Economy

Executive Summary Investors Think The Fed Will Not Be Able To Raise Rates Much Above 2% The neutral rate of interest is 3%-to-4% in the United States. This is substantially higher than the market estimate of around 2%. It is also higher than the central tendency range for the Fed’s terminal interest rate dot, which remained at 2.3%-to-2.5% following this week’s FOMC meeting. If the neutral rate turns out to be higher than expected, this is arguably good news for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value equities using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. Bottom Line: Global equities will rise over the next 12 months as the situation in Ukraine stabilizes, commodity prices recede, and inflation temporarily declines. Stocks will peak in the second half of 2023 in advance of a second, and currently unexpected, round of Fed tightening beginning in late-2023 or 2024.   Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the geopolitical implications of the war in Ukraine. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, April 7th. Best regards, Peter Berezin Chief Global Strategist https://www.linkedin.com/in/peter-berezin-1289b87/ https://twitter.com/BerezinPeter A Two-Stage Fed Tightening Cycle The FOMC raised rates by 25 basis points this week, the first of seven rate hikes that the Federal Reserve has telegraphed in its Summary of Economic Projections for the remainder of 2022. We expect the Fed to follow through on its planned rate hikes this year, but then go on pause in early-2023, as inflation temporarily comes down. However, the Fed will resume raising rates in late-2023 or 2024 once inflation begins to reaccelerate and it becomes clear that monetary policy is still too easy. This second round of monetary tightening is currently not anticipated by market participants. If anything, investors think the Fed is more likely to cut rates than raise rates towards the end of next year (Chart 1). The Fed’s own views are not that different from the markets’: The central tendency range for the Fed’s terminal interest rate dot remained at 2.3%-to-2.5% following this week’s FOMC meeting, with the median dot actually ticking lower to 2.4% from 2.5% (Chart 2). Chart 2The Fed Is Still In The Secular Stagnation Camp A Higher Neutral Rate Our higher-than-consensus view of where US rates will eventually end up reflects our conviction that the neutral rate of interest is somewhere between 3% and 4%. One can think of the neutral rate as the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.1 Anything that reduces savings or increases investment would raise the neutral rate (Chart 3). As we discussed last month, a number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 4). Household wealth has soared since the start of the pandemic (Chart 5). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by nearly 4% of GDP. Chart 5Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 6). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. Banks are easing lending standards on consumer loans across the board. Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 7). As baby boomers transition from savers to dissavers, national savings will decline. Chart 6US Household Deleveraging Pressures Have Abated Chart 7Baby Boomers Have Amassed A Lot Of Wealth Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 8). On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.2 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 9). Chart 8Fiscal Policy: Tighter But Not Tight Chart 9Much Of The Deceleration In Potential Growth Has Already Happened After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 10). Capex intention surveys remain upbeat (Chart 11). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 12). Chart 10Positive Signs For Capex (I) Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 13). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 11Positive Signs For Capex (II) Chart 12An Aging Capital Stock Chart 13Housing Is In Short Supply The New ESG: Energy Security and Guns The war in Ukraine will put further pressure on the neutral rate, especially outside of the United States. Chart 14European Capex Should Recover After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 14). Capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Meanwhile, European governments are trying to ease the burden from rising energy costs. France has introduced a rebate on fuel starting on April 1st. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. Other countries are considering similar measures. European military spending will also rise. Germany has already announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate potentially several million Ukrainian refugees. A Smaller Chinese Current Account Surplus? Chart 15Will China Be A Source Of Excess Savings? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 15). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic investment on infrastructure and/or consumption. Notably, the IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. The Path to Neutral: The Role of Inflation If one accepts the premise that the neutral rate in the US is higher than widely believed, what will the path to this higher rate look like? The answer hinges critically on the trajectory of inflation. If inflation remains stubbornly high, the Fed will be forced to hike rates by more than expected over the next 12 months. In contrast, if inflation comes down rapidly, then the Fed will be able to raise rates at a more leisurely pace. As late as early February, one could have made a strong case that US inflation was set to fall. The demand for goods was beginning to moderate as spending shifted back towards services. On the supply side, the bottlenecks that had impaired goods production were starting to ease. Chart 16 shows that the number of ships anchored off the coast of Los Angeles and Long Beach has been trending lower while the supplier delivery components of both the ISM manufacturing and nonmanufacturing indices had come off their highs. Since then, the outlook for inflation has become a lot murkier. As we discussed last week, the war in Ukraine is putting upward pressure on commodity prices, ranging from energy, to metals, to agriculture. BCA’s geopolitical team, led by Matt Gertken, expects the war to worsen before a truce of sorts is reached in a month or two. Meanwhile, a new Covid wave is gaining momentum. New daily cases are rising across Europe and have exploded higher in parts of Asia (Chart 17). In China, the number of new cases has reached a two-year high. The government has already locked down parts of the country encompassing 37 million people, including Shenzhen, a major high-tech hub adjoining Hong Kong. Chart 17Covid Cases Are On The Rise Again In Some Countries Most new cases in China and elsewhere stem from the BA.2 subvariant of Omicron, which appears to be at least 50% more contagious than Omicron Classic. Given its extreme contagiousness, China may be forced to rely on massive nationwide lockdowns in order to maintain its zero-Covid strategy. While such lockdowns may provide some relief in the form of lower oil prices, the overall effect will be to worsen supply-chain disruptions. Watch For Signs of a Wage-Price Spiral As the experience of the 1960s demonstrates, the relationship between inflation and unemployment is inherently non-linear: The labor market can tighten for a long time with little impact on prices and wages, only for a wage-price spiral to suddenly develop once unemployment falls below a certain threshold (Chart 18). Chart 18A Wage-Price Spiral Was Ignited By Very Low Unemployment Levels In The 1960s Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution For the time being, a wage-price spiral does not appear imminent. While wage growth has picked up, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 19). Chart 20More Low-Wage Employees Should Return To Work Low-wage workers have not returned to the labor force to the same extent as higher-wage workers (Chart 20). However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. An influx of workers back into the labor market will cap wage growth, at least for this year. Long-Term Inflation Expectations Still Contained A sudden increase in long-term inflation expectations can be a precursor to a wage-price spiral because the expectation of higher prices can induce consumers to shop now before prices rise further, while also incentivizing workers to demand higher wages. Reassuringly, long-term inflation expectations have not risen that much. Expected inflation 5-to-10 years out in the University of Michigan survey registered 3.0% in March, down a notch from 3.1% in February (Chart 21). While the widely followed 5-year, 5-year forward TIPS inflation breakeven rate has climbed to 2.32%, it is still at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 22).3 Chart 21Long-Term Inflation Expectations Remain Contained (I) Chart 22Long-Term Inflation Expectations Remain Contained (II) Chart 23The Magnitude Of Damage Depends On How Long The Commodity Price Shock Lasts Moreover, the jump in market-based inflation expectations since the start of the war in Ukraine has been fueled by rising oil prices. The forwards are pointing to a fairly pronounced decline in the price of crude and most other commodity prices over the next 12 months (Chart 23). If that happens, inflation expectations will dip anew. Investment Implications The neutral rate of interest is higher in the United States than widely believed. A higher neutral rate is arguably good for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value stocks using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. While the war in Ukraine and yet another Covid wave could continue to unsettle markets for the next month or two, global equities will be higher in 12 months than they are now. With inflation in the US likely to temporarily come down in the second half of the year, bond yields probably will not rise much more this year. However, yields will start moving higher in the second half of next year as it becomes clear that policy rates still have further to rise. The bull market in stocks will end at that point.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  These savings can either by generated domestically or imported from abroad via a current account deficit. 2  Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. 3  The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Special Report

Executive Summary Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries​​​​ Tectonic geopolitical trends are taking shape in Emerging Markets (EMs) today that will leave an indelible imprint on the next decade. First, EMs have gone on a relatively unnoticed public debt binge at a time when the economic prospects of the median EM citizen have deteriorated. This raises the spectre of sudden fiscal populism, aggressive foreign policy or social unrest in EMs. China, Brazil and Saudi Arabia appear most vulnerable to these risks. Second, the defense bill of major EMs could be comparable to that of the top developed countries of the world in a decade from now. Investors must brace for EMs to play a central role in the defense market and in wars, in the coming years. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. To extract most from the theme of EM militarization, we suggest a Long on European Aerospace & Defense relative to European Tech stocks.   Trade Recommendation Inception Date Return LONG EUROPEAN AEROSPACE & DEFENSE / EUROPEAN TECH EQUITIES (STRATEGIC) 2022-03-18   Bottom Line: Even as EMs are set to emerge as protagonists on the world stage, investors must prepare for these countries to exhibit sudden fiscal expansions, bouts of social unrest or a newfound propensity to initiate wars. The only way to dodge these volatility-inducing events is to leverage geopolitics to foresee these shocks. Feature Only a few weeks before Russia’s war with Ukraine broke out, a client told us that he was having trouble seeing the importance of geopolitics in investing. “It seems like geopolitics was a lot more relevant a few years back, with the European debt crisis, Brexit, and Trump. Now it does not seem to drive markets at all”, said the client. To this we gave our frequent explanation which is, “Our strategic themes of Great Power Struggle, Hypo-Globalization, and Nationalism/Populism are now embedded in the international system and responsible for an observable rise in geopolitical risk that is reshaping markets”. In particular we highlighted our pessimistic view on both Russia and Iran, which have incidentally crystallized most clearly since we had this client conversation. Related Report  Geopolitical StrategyBrazil: The Road To Elections Won't Be Paved With Good Intentions Globally key geopolitical changes are afoot with Russia at war. In the coming weeks and months, we will write extensively about the dramatic changes we see taking shape in the realm of geopolitics and investing. We underscored the dramatic geopolitical realignment taking place as Russia severs ties with the West and throws itself into China’s arms in a report titled “From Nixon-Mao To Putin-Xi”. In this Special Report we highlight two key geopolitical themes that will affect emerging markets (EMs) over the coming decade. The aim is to help investors spot these trends early, so that they can profit from these tectonic changes that are sure to spawn a new generation of winners and losers in financial markets. (For BCA Research’s in-depth views on EMs, do refer to the Emerging Markets Strategy (EMS) webpage). Trend #1: Beware The Wrath Of EMs On A Debt Binge Chart 1The Pace Of Debt Accumulation Has Accelerated In Major EMs Investors are generally aware of the debt build-up that has taken place in the developed world since Covid-19. The gross public debt held by the six most developed countries of the world (spanning US, Japan, Germany, UK, France and Italy) now stands at an eye-watering $60 trillion or about 140% of GDP. This debt pile is enormous in both absolute and relative terms. But at the same time, the debt simultaneously being taken on by EMs has largely gone unnoticed. The cumulative public debt held by eight major EMs today (spanning China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey) stands at $20tn i.e., about 70% of GDP. Whilst the absolute value of EM debt appears manageable, what is worrying is the pace of debt accumulation. The average public debt to GDP ratio of these EMs fell over the early 2000s but their public debt ratios have now doubled over the last decade (Chart 1). EMs have been accumulating public debt at such a rapid clip that the pace of debt expansion in EMs is substantially higher than that of the top six developed countries (Chart 1). These six DMs have a larger combined GDP than the eight EMs with which they are compared. Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em (For in-depth views on China’s debt, do refer to China Investment Strategy (CIS) report here). Now developed countries taking on more debt makes logical sense for two reasons. Firstly, most developed countries are ageing, and their populations have stopped growing. So one way to prop up falling demand is to get governments to spend more using debt. Secondly, this practice seems manageable because developed country central banks have deep pockets (in the form of reserves) and their central banks are issuers of some of the safest currencies of the world. But EMs using the same formula and getting addicted to debt at an earlier stage of development is risky and could prove to be lethal in some cases. Also distinct from reasons of macroeconomics, the debt binge in EMs this time is problematic for geopolitical reasons. This Time Is Different EMs getting reliant on debt is problematic this time because their median citizen’s economic prospects have deteriorated. Growth is slowing, inflation is high, and job creation is stalling; thereby creating a problematic socio-political backdrop to the EM debt build-up. Growth Is Slowing: In the 2000s EMs could hope to grow out of their social or economic problems. The cumulative nominal GDP of eight major EMs more than quadrupled over the early 2000s but a decade later, these EMs haven not been able to grow their nominal GDP even at half the rate (Chart 2). Inflation Remains High: Despite poorer growth prospects, inflation is accelerating. Inflation was high in most major EMs in 2021 (Chart 3) i.e., even before the surge seen in 2022. Chart 2Major EM’s Growth Engine Is No Longer Humming Like A Well-Tuned Machine​​​​​ Chart 3Despite Slower Growth, Inflation In Major EMs Remains High​​​​​ Rising Unemployment: Employment levels have improved globally from the precipice they had fallen into in 2020. But unemployment today is a far bigger problem for major EMs as compared to developed markets (Chart 4). If the economic miseries of the median EM citizen are not addressed, then they can produce disruptive sociopolitical effects that will fan market volatility. This problem of rising economic misery alongside a rapid debt build-up, can also be seen for the next tier of EMs i.e. Mexico, Indonesia, Iran, Poland, Thailand, Nigeria, Argentina, Egypt, South Africa and Vietnam. While the average public debt to GDP ratios of these EMs fell over the early 2000s, the pace of debt accumulation has almost doubled over the last decade (Chart 5). Furthermore, the growth engine in these smaller EMs is no longer humming like a well-tuned machine and inflation remains at large (Chart 5). Chart 4Unemployment - A Bigger Problem In Major EMs Today​​​​​ Chart 5Smaller EMs Must Also Deal With Rising Debt, Alongside Slowing Growth​​​​​ Chart 6The Debt Surge In EMs This Time, Poses Unique Challenges History suggests that periods of economic tumult are frequently followed by social unrest. The eruption of the so-called Arab Spring after the Great Recession illustrated the power of this dynamic. Then following the outbreak of Covid-19 in 2020 we had highlighted that Turkey, Brazil, and South Africa are at the greatest risk of significant social unrest. We also showed that even EMs that looked stable on paper faced unrest in the post-Covid world, including China and Russia. In this report we take a decadal perspective which reveals that growth is slowing, and debt is growing in EMs. Given that EMs suffer from rising economic miseries alongside growing debt and lower political freedoms (Chart 6), it appears that some of these markets could be socio-political tinderboxes in the making. Policy Implications Of The EM Debt Surge “As it turns out, we don't 'all' have to pay our debts. Only some of us do.” – David Graeber, Debt: The First 5,000 Years (Melville House Publishing, 2011) The trifecta of fast-growing debt, slowing growth and/or low political freedoms in EMs can add to the volatility engendered by EMs as an asset class. Given the growing economic misery in EMs today, politicians will be wary of outbreaks of social unrest. To quell this unrest, they may resort broadly to fiscal expansion and/or aggressive foreign policy. Both of these policy choices can dampen market returns in EMs. Chart 7India's Performance Had Flatlined Post Mild Populist Tilt Policy Choice #1: More Fiscal Spending Despite High Debt Policymakers in some EMs may respond by de-prioritizing contentious structural reforms and prioritizing fiscal expansion. The Indian government’s decision to repeal progressive changes to farm laws in late 2021, launch a $7 billion home-building program in early 2022 and withholding hikes in retail prices of fuel, illustrates how policymakers are resorting to populism despite high public debt levels. As a result, it is no surprise that MSCI India had been underperforming MSCI EM even before the war in Ukraine broke out (Chart 7). Brazil is another EM which falls into this category, while China’s attempts to run tighter budgets have failed in the face of slowing growth. Policy Choice #2: Foreign Policy Aggression EMs may also adopt an aggressive foreign policy stance. Russia’s decision to invade Ukraine, Turkey’s interventions in several countries, and China’s increasing assertiveness in its neighboring seas and the Taiwan Strait provide examples. Wars by EMs are known to dampen returns as the experience of the Russian stock market shows. Russian stocks fell by 14% during its invasion of Georgia in 2008 and are down 40% from 24 February 2022 until March 9, 2022, i.e. when MSCI halted trading. If politicians fail to pursue either of these policies, then they run the risk of social unrest erupting due to tight fiscal policy or domestic political disputes. In fact, early signs of social discontent are already evident from large protests seen in major EMs over the last year (see Table 1). Table 1Social Unrest In Major EMs Is Already Ascendant Bottom Line: The last decade has seen major EMs go on a relatively unnoticed public debt binge. This is problematic because this debt surge has come at a time when economic prospects of the median EM citizen have deteriorated. Politicians will be keen to quell the resultant discontent. This raises the specter of excessive fiscal expansion, aggressive foreign policy, and/or social unrest. All three outcomes are negative from an EM volatility perspective. Trend #2: The Rise And Rise Of EM Defense Spends Great Power Rivalry is an outgrowth of the multipolar structure of international relations. This theme will drive higher defense spending globally. In this report we highlight that even after accounting for a historic rearmament in developed countries following Russia’s invasion of Ukraine, a decade from now EMs will play a key role in driving global military spends. The defense bill of the six richest developed countries of the world (the US, Japan, Germany, UK, France and Italy) will increasingly be rivaled by that of the top eight EMs (China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey). While key developed markets like Japan and Germany in specific (and Europe more broadly) are now embarking on increasing defense spends, the unstable global backdrop will force EMs to increase their military budgets as well. The combination of these forces could mean that the top eight EM’s defense spends could be comparable to that of the top six developed markets in a decade from now i.e., by 2032 (Chart 8). This is true even though the six DMs have a larger GDP. The assumptions made while arriving at the 2032 defense spend projections include: Substantially Higher Pace Of Defense Spends For Developed Countries: To reflect the fact that Russia’s invasion of Ukraine will trigger a historical wave of armament in developed markets we assume that: (a) NATO members France, Germany and Italy (who spent about 1.5% of GDP on an average on defense spends in 2019) will ramp up defense spending to 2% of GDP by 2032, (b) US and UK i.e. NATO members who already spend substantially more than 2% of GDP on defense spends will still ‘increase’ defense spends by another 0.4% of GDP each by 2032 and finally (c) Japan which spends less than 1% of GDP on defense spends today, in a structural break from the past will increase its spending which will rise to 1.5% of GDP by 2032. China And Hence Taiwan As Well As India Will Boost Spends: To capture China’s increasingly aggressive foreign policy stance and the fact that India as well as Taiwan will be forced to respond to the Chinese threat; we assume that China increases its stated defense spends from 1.7% of GDP in 2019 to 3% by 2032. Taiwan follows in lockstep and increases its defense spends from 1.8% of GDP in 2019 to 3% by 2032. India which is experiencing a pincer movement from China to its east and Pakistan to its west will have no choice but to respond to the high and rising geopolitical risks in South Asia. The coming decade is in fact likely to see India’s focus on its naval firepower increase meaningfully as it feels the need to fend off threats in the Indo-Pacific. India currently maintains high defense spends at 2.5% of GDP and will boost this by at least 100bps to 3.5% of GDP by 2032. Defense Spending Trends For Five EMs: For the rest of the EMs (namely Russia, Saudi Arabia, South Korea and Brazil), the pace of growth in defense spending seen over 2009-19 is extrapolated to 2032. For Turkey, we assume that defense spends as a share of GDP increases to 3% of GDP by 2032. Extrapolation Of Past GDP Growth For All Countries: For all 14 countries, we extrapolate the nominal GDP growth calculated by the IMF for 2022-26 as per its last full data update, to 2032. This tectonic change in defense spending patterns has important historical roots. Back in 1900, UK and Japan i.e., the two seafaring powers were top defense spenders (Chart 9). Developed countries of the world continued to lead defense spending league tables through the twentieth century as they fought expensive world wars. Chart 8Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries​​​​​​ Chart 9Back In 1900, Developed Countries Like UK And Japan Were Top Military Spenders​​​​​​ Chart 10By 2000, EMs Had Begun Spending Generously On Armament But things began changing after WWII. Jaded by the world wars, developed countries began lowering their defense spending. By the early 2000s EMs had now begun spending generously on armament (Chart 10). The turn of the century saw growth in developed markets fade while EMs like China and India’s geopolitical power began rising (Chart 11). Then a commodities boom ensued, resulting in petro-states like Saudi Arabia establishing their position as a high military spender. The confluence of these factors meant that by 2020 EMs had becomes major defense spenders in both relative and absolute terms too (Chart 12). Going forward, we expect the coming renaissance in DM defense spending in the face of Russian aggression, alongside rising geopolitical aspirations of China, to exacerbate this trend of rising EM militarization. Chart 11The 21st Century Saw Developed Countries’ Geopolitical Power Ebb Chart 12EMs Today Are Top Military Spenders, Even In Absolute Terms Why Does EM Weaponizing Matter? History suggests that wars are often preceded by an increase in defense spends: Well before WWI, a perceptible increase in defense spending could be seen in Austria-Hungary, Germany, and Italy (Chart 13). These three countries would go on to be known as the Triple Alliance in WWI. Correspondingly France, Britain and Russia (i.e., countries that would constitute the Triple Entente) also ramped up military spending before WWI (Chart 14). Chart 13Well Before WWI; Austria-Hungary, Germany, And Italy Had Begun Ramping Up Defense Spends​​​​​​ Chart 14The ‘Triple Entente’ Too Had Increased Defense Spends In The Run Up To WWI​​​​​​ History tragically repeated itself a few decades later. Besides Japan (which invaded China in 1937); Germany and Italy too ramped up defense spending well before WWII broke out (Chart 15). These three countries would come to be known as the Axis Powers and initiated WWII. Notably, Britain and Russia (who would go on to counter the Axis Powers) had also been weaponizing since the mid-1930s (Chart 16). Chart 15Axis Powers Had Been Increasing Defense Spends Well Before WWII​​​​​ Chart 16Allied Powers Too Had Been Increasing Defense Spends In The Run Up To WWII​​​​​ Chart 17Militarily Active States Have Been Ramping Up Defense Spends Russia, Ukraine, Turkey and Gulf Arab states like Iraq have been involved in wars in the recent past and noticeably increased their defense budgets in the lead-up to military activity (Chart 17). Given that a rise in military spending is often a leading indicator of war and given that EMs are set to spend more on defense, it appears that significant wars are becoming more rather than less likely, which Russia’s invasion of Ukraine obviously implies. A large number of “Black Swan Risks” are clustered in the spheres of influence of Russia, China, and Iran, which are the key powers attempting to revise the US-led global order today (Map 1). Map 1Black Swan Risks Are Clustered Around China, Russia & Iran Distinct from major EMs, eight small countries pose meaningful risks of being involved in wars over the next. These countries are small (in terms of their nominal GDPs) but spend large sums on defense both in absolute terms (>$4 billion) and in relative terms (>4% of GDP). Incidentally all these countries are located around the Eurasian rimland and include Israel, Pakistan, Algeria, Iran, Kuwait, Oman, Ukraine and Morocco (Map 2). In fact, the combined sum of spending undertaken by these countries is so meaningful that it exceeds the defense budgets of countries like Russia and UK (Chart 18). Map 2Eight Small Countries That Spend Generously On Defense Chart 188 Countries Located Near The Eurasian Rimland, Spend Large Sums On Defense​​​​ Bottom Line: As EM geopolitical power and aspirations rise, the defense bill of top developed countries will be challenged by the defense spending undertaken by major EMs. On one hand this change will mean that certain EMs may be at the epicenter of wars and concomitant market volatility. On the other hand, this change could spawn a new generation of winners amongst defense suppliers. Investment Conclusions In this section we highlight strategic trades that can be launched to play the two trends highlighted above. Trend #1: Beware The Wrath Of EMs On A Debt Binge Investors must prepare for EMs to witness sudden fiscal expansions, unusually aggressive foreign policy stances, and/or bouts of social unrest over the next few years. The only way to dodge these volatility-inducing events in EMs is to leverage geopolitics to foresee socio-political shocks. Using a simple method called the “Tinderbox Framework” (Table 2), we highlight that: Table 2Tinderbox Framework: Identifying Countries Most Exposed To Socio-Political Risks Within the eight major EMs; China, Brazil, Russia and Saudi Arabia face elevated socio-political risks. Amongst the smaller ten EMs, these risks appear most elevated for Egypt, South Africa and Argentina. It is worth noting that Brazil, South Africa and Turkey appeared most vulnerable as per our Covid-19 Social Unrest Index that we launched in 2020. We used the tinderbox framework in the current context to fade out effects of Covid-19 and to add weight to the debt problem that is brewing in EMs. Client portfolios that are overweight on most countries that fare poorly on our “Tinderbox Framework” should consider actively hedging for volatility at the stock-specific level. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. China’s public debt ratio is high and social pressures may be building with limited valves in place to release these pressures (Table 2). The renminbi has performed well amid the Russian war, which has weighed down the euro, but China faces a confluence of domestic and international risks that will ultimately drag on the currency, while the euro will benefit from the European Union’s awakening as a geopolitical entity in the face of the Russian military threat. Trend #2: EM’s Will Drive Wars In The 21st Century Wars are detrimental to market returns.1 Furthermore, as the history of world wars proves, even the aftermath of a war often yields poor investment outcomes as wars can be followed by recessions. It is in this context that investors must prepare for the rise of EMs as protagonists in the defense market, by leveraging geopolitics to identify EMs that are most likely to be engaged in wars. While we are not arguing that WWIII will erupt, investors must brace for proxy wars as an added source of volatility that could affect EMs as an asset class. To profit from these structural changes underway we highlight two strategic trades namely: 1.  Long Global Aerospace & Defense / Broad Market Thanks to the higher spending on defense being undertaken by major EMs, global defense spends will grow at a faster rate over the next decade as compared to the last. We hence reiterate our Buy on Global Aerospace & Defense relative to the broader market. 2.  Long European Aerospace & Defense / European Tech Up until Russia invaded Ukraine and was hit with economic sanctions, Russia was the second largest exporter of arms globally accounting for 20% global arms exports. With Russia’s ability to sell goods in the global market now impaired, the two other major suppliers of defense goods that appear best placed to tap into EM’s demand for defense goods are the US (37% share in the global defense exports market) and Europe (+25% share in the global defense exports market). Chart 19American Defense Stocks Have Outperformed, European Defense Stocks Have Underperformed​​​​​​ Chart 20Defense Market: Russia’s Loss Could Be Europe’s Gain​​​​​ But given that (a) American aerospace & defense stocks have rallied (Chart 19) and given that (b) France, Germany, and Italy are major suppliers of defense equipment to countries that Russia used to supply defense goods to (Chart 20), we suggest a Buy on European Aerospace & Defense relative to European Tech stocks to extract more from this theme. In fact, this trade also stands to benefit from the pursuance of rearmament by major European democracies which so far have maintained lower defense spends as compared to America and UK. This view from a geopolitical perspective is echoed by our European Investment Strategy (EIS) team too who also recommend a Long on European defense stocks and a short on European tech stocks. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      Please see: Andrew Leigh et al, “What do financial markets think of war in Iraq?”, NBER Working Paper No. 9587, March 2003, nber.org.  David Le Bris, “Wars, Inflation and Stock Market Returns in France, 1870-1945”, Financial History Review 19.3 pp. 337-361, December 2012, ssrn.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary Profit Margins Are Headed Lower; So Are Equity Multiples The post pandemic profit recovery in India was driven by a one-off revival of demand from very depressed levels, which led to a spike in profit margins as companies’ sales outpaced their costs (hiring costs and financing cost). The glacial pace of job creation since the pandemic and the muted wage growth is to blame for weak household income, which in turn is hurting consumption. Indian growth is wobbling as household consumption is losing steam, and capital investments are decelerating. The Ukraine crisis and the resulting oil / commodity price surge will hurt Indian firms’ margins and profits even more in the months to come. Indian stocks are still expensive, and future profit expectations are elevated – especially relative to their EM and emerging Asian counterparts. This has set the stage for profit disappointment. Bottom Line: Indian growth is decelerating amid high stock valuations. Higher for longer commodity prices will hurt as well. Equity investors should downgrade Indian stocks tactically from neutral to underweight in EM and emerging Asian portfolios. Domestic bond investors should book profits on their Indian exposure, and downgrade to neutral in EM and emerging Asian baskets. Feature Chart 1Indian Stocks Are Headed For A Turbulent Time​​​​​​ Long COVID is a condition that manifests itself after a person recovers from the acute phase of the disease. The Indian economy is showing similar signs: after an initial post-COVID recovery, household consumption and investment have begun to disappoint. This is happening at a time when Indian equity valuations and investors’ profit expectations are much higher than those of the rest of the EM. As such, Indian share prices are set for a turbulent time ahead. Equity investors should tactically downgrade this bourse to underweight in EM and emerging Asian portfolios (Chart 1). Domestic bond investors should book profits on their Indian exposure, and downgrade it to neutral in EM and emerging Asian baskets. Consumer Spending During and in the immediate aftermath of the pandemic, the Indian government did not supplement lost household income caused by the lockdowns and the layoffs by any good measure. Tangible fiscal stimulus (i.e., excluding government guarantees etc.) amounted to less than 2% of GDP. Post-pandemic, jobs have been growing at a glacial pace. In fact, India’s total employment is estimated to be still 8% lower as of the end of 2021 compared to the first quarter of 2020, as per Oxford Economics data. Consistently, wage growth has been very poor as well – in both urban and rural areas (Chart 2). Wages in real terms (deflated by CPI) have been contracting. Household income has therefore remained severely impaired. The consequences of meagre household incomes can now be seen in persistently weak consumer durable sales. Chart 3 shows that passenger cars and 2-wheeler sales are languishing at much lower levels than they were in the pre-pandemic period. Chart 2Subdued Employment And Poor Wage Growth Sapped Household Income … Chart 3… Leading To Impaired Household Consumption Chart 4Signs Of Softening Business Activity The overall growth in India was seen to be softening even before the Ukraine crisis. The economy grew at a 5.4% YoY rate in the last quarter of 2021, down from 8.5% in the previous quarter. The trend appears to be continuing into this year. Corroborating evidence comes in the form of the number of E-way bills1 issued – which is a barometer of business activity. The number peaked in October last year and has been struggling since (Chart 4). Persistently weak consumer demand is a crucial reason why manufacturing production is also struggling to get back to the pre-pandemic trend – which would be a good 10% higher than the current level (Chart 4, bottom panel). Industrial production will face difficulty gaining traction should weakness in consumer demand linger. On the whole, the post-pandemic economic recovery in India was a rapid one initially; but is now gradually losing steam as joblessness remains high and wages remain low. Looming Energy Tax Ominously, odds have risen that core (non-oil) consumer demand could be even weaker in the months ahead. The sharp rise in crude prices will soon mean that Indian consumers and businesses will have to shell out more for their energy-related purchases. Chart 5 shows that retail gasoline and diesel prices in India did not keep pace with the global crude prices in recent months. Hence, if some or all of the rise is passed on to the consumers, domestic fuel prices could go up by about 10 - 20%. If so, that would be a major tax on the economy. Higher expenses on fuel and transportation – which make up about 15% of consumer spending – will force households to curtail their non-oil spending elsewhere. That means non-energy firms would see lower sales. Those firms would also see their own operating and raw material costs going up given the higher oil and other commodity prices. Together, these will have a pronounced negative impact on these firms’ profit margins. Lower margins are a harbinger of lower stock multiples (Chart 6). Chart 5Retail Gasoline And Diesel Prices Could Rise Materially Chart 6Profit Margins Are Headed Lower; So Are Equity Multiples Notably, Indian corporate profit margins had surged to decade high levels last year thanks mainly to cost cutting. Wage bills had gone down as businesses slashed employees; and were slow to re-hire them. Interest expenses had also gone down – both relative to sales and profits – as the central bank cut interest rates aggressively. When sales revived after the lockdowns, the higher/rising margins led to surging profits. But now, both sales and margins are in jeopardy as weak consumer demand is hurting the former, while rising raw materials cost will hurt the latter. Profits are set to disappoint as a result. Related Report  Emerging Markets StrategyEquity Capitulation, A Commodity Shock And Geopolitics What’s more, faltering profits could also lead to a premature slowdown in India’s capital investments. Firms’ capex plans are highly contingent on profit growth; and therefore, the former may see a dip in the coming months with dwindling profits (Chart 7). This potential development could be a major negative for India’s sustainable growth story, and its ill-effects may linger. What makes this episode of oil/commodity shock particularly negative for India is that it is taking place when consumer demand is already sluggish. Previous oil shocks in 2007-08 and 2011-12 took place when the underlying growth was quite robust. Stronger underlying growth allows for the absorption of negative exogenous shocks like higher oil & energy prices. Overall, rising oil prices have historically been bearish for Indian stocks’ relative performance. That correlation had broken down since the onset of the pandemic two years ago (Chart 8). However, now with the crude price hovering around $100 a barrel, India’s relative equity outperformance versus the EM benchmark will give up some of its gains of the past two years. Chart 7Dwindling Profits Could Lead To A Slowdown In Caital Expenditure Chart 8India’s Relative Equity Outperformance Cannot Continue With $100 Oil How About Inflation? Chart 9Global Commodity Prices Dictate Indian PPI, But Not So Much CPI India’s producer price inflation (PPI) is highly geared to global commodity prices. As such, one can expect PPI to re-accelerate in the months ahead. That said, commodity prices are not a major driver of India’s consumer price inflation (CPI). The latter will therefore likely remain more well behaved than PPI would (Chart 9). Historically, the two primary drivers of India’s CPI have been the economy’s productivity growth rate and broad money (M3) growth rate. Since productivity trends do not change much in the near term, it’s money supply that determines the short-term trajectory of CPI (Chart 10). Chart 10Money Supply Determines India’s CPI Over Cyclical Horizon Chart 11Drivers Of India’s Money Supply Will See Only A Mediocre Growth Money growth has been quite mediocre recently; and will likely stay that way. This is because neither of the two main drivers of money supply, bank credit and fiscal expenditure, are set to rise very strongly. In the proposed fiscal budget for April 2022 – March 2023, the government is planning to raise current expenditure2 by just 1% in nominal terms; and the total expenditure by 5%. Meanwhile, non-interest government spending growth has already come back to normal levels following the one-off surge during the pandemic (Chart 11, top panel). Bank credit has also slowed on the margin this year. That it has barely grown in real terms in the past couple of years is also dampening inflationary pressures (Chart 11, bottom panel). All this means that any rise in consumer price inflation will be limited. Notably, a marginal rise in consumer price inflation is unlikely to lead to policy tightening by the central bank. This is because the source of inflation would be supply driven, rather than demand driven. The central bank would recognize that higher commodity prices will exacerbate the already weak consumer demand; and therefore, any further policy tightening could decimate growth. On the whole, very sluggish wage growth and contained core CPI support the fact that there are no genuine demand-driven inflationary pressures in the country (Chart 12). A rise in global food prices should also not impact India much as the country is not a big importer of food grains and most of its food is domestically grown. All in all, the RBI is likely to ignore the slight pickup in CPI, and will refrain from raising rates. How Much Downside In Stocks? Indian stocks have been in a trading range relative to their EM counterparts since we downgraded them to neutral in October last year. In absolute terms also they have not fallen much so far – even though foreign investors have exited this market en masse over the past several months. The missing piece of the puzzle for this apparent dichotomy is the massive purchases by domestic mutual funds in recent months. This local demand is what prevented this bourse from tanking (Chart 13). Chart 12India’s Consumer Inflation Will Not Rise By Too Much Chart 13The Massive Purchases Of Mutual Funds Will Wane With Profit Disappointment Chart 14Indian Stock Multiples Are Still Very High Relative To Their Counterparts Going forward, however, those domestic purchases are likely to wane as growth and profits slow, and local investors become wary of their equity exposures. That would lead to a sell-off in stock prices. Notably, Indian stocks are still quite pricey when compared to both their EM and emerging Asian counterparts based on the cyclically adjusted P/E ratio (Chart 14). As explained above, Indian stock multiples are set to fall materially as firms’ profit margins are squeezed in the months to come. Investors have paid high equity multiples as they have extrapolated the strong profit recovery post-pandemic into the future. However, the profit recovery post-pandemic was driven by a one-off revival of demand from very depressed levels and a one-off spike in profit margins as companies’ sales outpaced their costs (hiring costs and financing cost). As and when investors realize that a sustainable profit growth rate is much lower than the initial post-pandemic trajectory, multiples will shrink somewhat. At the same time, firms’ topline will also wobble as non-oil consumer spending sees forced retrenchment. Weakish topline, multiplied by lower margins, entails weak earnings growth. That would be another drag (besides shrinking multiples) on Indian share prices. Notably, a sell-off in Indian stocks usually comes with a depreciating rupee – thereby compounding woes for foreign investors in Indian stocks. All in all, this bourse could witness a major down leg in absolute USD terms in the months to come. Relative to other EM and emerging Asian markets also they will trade on the weaker side. Book Profits On Domestic Bonds We have been overweight India in EM local currency bond portfolios given Indian bonds’ rather high yields, and the country’s prudent fiscal policy, benign inflation outlook, and a cheap currency. The call has worked out well (Chart 15, top panel). However, following the sharp rise in EM bond yields, Indian bond yields are no longer attractive in relative terms (Chart 15, bottom panel). A less sanguine rupee outlook over the short term is another cause for concern. Besides, rising US bond yields would make Indian bonds look less attractive. Considering all, we recommend EM local currency bond investors take profits on their overweight India exposure and reduce the allocation to neutral in EM and emerging Asian baskets. Investment Recommendations Equities: Indian firms’ profit outlook has deteriorated significantly given odds of disappointing margins and still high equity valuations. Investors should tactically downgrade this market from neutral to underweight in EM and emerging Asian equity portfolios. Absolute return investors should avoid this market outright. Currency and Bonds: The Indian rupee is at a risk of mild depreciation along with a sell-off in the Indian stock markets. However, given that the currency is cheap, its relapse will not be large (Chart 16). Chart 15Indian Domestic Bonds Are Not As Attractive Any More; Book Profits Chart 16Indian Rupee Is Cheap, And Hence Has Only A Limited Downside Indian government bonds have outperformed their EM counterparts over the past four years; but are no longer as attractive as the yield advantage has disappeared and the rupee has a weaker near-term outlook. Investors should book profits on their overweight allocations, and downgrade them to neutral relative to EM and emerging Asian baskets. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1     E-way bills are issued as part of Goods & Services Tax (GST) collection mechanism. 2     The rest is capital expenditure – which the government is planning to raise by 24%, albeit from a much smaller base (2.6% of GDP) compared to current expenditure (13.6% of GDP).

Executive Summary For the Fed, maintaining its credibility with a long sequence of rate hikes that does not crash the economy, real estate market, and stock market is akin to the ‘Hail Mary’ move of (American) football. The likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Hence, today we are opening a new trade. Go long the September 2023 Eurodollar futures contract. Additionally, stay underweight Treasury Inflation Protected Securities (TIPS) versus T-bonds. And on a 12-month horizon, underweight the commodity complex, whose elevated prices are highly vulnerable to a near-certain upcoming demand destruction. Fractal trading watchlist: US interest rate futures, 3-year T-bond, Canada versus Japan, AUD/KRW, and EUR/CHF. Spending On Goods Looks Like An Earthquake On A Seismograph Bottom Line: The likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Feature Amid the uncertainties of the Ukraine crisis, there is one certainty. The latest surge in energy and grain prices is a classic supply shock. Prices have spiked because vital supplies of Russian and Ukrainian energy and grains have been cut. This matters for central banks, because to the extent that they can bring down inflation, they can do so by depressing demand. They can do nothing to boost supply. In fact, depressing demand during a supply shock is a sure way to start a recession. But what about the inflation that came before the Ukraine crisis, wasn’t that due to excess demand? No, that inflation came not from a demand shock, but from a displacement of demand shock – as consumers displaced their firepower from services to goods on a massive scale. This matters because central banks are also ill placed to fix such a misallocation of demand. Chart I-1 looks like a seismograph after a huge earthquake, and in a sense that is exactly what it is. The chart shows the growth in spending on durable goods, which has just suffered an earthquake unlike any in history. Zooming in, we can see the clear causality between the surges in spending on durables and the surges in core inflation. The important corollary being that when the binge on durables ends – as it surely must – or worse, when durable spending goes into recession, inflation will plummet (Chart I-2). Chart I-1Spending On Goods Looks Like An Earthquake On A Seismograph Chart I-2The Goods Binges Caused The Core Inflation Spikes But, argue the detractors, what about the uncomfortably high price inflation in services? What about the uncomfortably high inflation expectations? Most worrying, what about the recent surge in wage inflation? Let’s address these questions. Underlying US Inflation Is Running At Around 3 Percent In the US, the dominant component of services inflation is housing rent, which comprises 40 percent of the core consumer price index. Housing rent combines actual rent for those that rent their home, with the near-identically behaving owners’ equivalent rent (OER) for those that own their home. Given the state of the jobs market, there is nothing unusual in the current level of rent inflation. Housing rent inflation closely tracks the tightness of the jobs market, because you need a job to pay the rent. With the unemployment rate today at the same low as it was in 2006, rent inflation is at the same high as it was in 2006: 4.3 percent. In other words, given the state of the jobs market, there is nothing unusual in the current level of rent inflation (Chart I-3). Chart I-3Given The Jobs Market, Rent Inflation Is Where It Should Be Given its dominance in core inflation, rent inflation running at 4.3 percent would usually be associated with core inflation running at around 3 percent – modestly above the Fed’s target, rather than the current 6.5 percent (Chart I-4). Confirming that it is the outsized displacement of spending into goods, and its associated inflation, that is giving the Fed and other central banks a massive headache. Yet, to repeat, monetary policy is ill placed to fix such a misallocation of demand. Chart I-4Given Rent Inflation, Core Inflation Should Be 3 Percent Still, what about the surging expectations for inflation? Many people believe that these are an independent and forward-looking assessment of how inflation will evolve. Yet nothing could be further from the truth. The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. And at that, an extremely short period of historic inflation, just six months.1  The upshot is that when the backward-looking six month inflation rate is low, like it was in the depths of the global financial crisis in late 2008 or the pandemic recession in early 2020, the market assumes that the forward-looking ten year inflation rate will be low. And when the backward-looking six-month inflation rate is high, like early-2008 or now, the bond market assumes that the forward-looking ten year inflation rate will be high. In other words: Inflation expectations are nothing more than a reflection of the last six months’ inflation rate (Chart I-5). Chart I-5Inflation Expectations Are Just A Reflection Of The Last Six Months' Inflation Rate Turning to wage inflation, with US average hourly earnings inflation running close to 6 percent, it would appear to be game, set, and match to ‘Team Inflation.’  Except that this is a flawed argument. To the extent that wages contribute to inflation, it must come from the inflation in unit labour costs, meaning the ratio of hourly compensation to labour productivity. After all, if you get paid 6 percent more but produce 6 percent more, then it is not inflationary (Chart I-6). Chart I-6If You Get Paid 6 Percent More But Produce 6 Percent More, Then It Is Not Inflationary In this regard, US unit labour costs increased by 3.5 percent through 2021, and slowed to just a 0.9 percent (annualised) increase in the fourth quarter.2 Still, 3.5 percent, and slowing, is modestly above the Fed’s inflation target, and could justify a slight nudging up of the Fed funds rate. But it could not justify the straight sequence of eight rate hikes which the market is now pricing. The Fed Is Praying For A ‘Hail Mary’ Fortunately, the bond market understands all of this. How else could you say 7 percent inflation and 2 percent long bond yield in the same breath?! This is crucial, because it is the long bond yield that drives rate-sensitive parts of the economy, such as housing and construction. And it is the long bond yield that sets the level of all asset prices, including real estate and stocks. Although the Fed cannot admit it, the central bank also understands all of this and hopes that the bond market continues to ‘get it.’ Meaning that it hopes that the long end of the interest rate curve does not lift too far and crash the economy, real estate market, and stock market. So why is the Fed hiking the policy interest rate? The answer is that there will be a time in the future when it does need to lift the entire interest rate curve, and for that it will need its credibility intact. Not hiking now could potentially shred the credibility that is the lifeblood of any central bank. Still, to maintain its credibility without crashing the economy the Fed will have to make the ‘Hail Mary’ move of (American) football. For our non-American readers, the Hail Mary is a high-risk desperate move with little hope of completion. Go long the September 2023 Eurodollar futures contract. To sum up, the likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Hence, today we are opening a new trade. Go long the September 2023 Eurodollar futures contract (Chart I-7). Chart I-7The Likelihood That The Fed Completes A Straight Sequence Of Eight Rate Hikes Seems Low Additionally, stay underweight Treasury Inflation Protected Securities (TIPS) versus T-bonds (Chart I-8). Chart I-8Underweight TIPS Versus T-Bonds And on a 12-month horizon, underweight the commodity complex, whose elevated prices are highly vulnerable to a near-certain upcoming demand destruction. Fractal Trading Watchlist Confirming the fundamental analysis in the preceding sections, the strong trend in both the 18 month out US interest rate future and the equivalent 3 year T-bond has reached the point of fragility that has identified previous turning-points in 2018 and 2021 (Chart I-9 and Chart I-10). This week we are also adding to our watchlist the commodity plays Canada versus Japan and AUD/KRW, whose outperformances are vulnerable to reversal. From next week you will be able to see the full watchlist of investments that are vulnerable to reversal on our website. Stay tuned. Finally, the underperformance of EUR/CHF has reached the point of fragility on its 260-day fractal structure that has identified the previous major turning-points in 2018 and 2020 (Chart I-11). Accordingly, this week’s recommended trade is long EUR/CHF, setting a profit target and symmetrical stop-loss at 3.6 percent. Chart I-9The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart I-10The Strong Trend In The 3 Year T-Bond Is Fragile Chart I-11Go Long EUR/CHF Canada Versus Japan Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The expected 10-year inflation rate = (deviation of 6-month annualized inflation from 1.6)*0.2 + 1.6. 2  Source: Bureau of Labor Statistics Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations