&P500 and EM stocks remain above their previous (2010-2020) lows (Charts 5 and 6 below). In addition, equity market breadth is deteriorating. Fundamental problems with financial markets are linked to mounting stagflation fears. Global trade volumes are set to contract in H2 due to a decline in US and European household spending on goods ex-autos and a delayed recovery in China as we discussed in last week’s report. In turn, US wage growth is accelerating, which will push up unit labor costs. US core inflation will likely drop due to base effects, but will remain above 3.5-4%, which far exceeds the Fed’s 2-2.25% target. Chart 1EM Share Prices: Their Long-Term Moving Averages Served As A Support In Bear Markets Chart 2 illustrates that stagflation fears have already gripped financial markets. Global defensive equity sectors have recently been outperforming global non-TMT stocks despite rising US and global bond yields (Chart 2). This is a major departure from the historical relationship between the two and likely foreshadows a period of continuous Fed tightening despite slower global growth. Global equity managers should favor defensive stocks as they will continue to outperform under the two most likely scenarios: (1) either these stagflation dynamics continue; or (2) a growth scare will dominate, during which US bond yields could drop. Chart 2Does This Divergence From A Historic Correlation Signify Stagflation? The US dollar continues to climb, and its strength has recently become very broad-based – extending to commodity currencies and Asian currencies. As we show in Charts 46-48 below, the US dollar has more upside.   Commodity prices are at an important juncture. On the one hand, supply shortages and risks to further supply disruptions could continue to support resource prices. On the other hand, demand will disappoint. Shrinking US and European consumer spending on goods ex-autos, contracting Chinese commodity intake and weakness in EM ex-China demand all suggest that global commodity consumption will decline in the months ahead. In our March 10 report, we noted that commodity prices would be volatile and this view has been validated: commodity prices swings have been extreme over the past two months. More recent evidence points to lower resource prices. Chart 3 shows that over the past 200 years raw material prices in real US dollar terms (deflated by US headline CPI) have oscillated around a well-defined downtrend. The pandemic surge in commodity prices has pushed them to two standard deviations above their time-trend. Historically, commodity rallies (and even their secular bull markets) ended when prices reached this threshold. Hence, odds are that industrial commodities might hit a soft spot. Energy prices remain a wild card due to geopolitics. It is critical to note that the raw materials price index shown in Chart 3 does not include energy, gold and semi-precious metals (the footnote of Chart 3 lists commodities included in this aggregate). Chart 3Raw Material Prices (In Real Terms) Are At The Upper End Of A 200-Year Downtrend Finally, Chart 4 demonstrates that Chinese materials stocks have plunged. We read this as a warning sign for global materials because China is by far the largest consumer of raw materials (excluding oil), accounting for about 50-55% of global industrial metal demand. Chart 4Chinese Material Stocks Are Signaling Trouble For Global Materials Investment Recommendations Stay defensive. Global equity and credit portfolios should underweight EM equities and credit, respectively. The rally in the US dollar might be the final upleg before a major downtrend sets in. However, this final rally will likely be considerable, i.e., the greenback will likely overshoot. The CNY has broken down versus the US dollar and our target is 6.70-6.75 for now. A depreciating yuan is bearish for Asian and EM currencies. We continue to recommend short positions in the following EM currencies versus the US dollar: ZAR, COP, PEN, HUF, IDR, PHP and PLN. A buying opportunity in EM local currency bonds will present itself when EM currencies hit a bottom versus the US dollar.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   US And EM Equity Capitulation Indicators These indicators have not reached their lows of 2010, 2011, 2018 and 2020. The magnitude of the S&P500 selloffs in 2011 and 2018, were 19.5% and 19.8%, respectively. Hence, our best guess for the size of a S&P500 drawdown in this selloff is about 20%. This puts the potential S&P500 low at 3800-3850. The latter is consistent with the technical support (3-year moving average) that held up in 2011, 2016 and 2018 (Chart 5, top panel).  Chart 5 Chart 6 Components Of Our US Equity Capitulation Indicator Not all components of our US Equity Capitulation Indicator have reached their previous lows. Odds are that US share prices will drop further. US equity valuations are still expensive, geopolitical risks are elevated, and inflation and inflation expectations are extremely high, which will limit the Fed’s maneuvering room. Chart 7 Chart 8 Components Of Our EM Equity Capitulation Indicator Similarly, the components of our EM Equity Capitulation Indicator have not reached their previous lows. The share of industry groups above their 200-day moving average, analysts’ net EPS revisions as well as the momentum and equity sentiment indicators remain above prior troughs. Further downside in EM share prices is likely.  Chart 9 Chart 10 S&P500 Overlays With Previous Geopolitical Crises The most recent examples of geopolitical shocks include the Cuban missile crisis in 1962, the oil embargo of 1973 in response to the Yom Kippur War and the Gulf War of 1990. The magnitude of the S&P 500 selloff was 28% in 1962, 23% in 1973 and 20% in 1990. Today, the S&P 500 is down only 12.8% from its peak. Based on the above three profiles, the current selloff in US stocks has further to go. This also means that non-US equities, including EM, will continue to suffer.  Chart 11 Chart 12 Chart 13 Table 1 Various EM Equity Indexes: Deteriorating Breadth Various EM equity indexes have been in a bear market. The deterioration has been broadening as recent leaders such as commodity producers and Taiwanese stocks have been gapping down. Yet, not all bourses are very oversold. We published a Special Report on semiconductors on April 14 arguing that semi stocks face more downside. Share prices of commodity producers have recently corrected, and, as we argue above, odds of a further drop are non-trivial. What are the odds that the overall EM equity index undershoots? See the next section.  Chart 14 Chart 15 Chart 16 Chart 17 EM Undershoot Is Likely Sentiment towards EM equities has fallen significantly, but it is not yet at previous lows. Similarly, there is still room for EM net EPS revisions by bottom-up analysts to fall further. Finally, platinum prices point to more downside in EM non-TMT share prices.  Chart 18 Chart 19 Chart 20 EM Bond Yields And Share Prices Historically, rising EM corporate USD bond yields and EM local currency bond yields led to a selloff in EM share prices. Unless EM USD and local currency bond yields start falling on a sustainable basis, EM equities will continue to struggle. Chart 21 Chart 22 Rising US Corporate Bond Yields Are Bearish For US Stocks Rising US corporate borrowing costs point to lower US share prices. Corporate bond yields could increase because of either rising US Treasury yields or widening credit spreads. Furthermore, bearish US equity market technicals are presently reinforcing this downbeat outlook for US stocks.  Chart 23 Chart 24 Chart 25 The S&P500 EPS Can Contract Outside Of A Recession Let’s recall what happened in 2000-2001 in the US. Real GDP contracted only slightly, household spending in real terms did not contract at all, and the housing market was booming. Yet, the S&P 500 operating EPS plunged by 30% and the stock index was down by 50%. In 1966, even though real and nominal GDP did not contract, the S&P500 operating EPS shrank by about 5% and share prices fell by 22%. This episode is the best analogy for US economic and financial market dynamics over the near term.  Chart 26 Chart 27 US Stagflation Scare US wage growth is accelerating, and unit labor costs are surging. The latter will make inflation sticky and hurt corporate profit margins. Besides, US consumer demand for goods ex-autos will shrink following a two-year period of overspending. This combination will produce a stagflation scare – a period when corporate profits are weak, but the Fed has little maneuvering room as core inflation is well above its target.  Chart 28 Chart 29 Chart 30 Chart 31 Global Trade Volumes Will Shrink Taiwanese shipments to China – which lead global exports – have started to contract. Korea’s business survey of exporting companies reveals that business conditions deteriorated substantially in April. Global cyclicals have been underperforming global defensives. Finally, early cyclical stocks in the US have sold off and have substantially underperformed domestic defensives. This also points to a slowdown in US growth. Chart 32 Chart 33 Chart 34 Chart 35 China’s Economy Requires Much More Aggressive Stimulus In China, monetary and fiscal stimulus have so far been insufficient to produce a major economic recovery given the headwinds from the property sector and the harsh lockdowns. The enacted fiscal stimulus has mainly been for infrastructure spending, and it does not include direct fiscal transfers to households who are losing income due to the lockdown. On the monetary front, the credit impulse – excluding local government bond issuance (which is counted in our fiscal spending impulse) – has barely bottomed.  Chart 36 Chart 37 Chart 38 Chart 39 China Has Been A Drag On Global Trade Chinese domestic demand was extremely weak even prior to the recent lockdowns in Shanghai. Chinese import volumes of various commodities, machinery, industrials goods and semiconductors were contracting as of March. Lockdowns and associated income/profit losses will further depress domestic demand. Chart 40 Chart 41 Chinese Property Woes Are Worsening Housing floor space sold in April is down by 50% from a year ago. Households are reluctant to borrow and buy, and property developers’ financing has dried up. All these point to shrinking construction activity. Chart 42 Chart 43 Chart 44 Chart 45 The US Dollar Has More Upside Our view on the greenback has played out well, and more upside is likely. The CNY has broken down against the dollar and it will reach at least 6.70-6.75. One exception to a strong US dollar might be the yen, as the trade-weighted yen has fallen to its previous lows. However, a rebound in the yen from current levels requires  a stabilization of US bond yields.  Chart 46 Chart 47 Chart 48 Chart 49 EM Currencies: Do Not Catch A Falling Knife EM currencies remain at risk. They are not cheap, and the recent rebound has faltered with many EM exchange rates unable to break above their technical resistance vis-à-vis the USD. However, we expect the US dollar to top and EM currencies to bottom later this year. Stay tuned.  Chart 50 Chart 51 EM Credit Markets: More Spread Widening Ahead EM and US credit spreads are not particularly wide and will likely widen further. China’s corporate USD bonds remain in a bear market. The two key drivers of EM credit spreads are the business cycle and exchange rates. EM growth will continue to disappoint, and EM currencies will relapse versus the US dollar. Hence, investors should be patient before buying/overweighting EM credit.  Chart 52 Chart 53 Chart 54 Chart 55 EM Domestic Bonds: A Buying Opportunity Down The Road The EM GBI domestic bonds total return index in USD terms has broken down and near-term weakness is likely. Meanwhile, EM local currency bond yields have risen significantly, and they offer good value. That said, a buying opportunity in local currency bonds will transpire only after their currencies bottom. Chart 56 Chart 57 Footnotes    

Highlights Several factors point to both an improvement and a deterioration in economic and financial market conditions, underscoring that the 6- to 12-month investment outlook is unavoidably uncertain. On the one hand, the US will likely avoid a recession over the coming year, slowing headline inflation will boost real wages and lower the equity risk premium, bond yields will not move much higher this year, and US services spending will support consumption as the pandemic continues to recede in importance. These are positive factors that will work to support economic activity and risky asset prices. On the other hand, the US will likely experience a recession scare focused on the housing market, the European economy may contract, Omicron’s spread in China threatens a further rise in shipping costs and a trade shock for Europe, and US inflation expectations may unanchor despite a falling inflation rate. For now, investors should remain minimally-overweight stocks over a 6- to 12-month time horizon, although that assessment may change in either a bullish or bearish direction over the coming several months. Within a global equity allocation, we recommend that investors maintain a neutral regional stance. The larger risk of a recession in Europe than in the US would normally imply that investors should be overweight US stocks, but euro area stocks have already underperformed global stocks significantly since Russia’s invasion of Ukraine. Within a fixed-income portfolio, we recommend that investors maintain a modestly short duration stance despite our forecast that long-maturity bond yields will not increase much this year. More nimble investors should be neutral duration, and should test a long stance if US data releases begin to exhibit meaningfully negative surprises. The US dollar is likely to strengthen over the near term, but we expect it to be lower a year from today. The Scourge Of Harry Truman US President Truman famously lamented the need for “one-handed” economists. His complaint reflected how essential it is for economic policymakers to receive clear advice about the best path forward. Investors understandably have even less tolerance for ambiguity than Truman did about the macro landscape and the attendant investment implications. However, there are times when the economic and financial market outlook is unavoidably uncertain. The current economic and geopolitical environment easily qualifies as one of those instances. Several factors point to both an improvement and a deterioration in economic and financial market conditions, which we review in detail below. The likely avoidance of a recession in the US over the coming year suggests that investors should remain minimally-overweight stocks over a 6- to 12-month time horizon, although that assessment may change in either a bullish or bearish direction over the coming several months. What Could Go Right The US Will Likely Avoid A Recession Over The Coming Year Chart I-1The Odds Of A US Recession Are Currently Low We downgraded our odds of an above-trend 2022 growth scenario in last month’s report,1 but noted that a stagflation-lite environment of below-trend growth and above-target inflation was a more likely outcome than recession. We based this assessment on our view that the US neutral rate of interest is likely higher than the Fed and investors expect, which we discussed at length in past reports.2 Chart I-1 highlights that our recession probability indicator also supports this view, as it does not yet signal that a recession is on the horizon.3 Table I-1 highlights the components of the model (which is significantly influenced by the Conference Board’s LEI), and shows that the model is not providing a meaningful warning signal. The Fed funds rate component of the model will likely flash red next month following the FOMC meeting, and we have listed it as providing a warning signal in Table I-1. But rising rates themselves have not proven to be a particularly timely indicator of a recession; this is similarly true with rising inflation expectations and oil prices. We noted in last month’s report that a surge in oil prices has not been an especially consistent indicator of a recession since 2000. Table I-1The Components Of Our Recession Model Are Not Yet Flashing A Warning Sign The yield curve component of the model is based on the spread between the 10-year Treasury yield and the 3-month T-bill yield in order to minimize false recession signals, and we agree that the 10-year / 2-year spread has better leading properties. But even the latter curve measure has recently moved back into positive territory (Chart I-2), which will certainly qualify as a false yield curve signal if a recession is avoided over the coming 18 months. Within the components of the Conference Board’s LEI, Table I-1 highlights that there have been signs of weakness from the manufacturing sector, consumer expectations, and the credit market. Chart I-3 aggregates the deviation of six of these components from their trend, and shows that they have indeed been consistent with a significant slowdown in economic activity. Chart I-2The 2/10 Yield Curve Is No Longer Inverted Chart I-3The Weakest Components Of The Conference Board's LEI Are Not Yet Signaling A Recession However, two caveats are warranted. First, part of this weakness reflects the ongoing shift from goods to services spending, unraveling the massive surge in goods spending that occurred during the pandemic (Chart I-4). Second, Chart I-3 highlights that similar weaknesses occurred in the past outside of the context of a recession, most notably in 1995/1996, in the aftermath of the 1994 bond market crisis; in 1998/1999, following the Long-Term Capital Management (LTCM) crisis; in 2015, following the collapse in oil prices; and, finally, in 2018/2019, in response to the Trump administration’s trade war. None of these instances resulted in a contraction in output. Headline Inflation Is Likely To Come Down Headline consumer price inflation is currently extremely high in the US. Rising prices do not just reflect energy, food, or pandemic-related effects. Chart I-5 highlights that trimmed mean CPI and PCE inflation rates have accelerated significantly since last summer, and are currently running at 6% and 3.6% year-over-year rates, respectively. Chart I-4Part Of The Weakness In Manufacturing Activity Indicators Reflects A Shift In Spending From Goods To Services Chart I-5There Is More To High Inflation Than Food, Energy, And Pandemic-Related Effects... However, it seems likely that inflation has peaked in the US (or is about to do so), even abstracting from base effects.Chart I-6 highlights that the one-month rate of change in trimmed mean measures seemingly peaked in October and January, and shows that the level of used car prices also appears to be trending lower (panel 2). The ongoing shift away from goods to services spending noted above will also push core ex-COVID-related consumer prices lower. Finally, BCA’s Commodity & Energy strategy service is forecasting that Brent crude oil prices will average roughly $90/bbl for the remainder of the year, which would likely bring US gasoline prices back toward $3.50/gallon and will lower both headline inflation and energy passthrough effects to core prices (Chart I-7). Chart I-6... But The Rate Of Headline Inflation Has Likely Peaked Chart I-7Our Forecast For Oil Implies US Gasoline Prices Will Fall     A meaningful deceleration in inflation will help reverse some of the recent decline in real wage growth that has occurred, and will likely lower the equity risk premium (see Section 2 of this month’s report).   Long-Maturity Bond Yields Will Not Move Much Higher This Year Chart I-8Our Inflation Probability Model Is Signaling Core Inflation That Is Roughly In Line With The Fed's Latest Forecast Chart I-8 highlights that our inflation probability model is currently signaling core PCE inflation of roughly 4.3% over the coming year. This is only moderately above the Fed’s forecast for this year, suggesting that a moderation in the rate of inflation makes it more likely that the Fed will raise rates in line with, or only moderately above, what was projected in the March Summary of Economic Projections (1.9% by the end of this year, and 2.8% by the end of 2023). By contrast, Chart I-9 highlights that the OIS curve is pricing the Fed funds rate at 80 basis points higher by the end of this year than what the Fed projected in March, suggesting that the bar for further hawkish surprises is quite high. We agree that the Fed will likely front-load a good portion of its planned tightening this year, and we agree that a 50 basis point hike is likely next month and also possibly in June. However, it is quite possible that the Fed will ultimately raise rates over the coming year at a slower pace than investors currently anticipate, which would lower yields at the front end of the curve. Chart I-9The Bar For Further Hawkish Surprises From The Fed Is Quite High If short-maturity yields are flat or trend modestly lower over the coming year, then a significant further rise in long-maturity yields would likely necessitate a major shift in neutral rate expectations on the part of investors or the Fed. We believe that such a shift will eventually occur, as the economic justification for long-maturity bond yields well below trend rates of economic growth disappeared in the latter half of the last economic expansion. However, we noted in last month’s Special Report that a low neutral rate outlook has become entrenched in the minds of investors and the Fed, and is only likely to change once the Fed funds rate rises meaningfully and a recession does not materialize.4 BCA’s fixed-income team currently recommends that investors maintain a neutral duration stance; the Bank Credit Analyst service is more inclined to recommend a modestly short stance. However, the key point for investors is that another significant rise in long-maturity bond yields is unlikely over the coming year, which is positive for economic activity and investor sentiment. The Pandemic Will Recede In Importance, Supporting Services Spending Chart I-10COVID Hospitalizations And Deaths Remain Low In The DM World While the pandemic is clearly not over in China (discussed below), it is likely to continue to recede in importance in the US and other highly vaccinated, and relatively highly exposed DM economies. Despite the fact that confirmed cases of COVID-19 have risen in the DM world in March and April, Chart I-10 highlights that there has been very little increase in ICU patients or deaths. A recent study from the US CDC suggests that 58% of the US population overall and more than 75% of younger children have been infected with the SARS-COV-2 virus since the start of the pandemic.5 When combined with a vaccination rate close to 70%, that signals an extraordinarily high national immunity to severe illness from the disease. Chart I-11 also highlights that deliveries of Pfizer’s Paxlovid continue to climb in the US, a drug that seemingly works against all known variants and has been found to reduce hospitalizations from COVID significantly if taken within the first five days of symptoms. Given that the decline in services spending that we showed in Chart I-4 has been clearly linked to the pandemic, we expect that a slowing pandemic will continue to support services spending. Goods spending is normally a more forceful driver of economic activity than is the case for services spending, but the magnitude of the recent contribution to growth from services spending has been absolutely unprecedented in the post-World War II economic environment (Chart I-12). This underscores that a continued recovery in services spending relative to its pre-pandemic trend will provide a ballast to overall consumer spending as goods spending continues to normalize. Chart I-11Paxlovid To The Rescue! Chart I-12Real Services Spending Will Continue To Be A Forceful Driver Of US Economic Activity What Could Go Wrong The US Will Likely Experience A Recession Scare Chart I-13US Housing Affordability Has Cratered, In Large Part Due To Surging House Prices Despite our view that the US economy will avoid a recession over the coming year, it seems likely that investors will experience a recession scare at some point over the coming 6 to 12 months. Even though it has recently moved back into positive territory, the inversion of the 2-10 yield curve has set the scene for a recessionary overtone to any visible weakness in the US macro data over the coming months. We noted above that the manufacturing and goods-producing sectors of the US economy are likely to slow as spending returns to services. More importantly, the extremely sharp increase in mortgage rates will likely cause at least a temporary slowdown in US housing activity, even if that slowdown does not ultimately prove to be contractionary.Chart I-13 highlights that the recent increase in mortgage rates will cause US housing affordability to deteriorate back to 2007 levels. While rising mortgage rates will be the proximate cause of this deterioration in affordability, panel 2 highlights that the real culprit has been a significant increase in house prices relative to income. There is strong evidence pointing to the fact that US real residential investment has been too weak since the global financial crisis (GFC).6 We agree that high prices will likely spur additional housing construction (which will support growth). But over the nearer-term, the sharp deterioration in affordability may imply that house price appreciation will have to fall below the rate of income growth, which would represent a very sharp correction in house price gains that would almost assuredly appear recessionary for a time. The European Economy May Contract We have discussed the risk of a European recession in past reports, and noted that it would be almost certain to occur in a scenario in which Russia’s energy exports to Europe were to be completely cut off. We continue to see this as an unlikely scenario, although the odds have increased significantly of late in light of Russia’s halt of gas supplies to Bulgaria and Poland and Germany’s apparent acceptance of an oil embargo against Russia. However, Chart I-14 highlights that a recession, at least a technical one, may occur in Germany even if its imports of Russian natural gas are not interrupted. The chart shows that the German IFO business climate indicator for manufacturing has deteriorated more than the Markit PMI has, and panel 2 highlights that IFO-reported service sector sentiment is considerably worse than what was suggested by the Markit services PMI. Chart I-15 highlights that European stocks are not fully priced for a European recession, either in relative or absolute terms. This underscores the risk to global equities if real euro area growth falls meaningfully below current consensus expectations of 1.9% this year. Chart I-14German Business Sentiment Suggests A Possible Recession Chart I-15Euro Area Stocks Are Not Fully Priced For A European Recession Omicron Will Continue To Spread In China Table I-2The Ports Of Shanghai and Ningbo Are Quite Important To Chinese Trade Flows Confirmed cases of COVID-19 have surged in China over the past two months, and it is now clear that the country’s zero-tolerance policy will fail to contain the spread of the disease. We initially downgraded the odds of our above-trend growth scenario in our January report specifically in response to the risk that the Omicron variant of the virus posed to China.7 That risk that is now manifesting itself most acutely in Shanghai, but also increasingly in other coastal and northeastern provinces. Chart I-16COVID Restrictions In China Are Causing Significant Delays In Suppliers' Delivery Times China’s COVID surge has two implications for the global economic and financial market outlook. The first is that the surge has led to increased port congestion and shipping delays, which clearly threaten to cause a further rise in global shipping costs. We have noted in past reports that shipping costs from China to the West Coast of the US surged following the one month shutdown of the port of Yantian last year. Table I-2 highlights that the ports of Shanghai and nearby Ningbo handle nearly 30% of China’s total ocean shipping volume. Chart I-16 highlights that road traffic restrictions in the Yangtze River Delta have caused significant delays in suppliers’ delivery times, further raising the risk of bottlenecks that may take months to clear. Chart I-17China's Battle With Omicron Further Raises The Risk Of A Euro Area Recession The second implication of China’s COVID surge is that China’s contribution to global growth is at risk of declining significantly further, at least for a time. If Chinese economic activity slows sharply in response to the lockdowns and a further spread of the disease, we fully expect Chinese policymakers to provide further stimulus to support household income in line with what occurred in DM countries two years ago. In addition, some investors have argued that reduced commodity demand from China is actually desirable in the current environment, as it would further reduce inflationary pressure in the US and other developed economies. However, Chart I-17 highlights that Chinese import growth has already slowed very significantly, which has clearly impacted euro area exports. European exports to China are not predominantly commodity-based, and it is yet unclear whether the form of stimulus that Chinese policymakers will introduce will be particularly import-intensive. As such, China’s failure to contain Omicron further adds to the risk of the European recession we noted above, and threatens our view that US headline inflation will trend lower this year. Inflation Expectations May Unanchor Despite Slowing Inflation We discussed above that US inflation will decelerate this year and that this may allow the Fed to raise interest rates at a slower pace than currently expected by market participants. One risk to this view is the possibility that inflation expectations may unanchor to the upside, despite an easing in inflation. Even though inflation expectations have not trended in a different direction than actual inflation since the GFC, Chart I-18 highlights that this has occurred in the past (from 2001-2006). In our view, the level of inflation that is likely to prevail over the coming two years will be an extremely important determinant of whether inflation expectations break above their post-2000 range. For now, Chart I-18 highlights that the Fed’s expectation for core inflation this year is reasonable, but it remains an open question whether core inflation will decelerate below 3% next year as the Fed is forecasting. This is notable, because US core PCE inflation peaked at a rate of 2.6% during the 2002-2007 economic expansion, which is the period when stable long-dated inflation expectations were prevalent. Chart I-19 highlights that market-based inflation expectations are currently challenging or have risen above their 2004-2014 average. We noted in last month’s report that long-dated household inflation expectations will be historically low, even if inflation decelerates in line with what near-dated CPI swaps are forecasting. Chart I-18Inflation Expectations May Still Unanchor Even If The Inflation Rate Comes Down Chart I-19Market-Based Inflation Expectations May Soon Rise Above Pre-GFC Range   The bottom line for investors is that a slowing of inflation over the coming several months may not be enough to prevent long-term inflation expectations from rising. That raises the risk of an even more aggressive pace of interest rates than currently expected by investors, because the Fed is determined to avoid repeating the mistakes of the 1970s when rising inflation expectations led to a wage-price spiral that required years of comparatively tight monetary policy to correct. By contrast, the Fed will view a temporary income-statement recession stemming from a sharp rise in interest rates as the lesser of two evils. A recession to prevent a long-lasting wage-price spiral would also probably be better for investors over the longer run, but a recession would clearly imply a significant decline in risky asset prices at some point over the coming two years were it to occur. Investment Conclusions Chart I-20Despite The Risks Facing Europe, Euro Area Stocks Are Not A Clear Underweight Candidate From the perspective of allocating to risky assets, the most important question for investors to answer is whether the US is likely to experience a recession over the coming year. As we noted above, in our view the answer is “no”, which implies that US earnings growth will remain positive and that investors should not be underweight stocks within a global multi-asset portfolio. It is true that earnings can decline outside of the context of a recession, but we discuss in Section 2 of our report that this has almost always been associated with a significant contraction in profit margins. The factors that have historically been associated with a nonrecessionary decline in profit margins may occur later this year, but our indicators so far point more to flat margins rather than a significant decline. For now, investors should remain minimally-overweight stocks over a 6 to 12 month time horizon, although that assessment may change in either a bullish or bearish direction over the coming several months. Within a global equity allocation, we recommend that investors maintain a neutral regional allocation. The larger risk of a recession in Europe than in the US would normally imply that investors should be overweight US stocks, but euro area stocks have already underperformed global stocks significantly since Russia’s invasion of Ukraine. Chart I-15 highlighted that they will underperform further if euro area growth turns negative. It is not clear, however, if that risk warrants an underweight stance today, especially considering the enormous valuation advantage offered by euro area stocks versus their US counterparts and the fact that the euro has already fallen to a five-year low (Chart I-20). Chart I-21Favor A Neutral Stance Towards Cyclical Stocks Versus Defensives Within the dimensions of the equity market, Chart I-21 highlights that the outperformance of cyclicals versus defensives was already late at the onset of Russia’s invasion of Ukraine, and that the uptrend in relative performance has seemingly ended. Still, a moderately overweight stance toward stocks overall does not especially support an underweight stance toward cyclicals; therefore, we recommend a neutral stance over the coming year. We continue to recommend that investors (modestly) favor value stocks over growth stocks on the basis of better value and as a hedge against potentially higher long-maturity yields, although we acknowledge that most of the outsized outperformance of growth stocks during the pandemic has already reversed. Despite their recent underperformance, we continue to favor global small-cap stocks over their large-cap peers, as they are now unequivocally inexpensive and have seemingly already priced in a likely recession scare in the US later this year (Chart I-22). Within a fixed-income portfolio, we recommend that investors maintain a modestly short duration stance despite our forecast that long-maturity bond yields will not increase much this year. We are wary of recommending a neutral duration stance given the possibility that investors or the Fed may upwardly revise their neutral rate expectations earlier than we anticipate; however, investors are also likely to see long-maturity yields come down for a time in response to a housing market slowdown over the coming several months. More nimble investors should be neutral duration, and should test a long stance if US data releases begin to exhibit meaningfully negative surprises. Finally, while we are bearish toward the dollar on a 6- to 12-month time horizon, it is likely to strengthen over the near term. Chart I-23 highlights that our composite technical indicator for the US dollar is now clearly in overbought territory. We expect that a downtrend will begin once the war in Ukraine reaches a durable conclusion and clarity about the economic impact of the spread of Omicron in China – and the likely policy response – emerges. Chart I-22The Selloff In Small Caps Seems Overdone Chart I-23US Dollar And Indicator The Dollar Is Ripe For A Major Pullback Beyond Likely Near-Term Strength   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst April 28, 2022 Next Report: May 26, 2022 II. The US Equity Market: A Fundamental, Technical, And Value-Based Review All four of our US Equity indicators are currently pointing in a bearish direction. Our Monetary Indicator has fallen to a three decade low, our Technical Indicator has broken into negative territory, our Valuation Indicator still signals extreme equity pricing, and our Speculation Indicator does not yet support a contrarian buy signal. Still, we do not expect a US recession over the coming year, which implies that S&P 500 revenue growth will stay positive. Nonrecessionary earnings contractions are rare, and are almost always associated with a significant contraction in profit margins. Our new profit margin warning indicator currently suggests the odds of falling margins are low, although the risks may rise later this year. Stocks are extremely expensive, but rich valuations are being driven by extremely low real bond yields, rather than investor exuberance. Valuation is unlikely to impact US stock market performance significantly over the coming year unless long-maturity bond yields rise substantially further. Technical analysis of stock prices has a long and successful history at boosting investment performance, which ostensibly suggests that investors should be paying more attention to technical conditions in the current environment. However, technical trading rules have been less helpful in expansionary environments when inflation is above average and when stock prices and bond yields are less likely to be positively correlated (as is currently the case). As such, the recent technical breakdown of the US equity market may simply reflect a reduced signal-to-noise ratio associated with these economic and financial market regimes. For now, we see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio over the coming 6 to 12 months. Rising odds of a recession, declining profit margins, and a large increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market, the risks of which should be monitored closely by investors. In Section 1 of our report, we reviewed why a recession in the US is unlikely over the coming 6 to 12 months. However, we also highlighted that the risks to the economic outlook are meaningful and that an aggressively overweight stance toward risky assets is currently unwarranted. During times of significant uncertainty, investors should pay relatively more attention to long-term economic and financial market indicators with a reliable track record. In this report we begin by briefly reviewing the message from our US Equity Indicators, and then turn to a deeper examination of the top-down outlook for earnings, the determinants of rich valuation in the US stock market, and whether investors should rely on technical indicators in the current environment. We conclude that, while an indicator-based approach is providing mixed signals about the US equity market, we generally see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. Aside from tracking the risk of a recession, investors should be closely attuned to signs of a contraction in profit margins or shifting neutral rate expectations as a basis to reduce equity exposure to below-benchmark levels. A Brief Review Of Our US Equity Indicators Chart II-1Our Equity Indicators Are Pointing In A Bearish Direction Chart II-1 presents our US Equity Indicators, which we update each month in Section 3 of our report. We highlight our observations below: Chart II-1 shows that our Monetary Indicator has fallen to its lowest level since 1995, when the Fed surprised investors and shifted rapidly in a hawkish direction. The indicator is most acutely impacted by the speed of the rise in 10-year Treasury yields and a massive surge in the BCA Short Rate Indicator to levels that have not prevailed since the late 1970s (Chart II-2). Our Technical Indicator has recently broken into negative territory, which we have traditionally interpreted as a sign to sell stocks. The indicator has been dragged lower by a deterioration in stock market breadth across several tracked measures and by weak sentiment (Chart II-3). The momentum component of the indicator is fractionally positive but is exhibiting clear weakness. Our Valuation Indicator continues to highlight that US equities are extremely overvalued relative to their history, despite the recent sell-off in stock prices. Our Speculation Indicator arguably provides the least negative signal of our four indicators, at least from a contrarian perspective. In Q1 2021, the indicator nearly reached the all-time high set in March 2000, but it has since retreated significantly and has exited extremely speculative territory. While this may eventually provide a positive signal for stocks, equity returns have historically been below average during months when the indicator declines. Thus, the downtrend in the Speculation Indicator still points to weakness in stock prices, at least over the nearer term. Chart II-2Our Monetary Indicator Is Falling In Part Because Of Surging Interest Rate Expectations Chart II-3All Three Components Of Our Technical Indicator Are Falling In summary, all four of our US Equity indicators are currently pointing in a bearish direction, which clearly argues against an aggressively overweight stance favoring equities within a multi-asset portfolio. At the same time, we reviewed the odds of a US recession over the coming year in Section 1 of our report and argued that a recession is not likely over the coming 12 months. Thus, one key question for investors is whether a nonrecessionary contraction in earnings is likely over the coming year. We address this question in the next section of our report, before turning to a deeper examination of the relative importance of equity valuation and technical indicators. Gauging The Risk Of A Nonrecessionary Earnings Contraction Chart II-4Nonrecessionary Earnings Declines Usually Occur Due To Falling Margins Based on S&P data, there have been five cases since 1960 when 12-month trailing earnings per share fell year-over-year, while the economy continued to expand (Chart II-4). Sales per share growth remained positive in four of these cases (panel 2), underscoring that falling profit margins have been mostly responsible for these nonrecessionary earnings declines. We have noted our concern about how elevated US profit margins have become and have argued that a significant further expansion is not likely to occur over the coming 12-24 months.8 To gauge the risk of a sizeable decline in margins over the coming year, we construct a new indicator based on the seven instances when S&P 500 margins fell outside the context of a recession. This includes two cases when margins fell but earnings did not (because of buoyant revenue growth). We based the indicator on these five factors: Changes in unit labor cost growth to measure the impact of wage costs on firm profitability; Lagging changes in commodity prices as a proxy for material costs; The level of real short-term interest rates as a proxy for borrowing costs; Changes in a sales growth proxy to measure the impact of operating leverage on margins; And changes in the ISM manufacturing index to capture any residual impact on margins from the business cycle. Chart II-5The Odds Of A Nonrecessionary Profit Margin Contraction Are Currently Low Chart II-5 presents the indicator, which is shaded both for recessionary periods and the seven nonrecessionary margin contraction episodes we identified. While the indicator does not perfectly predict margin contractions outside of recessions, it did signal 50% or greater odds of a margin contraction in four of the seven episodes we examined, and signals high odds of a contraction in margins during recessions. Among the three cases in which the indicator failed to indicate falling margins during an expansion, two of those failures were episodes when earnings growth did not ultimately contract. The inability to explain the 1997-1998 margin contraction is the most relevant failure of the indicator, in addition to two false signals in 1963 and 1988. Still, the approach provides a useful framework to gauge the risk of falling profit margins, and the results provide an interesting and somewhat surprising message about the relative importance of the factors we included. We would have expected that accelerating wages would have been the most significant factor explaining nonrecessionary profit margin declines. Wages were highly significant, but they were the second most important factor behind our sales growth proxy. Lagged commodity prices were the third most significant factor, followed by real short-term interest rates. Changes in the ISM manufacturing index were least significant, underscoring that our sales growth proxy already captures most of the effect of the business cycle on profit margins. This suggests that operating leverage is an important determinant of margins during economic expansions, and that investors should be most concerned about declining profit margins when both revenue growth is slowing significantly and wage growth is accelerating. The indicator currently points to low odds of a nonrecessionary margin contraction, but this is likely to change over the coming year. We expect that all five of the factors will evolve in a fashion that is negative for margins over the coming twelve months: While the pace of its increase is slowing, median wage growth continues to accelerate, even when adjusting for the fact that 1st quartile wage growth is growing at an above-average rate (Chart II-6). Combining the latter with higher odds of at or below-trend growth this year implies that unit labor costs may rise further over the coming twelve months. Analysts expect S&P 500 revenue growth to slow nontrivially over the coming year (Chart II-7). Current expectations point to growth slowing to a level that would still be quite strong relative to what has prevailed over the past decade; however, accelerating wage costs in lockstep with decelerating revenue growth is exactly the type of combination that has historically been associated with falling margins during economic expansions. Chart II-6Wage Growth Is Accelerating... Chart II-7...And Revenue Growth Is Set To Slow​​​​​​ Although these are less impactful factors, the lagged effect of the recent surge in commodity prices will also weigh on margins over the coming year, as will rising real interest rates and a likely slowdown in manufacturing activity in response to slower goods spending. In addition to our new indicator, we have two other tools at our disposal to track the odds of a decline in profit margins over the coming year. First, Chart II-8 illustrates that an industry operating margin diffusion index does a decent job at leading turning points in S&P 500 profit margins, despite its volatility. And second, Chart II-9 highlights that changes in the sales and profit margin diffusion indexes sourced from the Atlanta Fed’s Business Inflation Expectations Survey have predicted turning points in operating sales per share and margins over the past decade. Chart II-9 does suggest that profit margins may not rise further, but flat margins are not likely to be a threat to earnings growth over the coming year if a recession is avoided (as we expect). Chart II-8Sector Diffusion Indexes Are Not Signaling A Major Warning Sign For Margins... Chart II-9...Neither Are The Atlanta Fed Business Sales And Margin Diffusion Indexes     The conclusion for investors is that the odds of a decline in profit margins over the coming year are elevated and should be monitored, but are seemingly not yet imminent. In combination with expectations for slowing revenue growth, this implies, for now, that earnings growth over the coming year will be low but positive. Valuation, Interest Rates, And The Equity Risk Premium As noted above, our Valuation Indicator continues to highlight that US Equities are extremely overvalued relative to their history. Our Valuation Indicator is a composite of different valuation measures, and we sometimes receive questions from investors asking about the seemingly different messages provided by these different metrics. For example, Chart II-10 highlights that equity valuation has almost, but not fully, returned to late-1990 conditions based on the Price/Earnings (P/E) ratio, but is seemingly more expensive based on the Price/Book (P/B) and especially Price/Sales (P/S) ratios. In our view, this apparent discrepancy is easily resolved. Relative to the P/E ratio, both the P/B and especially P/S ratios are impacted by changes in aggregate profit margins, which have risen structurally over the past two decades because of the rising share of broadly-defined technology companies in the US equity index (Chart II-11). Barring a major shift in the profitability of US tech companies over the coming year, we do not see discrepancies between the P/E, P/B, or P/S ratios as being particularly informative for investors. As an additional point, we also do not see the Shiller P/E or other cyclically-adjusted P/E measures as providing any extra information about the richness or cheapness of US equities today, as these measures tend to move in line with the 12-month forward P/E ratio (Chart II-12). Chart II-10US Equities Are Extremely Overvalued, Based On Several Valuation Metrics Chart II-11Tech Margins Have Caused Stocks To Look Especially Expensive On A Price/Sales Basis In our view, rather than focusing on different measures of valuation, it is important for investors to understand the root cause of extreme US equity prices, as well as what factors are likely to drive equity multiples over the coming year. As we have noted in previous reports, the reason that US stocks are extremely overvalued today is very different from the reason for similar overvaluation in the late 1990s. Charts II-13 and II-14 present two different versions of the equity risk premium (ERP), one based on trailing as reported earnings (dating back to 1872), and one based on twelve-month forward earnings (dating back to 1979). Chart II-12The Shiller P/E Ratio Does Not Convey Any 'New' Information About Valuation Chart II-13The Equity Risk Premium Is In Line With Its Historical Average… The ERP accounts for the portion of equity market valuation that is unexplained by real interest rates, and the charts highlight that the US ERP is essentially in line with its historical average based on both measures, in sharp contrast to the stock market bubble of the late 1990s. This underscores that historically low interest rates well below the prevailing rate of economic growth are the root cause of extreme equity overvaluation in the US (Chart II-15), meaning that very rich pricing can be thought of as “rational exuberance.” Chart II-14…In Sharp Contrast To The Late 1990s Chart II-15US Equities Are Extremely Expensive Because Bond Yields Are Extremely Low     Chart II-16The Equity Risk Premium Is Fairly Well Explained By The Misery Index Over the longer term, the risks to US equity valuation are clearly to the downside, as we detailed in our October 2021 report.9 But over the coming 6 to 12 months, US equity multiples are likely to be flat or modestly up in the US. As we noted in Section 1 of our report, a significant further rise in long-maturity bond yields will likely necessitate a major shift in neutral rate expectations on the part of investors and the Fed, which we think is more likely a story for next year than this year. And Chart II-16 highlights that the ERP has historically been well explained by the sum of unemployment and inflation (the Misery Index), which should come down over the coming several months as inflation moderates and the unemployment rate remains low. To conclude, it is absolutely the case that US equities are extremely expensive, but this fact is unlikely to impact US stock market performance significantly unless long-maturity bond yields rise substantially further. Technical Analysis Amid A Shifting Economic Regime Technical analysis of financial markets, and especially stocks, has a long history. It has also provided disciplined investors with significant excess returns over time. A simple stock / bond switching rule based on whether stock prices were above their nine-month moving average at the end of the previous month has significantly outperformed since the 1960s, earning an average excess annual return of 1.3% relative to a 60/40 stock/bond benchmark portfolio (Chart II-17). This outsized performance has come at the cost of only a minor increase in portfolio volatility. Ostensibly, then, investors should be paying more attention to equity technical conditions in the current environment, which we noted above are not positive. Our Technical Indicator has recently broken into negative territory, and the S&P 500 has clearly fallen back below its 200-day moving average. However, Chart II-17 presented generalized results over long periods of time. Over the past two decades, investors have been able to rely on a durably negative correlation between stock prices and bond yields to help boost portfolio returns from technically-driven switching rule strategies. Chart II-18 highlights that this correlation has been much lower over the past two years than has been the case since the early 2000s, raising the question of whether similar switching strategies are viable today. In addition, there is the added question of whether technical analysis is helpful to investors during certain types of economic and financial market regimes, such as high inflation environments. Chart II-17Technically-Driven Trading Rules Have Historically Provided Investors With A Lot Of Alpha Chart II-18Switching-Rule Strategies May Not Work As Well When Stock Prices And Bond Yields Are Not Positively Correlated To test whether the message from technical indicators may be relied upon today, we examine the historical returns from a technically-driven portfolio switching strategy during nonrecessionary months under four conditions that reflect the economic and political realities currently facing investors: months when both stock and bond returns are negative; months of above-average inflation; months of above-average geopolitical risk; and the 1970s, when the Misery Index was very elevated. In all the cases we consider, the switching rule is simple: whether the S&P 500 index was above its nine-month moving average at the end of the previous month. If so, the rule overweights equities for the subsequent months; if not, the rule overweights a comparatively risk-free asset. We consider portfolios with either 10-year Treasurys or 3-month Treasury bills as the risk-free asset, as well as a counterfactual scenario in which cash always earns a 1% annual rate of return (to mimic the cash returns currently available to investors). Table II-1 presents the success and whipsaw rate of the trading rule. Table II-2 presents the annualized cumulative returns from the strategy. The tables provide three key observations: As reflected in Chart II-17, both Tables II-1 and II-2 highlight that simple technical trading rules have historically performed well, and that outperformance has occurred in both recessionary and nonrecessionary periods. Relative to nonrecessionary periods overall, technical trading rules have underperformed during the particular nonrecessionary regimes that we examined. It is the case not only that these strategies have performed in inferior ways during these regimes, but also that they were less consistent signals in that they generated significantly more “whipsaws” for investors. Among the four nonrecessionary regimes that we tested, technical indicators underperformed the least during periods of above-average geopolitical risk, and performed abysmally during nonrecessionary (but generally stagflationary) months in the 1970s. Table II-1During Expansions, Technically-Driven Switching Rules Underperform… Table II-2…When Inflation Is High And When Stocks And Bonds Lose Money The key takeaway for investors is that technical analysis is likely to be helpful for investors to improve portfolio performance as we approach a recession but may be less helpful in an expansionary environment in which inflation is above average and when stock prices and bond yields are less likely to be positively correlated. Investment Conclusions Echoing the murky economic outlook that we detailed in Section 1 of our report, our analysis highlights that an indicator-based approach is providing mixed signals about the US equity market. On the one hand, all four of our main equity indicators are currently providing a bearish signal, and the risk of a nonrecessionary contraction in S&P 500 profit margins over the coming year is elevated – albeit seemingly not imminent. On the other hand, our expectation that the US will not slip into recession over the coming year implies that revenue growth will stay positive, which has historically been associated with expanding earnings. In addition, US equity multiples are likely to be flat or modestly up, and the recent technical breakdown in the S&P 500 may simply reflect a reduced signal-to-noise ratio that appears to exist in expansionary environments in which inflation is high and the stock price / bond yield correlation is near-zero or negative. Netting these signals out, we see our equity indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. The emergence of a recession, declining profit margins, and a significant increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market. We will continue to monitor these risks and adjust our investment recommendations as needed over the coming several months. Stay tuned! Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate III. Indicators And Reference Charts As discussed in this month’s Section 2, BCA’s equity indicators do not paint an optimistic picture for stock prices. Our monetary indicator is at its weakest point in almost three decades, our valuation indicator continues to highlight that stocks are overvalued, and both our sentiment and technical indicators have broken down. An eventual easing in the latter two measures will ultimately prove positive for equities, but this will likely happen only once they reach extremes. Investors should be at most modestly overweight stocks versus bonds over the coming year. Forward equity earnings are likely pricing in too much of an increase in earnings per share over the coming year. Net earnings revisions and net positive earnings surprises have rolled over considerably, although there is no meaningful sign yet of a decline in the level of forward earnings. Earnings growth is more likely than not to be positive over the coming year, but will be modest. Within a global equity portfolio, we recommend a neutral stance towards cyclicals versus defensives, as well as a neutral regional equity stance. Euro area stocks are not a clear underweight candidate despite the risk of a European recession. Within a fixed-income portfolio, the 10-Year Treasury Yield has very little further upside over the coming year, arguing for a modestly short duration stance. We do not believe that the Fed will end up raising rates to a level higher than investors are forecasting over the coming year. Commodity prices continue to rise in a broad-based fashion following Russia’s invasion of Ukraine, and our composite technical indicator highlights that they remain significantly overbought. We expect oil and food prices to come down over the coming year, but there is a risk to that assessment. Russia aggression has very likely sped up Europe’s decarbonization timeline, suggesting that investors should be tactically, cyclically, and structurally bullish on industrial metals prices. US and global LEIs have rolled over from very elevated levels. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries. Leading and coincident indicators remain decently strong, and we do not expect a recession in the US over the coming year. However, the odds of a stagflationary-lite outcome of above-target inflation and at-or-below-trend growth have increased because of the war. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators Chart III-4US Stock Market Breadth Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate Footnotes 1     Please see The Bank Credit Analyst "April 2022," dated March 31, 2022, available at bca.bcaresearch.com 2     Please see The Bank Credit Analyst "Do Excess Savings Explain Low US Interest Rates?" dated March 31, 2022, and "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 3  Please see US Investment Strategy/ US Bond Strategy Special Report "Gauging The Risk Of Recession: Slowdown Or Double-Dip?" dated August 16, 2010, available at usbs.bcaresearch.com 4    Please see The Bank Credit Analyst "Do Excess Savings Explain Low US Interest Rates?" dated March 31, 2022, available at bca.bcaresearch.com 5    Clarke, KE, JM Jones, Y Deng, et al. Seroprevalence of Infection-Induced SARS-CoV-2 Antibodies — United States. September 2021–February 2022. 6    Please see The Bank Credit Analyst "Global House Prices: A New Threat For Policymakers," dated May 27, 2021, available at bca.bcaresearch.com 7     Please see The Bank Credit Analyst "January 2022," dated December 23, 2021, available at bca.bcaresearch.com 8    Please see The Bank Credit Analyst “OUTLOOK 2022: Peak Inflation – Or Just Getting Started?” dated December 1, 2021, available at bca.bcaresearch.com 9    Please see The Bank Credit Analyst “The “Invincible” US Equity Market: The Longer-Term Outlook For US Stocks In Relative And Absolute Terms,” dated September 30, 2021, available at bca.bcaresearch.com