Equities

Executive Summary Assessing the future scenarios discounted in asset prices is always a challenge, but investors need a consensus baseline so they can formulate their own investment strategy decisions. The conversations we had at BCA’s annual investment conference last week reinforced our view that investors are overly pessimistic about corporate earnings prospects. Fears about runaway compensation growth are unfounded. The money markets, on the other hand, appear to be overly blasé about the fed funds rate. We think terminal rate expectations will have to be revised higher and that investors will have to wait longer for rate cuts than the OIS curve currently projects. Margins Have Peaked, But They're Still High Bottom Line: We remain more optimistic than the consensus over the immediate term and continue to recommend a risk-friendly tilt in multi-asset portfolios over the next six months. We are more cautious about the twelve-month outlook and recommend neutral positioning over that timeframe. Feature BCA held its first in-person conference in three years last week at The Plaza Hotel in New York. The agenda offered attendees a smorgasbord of thought-provoking discussions with recognized experts inside and outside of BCA. We enjoyed the programmed content as well as the impromptu interactions with speakers, attendees, our colleagues and the financial media. Again and again, our unplanned conversations homed in on questions about the expectations embedded in stock prices and bond yields. The future scenarios that securities prices are discounting cannot be directly observed and therefore can never be known definitively in real time. If investors do not continuously approximate them, however, they will be unable to evaluate the likelihood that actual outcomes will be better or worse than expected. Our view that markets and the economy can surprise on the upside has been built on the idea that expectations are overly gloomy. That is still our view on balance, as we think the S&P 500 is pricing in a worse near-term earnings outlook than is likely to occur, though we expect the Fed to surprise markets hawkishly before this rate hiking cycle ends. The combination of positive earnings surprises over the next few quarters and a negative monetary policy surprise coming sometime by the second half of next year leaves us optimistic about risk assets over the next six months but wary of them over the next twelve months and beyond. Earnings The analyst consensus currently estimates that S&P 500 earnings per share over the next four quarters will exceed the second quarter’s annualized run rate by just 0.3% and the trailing four quarters by 5.5% (Table 1). Modest as those expectations may be, we do not sense that investors are counting on them. Financial media reports and our discussions with clients and colleagues suggest that investors are braced for peak-to-trough earnings declines in the double digits, consistent with past recessions (Chart 1). Those bandying about estimates of a 10-20% decline are not necessarily calling for them to occur in the next four quarters, but we think it is clear that the forward S&P 500 whisper number is below the official I/B/E/S consensus. Table 1The Official Bar Is Low, The Whisper Bar Is Lower Chart 1Recessions Are Hard On Earnings For nominal earnings growth to miss such meager expectations while inflation is high, profit margins will have to contract sharply, but we would also expect declining revenues to play a major role, as in the 2001 and 2007-2009 recessions (Chart 2). That expectation follows from our view that nominal GDP growth is a solid proxy for S&P 500 sales growth (Chart 3), with nominal GDP explaining 41% of the variation in S&P 500 sales since 1997 (64% correlation). Nominal GDP grew at close to a 10% clip in the first half, and if inflation is around 6% in the second half, we would expect 8% growth over the next two quarters and about 6% growth in the first half of next year.1 Chart 2Sales Fall In Downturns, Too Chart 3As Goes GDP, So Go Corporate Revenues Despite the revenue buffer provided by 7% nominal GDP growth, we expect S&P 500 profit margins will extend their decline from the 2Q21 peak (Chart 4). Investors nearly unanimously expect that margins are imperiled, but we are more sanguine about the pace of the decline than the consensus and suspect the difference comes down to the pace of wage growth. Compensation is the largest expense category by a wide margin and has the capacity to move the aggregate margin needle on its own. Just as the US growth outlook may rest on consumption, compensation may be the key to margins’ future path. Chart 4A Slower-Than-Expected Decline Much has been made of the shortage of available workers and its impact on wages, which are rising at the fastest pace in decades (Chart 5). In real terms, however, wage growth has been deeply negative ever since frontline workers stopped receiving hazard pay early in the pandemic (Chart 6). Real wages should find a footing as inflation cools and may eventually break into positive territory, but rampant talk of a wage-price spiral suggests that the consensus is factoring in much more. We think the prospects of a wage-price spiral like the one in the late seventies are being dramatically overestimated. Chart 5The Nominal Gains Have Been Great ...​​​​​ Chart 6... But They're Way Behind Consumer Prices​​​​​ We will not revisit the rationale for our wage-price spiral view in detail, but it is founded on the notion that workers’ current advantage, even if it were to persist for the rest of the Biden administration’s term, will not be sufficient to offset four decades of employers’ structural gains. Labor surely has the upper hand from a cyclical perspective – demand for workers exceeds supply – but we do not think it can convert its near-term advantage into durable gains. Private sector union membership has dwindled from over 30% at its mid-sixties peak to less than 7% today, leaving workers badly outgunned when trying to assemble a sellers’ cartel to counter the formidable buyers’ cartel enabled by 40 years of lax anti-trust enforcement. Even the “most pro-labor president leading the most pro-labor administration you’ve ever seen” isn’t likely to be able to counter several decades of weakened state-level labor protections.2 History says that employers will take as hard a line with their employees as is socially acceptable and what is deemed kosher has moved so far in their favor since President Reagan crushed the air traffic controllers’ union early in his first term that the seventies template does not apply. Monetary Policy If the earnings mood is unduly glum, however, it would seem to be offset by what strikes us as unfounded expectations that the Fed will stand down from its inflation fight before too long. Perhaps BCA strategists are a bit too credulous, but we are inclined to take the Fed at its word that, as former Vice Chair Richard Clarida put it at the conference, “failure [to subdue inflation] is not an option.” While we side with the consensus in our expectation that inflation will soon recede to 4% of its own accord as COVID bottlenecks are cleared, we judge that monetary and fiscal policymakers overstimulated aggregate demand in their efforts to shelter the economy from the pandemic. As a result, we expect that the Fed will have to administer much harsher monetary medicine to achieve its inflation mandate than markets are currently discounting. We have two objections to the money market’s fed funds rate expectations as derived from the overnight index swap curve (Chart 7). We think the fed funds rate will peak well north of 4% in this hiking cycle and there is almost no chance that the Fed will cut rates at any point in 2023. While markets have gotten more realistic about the monetary policy path than they were after the FOMC’s July meeting, we think they are still clinging to a vain hope. All financial assets will have to be repriced once it is snuffed out, and that repricing represents a significant risk to our constructive six-month view if it occurs before underweight asset managers are forced back into risk assets to protect their funds’ relative performance. Chart 7Magical Thinking The wide range of views about the neutral, or equilibrium, rate that demarcates the line where the fed funds rate flips from accommodative to restrictive explains the terminal rate uncertainty. The neutral rate cannot be directly observed and everyone from investors to central bankers is left to infer its location from the variables that they can see. We think the neutral rate is north of 4%, possibly as high as 4.5-5%, especially given our view that inflation will likely linger at 4%. New York Fed president John Williams suggested in a Wall Street Journal interview two weeks ago that it may be in the mid-3s. “We need to get the interest rate, relative to where inflation is expected to be over the next year, into a positive space and probably even higher.” The article said Williams expects inflation to range between 2.5 and 3% next year, suggesting that the real funds rate is on course to turn positive this fall. Melting one-year inflation expectations as implied by TIPS break-evens suggest that it’s been rising in sizable chunks week after week since the FOMC’s July meeting (Chart 8). We would take the over on Thursday’s 1.71% close if only it were available on New York’s newly legalized online sports books but someone who does expect sub-2% inflation next year might logically conclude that the Fed will be cutting rates soon. Chart 8Garbage In, Garbage Out Investment Implications Our conversations at the conference and its margins left us essentially where we began. We think investors are underestimating the economy’s ability to grow at a rate that will support continued corporate earnings growth over the next four quarters, albeit at a decelerating rate. On the other hand, we think markets face a reckoning when they are forced to price in a longer and more extensive rate hiking campaign than they currently expect. We square the circle from an investment strategy perspective by conditioning our views on investor timeframes. Because we think the earnings whisper numbers will be meaningfully revised higher before monetary policy expectations are reset more hawkishly, we remain tactically bullish. If rate expectations were to reset sooner than we currently expect (sometime early next year), our tactical call would be at significant risk and we would likely become as cautious over the six-month timeframe as we are over the twelve-month timeframe. As it stands now, we continue to recommend overweighting equities in balanced portfolios over the next six months while pursuing neutral risk asset positioning over timeframes of twelve months or more.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      Our nominal growth expectations assume the US economy maintains real growth at close to its 2% trend level, as consumption is supported by households’ considerable excess savings, but we do not repeat our case here. 2     The weather is fine, and the Saturday football unmatched, but it is flimsy labor protections that drew Boeing’s Dreamliner assembly work and a slew of foreign automakers to the Southeastern Conference’s legacy Deep South footprint and the other states competing for good factory jobs have taken notice.

Listen to a short summary of this report     Executive Summary On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall without much loss in production or employment. Skeptics will argue that such benign disinflations rarely occur, pointing to the 1982 recession. But long-term inflation expectations were close to 10% back then. Today, they are broadly in line with the Fed’s target. Equities will recover from their recent correction as headline inflation continues to fall and the risks of a US recession diminish. Go long EUR/USD on any break below 0.99. Contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted Bottom Line: The US economy is entering a temporary Goldilocks period of falling inflation and stronger growth. The latest correction in stocks will end soon. Investors should overweight global equities over the next six months but look to turn more defensive thereafter.   Dear Client, I will be attending BCA’s annual conference in New York City next week. Instead of our regular report, we will be sending you a Special Report written by Mathieu Savary, BCA’s Chief European Strategist, and Robert Robis, BCA’s Chief Fixed Income Strategist, on Monday, September 12. Their report will discuss estimates of global neutral interest rates. We will resume our regular publication schedule on September 16. Best Regards, Peter Berezin, Chief Global Strategist The Hawks Descend On Jackson Hole Chart 1Markets Still Think The Fed Will Start Cutting Rates Next Year Jay Powell’s Jackson Hole address jolted the stock market last week. Citing the historical danger of allowing inflation to remain above target for too long, the Fed chair stressed the need for “maintaining a restrictive policy stance for some time.” Powell’s comments were consistent with the Fed’s dot plot, which expects rates to remain above 3% right through to the end of 2024. However, with the markets pricing in rate cuts starting in mid 2023, his remarks came across as decidedly hawkish (Chart 1). While Fedspeak can clearly influence markets in the near term, our view is that the economy calls the shots over the medium-to-long term. The Fed sees the same data as everyone else. If inflation comes down rapidly over the coming months, the FOMC will ratchet down its hawkish rhetoric, opting instead for a wait-and-see approach. The Slope of Hope Could inflation fall quickly in the absence of a deep recession? The answer depends on a seemingly esoteric concept: the slope of the aggregate supply curve. Economists tend to depict the aggregate supply curve as being convex in nature – fairly flat (or “elastic”) when there is significant spare capacity and becoming increasingly steep (or “inelastic”) as spare capacity is exhausted (Chart 2). The basic idea is that firms do not require substantially higher prices to produce more output when they have a lot of spare capacity, but do require increasingly high prices to produce more output when spare capacity is low. Chart 2The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted When the aggregate supply curve is very elastic, an increase in aggregate demand will mainly lead to higher output rather than higher prices. In contrast, when the aggregate supply curve is inelastic, rising demand will primarily translate into higher prices rather than increased output. In early 2020, most of the developed world found itself on the steep side of the aggregate supply curve. The unemployment rate in the OECD stood at 5.3%, the lowest in 40 years (Chart 3). In the US, the unemployment rate had reached a 50-year low of 3.5%. Thus, not surprisingly, as fiscal and monetary policy turned simulative, inflation moved materially higher. Goods inflation, in particular, accelerated during the pandemic (Chart 4). Perhaps most notably, the exodus of people to the suburbs, combined with the reluctance to use mass transit, led to a surge in both new and used car prices (Chart 5). The upward pressure on auto prices was exacerbated by a shortage of semiconductors, itself a consequence of the spike in the demand for electronic goods. Chart 3The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low Chart 4With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic The supply curve for labor also became increasingly inelastic over the course of the pandemic. Once the US unemployment rate fell back below 4%, wages began to accelerate sharply. The kink in the Phillips curve had been reached (Chart 6). Chart 5Car Prices Went On Quite A Ride During The Pandemic Chart 6Wage Growth Soared When The Economy Moved Beyond Full Employment Chart 7Job Switchers Usually See Faster Wage Growth Faster labor market churn further turbocharged wage growth. Both the quits rate and the hiring rate rose during the pandemic. Typically, workers who switch jobs experience faster wage growth than those who do not (Chart 7). This wage premium for job switching increased during the pandemic, helping to lift overall wage growth. A Symmetric Relationship? All this raises a critical question: If an increase in aggregate demand along the inelastic side of the aggregate supply curve mainly leads to higher prices rather than increased output and employment, is the inverse also true – that is, would a comparable decrease in aggregate demand simply lead to much lower inflation without much of a loss in output or employment? If so, this would greatly increase the odds of a soft landing. Skeptics would argue that disinflations are rarely painless. They would point to the 1982 recession which, until the housing bubble burst, was the deepest recession in the post-war era. The problem with that comparison is that long-term inflation expectations were extremely high in the early 1980s. Both consumers and professional forecasters expected inflation to average nearly 10% over the remainder of the decade (Chart 8). To bring down long-term inflation expectations, Paul Volcker had to engineer a deep recession. Chart 8Long-Term Inflation Expectations Are Much Better Anchored Now Than In The Early 1980s Chart 9Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Jay Powell does not face such a problem. Both survey-based and market-based long-term inflation expectations are well anchored. Whereas real long-term bond yields reached 8% in 1982, the 30-year TIPS yield today is still less than 1% (Chart 9). The Impact of Lower Home Prices Chart 10Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices While falling consumer prices would boost real incomes, helping to keep the economy out of recession, a drop in home prices would have the opposite effect on consumer spending. As occurred with other durable goods, a shortage of building materials and qualified workers prevented US homebuilders from constructing as many new homes as they would have liked during the pandemic. The producer price index for construction materials soared by over 50% between May 2020 and May 2022 (Chart 10). As a result, rising demand for homes largely translated into higher home prices rather than increased homebuilding.  Real home prices, as measured by the Case-Shiller index, have increased by 25% since February 2020, rising above their housing bubble peak. As we discussed last week, US home prices will almost certainly fall in real terms and probably in nominal terms as well over the coming years. Chart 11Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs How much of a toll will falling home prices have on the economy? It took six years for home prices to bottom following the bursting of the housing bubble. It will probably take even longer this time around, given that the homeowner vacancy rate is at a record low and reasonably prudent mortgage lending standards will limit foreclosure sales. Thus, while there will be a negative wealth effect from falling home prices, it probably will not become pronounced until 2024 or so. Moreover, unlike during the housing boom, US households have not been tapping the equity in their homes to finance consumption (Chart 11). This also suggests that the impact of falling home prices on consumption will be far smaller than during the Great Recession. Inelastic Commodity Supply While inelastic supply curves had the redeeming feature of preventing a glut of, say, new autos or homes from emerging, they also limited the output of many commodities that face structural shortages. Compounding this problem is the fact that the demand for many commodities is very inelastic in the short run. When you combine a very steep supply curve with a very steep demand curve, small shifts in either curve can produce wild swings in prices.  Nowhere is this problem more evident than in Europe, where a rapid reduction in oil and gas flows has caused energy prices to soar, forcing policymakers to scramble to find new sources of supply.  Europe’s Energy Squeeze At this point, it looks like both the UK and the euro area will enter a recession. In continental Europe, the near-term outlook is grimmer in Germany and Italy than it is in France or Spain. The latter two countries are less vulnerable to an energy crunch (Spain imports a lot of LNG while France has access to nuclear energy). Both countries also have fairly resilient service sectors (Spain, in particular, is benefiting from a boom in tourism). The good news is that even in the most troubled European economies, the bottom for growth is probably closer at hand than widely feared. Despite the fact that imports of Russian gas have fallen by more than 60%, Europe has been able to rebuild gas inventories to about 80% of capacity, roughly in line with prior years (Chart 12). It has been able to achieve this feat by aggressively buying gas on the open market, no matter the price. While this has caused gas prices to soar, it sets the stage for a possible retreat in prices in 2023, something that the futures market is already discounting (Chart 13). Chart 12Europe: Squirrelling Away Gas For The Winter Chart 13Natural Gas Prices In Europe Will Come Back Down To Earth Europe is also moving with uncharacteristic haste to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG. A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. In the meantime, Germany is building two “floating” LNG terminals. Germany has also postponed plans to mothball its nuclear power plants and has approved increased use of coal-fired electricity generators. Chart 14The Euro Is Undervalued France is seeking to boost nuclear capacity. As of August 29, 57% of nuclear generation capacity was offline. Electricité de France expects daily production to rise to around 50 gigawatts (GW) by December from around 27 GW at present. For its part, the Dutch government is likely to raise output from the massive Groningen natural gas field. All this suggests that contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The euro, which is 30% undervalued against the US dollar on a purchasing power parity basis, will rally (Chart 14). Go long EUR/USD on any break below 0.99. Investment Conclusions Chart 15Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall with little loss in production or employment. Will this be the end of the story? Probably not. As inflation falls, US real wage growth, which is currently negative, will turn positive. Consumer confidence will improve, boosting consumer spending in the process (Chart 15). The aggregate demand curve will shift outwards again, triggering a “second wave” of inflation in the back half of 2023. Rather than cutting rates next year, as the market still expects, the Fed will raise rates to 5%. This will set the stage for a recession in 2024. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on            LinkedIn & Twitter   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores      

Next week, on September 7-8, is the BCA New York Conference, the first in-person version since 2019. I look forward to seeing many of you there, and if you haven’t already booked your place, you still can! (a virtual version is also available). As such, the next Counterpoint report will come out on September 15. Executive Summary The 2022-23 = 1981-82 template for markets is working well. If it continues to hold, these are the major investment implications: Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential correction that lifts the yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023. Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals. Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023. Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85, though our central case is $55 in 2023.  If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Bottom Line: The 2022-23 = 1981-82 template for markets is working well, and should continue to do so. Feature History doesn’t repeat, but it does rhyme. And the period that rhymes closest with the current episode in the global economy and markets is 1981-82, a rhyming which we first highlighted four months ago in Markets Echo 1981, When Stagflation Morphed Into Recession, and then developed in More On 2022-23 = 1981-82, And The Danger Ahead. In those reports, we presented three compelling reasons why 2022-23 rhymes with 1981-82: 1981-82 is the period that rhymes closest with the current episode in the global economy and markets. First, the simultaneous sell-off in stocks, bonds, inflation protected bonds, industrial commodities, and gold in the second quarter of 2022 is uniquely linked with an identical ‘everything sell-off’ in the second quarter of 1981. It is extremely rare for stocks, bonds, inflation protected bonds, industrial commodities, and gold to sell off together. Such a simultaneous sell-off has happened in just these 2 calendar quarters out of the last 200. Meaning a ‘1-in-a-100’ event conjoins 2022 with 1981 (Chart I-1 and Chart I-2). Chart I-1A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... Chart I-2...And The 'Everything Sell-Off' In 1981 Second, the Jay Powell Fed equals the Paul Volcker Fed. Now just as then, the world’s central banks are obsessed with ‘breaking the back’ of inflation. And now, just as then, the central banks are desperate to repair their badly battered credibility in managing inflation. Third, the Russia/Ukraine war that started in February 2022 equals the Iraq/Iran war that started in September 1980. Now, just as then, a war between two commodity producing neighbours has unleashed a supply shock which is adding to the inflation paranoia. To repeat, it is a 1-in-a-100 event for all financial assets to sell off together. This is because it requires an extremely rare star alignment. Inflation fears first morph to stagflation fears and then to recession fears. Leaving investors with nowhere to hide, as no mainstream asset performs well in inflation, stagflation, and recession. So, the once-in-a-generation star alignment conjoining 2022 with 1981 is as follows: Inflation paranoia is worsened by a major war between commodity producing neighbours, forcing reputationally damaged central banks to become trigger-happy in their battle against inflation, dragging the world economy into a coordinated recession. September 2022 Equals August 1981 If 2022-23 = 1981-82, then where exactly are we in the analogous episode? There are two potential synchronization points. One potential synchronization is that the Russia/Ukraine war which started on February 24, 2022 equals the Iraq/Iran war which started on September 22, 1980. In which case, September 2022 equals April 1981. But given that inflation is public enemy number one, a better synchronization is the Fed’s preferred measure of underlying inflation, the US core PCE deflator. Aligning the respective peaks in core PCE inflation, we can say that February 2022 equals January 1981. Meaning that our original report in May 2022 aligned with April 1981, and September 2022 equals August 1981 (Chart I-3 and Chart I-4). Chart I-3The Peak In Core PCE Inflation In ##br##February 2022 Chart I-4...Aligns With The Peak In Core PCE Inflation In ##br##January 1981 In which case, how has the template worked since we introduced it on May 19th? The answer is, very well. The template predicted that the long bond price would track sideways, which it has. The template predicted that the S&P 500 would decline from 4200 to 4000, which it has. The template predicted that the copper price would decline from $9250/MT to $8500/MT. In fact, it has fallen even further to $8200/MT. In the case of oil, the better synchronization is the starts of the respective wars. This template predicted that the Brent crude price would decline sharply from a knee-jerk peak in the $120s, which it has. Not a bad set of predictions! If 2022-23 = 1981-82, Here’s What Happens Next Assuming the template continues to hold, here are the major implications for investors: Bond prices will enter a sustained rally in 2023. Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential tactical correction that takes its yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023 in which the 30-year T-bond yield will fall to sub-2.5 percent (Chart I-5). Chart I-5If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500 in the coming months. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023 (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023 (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85 (Chart I-9) though our central case is $55 in 2023.  Chart I-9If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price But What If 2022-23 Doesn’t = 1981-82? And yet, and yet…what if the Jay Powell Fed doesn’t equal the Paul Volcker Fed? What if central banks lose their nerve before inflation is slayed? Long bond yields could gap much higher, or at least not come down, causing a completely different set of investment outcomes. In this case, the correct template would not be 1981-82, but the 1970s. If central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. However, there is one huge difference between now and the 1970s, which makes that template highly unlikely. In the 1970s, the global real estate market was worth just one times world GDP, whereas today it has become a monster worth four times world GDP, and whose value is highly sensitive to the long bond yield. In the US, the mortgage rate has surged to well above the rental yield for the first time in 15 years. Simply put, it is now more expensive to buy than to rent a home, causing a disappearance of would be homebuyers, a flood of home-sellers, and an incipient reversal in home prices (Chart I-10). Chart I-10If Bond Yields Don't Come Down, Then House Prices Will Crash Hence, if long bond yields were to gap much higher, or even stay where they are, it would trigger a housing market crash whose massive deflationary impulse would swamp any inflationary impulse. The upshot is that the 2022-23 = 1981-82 template would suffer a hiatus. Ultimately though, it would come good, because a crash in the $400 trillion global housing market would obliterate inflation. In other words, if central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. Fractal Trading Watchlist As just discussed, copper’s tactical rebound is approaching exhaustion. This is confirmed by the 130-day fractal structure of copper versus tin reaching the point of extreme fragility that has consistently marked turning-points in this pair trade (Chart I-11). Chart I-11Copper's Tactical Rebound Is Exhausted Hence, this week’s recommendation is to short copper versus tin, setting the profit target and symmetrical stop-loss at 12 percent.   Chart 1Expect Hungarian Bonds To Rebound Chart 2Copper Is Experiencing A Tactical Rebound Chart 3US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started To Reverse Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 11The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 12A Potential Switching Point From Tobacco Into Cannabis Chart 13Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-12 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  

Executive Summary   Reshoring And FDI Job Creation Have Accelerated After The Pandemic The US is entering a period of an industrial boom thanks to limited manufacturing capacity paired with strong demand for industrial and consumer goods. In addition, a trifecta of positive developments is further boosting US manufacturing: Onshoring, automation, and fiscal stimulus. Onshoring has accelerated after the onset of the pandemic and reshoring announcements are growing steadily. Automation and robotization allow industrial companies to circumvent labor shortages and rising wages and, hence, boost their profit margins.  The domestic political landscape in the US is also favorable for industrial stocks given the three major legislative Acts (Infrastructure Investment & Jobs, Inflation Reduction, and National Defense Authorization) that will secure a healthy demand pipeline. While long-term trends are favorable for the sector, a macroeconomic backdrop of slowing growth is a headwind.  However, thanks to a confluence of positive long-term trends, most companies are optimistic. Bottom Line: The US industrial sector is in the middle of a boom fueled by onshoring, automation, and favorable government policy. This trifecta of positives helps the sector to defy the gravity of the slowing economy. We remain overweight Industrials on both tactical and strategical time horizons but will continue to monitor it closely, watching out for potential cracks in operating performance. Feature A little over a year ago EMS, GIS, and USES co-published a report “Industrials as equity sector winner in the coming years”. In that report, we posited that the Industrial sector is poised for outperformance as it enjoys a boom thanks to strong new trends in onshoring and automation. In addition to the tectonic shifts described above, the sector has also found itself at the epicenter of the US legislative activity, which will provide a significant tailwind for its performance. Since we published the report on July 30, 2021, Industrials have performed in line with the S&P 500. However, since the beginning of the year, Industrials and Capital Goods outperformed the index by 7%, showing impressive resilience (Chart 1 and Table 1). Chart 1A Resilient Cyclical Sector In this week’s report, we take a close look at the trends highlighted above and conduct a deep dive to evaluate whether the sector is still attractive on a tactical basis considering the backdrop of rising rates and slowing economic activity. Our focus is on the Industrial sector in general, and the Capital Goods Industry Group, in particular. We will also assess which industries are best positioned for outperformance. Table 1Industrials Outperformed On The Way Down And During The Summer Rally Sneak Preview: The US industrial sector is in the middle of a boom fueled by onshoring, automation, and favorable government policy. This trifecta of positives helps the sector to defy the gravity of the slowing economy. For now, we are both strategically and tactically bullish on the sector but remain vigilant. US Manufacturing Capacity Has Been Severely Limited For Years US manufacturing capacity has been stagnant over the past 20 years, and the level of US manufacturing employment has declined by 30% since 2000 (Charts 2 & 3). Presently, manufacturing employment accounts for only 8% of total US employment. Chart 2US Manufacturing Employment Has Been Shrinking For Decades Chart 3US Manufacturing Capacity Has Not Expanded In The Past Two Decades The reason for the lack of capacity expansion over the past 20 years has been the outsourcing and shifting of production to other countries, especially China. The peak in US manufacturing capacity and employment occurred after the massive Asian currency devaluation in 1998 and China’s WTO admission in 2001. The semiconductor sector, which has recently come into the limelight, is a case in point: From 1990 to 2020, the percentage of chips manufactured in the US has fallen from 37% to 10%, with the lion’s share of chips manufactured in Asia. This trend has brought about The Chips Act which seeks to reverse the trend for national security reasons. Notably, more recently, the decline in manufacturing capacity and employment has started to reverse. More about this later. American Manufacturing Is Booming Again Limited manufacturing capacity paired with a strong demand for industrial and consumer goods translates into an industrial boom. Industrial companies are incentivized to expand given they are already operating at nearly full capacity (Chart 4) and enjoying considerable pricing power. Building industrial capacity in itself lifts demand for industrial goods and the US may be in the early innings of the new Capex cycle, unless the trend is derailed by headwinds from a significantly tighter monetary policy. After all, the age of US capital stock, at 24 years, is two years older than at previous peaks, indicating that many companies are overdue for replacing some of their equipment and machinery (Chart 5). Chart 4Industrial Companies Operate At Nearly Full Capacity Chart 5The US Capital Stock Has To Be Renewed Indeed, this may already be happening. According to S&P Dow Jones Indices, which analyzed second-quarter earnings season data, capital expenditures of the companies in the S&P 500, have been growing at a faster pace than stock repurchases for the first time since the first quarter of 2021, rising by 20% from a year earlier. Companies from Pepsi to Google to GM are investing in their production capacity, which in itself may be an encouraging sign that they are comfortable with the demand outlook. Of course, the caveat here is that industrials are late in cycle performance, as companies usually wait towards the end of the cycle to expand, only to find waning demand for their products. You Say “Reshoring,” I Say “Onshoring” A multi-decade decline in US manufacturing employment has started to reverse after the GFC, with the onset of the pandemic and geopolitical tensions accelerating the pace of reshoring and Foreign Direct Investing (FDI). Reshoring and FDI job announcements have increased from 6K in 2010 to 345K in 2022 (Chart 6). The resulting cumulative 950,000 incremental hires represent about 7% of US manufacturing employment. The acceleration of jobs coming back combined with the decline in the rate of offshoring has resulted in a 12-year steady uptrend in US manufacturing jobs. Truly amazing! Onshoring remains on top of mind for companies’ management. According to Statista, mentions of onshoring buzzwords in earnings calls and presentations of US public companies have increased from about 100 throughout 2020 to nearly 200 in Q2-2020. Chart 6Reshoring And FDI Job Creation Have Accelerated After The Pandemic According to Morgan Stanley’s survey of more than 400 executives of large corporations from the US to Germany to Japan, the most important factor in supply chain decisions is geopolitical stability, followed by skilled labor, physical infrastructure, and a developed supply chain ecosystem. On nearly every count, the US outranked Europe, China, and Mexico. Some 18% of the companies planned to significantly expand US manufacturing in the next 12 months, while 36% anticipated doing so within three years. More than 40% of US companies were taking steps to “onshore” supply chains. The reasons are well publicized: The COVID crisis has revealed over-dependence on imports. China’s decoupling from the US, tensions in the Taiwan Strait, and the Russian/Ukraine war have invoked concerns about the reliability of the existing supply chains. Supply chain disruptions have highlighted corporate vulnerabilities and had made companies realize that “just-in-case” trumps “just-in-time.” The US is pursuing protectionist policies that are to benefit companies operating in the US, Mexico, and Canada. According to Reshoring Initiative,1 Industrial and Tech companies are at the forefront of reshoring: Electrical Equipment, Chemicals, Transportation Equipment, Computer, and Electronic Products, and Medical Equipment suppliers are the leaders in onshoring (Table 2). Many large manufacturers such as Caterpillar have implemented or announced plans to bring offshore manufacturing back to the US. Table 2Reshoring Jobs By Top 5 Industries Will onshoring benefit some of the former manufacturing hubs? We believe it will, as Kentucky, North Carolina, Georgia, Ohio, and Alabama are the top five destinations (Table 3). However, there is a hitch. The US unemployment rate, which is at an all-time low of 3.5%, is certainly a speed limit. Moreover, companies that bring their businesses back home do realize that labor costs in this country are many times higher than, say, in Asia. Hence, one of the solutions they pursue is automation. After many years in the making, onshoring is finally gaining pace, benefiting the US manufacturing base. Table 32022 Projected Reshoring Jobs By Top 10 States Automation To The Rescue! The Pace of Robotization And Automation Is Accelerating A critical constraint for the expansion of US manufacturing is the labor shortage. Open vacancies in manufacturing are now at a record high, 100% above the 2018 peak (Chart 7, top panel). Notably, industrial companies have been experiencing difficulties hiring qualified staff over the past 10 years which has led to high wage growth (Chart 7, bottom panel). Chart 7US Manufacturers Cannot Fill Vacant Positions, Wages Are Surging Chart 8Automation Expands Profits Margins Of Global Industrials One remedy is automation. Replacing labor with automation/robots allows companies to produce more and avoid a profit margin squeeze (Chart 8). In a recent report published by the International Federation of Robotics, industrial robots reported record preliminary sales in 2021 with 486,800 units shipped globally, a 27% increase from 2020. The US has been lagging behind other developed countries in terms of automation and robotization (Chart 9). However, labor shortages brought about by the pandemic appear to have “moved the needle.” According to the Association for Advancing Automation (A3),2 the number of robots sold in the US in 2021 rose by 27% over 2020 with 49,900 units installed. 2022 is on pace to exceed previous records, with North American companies ordering a record 11,595 robots. Chart 9US Has Been Lagging Other Developed Nations In Robot Installations Non-automotive sales now represent 58% of the total, demonstrating a broadening reach of automation. Metals, Auto, and Food and Consumer Goods have the highest growth in the purchase of robots (Chart 10). Chart 10In 2021 The Pace Of Robot Installation Has Picked Up Implications For Industrial Companies The Industrials sector is home to companies that create robots and offer automation solutions as well as companies on the receiving end of the trend. Both sellers and buyers are to benefit: Buyers Of Robots: Manufacturing companies automating production and enlisting robots into their operations will enjoy higher operating leverage, lower labor costs, and more resilient margins. It is easier to automate processes in manufacturing than in service sectors. Consequently, we believe profit margins in manufacturing will outperform those of service sector companies, where automation will be slower. Sellers Of Robots: The sizzling demand for robots demonstrates that technological breakthroughs are no longer just about the Tech companies, and many industrial companies are to benefit from these nascent trends. Rockwell Automation, Eaton, and Caterpillar are the leaders in industrial automation. These companies also reach across the aisle to software companies to leverage their expertise in data storage, computing, and artificial intelligence. Rockwell has just recently partnered with Microsoft, while others are acquiring software companies. Deere has acquired GUSS Automation, a pioneer in semi-autonomous springs for high-value crops. These companies are to benefit from strong demand for their products and should exhibit strong sales and profit growth. To meet strong demand, industrial/manufacturing companies will automate their processes. This will allow them to boost volume and cap costs resulting in widening profit margins. Uncle Sam Loves American Manufacturing Both Biden and Trump before him, have stated that their overarching objective is to revive America’s manufacturing. However, their methods were drastically different, with Trump introducing tax cuts and tariffs, while Biden leans heavily on fiscal stimulus. The following is a recap of some of the recent laws passed by Congress and signed by President Biden. Infrastructure Investment And Jobs Act The $1.2-trillion Infrastructure Investment and Jobs Act will increase US government non-defense spending to bring it to around 3% of GDP, a level comparable to the 1980s-90s and larger than the 2010s. The bill’s focus is on traditional infrastructure – roads, bridges, ports, and electrical grid modernization – but also includes more modern elements such as $65 billion for 5G broadband Internet and $36 billion for electric vehicles and environmental remediation (Table 4). Implementation of the bill is delayed to 2023-24. Table 4Itemized Infrastructure Plan However, the market is forward-looking and companies in Construction & Engineering, and Building Products industries are already winners, and are up 12% in relative terms since the bill was passed on November 15, 2021. The potential increase in public construction will help offset a slump in residential construction on the back of the softening housing market (Chart 11). Chart 11The Increase In Public Construction Will Help Offset A Slump In Residential Construction Inflation Reduction Act (IRA) The bill earmarks $370 billion for clean energy spending as well as EV tax credits for both new and used cars. We have written on the topic of “Green and Clean” and the effect of the IRA on renewable energy and EV industries, two industries that are major beneficiaries of the bill. However, the bill also creates an enormous opportunity for industrial companies, which can build and service renewable infrastructure, such as Quanta Services (PWR) and Eaton (ETN). Companies that produce and service wind turbines (GE) and solar batteries will also get a revenue boost from the package. Chips Act Congress has passed the CHIPS+ bill to alleviate the chip shortage and shore up US competitiveness with China. Money is earmarked for domestic semiconductor production and research, and factory construction. While the key beneficiaries are chip foundries, construction of new factories will require equipment and services of a wide range from industrial companies from Construction to Machinery. National Defense Authorization Act In December, the House and Senate Armed Services Committee leadership released the Fiscal Year 2022 National Defense Authorization Act (NDAA). This bill introduces an overall discretionary authorization of $768.2 billion including $740.3 billion for base Department of Defense programs and $27.8 billion for national security programs in the Department of Energy. At a later date, another $37 billion was amended to the bill to include $2.5 billion to help pay higher fuel costs; $550 million for Ukraine, funding for five ships, eight Boeing Co-made F-18 Super Hornet fighter jets, and five Lockheed Martin C-130 Hercules planes; and about $1 billion for four Patriot missile units. For FY 2023, the House has already passed $839 billion, which is $37 billion above the White House request. The Senate will work on the bill after the summer recess. But it is already clear that defense spending has become a bipartisan issue. The increase in the defense budget, as well as additional allocation of funds towards Ukraine, have been a major boost for the Aerospace and Defense industry. We overweighted the sector back in January and it is up 24% in relative terms. Overweight Or Not, That Is The Question Macroeconomic Backdrop Business Cycle: Performance of the Industrial sector tends to lag the business cycle, as sector customers tend to wait until they are sure of recovery and have high utilization of their existing capacity before they expand their own production. However, demand is not entirely cyclical, as the need to replace obsolete or aging equipment or machines is relatively stable. There is also a stark difference in behavior of the largest industrial companies and smaller companies in their ecosystems. Larger manufacturers are long-cycle as it takes months to build machines, planes, or equipment. These companies are less sensitive to the business cycle. On the other hand, their suppliers are “short cycle” as they sell parts to many customers, turn their inventory frequently, and are very sensitive to the economic condition. At present, as economic growth is slowing, long-cycle industrial companies are preferable to short-cycle ones. Despite a bifurcation in demand, Industrials tend to underperform in a generic economic slowdown (Chart 12). This is unsurprising as the relative performance of Industrials is correlated to industrial production and the ISM PMI (Chart 13). Chart 12Historically, Industrials Underperformed During The Slowdown Stage Of The Business Cycle Chart 13Industrials Usually Underperform When IP And ISM PMI Decline Chart 14Survey Of Capex Intentions Is Weakening And while we touted the beginning of the new industrial boom in the US, and a brand new Capex cycle, we need to monitor it carefully, as multiple surveys of Capex intentions are decelerating (Chart 14). Tighter Monetary Policy: Another potential headwind comes from rising rates. After all, the higher cost of corporate borrowing may weigh on demand for industrial goods. However, historically, US industrial stocks outperformed the S&P 500 Index in the past 70 years during periods of rising bond yields, including the inflation decade of the 1970s (Chart 15). Industrial companies are well positioned to withstand inflation as strong pricing power allows them to pass on their costs to customers. Chart 15When Rates Rise, Industrials Outperform The macroeconomic backdrop presents challenges to Industrial companies Fundamentals Are Strong Significant Pricing Power: While dangers are looming in the macroeconomic backdrop, so far industrial companies have been doing well thanks to their significant pricing power (Chart 16), which they enjoy due to high capacity utilization. The relationship between capacity utilization and selling prices is not linear but exponential. When capacity reaches its limit and shortages arise, potential buyers will likely be willing to pay considerably higher prices to secure the supply of goods that they require. High Operating Leverage: In addition to high pricing power, industrial companies enjoy high operating leverage, which implies that while the economy is growing, even if at a slower pace, they can easily convert sales into profits. This will not be the case when the economy is outright contracting – then high operating leverage will become a liability. Chart 16Industrials Enjoy Substantial Pricing Power Strong Q2-2022 Earnings And Sales Results: This explains the strong Q2-2022 sales and earnings results of the Industrial sector. Industrial earnings grew at 17.4%, while its sales increased by 13.3% – a remarkable feat, considering that many companies, especially consumer-facing ones, are struggling with shrinking profitability – earnings growth of the Consumer Discretionary sector was down 12.6%. Clearly, business-to-business companies are faring much better than consumer-facing ones, whose demand was pulled forward by the pandemic, and whose customers are reeling from rising prices and are tightening their belts. Looking ahead, margins are expected to shrink by 0.5% (Chart 17), which is modest compared to the 2.5% contraction expected for the S&P 500. In terms of earnings growth expectations, they have fallen but still exceed the market by an impressive 10% even after a series of downgrades. Importantly, earnings growth in real terms is also positive (Charts 18 & 19). Chart 17Operating Margins Are Expected To Hold Up Well Chart 18Industrial Earnings Will Grow Faster Than The Market Chart 19Earnings Expectations Have Been Re-calibrated What Companies Are Saying All the charts and numbers align well with what we have heard from companies during the earnings season. For instance, nearly every major player within its own respective sub-industry reported healthy demand, low inventories, and a hefty backlog this quarter. Here are a few quotes from the largest players: Caterpillar (CAT): “We expect production and utilization levels will remain elevated, and our autonomous solutions continued to gain momentum … overall demand remained healthy across our segments … was unable to completely satisfy strong customer demand for our machines and engines.” MMM: “Continued strong demand for our solutions in semiconductor, factory automation, and automotive end markets.” GE: “In Renewables, … we are making progress. Our pricing has substantially improved onshore … we're growing our higher-margin businesses, such as grid automation, which delivered double-digit orders growth.” Honeywell (HON): “Orders were up 12% year over year and closing backlog was also up 12% year over year.” The profitability of the Industrial sector is expected to be resilient and to better the market. Valuations And Technicals The Industrial sector and the Capital Goods Industry group trade on par with the S&P 500 on a forward earnings basis (17.7x and 17.9x to 18.0x). The BCA Valuations Indicator signals a neutral level of valuation which is roughly in line with the 10-year average. From the BCA Technical Indicator standpoint, Capitals Goods are also in the neutral zone (Chart 20). Valuations and technicals are moderate for the sector. Chart 20Valuations And Technicals Investment Implications The US industrial sector is in the middle of a boom fueled by a trifecta of positives: Onshoring, automation, and favorable government policy. And while it is hard to fight the Fed and the business cycle, it appears that for now, the sector is defying gravity despite slowing manufacturing surveys and tighter monetary policy. So far fundamentals appear strong, and earnings expectations are robust thanks to the high pricing power and operating leverage of the sector. Within Capital Goods, we favor industries and companies that benefit from these tailwinds: Aerospace and Defense which is to benefit from increased federal defense spending; Robotics and Automation which is overrepresented in the Electrical Equipment industry; and Renewables, i.e., companies that manufacture and service wind turbines and solar panels. Construction and building materials will have a second breath when Infrastructure spending projects will actually get selected and approved. We are both strategically and tactically bullish on the sector but will monitor it closely from a tactical standpoint. After all, industrial surveys are at odds with the resilient earnings expectations. ETFs There are a number of very inexpensive and highly liquid ETFs from Vanguard, iShares, and State Street, that capture the performance of the Industrial sector (Table 5). Table 5Industrial Sector ETFs Bottom Line The US industrial sector is in the middle of a boom fueled by onshoring, automation, and favorable government policy. This trifecta of positives helps the sector to defy the gravity of the slowing economy. Companies are optimistic and earnings growth expectations are both robust and resilient. We are both strategically and tactically bullish on the sector but will continue to monitor it closely, watching out for potential cracks in operating performance.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     Reshoring Initiative reshorenow.org 2     https://www.automate.org/   Recommended Allocation Recommended Allocation: Addendum 

Executive Summary Cheap But Challenged European equities have bottomed in absolute terms, but they are still underperforming US ones. Eurozone equities are very cheap compared to US ones, but their profitability remains inferior. Five problems continue to hang over the relative performance of European stocks. The first problem is the Chinese and global growth outlook. The second problem is the natural gas crisis. The third problem is Europe’s expanding liquidity risk. The fourth problem is the weak euro. The fifth problem is Europe’s structural profitability weaknesses.     Bottom Line: European stocks may be inexpensive, but too many problems are hanging over their profit outlook. As a result, European shares are unlikely to outperform until natural gas prices peak and the ECB activates the TPI. Until then, continue to underweight European stocks in global equity portfolios.   European assets are on sale. Equities are trading at multigenerational lows against their US counterparts. Meanwhile, the euro is back below parity and embedding a 30% discount to purchasing power parity against the US dollar. These observations suggest that European stocks are very attractive relative to their US counterparts — but are they? Related Report  European Investment StrategyQuestions From The Road On July 4, 2022, we turned positive on European stocks in absolute terms. Nonetheless, we expected US stocks to outperform because of their larger weighting toward defensive and growth names, which derive greater benefit from lower rates, especially when economic activity remains vulnerable. At this point, we maintain this stance. European valuations are appealing, but the entry point is still not right because the global environment continues to be hostile to the relative performance of European equities. Attractive Valuations Anyway you cut it, European stocks are much less expensive than their US counterparts. In theory, these attractive valuations imply higher long-term rates of return in European markets compared to US ones. Chart 1Cheap European Stocks Based on the MSCI indices, the relative forward P/E ratio of Eurozone shares is 25% below that of US stocks, or the deepest discount in more than 20 years (Chart 1, top panel). European shares should naturally sport lower valuations than US ones due to sectoral biases. However, even when we adjust for those sectoral differences, European stocks stand out as exceptionally cheap. A P/E ratio calculated by giving equal weights to all the sectors in both Europe and the US reveals that, outside of the COVID-19 selloff, the European valuation discount has never been lower in the post-dotcom bubble era (Chart 1, bottom panel). Comparing individual sector performances to earnings reinforces that European stocks are uniquely inexpensive compared to US ones. Since 2018, the relative prices of most European sectors compared to their US competitors have underperformed relative earnings (Chart 2). Chart 2ABroad-based Cheapness Chart 2BBroad-based Cheapness The problem with valuations is that they can be misleading. If European earnings continue to underperform US ones, European equities are likely to underperform further. And, whether we adjust or not for sector composition, European earnings remain in a pronounced downtrend compared to US profits, which is driving relative performance (Chart 3). Perhaps there is hope for European earnings, but, in the short term, we doubt it. European earnings expectations have been downgraded already, with 2022 and 2023 earnings excluding the energy sector, already down 10% and 12% respectively since their February peak (Chart 4). However, five problems are likely to lead to a greater downgrade relative to the US in the coming months. They are the following: the Chinese and global growth difficulties, the energy market’s ructions, the European liquidity risk, the weakness in the euro, and Europe’s structural lack of profitability. Chart 3Earnings Are In The Driving Seat Chart 4Downward Revisions Have Begun Bottom Line: Compared to the US, European stocks are very cheap. However, European stocks will only begin to outperform once investors see reasons to upgrade European relative earnings. For now, too many problems continue to place Europe’s profit outlook at a disadvantage. Problem 1: Chinese And Global Growth Chart 5Europe Is More Cyclical than the US The performance of European equities relative to that of US stocks tracks the evolution of the global manufacturing PMI (Chart 5). This makes sense. Europe’s economy and markets are more specialized in the manufacturing sector, whether consumer or capital goods. Consequently, European earnings are also more geared to the fluctuations of global industrial activity and Chinese imports. Today, China remains one of the major risks to European stocks. Despite efforts by Beijing to stabilize growth, the private sector continues to retrench. The zero-tolerance toward COVID creates a powerful brake on animal spirits as lockdowns shift from one city to the next. Most crucially, the real estate sectors’ woes show no end in sight. Floor spaces sold, started, and completed are contracting at double-digit paces and real estate investment is declining at a 12% annual rate (Chart 6 top and second panels). Moreover, the 47% annual contraction in land purchases indicates that the situation will not improve soon. Consequently, consumer loan growth will decelerate further (Chart 6, bottom panel). While authorities are trying to manage the economic slowdown, they are still too concerned with real estate speculation to push as aggressively as the Chinese economy needs. Even the recent 19-point package from the State Council came with a warning that, although “the foundation of economic recovery is not solid,” Beijing will avoid “resorting to massive stimulus or compromising longer-term interests.” In this context, it is likely that China’s marginal propensity to consume will remain weak, that Chinese yields will decline further, and that the CNY will experience additional weaknesses. All these developments are consistent with a deeper underperformance of European equities (Chart 7). Chart 6China's Real Estate Industry Is Sick Chart 7Weak China = Weak Europe Looking at the global economy offers little hope. A weak China weighs on EMs’ growth prospects. Moreover, the strong dollar invites EMs’ central banks to tighten domestic liquidity and financial conditions, which historically results in lower growth. This softer economic activity ultimately hurts European earnings more than US ones and causes Eurozone shares to underperform US ones (Chart 8). Beyond EMs, the leading indicators of global economic activity do not inspire much confidence either. Arthur Budaghyan, BCA’s Emerging Market chief strategist, often highlights the downside risk to global exports, which would generate an underperformance of European earnings relative to those of the US. In fact, Taiwanese export orders, which lead global exports, are contracting anew. So is the Global Leading Economic Indicator (Chart 9). Ultimately, the tightening in global policy rates is doing what it should do: slowing global growth. Chart 8EM FCIs Matter To Europe's Relative Performance Chart 9Clouds Over The Global Economy Bottom Line: The weakness in Chinese economic activity is not over yet. Global growth will also continue to suffer as global exports are set to weaken considerably in the coming months. Together, these forces will hurt the earnings prospects of Europe compared to the US. Problem 2: The Energy Market Chart 10Pricey Nat Gas And Electricity Let’s be more specific here: natural gas continues to weigh more on Europe’s earnings prospects than those of the US. European natural gas prices have surged, even when compared to US ones. As a result, electricity prices have also increased across the Eurozone’s main economies (Chart 10). This is deeply negative for domestic economic activity and hurts the competitiveness of European businesses. Consequently, as long as natural gas prices climb higher, European profitability will deteriorate relative to that of US firms. Unsurprisingly, investors are deeply aware of these dynamics. The more natural gas prices rise, the greater European equities underperform. In fact, since mid-2021, Dutch natural gas prices have become the single best explanatory variable for the relative performance of European stocks (Chart 11). Natural gas is likely to remain a problem for European equities until the beginning of the winter. We are currently in the peak period of upward pressure on natural gas prices in Europe. Relentless inventory buildup introduced an inelastic buyer to the market, which is propelling natural gas prices to new heights even though consumption is receding (Chart 12, top panel). In response to these efforts, European natural gas inventories have hit 80% of capacity and are set to rise to 90% by November, even though Russian flows have collapsed (Chart 12, bottom two panels). However, in November, natural gas prices are likely to peak. The re-stocking effort will be completed, coal power will fill in many gaps, and selective conservation efforts will allow most industries and heating to function. Chart 11Europe vs US = Nat Gas Chart 12The Worse Is Now Bottom Line: The surge in natural gas prices is the key force currently hurting the relative performance of Eurozone equities. However, this negative dynamic is likely to fade in the winter because the current price jump reflects inventory building. By November, inventories will be at the 90% of capacity targeted by the European Commission and coal power will fill the remaining production gap. Until then, natural gas prices will continue to hurt European profit margins. Problem 3: European Liquidity Risk Chart 13Unhinged Credit Markets European equities are also hurt by an increase in risk premia relative to the US. Italian spreads continue to show upside and European junk spreads are widening compared to US ones (Chart 13). This problem could remain saliant in the coming months. The ECB is tightening policy in an economy already fettered by a severe energy shock. This process increases risk aversion. Moreover, because European inflation is likely to prove more sticky than that of the US this fall, this development will continue to hurt the price of European assets compared to US ones. Chart 14A Key Vulnerability The imbalances in the Euro Area create a further source of liquidity risk. The TARGET2 balances remain extremely large, which indicates that Dutch, Luxembourg, and German savings continue to finance France, Spain, and Italy (Chart 14, top panel). However, the import-boosting impact of high energy costs and the negative effects of weaker global growth on exports are likely to worsen the current account balance of the Eurozone, including that of Germany, which acts as the Eurozone’s banker (Chart 14, bottom panel). The decreasing savings of Germany and the Netherlands in conjunction with the wide difference in neutral rates between Germany and France, Italy and Spain increase the odds that peripheral spreads will widen further in the short term. However, this too is likely to be a temporary risk that ebbs after the winter. First, as we wrote four weeks ago, the differences in neutral rates will force the ECB to activate the TPI before year-end. Second, once energy prices peak, the downward pressure on European gross savings will also ease, which will restore liquidity conditions in European credit markets. Bottom Line: The combination of an ECB tightening policy in a weak economy as well as TARGET2 imbalances and declining savings increase the likelihood of a liquidity shortage in European debt markets. Tremors in the credit market would translate into further underperformance of European equities relative to US ones. Problem 4: The Weak Euro At first glance, the weak euro is positive for European equities since it subsidizes profitability. However, in a context in which costs of production are rising faster in Europe than in the US, this benefit is elusive. The weak euro is not translating into greater pricing power for European firms. The increase in producer prices supercharged by higher natural gas prices (among others) is not met by a commensurate rise in consumer prices. The same is true in the US, but to a much lesser extent; as a result, the ratio of CPI to PPI is declining in Europe relative to the US. Chart 15A Weak Euro Reflects Poor Pricing Power This lack of pricing power is an important driver of the weakness in the euro. EUR/USD closely tracks the evolution of the CPI-to-PPI ratio in Europe relative to the US (Chart 15). This confirms that a weaker euro is not helping the relative performance of European shares because it indicates a problem with the comparative profitability of European businesses. It also implies that the euro will weaken as long as Dutch natural gas prices are rising (Chart 15, bottom panel).  Historically, a weak euro is associated with underperforming European equities. At the most basic level, a depreciating euro arithmetically derails the common-currency performance of European shares. Moreover, because a falling euro is often linked to poor rates of return in the Euro Area, it corresponds to periods when investors prefer foreign shares to European ones. For now, we see a large left tail in short-term distributions of the EUR/USD’s returns, even if the long-term prospects of the euro are brighter. This also signifies that the euro will remain a hurdle for the relative performance of European shares in the coming weeks. Bottom Line: The lack of pricing power of European firms weighs on the profitability of Eurozone businesses compared to that of US ones and on the euro. As long as this problem persists, the euro will suffer, which implies additional weaknesses in the relative performance of European shares. Problem 5: Europe Structurally Poor Profitability Chart 16Europe's Structural Profitability Problem Since 2008, the EPS of the Eurozone MSCI benchmark have collapsed 73% compared to those of the US index. Moreover, this fall has followed a nearly straight line. This poor performance reflects an underlying structural challenge to European profitability. Europe’s low profit growth follows poor returns on assets. At first glance, lower levels of stock repurchases explain some of the underperformance of European earnings. However, the lower propensity of European firms to conduct buybacks mirrors their poor profitability. As Chart 16 highlights, European firms have much lower RoEs, RoAs, profit margins, and asset utilization rates than their US counterparts. The low profitability of European shares is multifaceted. To a large degree, it corresponds to the Eurozone’s anemic growth, whereby nominal as well as real GDP per capita continue to lag those of the US (Chart 17). This weak per-capita GDP is a consequence of the meager underlying productivity of the Euro Area. Many elements cause Europe’s lower productivity growth. The two most obvious culprits are the region’s greater economic fragmentation and its heavier regulatory burden when compared to the US. But also, the return on investment is much lower in Europe (Chart 17, bottom panel). The lower European return on investment is more complex. A key driver is the greater degree of misallocated capital in Europe than in the US. Europe’s capital stocks, especially in the periphery, represents a much greater share of GDP than it does in the US (Chart 18). A larger capital stock increases the odds that some previous capex was misallocated. Moreover, the greater prevalence of small businesses in Europe compared to the US also increases the likelihood of redundant and misallocated capital. Poor capital allocation hurts investment returns and productivity. Chart 17Weak Growth = Weak ROI Chart 18Too Much Capital Another reason for Europe’s poor profitability has nothing to do with productivity and tepid growth. European industries are less concentrated than US ones (Chart 19). Lower concentration means higher competition between businesses, which erodes markups and returns on assets.  Chart 19Smaller Profitability Moats In Europe None of Europe’s structural weaknesses in relation to profitability has been addressed. Consequently, this drag on the relative performance of Euro Area equities remains firmly in place, which warrants a significant discount in European equity valuations relative to US ones. Bottom Line: The last problem for European shares is the structural under profitability of the Eurozone. Because of lower productivity, misallocated capital, and lower industry concentration, European firms offer permanently weaker returns on assets than US businesses. Their disadvantage remains unaddressed, which suggests that structural forces are unlikely to generate a re-rating of European shares any time soon. Investment Implications Conditions are still not supportive for an outperformance of European equities relative to US ones. European stocks may have already bottomed in absolute terms and they are very cheap compared to US shares, but Euro Area earnings are set to underperform further. European stocks cannot beat US stocks until most of the five headwinds impacting Europe come to pass. The deceleration in Chinese and global growth, the surge in Dutch natural gas prices, the growing liquidity risk in the Eurozone, the collapse of EUR/USD, and the structural impediments to European profitability are just too strong collectively to allow Europe’s attractive valuation to crystalize into immediate high returns. Nonetheless, we cannot be dogmatic. Before year-end, we expect three of these variables to become favorable for European stocks. Namely, we anticipate the natural gas crisis to reach its apex around November 2022, the ECB to activate the TPI, which will tackle the budding illiquidity in European credit markets, and the euro to bottom. Hence, we are in the late stage of this year’s underperformance of European equities. An opportunity to upgrade Europe is around the corner – we are just not there yet. Even after all the cyclical and short-term negatives ebb, one key hurdle for European stocks will remain intact: the structural under profitability. This force suggests that periods of outperformance of European stocks are likely to be short-lived and that, as long as the profitability gap remains open, the structural relative bear market in European stocks will persist. Bottom Line: It is still too early to overweight European equities. Euro Area stocks are much cheaper than their US counterparts, but too many headwinds continue to blow that are likely to weigh on relative performance. Only after European natural gas prices peak will Europe enjoy a period of outperformance. This is unlikely to happen until this winter.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations