Financial Markets

Executive Summary A Floor In Biden’s Approval? Biden’s approval rating is forming a bottom. Democrats will pivot away from Covid-19 to boost the economy and consumer sentiment. While Democrats face a dismal midterm election, Republican infighting could conceivably cost the GOP control of the Senate. Policy uncertainty will rise as the election approaches. Republican infighting is unlikely to affect the outcome in the House of Representatives, although Republicans could lose three-to-nine seats that they might otherwise hold if the party establishment fails to coordinate effectively with former President Trump as we expect. Our tactical trades hinge on Biden’s near-term external risks: the risk of an energy shock that weighs on Treasury yields and pushes up the dollar. Defensives like health care should benefit. Our cyclical recommendations continue to favor cyclical equities such as small cap energy stocks.     Bottom Line: Investors should be tactically prepared for geopolitical risks to push up the dollar and push down Treasury yields in the short run, contrary to the cyclical BCA House View. Feature Has Biden’s Approval Hit The Floor? Probably. President Biden’s net approval rating is still under water at -9%, only slightly better than President Trump’s at this stage in the approach to the 2018 midterm elections. Biden’s handling of the economy receives a lower approval rating, which is dangerous for his party because the economy is likely to be the most important issue in the midterm election, given that the Covid-19 pandemic is waning. If Biden follows the path of his predecessors then his approval rating will trend upward as the midterm approaches. That will not prevent a Republican victory in the House but it could affect the Senate and the size of the Republican majority (Chart of the Week). The latest jobs report saw 467, 000 new jobs created. The labor participation rate grew from 81.9% to 82%, while women’s participation rose from 56.5% to 56.8%. The unemployment rate ticked up from 3.9% to 4%, with the broader U6 measure rising from 7.2% to 7.9%, but the reason was that more workers joined the workforce, which is a good thing for the economy (Chart 1). The Omicron variant of the Covid-19 virus is having little impact so the labor market is continuing to heal, a positive for the Biden administration, which is otherwise struggling. Chart 1A Solid Jobs Report American sentiment about the economy will hinge on inflation. If inflation abates along with the virus then the Democratic Party will be able to pare some losses in the midterms. At the moment the polarization of economic sentiment – divergence based on partisan affiliation – is declining, but for reasons that will give the administration a headache. Democratic sentiment is falling while Republican sentiment is improving (Chart 2). If inflation stays high, Republican sentiment will tick back down and  the public will be increasingly united in a negative view of the president’s economic management. If inflation peaks and rolls over, Democratic sentiment will recover as the election approaches and Republican sentiment will at least not get much worse. Chart 2Economic Sentiment Polarization In Decline For this reason Biden and the Democrats are rapidly pivoting away from Covid-19 and social restrictions and trying to create the “return to normalcy” that failed last year. While they were in the opposition they had an interest in hyping the virus but now they are the incumbents and it is important to show that the pandemic is in the rear-view mirror. With 64% of Americans now vaccinated, and 40% having received booster shots, government social restrictions are likely to become less stringent (Chart 3). The latest data from the service sector will motivate this policy pivot away from the virus. The manufacturing sector improved again last month but the non-manufacturing sector was less upbeat in January. Services activity declined by a whopping 12% in January. It is still above its November 2020 level, when Biden got elected, but only by around 2.2%. The non-manufacturing employment index declined by 4.3% and only stands 0.8% above its November 2020 level. The ratio of new orders to inventories declined by 0.6% in January (Chart 4). Chart 3Democrats To Pivot Away From Covid-19These statistics suggest that the non-manufacturing sector slowed down sharply in January, probably due to omicron and post-Christmas belt tightening. But employers did not let go of a lot of workers, as seen by the discrepancies between business activity and employment. The mostly positive jobs report reinforces this point. The weakness is seen as temporary and employers expect higher demand in coming months. Now that consumer durable spending is running out of steam (at least, excluding cars), consumers are likely to switch to consuming services, as long as services are open for them to consume. There is little reason to think restrictions will stay tight, given the political points cited above. Even in Europe the Covid “hawks” are loosening controls. Chart 4Democrats Want To Boost Service Sector All that being said, the Biden administration has limited ability to control inflation that emanates from foreign supply shocks (e.g. Asia, Russia, Iran). Also voter perceptions of inflation will lag, even if inflation starts to abate. Crime and immigration will also weigh on the administration this fall. And the political clockwork favoring the opposition in midterm elections is remorseless. Bottom Line: Biden and the Democrats are likely to shift policy focus away from emphasis on the pandemic, which weighs on the service sector and employment, and instead pursue other policy options in preparation for the midterm election. The outlook is not positive but if Biden’s approval rating bottoms then Democrats’ chances of performing better in the midterm elections will rise and policy uncertainty will also rise. Will GOP Infighting Affect The Midterms? Maybe In The Senate Former President Trump clashed with former Vice President Mike Pence and others in the Republican Party over whether Pence had the right “to change the Presidential Election results” in 2020 by refusing to validate electoral college votes from states in which electoral fraud was alleged. Pence called the idea “un-American” and reiterated his position that the vice president has no “unilateral authority” to discard a state’s electoral votes while certifying the electoral count.1 Trump lashed out because moderate Republicans are flirting with Democrats over how to pass a bipartisan revision to the Electoral Count Act of 1887, which left a number of ambiguities in the US electoral process, including about the vice president’s role in election certification. It is conceivable that the law will be revised in time for the 2024 election but odds are against a quick solution: the original law took 10 years to pass. Throughout the 2022-24 election cycle, Trump will continue to clash with his party, which raises the single greatest risk to Republicans: that they will be too divided to capitalize fully on the Democrats’ weaknesses. We do not expect Trump to coordinate effectively with Republicans. His interest in revolutionizing the political establishment and winning a second term in 2024 diverges from the interest of the traditional Republicans, who want to preserve the political establishment with themselves on top, and want a fresh face to contend for eight years in the White House in 2024. However, Trump controls a plurality of the party’s grassroots voters (about 54%2 according to opinion polls) so that the Republican Party cannot afford to spurn him. If Trump were willing to cooperate with party leaders, then he would have cooperated when it mattered most: ahead of the Georgia special elections on January 5, 2020. If he had recognized the constitutional supremacy of the electoral college vote, he might have saved Republican control of the Senate. He did not, so the burden of proof falls on those who say that Trump can coordinate effectively with the Republican Party at critical junctures. Most likely the party will continue to play both sides, keeping Trump in the party but seeking a post-Trump future. Trump will continue to pursue the Republican nomination in 2024 and the party will have to acquiesce to him as long as he retains the support of a majority of the party’s grassroots. Trump’s conflict with the party will flare up in the primary elections this spring because Trump will endorse his own favorite candidates regardless of whether the Republican establishment agrees and views them as the most likely to win. Any success of Trump-backed populists in the primaries may become a liability for Republicans in the general election if the seat is competitive and the Democrats put up a moderate candidate. This point is primarily relevant in the Senate: Five Senate Republicans are stepping down, leaving an open competition in Alabama, Missouri, North Carolina, Ohio, and Pennsylvania (Table 1). The last three of these (NC, OH, PA) are competitive seats, especially if the Republican candidate is weak and Biden’s approval revives by the time of the vote. Trump has only made an endorsement in North Carolina, where his candidate is far from assured to win. Given that control of the Senate could hang on a single seat, it is at least possible that Trump’s split with the GOP could affect the Senate balance of power in 2023-24. Table 1Senate Incumbents Not Seeking Re-Election, 2022 Trump will also have an impact on the House of Representatives but he is less likely to affect the outcome of the midterm there, given that Republicans are likely to win 40 seats when they only need five to take control. There are a lot more Democrats retiring from the House than Republicans in this cycle, a positive indication for Republicans (Chart 5). In total there are 48 competitive seats (13 Republican-leaning, 22 Democrat-leaning, and 13 toss-up).3 Of these 48 competitive seats, 12 seats are “open” (no incumbent), divided evenly among Republicans and Democrats. In most of these competitive seats, but especially in Democrat-leaning seats and toss-up seats, a Trump-backed Republican will have a harder time winning than a traditional Republican.  All ten Republicans who voted to impeach President Trump after the January 6 rebellion are vulnerable to Trump challengers (Table 2). Three are already retiring. Given that Wyoming Representative Liz Cheney won her seat by a 44% margin, and yet is polling poorly relative to her Trump-backed challenger, it is fair to say that all seven of the remaining Republican impeachers are vulnerable to a Trumpist challenge. Of these, the general election could be competitive in five seats, i.e. those held by John Katko (R, NY-24), David Valadao (R, CA-21), Peter Meijer (R, MI-3), Fred Upton (R, MI-6), and Jaime Herrera Beutler (R, WA-3). However, given that the national tide does not favor the Democrats, five seats is the maximum that Democrats could poach from this group of lawmakers due to Republican infighting (three is a more likely number).   Chart 5House Members Not Seeking Re-Election, 2022 Table 2House Republicans Who Voted To Impeach President Trump More broadly there are 21 moderate Republicans in the House whose seats could be vulnerable to intra-party struggle (Table 3): So far President Trump has only endorsed candidates in seats which Republicans are highly likely to win anyway: namely Beth Van Duyne (R, TX-24), Mario Diaz-Balart (R, FL-25), and Carlos Gimenez (R, FL-26). But as the primary heats up, Trump’s endorsements could cause more tension with the Republican Party machinery.  The following six moderate Republicans’ seats could be at risk: Maria Elvira Salazar (R, FL-27), Rodney Davis (R, IL-13), Jeff Van Drew (R, NJ-2), Andrew Garbarino (R, NY-2), Mike Turner (R, OH-10), and Brian Fitzpatrick (R, PA-1). Of these, Fitzpatrick and Garbarino do not face any challengers yet, and only Davis faces a Trump-backed challenger. So six is the maximum Democrats could steal while one-to-three vulnerable seats is more likely. Table 3Republican Moderates Vulnerable To Populist Challengers Summing up, the Republican Party could fail to retain three-to-nine Republican seats that they might otherwise win in this cycle. Previously we put the number at five-to-nine seats.   These numbers do not include any Democratic-leaning seats that Republicans could fail to poach if they choose a populist candidate who is not competitive in a “purple” state or district. In conclusion, Republican infighting will not prevent Republicans from retaking the House of Representatives this fall. Cyclical factors in favor of Republicans will overwhelm their internal differences. But infighting could leave them with a smaller majority than consensus expects. In 2024 Republican internal divisions will become much more important than in 2022. A competitive Republican primary election for president will reduce Republican odds in the general election. If President Trump fails to win the nomination, he could defect and form his party. If he wins the nomination, Liz Cheney or another traditional Republican could defect and run as a third party, acting as a spoiler. Given the tight margins of victory in presidential elections, even a splinter group could steal enough votes to determine the outcome. The midterms will shed light on the depth of GOP divisions but in general these divisions reinforce our view that while Democrats will perform poorly in the midterms, they are still favored to retain the White House in 2024. Bottom Line: While the odds are stacked against Democrats in the midterms, Republican infighting could affect several Senate seats and will subtract anywhere from three-to-nine seats from expected seat gains in the House. While control of the House will not be affected, it is conceivable that control of the Senate could hang in the balance. Policy uncertainty will rise if Republican infighting makes Senate races more competitive later this year. Housekeeping To conclude we offer a few remarks on our outstanding investment recommendations: Cyclically Long Energy Small Caps: US energy production is rising in keeping with global oil and commodity prices. West Texas Intermediate crude sells for $89 per barrel on the spot market, inventories are drawing, OPEC 2.0 is intact, and there are plenty of supply risks on the horizon. American natural gas exports are picking up but not enough to meet demand if conflict in Ukraine causes a European shortage, while US oil exports are falling (Chart 6). Chart 6US Energy Production Picking Up Evidence from initial unemployment claims in O&G-dependent states like North Dakota and Wyoming suggests that shale producers need more time to ramp up production (Chart 7), as highlighted by our Commodity Strategist Bob Ryan.  Small cap energy stocks have not benefited much from the sharp spike in energy prices this year. We see this as an opportunity, given that US small caps are insulated from geopolitical troubles and will become key players if shortages occur (Chart 8). The risk comes if the supply response overwhelms the supply disruptions, as occurred in 2014 – but oil companies were in a much better position to surge production at that time. The 2015 nuclear deal with Iran also appeared more durable at that time than it will this year if it is rejoined, and there is no guarantee it will be rejoined. Cyclically Long Infrastructure Stocks: Infrastructure stocks peaked along with the equity market and in the wake of the Biden administration’s $550 billion Infrastructure Investment and Jobs Act, which is now being implemented. Indicators of infrastructure construction peaked in late 2020 and early 2021 and are slipping of late. But as long as the economy does not relapse into recession they should stabilize, especially as the virus wanes and global demand recovers (Chart 9). Cyclically Long Cyber-Security Stocks: Global threats, proxied by the Canadian dollar’s exchange rate with the Russian ruble, suggest that cyber security stocks will rebound after getting caught up in the current tech selloff (Chart 10). Tech stocks are also likely to bounce if inflation expectations peak as the Federal Reserve kicks into action.     Chart 7It Takes Time To Boost Shale Output Chart 8US Small Caps Yet To Benefit From Oil Price Chart 9Buy The Dip In Infrastructure Stocks Chart 10Cyber Stocks A 'Buy' In Tech Selloff Investment Takeaways Chart 11A Floor In Biden’s Approval? US financial markets do not care about the midterm elections in the near term but that will change as policy uncertainty will rise over the course of the year. A bottom in Biden’s approval rating (Chart 11) and Republican primary election infighting both suggest that the Democratic Party’s odds in the midterms will improve going forward, raising policy uncertainty, especially over the Senate. Midterm uncertainty typically works in favor of the US dollar, Treasuries, defensive equity sectors, and growth stocks. As such it poses a risk to current market trends. The recent selloff in Big Tech confirms what we have argued since we launched the US Political Strategy: the tech sector faces a slow boil from inflation and rising interest, which are more immediate threats than government regulation. Having said that, we favor growth versus value on a tactical basis as we expect the dollar to rise and Treasury yields to fall on the back of geopolitical risks in the near term (Chart 12).  Chart 12A Tactical Bounce For Tech Stocks?   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com   Footnotes 1     See Vice President Michael R. Pence’s letter, dated January 6, 2021, available at “Read Pence’s full letter saying he can’t claim ‘unilateral authority’ to reject electoral votes,” PBS, pbs.org. See also Mychael Schnell, “Trump says he wanted Pence to overturn election, eyes effort to reform law,” January 31, 2022, and Brett Samuels, “Pence breaks with Trump: ‘I had no right to overturn the election,’” February 4, 2022, thehill.com. 2     Please see “Over half of Americans believe the country's economy is headed in the wrong direction,” Ipsos, December 29, 2021, Ipsos.com 3    See Cook Political Report, “2022 House Race Ratings,” February 8, 2022, cookpolitical.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Executive Summary Macroeconomic Backdrop Favors Defensive Consumer Staples Markets now expect five-to-six rate hikes in 2022  The rate of change in rates as opposed to their level has triggered the fast and furious repricing of long-duration assets.  However, rising rates are a temporary headwind to equities The repricing of the equity market came through the P/E as opposed to the “E” Demand is clearly shifting from goods to services. Supply disruptions are clearing Earnings were strong, but investors expected more We are upgrading Consumer Staples, which is a “deep” defensive sector that offers downside protection in an environment of heightened volatility and slowing economic growth   Bottom Line: While it is impossible to time the market, we believe that the worst is behind us. US equities are outright oversold, and valuations are much more reasonable. However, we recommend investors be cautious in sector selection: For now, stay away from Tech, and add to Consumer Staples to reduce portfolio volatility. Feature Performance Hit Undo 2021 January had a nasty shock in store for equity investors: At the lowest point, the S&P 500 was down 12% from its peak, and NASDAQ was down 20%, officially entering correction territory. January market moves were a partial reversal of the 2021 gains (Chart 1A), with some of the hottest investment themes, such as clean energy, fintech, and Cathie Wood's innovation ETFs hit the hardest (Chart 1B). Investors were rushing to monetize their super-charged gains before the Fed starts draining liquidity off the market. Chart 1APerformance: Sectors And Styles Chart 1BPerformance: Investment Themes Post-Mortem A post-mortem of the sell-off shows that the stocks that have pulled back most, were trading at extended valuations and had long duration, i.e., companies that are not very profitable now but expect to grow earnings at a robust pace far into the future. These companies are akin to lottery tickets – a small payment now may result in a low-probability event of a high gain in the future. Small-cap growth stocks are down 30% from their peak. Over time, the sell-off of small-cap growth has spread to other areas of the market and has hit all sectors but Energy, almost indiscriminately. Overall, the S&P 500's multiple has contracted by over 10% (Chart 1C). Chart 1CJanuary Correction Was Down To Multiple Contraction Valuations And Technicals Pullbacks are responsible for equity market hygiene, cleansing the market of overextended valuations, taking the froth off the names that got ahead of themselves, and offering a reset for a new leg of upward moves, fueled by inflows into oversold names and cash deployed by new market entrants. Forward multiples of the S&P 500 have come down from 21.7x to a more reasonable 19.5x (Chart 2A). Now, 8 out of the 11 sectors have a forward PE below 20x (Chart 2B). Chart 2AMultiples Have Come Down A lot From The Peak Chart 2BValuations Moderated Across All Sectors But Energy By many technical metrics, such as the bull/bear ratio (Chart 2C), market breadth, and RSI, the market appears oversold. Many investors may consider this a good entry point. Chart 2CRetail Investors Have Capitulated Macroeconomic Backdrop Six Is The New Four This correction was triggered by a market surprised by the grave tone of Fed officials, acknowledging their concern about the intransigent, as opposed to transient, inflation. While monetary tightening has been on the cards for a while now, what a difference a month makes! In December, the market was pricing in three rate hikes in 2022, while currently, the probability of five rate hikes stands at over 90%, and of six rate hikes at over 80% (Chart 3A). The 10-year Treasury yield moved from 1.5% at the end of December to 1.87% at its January peak. It is important to note that monetary policy is still easy and it was the rate of change in rates as opposed to their level that triggered the fast and furious repricing of long-duration assets. Chart 3AInvestors Expect Five-To-Six Hikes In 2022 Is Monetary Tightening A Death Knell For US Equities? Historically, equities wobbled two-to-three months prior to the first rate hike, and then took a breather for another couple of months for the dust to settle (Chart 3B). January and now February volatility and pullbacks are textbook behavior of equities at the cusp of a new monetary regime. However, in three of the four tightening cycles since 1990, the stock market was higher a year later. The same is true for long-term rates: In all but one of the episodes of a sharp rise in the 10-year Treasury yield since 1990, the stock market rose (Table 1). Chart 3BEquities Wobble Around The First Rate Hike Table 1Equity Performance Around Periods Of Rising Treasury Yields Economic Growth: Supply (Finally) Meets Demand Of course, the best antidote to higher rates is strong economic growth. So far, everything is in order on that front, with economists projecting solid 2022 nominal GDP growth of around 7.6%. Economic growth is slowing but off high levels. At last, global supply chains are gradually unclogging, and shipping bottlenecks are starting to clear. Even automakers are now saying that auto chips are becoming more readily available. However, part of the reason that supply and demand are getting closer to each other is that demand for goods is waning, dampened by both saturation and higher costs. The latest ISM PMI reading shows that both new orders and the backlog of orders are falling (Chart 4, top panel). Prices paid have also turned, heralding that the worst of price increases may be behind us (Chart 4, bottom panel). Will this contain inflation enough to appease the Fed? Possible, but not highly likely. Chart 4Demand Is Weakening Earnings: Good But Not Good Enough With economic growth slowing, earnings and sales growth are also rolling over (Chart 5A). As investors are trying to decipher the state of the American economy, they are increasingly focused on corporate guidance. So far 12 companies offered positive guidance vs 28 with negative guidance. The Negative/Positive ratio for Q4-2021 currently stands at 2.3, compared to 0.8 in the prior four quarters. Price action in response to projected lower growth has been brutal. And while 78% of companies have beaten earnings expectations, this is a smaller share than during the other pandemic recovery quarters. The magnitude of the earnings surprise has also fallen (Chart 5B). Chart 5AEarnings And Sales Growth Are Slowing Chart 5BThe Magnitude Of Earnings Surprises Has Fallen This earnings season has also seen some of the largest moves on the back of companies’ reports. Positive surprises by Google, Microsoft, and Amazon have soothed investors' fears and led to broad-based next-day rallies, while skimpy results from PayPal and Meta, not only have sent these companies down more than 20%, erasing billions in market capitalization, but also have dragged down their nearest competitors (Square, Snap, etc.). Also, many companies are complaining about rising input and labor costs cutting into their profitability. This is hardly a surprise. According to our analysis of the NIPA accounts, in the US labor costs constitute 55% of sales. With wages rising at the fastest pace in years, their effect on corporate profitability can be meaningful (Chart 6A). To make things worse, input costs are also soaring – the latest PPI reading is 9.7%. Chart 6AMargins Are Contracting As... However, companies are more and more constrained in their ability to pass on their cost increases to customers, although the elasticity of demand varies across industries. Many companies can no longer afford to raise prices without suppressing demand for their products. Corporate pricing power has turned decisively lower (Chart 6B). As a result, profit margins have contracted across all sectors, except Energy. Bottom-line – earnings are good so far, but they have failed to allay investor fears of waning profitability. Chart 6B...Corporate Pricing Power Is Declining Sector Positioning Revenge Of The Nerds – Be Granular While we believe that equities are poised for another leg up, as economic growth remains strong and corporate earnings are decent, we recommend that investors be granular in their sector selection: Avoid areas most adversely affected by a tighter monetary regime and slowing growth. Per our previous analysis, we recommend underweighting the Technology sector on a tactical basis, but within Tech, stay overweight more defensive Software and IT Services. We also like Banks and Insurers that benefit from rising rates and prefer Value and Small over Growth. We are also constructive on Industrials, which are the primary beneficiaries of the new Capex cycle and the US industrial renaissance. Consumer Services Are Finally Rebounding In the meantime, with Omicron finally receding, consumer spending is shifting from consumer goods to services (Chart 7A). Consumers are flush with cash, and still have $2.2 trillion in their coffers. We have been overweight the Travel complex (Hotels, Restaurants, Cruises) since October. However, performance was derailed in the late fall as many consumers chose to stay at home and wait for the variant to pass. Also, many of the industries in the Travel complex have been challenged by the sheer number of staff quarantining or on sick leave. We upgraded Airlines at the beginning of January and remain optimistic about the outperformance of the Consumer Services sector. Upgrading Consumer Staples We are also upgrading Consumer Staples, which is a “deep” defensive that offers downside protection in an environment of heightened volatility and slowing economic growth (Chart 7B). Moreover, consumer confidence is down as Americans are disheartened by prices in the supermarket and at the gas station. However, demand for consumer staples is inelastic and should be inflation-proof. The sector is trading at 21x forward multiples and is expected to grow earnings at 6% over the next 12 months, bettering the S&P 500. Chart 7AWaning Demand For Goods Is Replaced By Demand For Services Chart 7BMacroeconomic Backdrop Favors Defensive Consumer Staples Investment Implications The market correction is still running its course, and while it is impossible to time the market, we believe that the worst is behind us. US equities are outright oversold, and valuations are much more reasonable. Rising rates are a temporary headwind. However, we recommend investors be cautious in sector selection: For now, stay away from Tech, and add to Consumer Staples to reduce portfolio volatility.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     S&P 500  Chart 8Macroeconomic Backdrop Chart 9Profitability Chart 10Valuations And Technicals Chart 11Uses Of Cash Communication Services Chart 12Macroeconomic Backdrop Chart 13Profitability Chart 14Valuations And Technicals Chart 15Uses Of Cash Consumer Discretionary Chart 16Macroeconomic Backdrop Chart 17Profitability Chart 18Valuations And Technicals Chart 19Uses Of Cash Consumer Staples Chart 20Macroeconomic Backdrop Chart 21Profitability Chart 22Valuations And Technicals Chart 23Uses Of Cash Energy Chart 24Macroeconomic Backdrop Chart 25Profitability Chart 26Valuations And Technicals Chart 27Uses Of Cash Financials Chart 28Macroeconomic Backdrop Chart 29Profitability Chart 30Valuations And Technicals Chart 31Uses Of Cash Health Care Chart 32Sector vs Industry Groups Chart 33Profitability Chart 34Valuations And Technicals Chart 35Uses Of Cash Industrials Chart 36Macroeconomic Backdrop Chart 37Profitability Chart 38Valuations And Technicals Chart 39Uses Of Cash Information Technology Chart 40Macroeconomic Backdrop Chart 41Profitability Chart 42Valuations And Technicals Chart 43Uses Of Cash Materials Chart 44Macroeconomic Backdrop Chart 45Profitability Chart 46Valuations And Technicals Chart 47Uses Of Cash Real Estate Chart 48Macroeconomic Backdrop Chart 49Profitability Chart 50Valuations And Technicals Chart 51Uses Of Cash Utilities Chart 52Macroeconomic Backdrop Chart 53Profitability Chart 54Valuations And Technicals Chart 55Uses Of Cash Recommended Allocation Footnotes

Executive Summary Inflation has broken out to 40-plus-year highs in the US and is rapidly becoming a pressing issue for major central banks around the world. Financial markets are vulnerable to upside inflation surprises, which could induce the Fed and its peers to pursue markedly less friendly monetary policy. Despite the ongoing surge in consumer and producer prices, longer-term inflation expectations remain firmly anchored at low levels. Surveys and market prices betray no concern about a lasting inflection. We have ticked a majority of the boxes on our inflation checklist, but we will remain constructive on risk assets as long as inflation expectations remain well-behaved. Long-Run Inflation Expectations Are Well Anchored Bottom Line: The Fed will only slam on the brakes if long-run inflation expectations break out, opening the door to a vicious circle in which inflation begets inflation. Risk assets will outperform this year unless expectations become unmoored. Feature We will be holding our quarterly webcasts next Monday, February 14, for clients in EMEA and the Americas and Tuesday, February 15, for Asia-Pacific clients in lieu of publishing a Weekly Report. Please join us with your questions to make it a fully interactive event. We will resume our regular publication schedule on the 21. Chart 1Inflation And The Fed Have Markets On Edge When we assembled our inflation checklist last May, the future path of consumer prices was still quite uncertain. At the time, the drivers of elevated inflation readings were concentrated in categories that had suffered the worst pandemic disruptions, like air fares, hotels, new cars, used cars, rental cars and auto insurance, and it was unclear how much upward price pressures would spread more broadly across the economy. Delta and Omicron had yet to worsen existing supply chain tangles. While inflation was sure to exceed its post-crisis levels for an extended period, it was not at all clear that it would do so by a significant margin. Now that inflation has broken out to Volcker-era highs, investors’ focus is squarely on the Fed’s response. Fears that inflation would prompt the Fed to tighten policy more and faster than previously expected underpinned the selling spasm that stretched across the last two full weeks of January (Chart 1). The equity market had moved on from the Fed outlook before Friday’s employment report pushed the 10-year yield to a new pandemic high, but it promises to be a recurring theme until the impending rate hike cycle is complete. Turning to our checklist, we contend that inflation expectations hold the key to the Fed’s reaction and that they continue to hold fast as a bulwark against the Fed adopting a war footing that would torpedo financial markets and the economy. Making A List (And Checking It Seven Times) It doesn’t take a certified market technician to confirm that inflation has broken out (Chart 2). It doesn’t take our checklist, either, though we’ve now checked seven of its twelve boxes (Table 1). Its purpose wasn’t to replace what investors could see with their own eyes but rather to augment it with a framework for assessing future inflation moves and their impact on monetary policy settings. We do not expect that the FOMC will bring the party to an abrupt end while investors, businesses and consumers remain untroubled about long-run inflation. Chart 2Breakout Table 1Inflation Checklist Though we think the Inflation Expectations boxes are the key, we make a full tour through the checklist to spotlight the data behind each line. We have ticked the Labor Supply/Utilization box, despite the still-low labor force participation rate (Chart 3, top panel) because the evidence suggests it is not going to return to its pre-pandemic level any time soon. The prime age employment-to-population ratio has made much more steady progress and is back within the range of the last three expansions, suggesting that the economy has returned to full employment with the exception of industries hit hardest by the pandemic1 (Chart 3, bottom panel). Chart 3The Economy Is Closing In On Full Employment ... Labor demand continues to soar, with nearly half of all respondents to the NFIB survey indicating that they have unfilled job openings and the Department of Labor’s job openings rate routinely setting new records (Chart 4). The combination of roaring demand and limited supply would seem to be a recipe for salary and wage growth, but it still hasn't come to pass. Though the main wage series have all picked up in nominal terms (Chart 5), the supply/demand imbalance has yet to produce compensation increases that can outpace inflation (Chart 6). Rampant concerns that wage gains will drag on corporate profit margins have yet to materialize and we leave the wage box unchecked. Chart 4... And Demand For Workers Is Still Exploding Chart 5Nominal Wage Gains Look Large, ...​​​​​​ Chart 6... But They're Lagging Inflation​​​​​​ The breakouts in the marquee core CPI (Chart 7, top panel) and PCE (Chart 7, bottom panel) indexes have captured a lot of attention, but their trimmed-mean measures have quietly overtopped their longstanding ranges as well. The trimmed-mean series, which throw out the outliers at both ends of the distribution, supported the transitory view last summer but are now confirming that the underlying pace of consumer price increases has materially quickened. Chart 7It's Not Just About The Outliers Anymore As for future inflation, our pipeline inflation indicator has eased over the last few months (Chart 8, top panel), but remains elevated and the preponderance of other cost pressure evidence keeps us from unchecking its box. Dollar strength has helped to guard against imported inflation pressures (Chart 8, bottom panel). They have been tame so far, but with inflation breaking out in Europe (Chart 9, top panel) and just about every major economy except China (Chart 9, bottom panel), rising import costs are likely to add some inflation momentum at the margin. Chart 8The Dollar's Tailwind Has Been An Inflation Headwind, ... Chart 9... But Inflation's Become A Problem Everywhere But China The Levees Are Holding Firm Although we checked six of the first eight boxes, we maintain a sanguine view about inflation’s impact on monetary policy and financial markets. Some of the boxes are more equal than others, and if we had to pick just one indicator to determine whether inflation will compel the Fed to take stern action, it would be the shape of the inflation expectations curve. Inflation begins to beget inflation when economic actors – workers, businesses, consumers and lenders – begin to expect it will linger into the future and change their behavior to align with their expectations. When inflation is expected to remain persistently high over the long term, individual workers or their unions insist on higher wages to maintain purchasing power, businesses at all points of the supply chain demand higher prices to protect their margins, consumers accelerate their big-ticket purchase decisions to get the most bang for their buck and lenders require higher nominal pro forma returns. The resulting feedback loops help inflation become entrenched in the same way that expectations of falling prices have paved the way for a deflationary mindset to grip Japan. Despite all the attention that rising prices have drawn, investors (Table 2) and households (Chart 10) continue to expect inflation to decelerate from the short term to the intermediate term, and again from the intermediate term to the long term. As long as economic actors are unconcerned about the longer-term picture, the Fed will be able to remove accommodation at a deliberate pace that will not pull the rug out from under financial markets. Table 2These Inverted Curves ... Chart 10... Are Good Omens To that end, the FOMC has heretofore limited itself to open mouth operations. Chair Powell may have talked tough at last month’s post-meeting press conference, but the committee passed on the chance to terminate the asset purchase program early. A rate hike is all but assured at the next meeting in mid-March and Powell indicated that investors should expect the Fed to move faster than the 25-basis-points(bps)-every-other-meeting pace of the last tightening cycle, but our US Bond Strategy team is inclined to bet the under on the money market’s 125-bps full-year expectation. We have checked the commentary box but are not going to check the dots box ahead of the March meeting’s update. It is further possible that the Fed’s expressed concerns about inflation will reduce the need for it to take action to combat it. We have previously cited our Global Fixed Income Strategy colleagues’ view that investors need only worry about inflation when central banks don't. One-year inflation expectations have come down considerably and intermediate- and long-term expectations have eased since late November (Chart 11), when Omicron’s emergence and the Fed’s hawkish pivot stirred concern. Omicron caused less supply-side disruption than initially feared and markets have relaxed a little now that the inflation cop is once again walking the beat. Chart 11Long-Term Expectations Stay Put, No Matter What Happens At The Short End Investment Implications Ever since the year began, we have stressed the point that tighter policy is not necessarily tight policy. Economic and market inflection points are conditioned upon the level of the fed funds rate, not its direction. Restrictive monetary policy settings are not yet in sight and we doubt that they will emerge in time to shadow risk assets’ 2022 prospects. We like the tighter-does-not-equal-tight formulation, but it obscures an important nuance. Strictly speaking, the Fed is not tightening monetary policy when it tapers its monthly asset purchases – it’s merely dialing down the level of monetary accommodation. Similarly, raising the target fed funds rate from an emergency range of 0 to ¼% two years after COVID reached the US and several months after it ceased to be an acute threat merely reduces the level of monetary stimulus. Even if the FOMC does deliver 125 bps of hikes by year end, lifting the funds rate to 1⅜%, it will still be egging on the economy because no one believes the neutral rate is 1⅜% or lower. Removing accommodation is more like easing up on the gas than squeezing the brakes. As long as inflation doesn’t scare economic participants, causing their longer-run inflation expectations to become unmoored, the Fed will be able to reduce monetary stimulus in an incremental fashion akin to applying less pressure to the gas pedal. That does not mean investors can forget about the Fed; we expect policy scares will roil financial markets off and on throughout the rest of the year. Ultimately, though, we think the elevated volatility will prove unfounded as our base case is that the Fed will not have to slam on the brakes. The steeply downward sloping inflation expectations curve suggests that it will take a lot for expectations to reset but we will be keeping an eye on it nonetheless, because uncomfortably high inflation, and the Fed’s eagerness to counter it, remains the biggest risk to our view.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      Per the January Employment Situation Report, Leisure and Hospitality now accounts for nearly 60% of nonfarm payroll and 97% of private sector service employment losses since February 2020.

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The golden rule for investing in the stock market simply states: “Stay bullish on stocks unless you have good reason to think that a recession is imminent.” The catch, of course, is that it is difficult to know whether a recession is lurking around the corner. Still, we can learn a lot from past recessions. As we document in this week’s report, every major downturn was caused by the buildup of imbalances within the economy, which were then laid bare by some sort of catalyst, usually monetary tightening. Today, the US is neither suffering from an overhang of capital spending, as it did in the lead-up to the 2001 recession, nor an overhang of housing, as it did in the lead-up to the Great Recession. US inflation has risen, but unlike in the early 1980s, long-term inflation expectations remain well anchored. This gives the Fed scope to tighten monetary policy in a gradual manner. Outside the US, vulnerabilities are more pronounced, especially in China where the property market is weakening, and debt levels stand at exceptionally high levels. Fortunately, the Chinese government has enough tools to keep the economy afloat, at least for the time being. Equity Bear Markets And Recessions Go Hand In Hand Bottom Line: Equity bear markets rarely occur outside of recessions. With global growth set to remain above trend at least for the next 12 months, investors should continue to overweight equities. However, they should underweight the tech sector since tech stocks remain disproportionately vulnerable to rising rates, increased regulation, and a retrenchment in pandemic-induced spending on electronics and online services. Macro Matters Investors tend to underestimate the importance of macroeconomics for stock market outcomes. That is a pity. Charts 1, 2, and 3 show that the business cycle drives the evolution of corporate earnings; corporate earnings, in turn, drive the stock market; and as a result, the business cycle determines the path for stock prices. Chart 1The Business Cycle Drives Earnings… Chart 2…Earnings In Turn Drive Stock Prices… An appreciation of macro forces leads to our golden rule for investing in the stock market. It simply states: Stay bullish on stocks unless you have good reason to think that a recession is imminent. Chart 3…Hence, The Business Cycle Is The Main Driver Of Equity Returns Historically, stocks have peaked about six months before the onset of a recession. Thus, it usually does not pay to turn bearish on stocks if you expect the economy to grow for at least another 12 months. In fact, aside from the brief but violent 1987 stock market crash, during the past 50 years, the S&P 500 has never fallen by more than 20% outside of a recessionary environment (Chart 4). Peering Around The Corner The catch, of course, is that it is difficult to know whether a recession is lurking around the corner. Leo Tolstoy began his novel Anna Karenina with the words “Happy families are all alike; every unhappy family is unhappy in its own way.” By the same token, every economic boom seems the same, whereas every recession has its own unique features. This makes forecasting recessions difficult. Difficult, but not impossible. Even though recessions differ substantially in their magnitude and causes, they all share the following three characteristics: 1) The buildup of imbalances that make the economy vulnerable to a downturn; 2) A catalyst that exposes these imbalances; and 3) Amplifiers or dampeners that either exacerbate or mitigate the slump. Let us review six past recessions to better understand what these three characteristics reveal about the current state of the global economy. Chart 4Equity Bear Markets And Recessions Go Hand In Hand The 1980 And 1982 Recessions The double-dip recessions of 1980 and 1982 were the last in which inflation played a starring role. Throughout the 1970s, the Fed consistently overstated the degree of slack in the economy (Chart 5). This led to a prolonged period in which interest rates stayed below their equilibrium level. The resulting upward pressure on inflation from an overheated economy was compounded by a series of oil shocks, the last of which occurred in 1979 following the Iranian revolution. Chart 6The Volcker Era: It Took Massive Monetary Tightening To Bring Down Inflation Chart 5The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s In an effort to break the back of inflation, newly appointed Fed chair Paul Volcker raised rates, first to 17% in April 1980, and then following a brief interlude in which the effective fed funds rate dropped back to 9%, to a peak of 19% in July 1981 (Chart 6).   The 1990-91 Recession Overheating also contributed to the early 1990s recession. After reaching a high of 10.8% in 1982, the unemployment rate fell to 5% in 1989, about one percentage point below its equilibrium level at that time. Core inflation began to accelerate, reaching 5.5% by August 1990. The Fed initially responded to the overheating economy by hiking interest rates. The fed funds rate rose from 6.6% in March 1988 to a high of 9.8% by May 1989. By the summer of 1990, the economy had already slowed significantly. Commercial real estate, still reeling from the effects of the Savings and Loan crisis, weakened sharply. Defense outlays continued to contract following the collapse of the Soviet Union. The final straw was Saddam Hussein’s invasion of Kuwait, which caused oil prices to surge and consumer confidence to plunge (Chart 7).   The 2001 Recession An overhang of IT equipment sowed the seeds of the 2001 recession. Spending on telecommunications equipment rose almost three-fold over the course of the 1990s, which helped lift overall nonresidential capital spending from 11.2% of GDP in 1992 to 14.7% in 2000 (Chart 8). Chart 7Overheating In The Leadup To The 1990-91 Recession The recession itself was fairly mild. After subsequent revisions to the data, growth turned negative for just one quarter, in Q3 of 2001. However, due to the lopsided influence of the tech sector in aggregate profits – and even more so, in market capitalization – the dotcom bust had a major impact on equity prices (Chart 9). Chart 9The Dotcom Bust Dragged Down Tech Earnings Chart 8A Glut Of I.T. Equipment Sowed The Seeds Of The 2001 Recession Having raised rates to 6.5% in May 2000, the Fed responded to the downturn by easing monetary policy. Falling rates were effective in reviving the economy – indeed, perhaps too effective. The resulting housing boom paved the way for the Great Recession.   The Great Recession (2007-2009) The housing sector was the source of imbalances in the lead-up to the Great Recession. In the US, and in other countries such as Spain and Ireland, house prices soared as lenders doled out credit on increasingly lenient terms. Chart 10A Long House Party Rising house prices stoked a consumption boom and incentivized developers to build more homes. In the US, the personal savings rate fell to historic lows. Residential investment reached a high of 6.7% of GDP, up from an average of 4.3% of GDP in the 1990s (Chart 10). While the housing bubble would have burst at some point anyway, tighter monetary policy helped expedite the downturn. Starting in June 2004, the Fed raised rates 17 times, pushing the fed funds rate to 5.25% by June 2006. The ECB also hiked rates; it raised the refi rate from 2% in December 2005 to 4.25% in July 2008, continuing to tighten policy even after the Fed had begun to cut rates. Once global growth started to weaken, a number of accelerants kicked in. As is the case in every recession, rising unemployment led to less spending, which in turn led to even higher unemployment. To make matters worse, a vicious circle engulfed the housing market. Falling home prices eroded the collateral underlying mortgage loans, producing more defaults, tighter lending standards, and even lower home prices. The Fed responded to the crisis by cutting rates and introducing an alphabet soup of programs to support the financial system. However, the zero lower-bound constraint limited the degree to which the Fed could cut rates, forcing it to resort to unorthodox measures such as quantitative easing. While these measures arguably helped, they fell short of what was needed to resuscitate the economy. Fiscal policy could have picked up the slack, but political considerations limited the scale and scope of the 2009 Recovery Act. The result was a needlessly long and drawn-out recovery.   The Euro Crisis (2012) Chart 11The State Is Here To Mop Up The Mess A reoccurring theme in economic history is that financial crises often force governments to assume private-sector liabilities in order to avoid a full-scale economic collapse. Unlike Greece, where government debt stood at very high levels even before the GFC, debt levels in Spain and Ireland were quite modest before the crisis. However, all that changed when Spain and Ireland were forced to bail out their banks (Chart 11). Unlike the US, UK, and Japan, euro area member governments did not have access to central banks that could serve as buyers of last resort for their debts. This limitation created a feedback loop where rising bond yields made it more onerous for governments to service their debts, which led to a higher perceived likelihood of default and even higher yields (Chart 12). Chart 12Multiple Equilibria In The Debt Market Are Possible Without A Lender Of Last Resort The ECB could have short-circuited this vicious cycle. Unfortunately, under the hapless leadership of Jean-Claude Trichet, instead of providing assistance, the central bank raised rates twice in 2011. This helped spread the crisis to Italy and other parts of core Europe. It ultimately took Mario Draghi’s “whatever it takes pledge” to restore some semblance of normality to European sovereign debt markets. Lessons For Today The current environment bears some resemblance to the one preceding the recessions of the early 1980s. As was the case back then, inflation today has surged well above the Federal Reserve’s target, forcing the Fed to turn more hawkish. Oil prices have also risen, despite slowing global growth. Even Russia has returned to its status as the world’s leading geopolitical boogeyman. Yet, digging below the surface, there is a big difference between today and the early ‘80s. For one thing, long-term inflation expectations remain well anchored. While expected inflation 5-to-10 years out has risen to 3.1% in the latest University of Michigan survey, this just takes the reading back to where it was not long after the Great Recession. It is still nowhere near the double-digit levels reached in the early ‘80s (Chart 13). Market-based inflation expectations are even more subdued. In fact, the widely watched 5-year/5-year forward TIPS breakeven inflation rate is currently well below the Fed’s comfort zone (Chart 14). Chart 13Long-Term Inflation Expectations Are Inching Up But Are Still Low Chart 14Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Higher oil prices are unlikely to have the sting that they once did. The energy intensity of the global economy has fallen steadily over time, especially in advanced economies (Chart 15). Today, the US generates three-times as much output for every joule of energy consumed than it did in 1970. Household spending on energy has declined from a peak of 8.3% of disposable income in 1980 to 3.8% in December 2021. The US also produces over 11 million barrels of oil per day, more than Saudi Arabia (Chart 16). Chart 15The Global Economy Has Become Less Energy Intensive Over Time Chart 16When It Comes To Energy Production, The USA Is Now #1 Unlike in the late 1990s, advanced economies do not face a significant capex overhang. Quite the contrary. Capital spending has been fairly weak across much of the OECD. In the US, the average age of the nonresidential capital stock has risen to the highest level since the 1960s (Chart 17). Looking out, far from cratering, capital spending is set to rise, as foreshadowed by the jump in core capital goods orders (Chart 18). Chart 17The Aging Capital Stock Chart 18The Outlook For US Capex Is Bright Chart 19Need More Houses In contrast to the glut of housing that helped precipitate the Global Financial Crisis, housing remains in short supply in many developed economies. In the US, the homeowner vacancy rate has fallen to a record low. There are currently half as many new homes available for sale as there were in early 2020 (Chart 19). Even in Canada, where homebuilding has held up well, government officials have been hitting the panic button over a brewing home shortage.   The Biggest Risk Is Debt The biggest macroeconomic risk the global economy faces stems from high debt levels. While household debt has fallen by 20% of GDP in the US, it has risen in a number of other economies. Corporate debt has generally increased everywhere, in many cases to finance share buybacks and M&A activity (Chart 20). Public debt has also soared to the highest levels since during World War II. Chart 20Mo' Debt Among emerging markets, China’s debt burden is especially pronounced. Total private and public debt reached 285% of GDP in 2021, nearly double what it was in early 2008. The property market is also slowing, which will weigh on growth. Like many countries, China finds itself in a paradoxical situation: Any effort to pare back debt is likely to crush nominal GDP by so much that the debt-to-GDP ratio rises rather than falls. Ironically, the only solution is to adopt reflationary policies that allow the economy to run hot. In the near term, this could prove to be a favorable outcome for investors since it will mean that monetary policy stays highly accommodative. Over the long haul, however, it may lead to a stagflationary environment, which would be detrimental to equities and other risk assets. In summary, investors should remain overweight stocks for now. However, they should underweight the tech sector since tech stocks remain disproportionately vulnerable to rising rates, increased regulation, and a retrenchment in pandemic-induced spending on electronics and online services.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The US midterm elections will bring another round of intense polarization and policy uncertainty this year, though the overall stock market today appears well prepared for the most likely result: a GOP victory in House and Senate. Yet our quantitative Senate election model is “too close to call.” It expects Democrats to retain 50 seats in the Senate and hence the thinnest possible majority. We doubt it, subjectively, but the important point is that the Senate will be stymied either way. Indeed, the only way investors could truly be surprised would be if Democrats made a comeback and retained control of both chambers, but this outcome is very unlikely.  Voters make up their minds early in the year during midterm elections, so Democrats may not benefit from any softening of inflation later this year. Still, gridlock ensures that domestic policy uncertainty will rise as well as foreign policy uncertainty. The  dollar will be resilient, favoring a tactically defensive positioning. Quant Model For US Senate Election Bottom Line: While we expect Republicans to win both the House and the Senate in 2022, our quant model says the Senate is too close to call. Value has bottomed on a structural time frame but the coming months will be challenging and we recommend growth stocks tactically. Feature This report updates our quantitative models for the 2022 Senate and 2024 presidential elections (Chart of the Week). As always, we use the quantitative modeling as a complement to our qualitative analysis. Formal modeling helps to question our assumptions and views. It is not a substitute for empirical analysis and good judgment, whether in economics or politics. Our qualitative analysis utilizes the geopolitical method, a method based on realist political theory, in which we analyze the concrete checks and balances (constraints) that prevent policymakers from achieving their objectives. We then assign scenario probabilities and compare with BCA Research macro and market views to identify investment risks and opportunities. Advantage Republicans In Midterm Elections Our base case for the midterm election is a Republican victory in both the House of Representatives and the Senate. This outlook is consensus in online betting odds (Chart 1). However, the consensus may be underestimating the Democrats in the Senate election. The Senate is still in play and that is where investors should focus this year. However, the only true risk to expectations would be Democrats keeping the House and Senate. Every other scenario involves different shades of gridlock. Democrats can only hold onto both chambers if a shock event occurs that massively upsets expectations. Such a shock would have to be devastating for the Republicans, as it would go against long-established political cycles and current trends. The implication would be a rare chance to pass major legislation on partisan lines: corporate tax hikes and social programs cut out of the current “Build Back Better” planning. Online betters currently give this Democratic scenario a 10% probability: it is essentially a “black swan” and would be inflationary on the margin. Chart 1Midterm Election Odds Favor Republicans Other scenarios are more or less disinflationary as Republicans in the opposition will attempt to rein in government spending: If Republicans win both chambers, then they will have an impetus to pass legislation and it is more likely that they will do so, as President Biden could find common ground (a la Bill Clinton after 1994). But if Republicans win only the House, then they will only be capable of obstruction and brinksmanship, a la the “Tea Party” Republicans of 2010-16. This scenario would be disinflationary and would heighten political risks such as the risk of a national debt default over a refusal to raise the debt ceiling in 2023. Bottom Line: The only midterm election outcome that could surprise US markets in a major way in 2022 would be a Democratic victory in both houses of Congress. But the consensus is right to put the odds of that at 10%. Otherwise the midterm scenarios are just different shades of gridlock, albeit with higher policy uncertainty under a split Congress. Republicans Highly Likely To Take The House We have not yet unveiled our House Election model but here we can make some preliminary predictions. The opposition party has gained seats in the House in 90% of the midterm elections since 1862 (incumbent party gained seats four out of 40 times). Exceptions are rare (e.g. 1902, 1934, 1998, and 2002) and not applicable to the 2022 context so far.1 About 47 seats in the House are thought to be competitive this year, compared to around 75 in 2018, 81 in 2010, and 38 in 2002. Of the 47 competitive seats, 30 are especially competitive, with 18 Democratic and 12 Republican. Four Democratic seats are wide open to competition, i.e. lacking an incumbent, the same as four Republican seats. However, more Democrats (29) are stepping down than Republicans (13), a sign that Democratic incumbents recognize cyclical patterns turning against them.2 President Biden has a net negative approval rating (53% disapprove while 42% approve), similar to President Trump in 2018, when Republicans lost 42 seats in the House. Presidential approval has a significant correlation with House losses for the president’s party since the end of World War II. This is especially true when taking the average of presidential approval and his party’s support in the generic congressional ballot. By this measure Democrats are lined up to lose 40 House seats, whereas they only need to lose a net of five to lose control. The nation’s woes are unlikely to improve significantly in time for the election: Inflation is surging and real wages are collapsing (Chart 2). Even if economists observe inflation rolling over before the election, voter inflation expectations will lag, and will be brought into the ballot box. Americans are the unhappiest they have been since the 1970s, as a consequence of the pandemic, the economy, toxic society and politics, and other factors (Chart 3). Chart 2Consumers Facing Rising Prices Amid Declining Incomes Chart 3Unhappiness Reaches New High A rebound in consumer confidence is not enough to save Biden’s party from losses at the ballot box, as President Obama learned in 2010 and 2014 (Chart 4). Similarly a big drop in confidence can hurt the president in the midterms even if confidence recovers in time for the vote, as happened to Republicans in 2018. Biden has another foreign policy crisis on his hands (Russia), after losing trust on his handling of Afghanistan, and may have more crises to deal with by November (Iran, Latin America). If a crisis hits the oil price, as with Russia or Iran, then prices at the pump will go higher, as we discussed in “Biden’s External Risks.” As for the immigration surge, while it will not concern the business community during a time of labor shortage and inflation, it will concern voters, especially in border states like Arizona (Chart 5). The current surge is historic and may come back to haunt the Democrats. Chart 4Lackluster Consumer Confidence Won't Help Democrats Chart 5Immigration Crisis Looms On Southern Border Republicans will benefit slightly from the post-2020 congressional redistricting. Democrats will probably not make substantial gains as a result of Republican infighting in the primaries, though it could make a big difference in the Senate. We will revisit the latter two issues in future reports (redistricting and Republican primaries) but they only matter if Democrats make a significant comeback in opinion. Otherwise the general swing of public opinion will swamp these marginal effects in the House elections. Worst of all for Democrats, evidence shows that voters tend to make up their minds early in the year. That is when the correlation is strongest between the generic congressional opinion poll and the vote share of elections, though for Democrats in particular late-year polling is equally significant (Chart 6). Chart 6AMidterm Voters Mostly Decided At The Start Of The Year Chart 6BMidterm Voters Mostly Decided At The Start Of The Year What could lift the Democrats’ odds? The following factors: The relevance of the Covid-19 pandemic will wane. The economy, while slowing, will continue expanding and unemployment will be very low (Chart 7). Democrats are still somewhat likely to pass a reconciliation bill with the most popular parts of their “Build Back Better” agenda. Democrats will use social “wedge issues” to mobilize their political base. A racialized battle over the Supreme Court nomination and any conservative Supreme Court ruling on abortion may mobilize African Americans and women. It is possible, not likely, that a foreign policy crisis could generate a lasting patriotic backlash against foreign insults, as we discussed last week. This dynamic is relevant given our Geopolitical Strategy’s 75% odds of new Russian military action in Ukraine. A lot can change in nine months during rapidly changing and highly polarized contests in which every marginal vote matters. Bottom Line: While Republicans are highly likely to retake control of the House, the Senate is still in competition. Chart 7Economy Will Slow, Unemployment To Remain Low The Senate Leans GOP But Still In Play The Senate is more competitive than the House in this year’s election, as 20 Republican seats are up for grabs versus only 14 Democratic seats. About nine of these seats are truly competitive, compared to 13 in 2018, 11 in 2010, and 15 in 2002.3 Only one Democrat is stepping down, in the very blue state of Vermont, whereas five Republicans are stepping down, three of which from competitive states. Hence Democrats have a better chance of picking up Republican seats in North Carolina and Pennsylvania than otherwise. However, even here, Democrats only have a one-seat margin of safety. A net loss of a single seat will yield control of the chamber. Our quantitative model relies on the following six variables: State-level economic health Incumbent party margin of victory in state’s previous Senate race (i.e. 2020) The incumbent president’s net average approval rating Average net support rate of incumbent party in generic congressional ballot A dummy variable for the generic ballot, for statistical purposes A “time for change” penalty for any party that has controlled the Senate for six or more years The model’s results are shown in Chart 8. Currently the model says the status quo will hold, with a 50/50 split in the Senate. Democrats lose Georgia but gain Pennsylvania and hence the balance of power stays the same, as Vice President Kamala Harris casts any tie-breaking vote. Chart 8Senate Quant Election Model Points To Even Split Specifically the model says: Arizona is a toss-up but leans Democratic, with 55% odds. Pennsylvania is a toss-up but switches to the Democrats with 54% odds. North Carolina is a toss-up but leans Republican with 47% odds. Georgia switches to the Republican side and is no longer viewed as a toss-up at 43% odds. Looking at the change in these election probabilities since November 2020, North Carolina has seen the biggest drop for the Democrats, followed by Arizona (Chart 9). Democratic odds are worsening in four states, while Republican odds are worsening in three states. Since North Carolina and Pennsylvania are losing their Republican incumbents, this change in odds is a problem for the GOP. By contrast, Democrats are running incumbents in the four states where they are vulnerable. The problem for Democrats, again, is that voters make up their minds early. The closest correlation between the generic party polling and the incumbent party’s performance in the Senate in a midterm election occurs in February at 94% (Chart 10). Chart 9Senate Model: Change In Predicted Probability Senate elections, like all American elections, are increasingly nationalized.4 This is evident in the 75% correlation we find between the generic polls and the performance of the incumbent party in the Senate (Chart 10 again). So, for example, while one might view Senator Mark Kelly of Arizona as likely to win given the incumbent advantage and the fact that he is a former astronaut and US Navy captain, and he may indeed win, nevertheless a national wave of anti-incumbent feeling could overwhelm his re-election bid. Still, state effects could matter. To examine these from a macro perspective we look at each state’s Misery Index (inflation plus unemployment) compared to the national average in Chart 11. Here are the notable takeaways: Chart 10Midterm Voters Mostly Decided At The Start Of The Year Chart 11AState Level Miseries Point To Risks For Democrats In GA And AZ… Chart 11B… And To Republicans In PA And WI Misery in Arizona, Georgia, and Pennsylvania is higher than average and rising – negative news for Democrat Kelly, Democrat Raphael Warnock, and the yet-to-be-decided Republican candidate in Pennsylvania. Misery in Florida is also slightly above the national average and rising, though Senator Marco Rubio is likely secure. Wisconsin misery is lower than national average and rising (possibly hurting Republican incumbent Senator Ron Johnson). North Carolina misery is lower than national average and falling (helping the yet-to-be-decided Republican candidate). In other words, Misery Indexes support our model’s findings, yet suggest that Democrats face a headwind in Arizona – where our model is also flagging an important risk for Democrats. In sum, our model’s direction of change suggests Democrats will lose another seat and thus the Senate. Going forward, the key moving parts are the economy and the president’s and his party’s approval ratings. There is a chance that these variables will bottom early in the year and improve later, which underscores that the Senate will remain competitive. What investors can be certain about is that Democrats are extremely unlikely to make significant seat gains in the Senate. So even if they retain control, it will be with the thinnest of possible majorities, and hence the Senate will only be capable of passing bipartisan Republican-authored House bills – or vetoing Republican House bills to save the president from having to veto them. It is also certain that Republicans will fall far short of the 67 votes they would need to remove Biden from office, if House Republicans find or invent a reason to impeach him. Bottom Line: The Senate outcome is too close to call but subjectively we doubt Democrats will pull it off given the negative macro trends cited above. Our Senate election model gives 51% odds that Democrats will retain a de facto majority with 50 seats. 2024 Presidential Vote: Odds Favor Democrats For Now The US presidential election is 34 months away. Investors need to be prepared for any outcome, including another contested election. But it is important to have a base case – especially because a Republican (or Democratic) victory in both House and Senate in 2022 would open up the prospect of single-party control in 2025, which has much bigger policy implications than various shades of gridlock. As a rule of thumb, investors should think of presidential elections as a referendum on the incumbent party, not the president’s person, for the prior four years of material performance. Thus Democrats are currently favored to keep the White House. Voters will feel better than they did in 2020, which suffered a triple crisis of pandemic, recession, and unrest. Significant changes must occur to alter this trajectory – such as a recession, Biden’s stepping down, or a humiliating foreign policy defeat.5 Our quantitative model supports this view: it currently gives a 55.2% chance of Democratic victory in the Electoral College (Chart 12). Chart 12US Election 2024: Quant Model Tips Dems Our model relies on the following four variables: State economic health Incumbent party margin of victory in the previous election A penalty for parties that have held the White House for two terms (not applicable in 2024) The president’s approval rating (level) Interestingly our model produces 308 electoral votes for Biden, compared to his actual 306 in 2020, except that some states trade places: Democrats win Florida while Republicans take back Arizona and Georgia. Specifically the model says: North Carolina is a toss-up state but leans Republican. Wisconsin is a toss-up state but just slightly leans Democratic. Florida and Pennsylvania have moved above toss-up range into the Democratic camp. Arizona and Georgia have slipped beneath the toss-up range into the Republican camp. Looking at the change in each state’s odds of voting for the incumbent, Democrats’ chances are falling in eight states while Republicans chances are falling in three states (Chart 13). Wisconsin and Arizona are seeing the most substantial drops, followed by Pennsylvania. Thus the current direction of change is negative for Democrats as one would expect. Biden’s thin margin of victory in 2020 and weak approval ratings make him vulnerable, so the economic performance will largely determine the model’s results going forward. If Biden avoids a recession, that may be enough to retain the White House according to the model. Florida is an interesting case. The model gives a 59% chance it will go to the Democrats. We are suspicious of this outcome but it suggests investors should not take a Republican victory there for granted. Consider: Chart 13Presidential Model: Change In Predicted Probability While we gave President Trump 45% odds of winning in 2020, we predicted he would win Florida due to the state’s partisan leaning.6 That leaning has probably not changed much, although Governor Ron DeSantis’s latest approval rating is only at 45%. However, the six-month change in Florida’s coincident economic indicator has fallen 0.6% since November 2020 and the Misery Index is rising above the national average, as noted above. If Biden loses Florida but the rest of our model is correct, Democrats will retain the White House with 279 electoral college votes. That would leave Wisconsin as the decisive battleground. Yet Wisconsin is very tenuously in their camp today, so any change in the model that gives Florida back to the Republicans would likely give them Wisconsin as well … The result of Biden losing Arizona, Georgia, and Wisconsin (among other combinations) would be a 269-269 tie in the electoral college, in which each state’s delegation to the House of Representatives would have a single vote. A Republican win in the House in 2022 would thus result in a Republican White House in another explosive contested election. But let’s not get ahead of ourselves, 2024 is more than two years away. Bottom Line: Our presidential model gives a 55% chance that Democrats will retain the White House in 2024. Subjectively we agree. A Democratic defeat in 2022 will not rule out a Democratic victory in 2024, especially if Biden is alive and kicking, given the incumbent advantage. But economic factors will largely determine how the model evolves over the next 34 months. Our model also suggests the Electoral College math will be close and that another contested election is possible. Investment Takeaways Based on the current stock market correction, financial markets have priced a fair amount of policy uncertainty already. And this report suggests the midterms merely offer different shades of gridlock. However, Biden’s external risks – namely conflict with Russia – could cause further risk-off moves. And uncertainty will increase as midterms get closer. US policy uncertainty is falling relative to the rest of the world (Chart 14). This is positive for King Dollar, at least over a tactical time frame. The Fed’s interest rate liftoff is also positive for the dollar. Chart 14Lower US Uncertainty In The Near Future Supports The DXY Hence on a short-term basis, the stock-to-bond ratio can fall further and cyclicals can fall further relative to defensives. Tactically we recommend going long growth versus value stocks (Chart 15). Value has surged in the New Year and the dollar and rate hikes will counteract that, as well as any global energy shock that kills demand. Chart 15Tactically Go Long Growth Versus Value However, this is a tactical call. Otherwise, we remain in line with the BCA House View, which favors stocks over bonds and a weaker dollar over the next 12 months.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Guy Russell Research Analyst guyr@bcaresearch.com   Footnotes 1     Brookings Institution, “Losses by the President’s Party in Midterm Elections, 1862-2014,” Vital Statistics on Congress, February 8, 2021, www.brookings.edu. 2     For the number of competitive seats, see Cook Political Report, cookpolitical.com, and Fair Vote, fairvote.org.  3    See footnotes 1 and 2 above. In addition see the Green Papers, “General Election 2002 – Contests to Watch,” October 25, 2002, thegreenpapers.com, and Ken Rudin, “2010 Senate Ratings: 11 Seats Seen As Tossups; GOP With At Least 3 Pickups,” NPR, July 9, 2010, npr.org. 4    See Joel Sievert and Seth C. McKee, “Nationalization in U.S. Senate and Gubernatorial Elections,” American Politics Research 47:5 (2019), pp. 1036-1054. 5    Our qualitative presidential election framework relies heavily on the work of Professor Allan Lichtman, American University. See our updated Lichtman-style checklist in BCA US Political Strategy, “Biden Is Underwater But His Legislation Will Float,” September 8, 2021, bcaresearch.com. 6    See BCA Research Geopolitical Strategy, “Upgrading Trump’s Odds of Re-Election,” October 26, 2020, bcaresearch.com. See also my interview on Bloomberg’s The Tape Podcast, “Full Blue Sweep Will Push Biden To Left,” July 13, 2020, Bloomberg.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary Asian Inflation Has Diverged From US Inflation has been largely subdued in emerging Asia and will remain so for now. This argues for the outperformance of emerging Asian local bonds versus their EM peers, as well as DM/US bonds.   The most important macro driver of Asian domestic bond yields is inflation. Rising inflation usually also hurts local currencies – creating a toxic cocktail for bonds’ total returns in US dollar terms. Diverging currency dynamics in emerging Asia is what will determine the relative performances of individual bond markets. Chinese, Indian, and Malaysian currencies have a better outlook than currencies in Indonesia, Thailand and the Philippines. Book profits on the short Korean won position: this trade has generated a 5.2% gain since its initiation on March 25, 2021. Recommendation   Initiation Date Return to Date Short KRW / Long USD 2021-03-25 5.2% Bottom Line: Regional fixed income managers should overweight China, Korea, India and Malaysia, and underweight Indonesia, Thailand and the Philippines within an emerging Asian bond portfolio. In an overall EM domestic bond portfolio however, Thailand and the Philippines should be accorded a neutral allocation, given their better inflation outlook compared to their peers in EMEA and Latin America. Feature US Treasury yields will likely go up further. If history is any guide, EM Asian bond yields should also rise in tandem (Chart 1). The basis is that business cycles in Asia and the US usually move together. Yet, in this cycle, inflation in emerging Asia has diverged considerably from that of the US. US core consumer price inflation has surged while in Asia, core inflation remains largely contained (Chart 2). How should bond investors position themselves in Asian domestic bond markets? Chart 1Asian Bond Yields Usually Move In Line With US Treasury Yields... Chart 2...But Diverging Inflation Means Asian Bonds Will Outperform US Bonds Chart 3Relative Domestic Bond Performances In Asian Markets In this report, we will discuss some of the common factors that drive Emerging Asian bond markets. We will also highlight each individual market’s idiosyncrasies to explain our recommended allocation across local currency bond markets in emerging Asia for the coming year.     Our recommended allocation is as follows: China, Korea, India and Malaysia merit an overweight stance in an emerging Asia domestic bond portfolio, while Indonesia, Thailand, and the Philippines warrant an underweight allocation (Chart 3). That said, given a much more benign inflation outlook in Asia than elsewhere in EM, we recommend that Thailand and the Philippines be accorded a neutral allocation in an overall EM domestic bond portfolio. The Two Drivers For international investors in local bonds, total returns are predicated on two main drivers: (1) the direction and magnitude of change in bond yields; and (2) currency performance. In all Asian countries, the most potent macro factor that drives local bond yields is the country’s inflation. Rising inflation is usually a harbinger of higher bond yields (and hence, worsening bond performance); and falling inflation is an indicator of lower yields (Charts 4 and 5). Chart 4Inflation Is The Most Important Macro Driver … Chart 5… Of Bond Yields In Emerging Asia What’s more, rising inflation in a country is also often associated with a depreciating currency. Currencies in countries with higher/rising inflation in general do worse than in countries with lower/falling inflation. This aspect is especially important when doing a cross-country comparison. The fact that higher inflation negatively impacts both the drivers of bond performance – it pushes up yields and weakens the currency – can indeed be seen happening in Asian financial markets. Rising inflation leads to poor performance of domestic bonds’ total return in dollar terms; and falling inflation leads to a better performance. The upshot is that the potential inflation trajectory is key to any country’s domestic bond performance in both absolute and relative terms. Inflation In Asia Is Benign Most of the Asian countries have their core and trimmed mean consumer price inflation running at or well below their central banks’ targets (Charts 6 and 7). Their inflation outlook also remains largely benign.1 As such, bond yields in these countries are unlikely to rise materially in the near future. Chart 6Inflation Is Running At Or Below … Chart 7… Central Banks’ Target in Asia Notably, even the recent surge in US yields did not spook Asian bond yields. The yield differentials between individual Asian domestic and US yields have remained flattish in the past few months. All this implies that Asian domestic bonds, in general, would likely fare better relative to the rest of the EM and the US – where inflation is high and well above their central banks’ targets. Currency Is A Key Differentiator Given inflation, and therefore the bond yield trajectories among Asian economies are unlikely to deviate significantly from one another, the key differentiator of their bond market performance (on a total return basis) will be their exchange rates. In fact, Asian currencies do vary considerably in their outlooks as their fundamentals differ.  For instance, in China and Korea, higher bond yields are usually associated with an appreciating currency (Chart 8, top and middle panels). The key driver of bond yields in these economies is the business cycle. Accelerating growth often pushes up both the currency as well as interest rates. The opposite is also true: decelerating growth usually leads to a weaker currency and falling bond yields.  The consequence is that in these countries, bond performance is tempered by two opposing forces. For example, the effect of falling yields (which is a positive for total return) is often mitigated by the effect of a falling currency (which is a negative for total return), or the other way around. In contrast to China and Korea, ASEAN countries usually experience rising bond yields accompanied by a depreciating currency (Chart 9). A crucial reason for this is significantly higher foreign ownership of their domestic bonds. In periods of stress, when foreigners exit their bond holdings, this leads to both higher yields and a falling currency. During risk-on periods, foreigners’ purchases do the opposite. Chart 8Higher Bond Yields Coincide With A Stronger Currency In China And Korea Chart 9Higher Bond Yields Coincide With A Weaker Currency In ASEAN In this context, foreign ownership of domestic bonds in ASEAN countries has fallen in the past few years, but remains non-trivial: 19% in Indonesia, 24.2% in Malaysia, 19.9% in the Philippines, and 11.3% in Thailand. Hence, the currency view on ASEAN countries is crucial to get the outlook right for their domestic bond performance. Incidentally, Thailand, the Philippines and Indonesia have a weak currency outlook, while Malaysia’s is neutral. We discuss the individual currency outlooks in more detail in the respective country sections below. But in summary, this warrants a more positive stance on Malaysian domestic bonds compared to Indonesian, Thai and Filipino bonds. Finally, in case of India, bond yields and the rupee have little correlation (Chart 8, bottom panel). The main reasons for that are near absence of foreign investors in Indian government bond markets, and large captive domestic bond investors (its commercial banks). Yet, unlike China and Korea, India also has higher inflation and a persistent current account deficit. All these make the correlation of bond yields with the exchange rate different in India from both ASEAN as well as China and Korea. In the sections below, we discuss each country’s currency and overall bond outlook in more detail. We also explain the reasons behind our relative bond strategy. China: Overweight Chart 10Chinese Bond Yields Will Likely Fall More China’s economy will remain weak in the coming months. The hit to the economy from slowing property construction is material. Besides, COVID-induced rotational lockdowns are hurting consumption, income and investment in the service sector. The latest round of stimulus has so far not been sufficient to produce an immediate recovery. We expect growth to revive only in H2 2022. For now, the PBOC will reduce its policy rate further. This and the fact that the yield curve is positively slopped heralds more downside in Chinese government bond yields (Chart 10). Concerning the exchange rate, the ongoing US dollar rally could eventually cause a short period of yuan weakness. However, the latter will be small and short lived. In brief, Chinese domestic bonds will outperform both their Asian and EM peers in the coming months. Korea: Overweight The following factors argue for overweighting Korean bonds within both emerging Asian and EM domestic bond portfolios: Chart 11Korea Has No Genuine Inflation The Korean won has already depreciated quite a bit against the US dollar. While further downside is possible in the very near term, the medium-term outlook is positive. Even though headline and core inflation have exceeded the central bank’s target of 2%, trimmed mean consumer price inflation has not yet exceeded 2% (Chart 4, middle panel) and services CPI, excluding housing, seems to have rolled over. Importantly, no wage inflation spiral is evident. Unit labor costs have been falling in both the manufacturing and service sectors (Chart 11). Hence, there is little pressure for companies to hike prices. India: Overweight Indian bonds should continue to outperform other EM domestic bonds (Chart 3, middle panel). The combination of prudent fiscal policy, a benign inflation outlook and a cheap currency makes Indian bonds attractive to foreign investors. Even though yields will go up somewhat given a recovering economy, the rise will be capped as the inflation outlook remains benign. The reason for a soft inflation outlook is wages and expectations thereof are quite low (Chart 12). Global commodity prices will also likely soften in the months ahead. That will ease price pressures in India. The Indian rupee is cheap – it is now trading 12% below its fair value versus the US dollar (Chart 13). The rupee will likely be one of the best performers among EM currencies in the year ahead. Chart 12Low Urban And Rural Wages Will Keep A Lid on Indian Inflation Chart 13Indian Rupee Is Cheap   The spread of India’s 10-year bonds over that of GBI-EM Broad index is 190 basis points. The currency performance will likely offset any possible capital loss owing to rising yields, while a positive carry will boost total returns. Stay overweight. Indonesia: Underweight Indonesian relative bond yields versus both EM and the US have already fallen massively and at multi-year lows (Chart 14). The currently low yield differential between Indonesia and the aggregate EM local bonds as well as US Treasury yields is a negative for Indonesia’s relative performance going forward. Chart 15 shows that the rupiah is also vulnerable over the next several months as the Chinese credit and fiscal impulse has fallen to its previous lows while the rupiah has not yet depreciated. We believe raw material prices will correct in the coming months, weighing on the rupiah. Hence, the country’s local bonds’ relative performance is facing a currency headwind too. Chart 14Indonesian Relative Bond Yields Are Quite Low Chart 15Indonesian Rupiah Is Vulnerable   Notably, a weaker currency by itself could cause bond yields to rise – because that may prompt foreign bond holders to exit this market. For now, investors would do well to underweight this domestic bond market in an emerging Asian or global EM portfolio. Malaysia: Overweight Chart 16Malaysian Yield Curve Is Too Steep Given The Deflationary Macro Backdrop Malaysian domestic bonds will likely fare well as the nation’s economy is still working through credit excesses of the previous decade. Domestic demand weakness has been exacerbated by a constrained fiscal policy. All of this has paved the way for a strong disinflationary backdrop.   The job market has not recovered either: the unemployment rate is hovering at a high level. That in turn has put downward pressures on wages. Average manufacturing wages are weak. Dwindling wages have contributed to depressed household incomes, leading to weak consumption and falling house prices (Chart 16). Considering the economic backdrop, Malaysia’s yield curve is far too steep (Chart 16, bottom panel). Odds are that the curve will flatten going forward – yields at the long end of the curve are likely heading lower. At a minimum, they will rise less than most other EM countries. Notably, the ringgit is quite cheap, and is unlikely to depreciate much versus the US dollar. Hence, it will outperform many other Asian/EM currencies. That calls for an overweight position in Malaysian local bonds within an Asian/EM universe.  Thailand: Underweight To Neutral Given the high correlation between Thai bond yields and the baht (rising yields coincide with a weakening currency), the total return of Thai bonds in USD terms is highly dependent on the baht’s performance. (Chart 17). The baht outlook remains weak, as the two main drivers of the currency, exports and tourism revenues, remain sluggish and absent, respectively. As such, absolute return investors in Thai domestic bonds should continue to avoid this market. Asset allocators should underweight Thai domestic bonds in an emerging Asia basket. In an overall EM domestic bond portfolio, however, Thai bonds warrant a neutral allocation. That’s because Thailand has been a defensive bond market due to its traditionally strong current account, very low inflation, and lower holding of bonds by foreigners (now at 11.3% of total). In periods of stress, the baht usually falls less than most other EM currencies; and often Thai bond yields fall more (or rise less) than overall GBI-EM yields (Chart 18, top panel). Chart 18Thai Bonds' Relative Performance Can Get Better During Periods Of Risk-Off Chart 17Thai Domestic Bonds' Absolute Performance Is Highly Contingent On The Baht   The net result is that Thai bonds outperform their overall EM brethren in common currency terms during risk-off periods. This is what happened during the EM slowdown of 2014-15, and again during the pandemic scare in early 2020 (Chart 18, bottom panel). Given we are entering a period of volatility in risk assets, it makes sense to have a neutral positioning on Thai bonds in an EM domestic bond portfolio. The Philippines: Underweight To Neutral The Philippines also merits an underweight allocation in an emerging Asian domestic bond portfolio, but a neutral stance within EM. This is because of this market’s dependence on the appetite of foreign debt investors for Philippine debt securities. This appetite depends on how much extra yield the country offers over US Treasuries. Chart 19 shows that whenever the yield differential between the Philippines’ local bonds and US Treasuries widens to 400 basis points or more, the Philippines typically witnesses net debt portfolio inflows over the following year. On the other end, when the yield differential narrows to around 300 basis points or less, foreign fixed income inflows typically stop, and often turn into outflows during the following year. This is what is happening now. Chart 19Narrow Yield Differential With US Treasuries Is Hurting Philippines' Portfolio Inflows Chart 20Philippines Peso Is At Risk As The Current Account Has Slid Back Into Deficit Going forward, rising US yields would mean that the Philippines’ bond spreads over US Treasuries will continue to stay less than 300 basis points. Consequently, reduced foreign debt inflows will weigh on the peso. Notably, the Philippines’ current account balance has also slid back to deficit, which makes the peso more vulnerable (Chart 20). On a positive note, contained inflation means little upward pressure on bond yields. Further, there might be a lower need of new bond issuances this year as a substantial amount of proceeds from past bond issuances are lying unspent with the central bank. This would help put a cap on bond yields.  Investment Conclusions Emerging Asian local bonds will outperform their counterparts in Latin America and EMEA in common currency terms for now. In the medium and long run, emerging Asian bonds will outperform US/DM bonds on a total return basis in common currency terms. We will discuss rationale for the latter in our future reports. Considering both the overarching macro backdrop as well as their individual situations, it makes sense to overweight China, Korea, India and Malaysia in an emerging Asian domestic bonds portfolio. Whereas Indonesia, Thailand and the Philippines warrant an underweight allocation. Yet, in an overall EM domestic bond portfolio, we recommend a neutral allocation for Thailand and the Philippines. The reason is they have a much better inflation outlook compared to economies in EMEA and Latin America. Chart 21Book Profit On Our Recommended Short Korean Won Trade Notably, among the Asian currencies, we have a positive bias on the Chinese yuan and the Indian rupee. On the contrary, we have been shorting the Korean won, the Thai baht, the Philippine peso and the Indonesian rupiah vis-à-vis the US dollar. That said, this week we recommend taking profits on the short Korean won position: this trade has generated a 5.2% gain since its initiation on March 25, 2021 (Chart 21). Our view on the won has played out well. While the exchange rate might continue depreciating in the near run, the risk/reward of staying short is not very attractive now. Finally, we recommend continuing to receive 10-year swap rates in China and Malaysia. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     For a detailed discussion on each country’s inflation dynamics, please click on our reports on China, India, Indonesia, Malaysia, Thailand, Philippines.

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary Cyclical UST Curve Flattening, But With Unusually Low Rate Expectations The US Treasury curve is unusually flat given high US inflation and with the Fed not having begun to raise interest rates. The dichotomy between deeply negative real interest rates and a flattening yield curve is not only evident in the US, but in other major developed countries like Germany and the UK. A low term premium on longer-term US Treasury yields is one factor keeping the curve so flat, but the term premium will likely rise as the Fed begins to hike rates. An overly flat US Treasury curve more likely reflects a belief that the neutral real fed funds rate (r-star) is actually negative. This is consistent with markets pricing in a very low peak in the funds rate for the upcoming tightening cycle, despite the current high inflation and tight labor market. Bottom Line: The Fed will hike by less than the market expects in 2022 and longer-term Treasury yields remain too low versus even a moderate 2-2.5% peak in the fed funds rate. Stay in US curve steepeners, as the Treasury curve is already too flat and will not flatten as much as discounted in forward rates this year. Feature Last week’s FOMC meeting essentially confirmed that the Fed will begin lifting rates in March and deliver multiple rate hikes this year. This was considered a hawkish surprise as the Fed signaled imminently tighter monetary policy even with the elevated financial market volatility seen so far in 2022. Fed Chair Jerome Powell noted that the US economy was in a stronger position compared to the 2016-18 tightening cycle, justifying a faster pace of hikes – and an accelerated pace of QE tapering – this time around. Markets have responded to the increasingly hawkish guidance of the Fed by pushing up rate expectations for 2022, continuing a path dating back to last September’s FOMC meeting when the Fed first signaled that QE tapering was imminent (Chart 1). There are now 163bps of Fed rate hikes by year-end discounted in the US overnight index swap (OIS) curve. Some Wall Street investment banks are calling for the Fed to hike as much as 6 or 7 times in 2022. We see this as much too aggressive. Chart 1Fed Hawkishness Pushing Up Rate Expectations For 2022/23 - But Not Beyond That Our base case scenario calls for the Fed to lift rates “only” 3-4 times this year. The persistently high inflation that is troubling the Fed is likely to peak in the first half of 2022, taking some heat off the FOMC to move as aggressively as discounted in markets this year. Although inflation will remain high enough, and the labor market tight enough, to keep the Fed on a tightening path into 2023. The US Treasury Curve Looks Too Flat What is unique about the upcoming Fed tightening cycle is that it is starting with such a flat US Treasury curve. The spread between the 2-year and 10-year yield now sits at 61bps, the lowest level since October 2020. This dynamic is not unique to the US, as yield curves are quite flat in other major countries where policy rates are near 0% and inflation remains relatively high, like the UK and Germany (Chart 2). In the US, the modest slope of the Treasury curve is notably unusual given a growth and inflation backdrop that would be more consistent with much higher bond yields: The US unemployment rate fell to 3.9% in December, well within the range of full employment estimates from FOMC members (Chart 3, top panel) Chart 2Bond Bearish Yield Curve Flattening In The US & UK US labor costs are accelerating; the wages and salaries component of the Employment Cost Index for Private Industry Workers rose to a 38-year high of 5.0% on a year-over-year basis in Q4/2021 (middle panel) Chart 3Challenges To The Fed's Inflation Fighting Credibility​​​​​​ Higher inflation is becoming more embedded in medium term consumer inflation expectations measures like the University of Michigan 5-10 year ahead series that climbed to 3.1% last month (bottom panel). Importantly, market-based measures of inflation expectations have pulled back, even with little sign of inflation pressures easing. The 5-year TIPS breakeven, 5-years forward has fallen 35bps from the October 2021 peak of 2.41%. The bulk of that decline occurred in January of this year, alongside a rising trend in real TIPS yields as markets began pricing in a faster pace of Fed rate hikes. TIPS breakevens can often be something of a “vote of confidence” by the markets in the appropriateness of the Fed’s policy stance; rising when policy appears overly stimulative and vice versa. Thus, the decline in the TIPS 5-year/5-year forward breakeven, which climbed steadily higher since the Fed introduced massive monetary easing in March 2020 in response to the pandemic, can be interpreted as a sign that markets agree with the Fed’s recent hawkish turn. However, while the move in TIPS breakevens is sensible, the flatness of the Treasury curve appears unusual. In Chart 4, where we look at the previous times since 1975 that the 2-year/10-year US Treasury spread flattened to 70bps (just above the current level). In past cycles, the Treasury curve would be flattening into such a level after the Fed had already hiked rates a few times, which is obviously not the case today. Also, US unemployment was typically approaching, or falling through, the full employment NAIRU when the 2/10 Treasury curve fell to 70bps, suggesting diminished spare economic capacity and rising inflation pressures – similar to the current backdrop. Chart 4The UST Curve Is Unusually Flat Right Now Chart 5UST Curve Too Flat Relative To Inflation Pressures In those past cycles, the funds rate was rising at a faster pace than that of core inflation, suggesting that the Fed was pushing up real interest rates. The backdrop looks very different today, with US realized inflation soaring and the real funds rate now deeply negative. In the top panel of Chart 5, we show a “cycle-on-cycle” chart of the 2/10 Treasury curve versus an average of the previous five instances where the curve flattened to 70bps. The green line is the median outcome of all the cycles, while the shaded region represents the range of all the outcomes. In the other panels of the chart, we show US economic variables (the Conference Board leading economic index and the ISM Manufacturing index) and US inflation variables (the wages and salaries component of the Employment Cost Index and the US Congressional Budget Office estimate of the US output gap). The panels are all lined up so that the vertical line in the middle of the chart represents the date that the 2/10 curve falls to 70bps. The conclusion from Chart 5 is that the US economic variables shown are currently at the high end of the range of past curve flattening episodes, but the inflation variables are well above the high end of the historical range. In other words, the current modest slope of the 2/10 Treasury curve is in line with US growth momentum but is too flat relative to US inflation trends. So Why Isn’t The US Treasury Curve Steeper? There are a few possible reasons why the US curve is as flat as it is before the Fed has even begun tightening amid above-trend US growth and very high US inflation: Fears of a deeper financial market selloff The Fed believes strongly in the role of financial conditions in transmitting its monetary policy into the US economy. That often means that, during tightening cycles, the Fed hikes rates “until something breaks” in the financial markets, like a major equity market downturn or a big widening in corporate credit spreads. Such moves act as a brake on US growth through negative wealth effects for investors and by raising the cost of capital for businesses – reducing the need for additional Fed tightening. If bond investors thought that a major market selloff was likely before the Fed could successfully lift rates back to neutral (or even restrictive) levels during a tightening cycle, then they would discount a lower peak level of the funds rate. This would also lower the expected peak level of longer-term Treasury yields, resulting in a flatter Treasury yield curve. Given the current elevated valuations on so many asset classes – like equities, corporate credit and housing – it is likely that the relatively flat Treasury curve incorporates some believe that the Fed will have difficulty delivering a lot of rate hikes in this cycle. However, it should be noted that the US financial conditions remain quite accommodative, even after the recent equity market turbulence (Chart 6), and represent no impediment to US growth that reduces how much tightening the Fed will need to do. Longer-term bond term premia are too low A relatively flat yield curve could reflect a lack of a term premium on longer-maturity bonds. That is certainly the case when looking at the slope of the 2/10 government yield curve in the US, as well as in the UK and Germany (Chart 7).1 Chart 6US Financial Conditions Are No Impediment To US Growth​​​​​​ Chart 7Flatter Yield Curves? Or Just Lower Bond Term Premia?​​​​​ The term premium is the defined as the extra yield that investors require to commit to own a longer-maturity bond instead of the compounded yield from a series of shorter-maturity bonds. The latter can also be expressed as the “expected path of short-term interest rates”, which is often proxied by an average expected path of the monetary policy rate over the life of the longer-maturity bond. So the term premium on a 10-year US Treasury yield is the difference between the actual 10-year Treasury yield and the expected (or average) path of the fed funds rate over the next ten years. The term premium can also be thought of as a risk premium to holding longer-term bonds. On that basis, the term premium should correlate to measures of bond risk, like bond price volatility or inflation volatility. That is definitely true in the US, where the 10-year Treasury term premium shows a strong correlation to the MOVE index of Treasury market option-implied volatility or a longer-term standard deviation of headline CPI inflation (Chart 8). Estimated term premia can also rise during periods of slowing economic growth momentum, but that is typically due to a rapid decline in the expected path of interest rates rather than a rise in bond risk premia (in this case, this is probably more accurately described as a rise in bond uncertainty). Currently, a low term premium on US Treasury yields is justified by the relatively low level of bond volatility and solid US growth momentum. However, the term premium looks far too low compared to the more volatile US inflation seen since the start of the COVID-19 pandemic. With the Fed set to respond to that higher inflation with rate hikes, rising real interest rate expectations could also give a lift to the Treasury term premium. Our favorite proxy for the market expectation of the peak/terminal real short-term interest rate for the major developed market economies is the 5-year/5-year forward OIS rate minus the 5-year/5-year forward CPI swap rate. That “real” 5-year/5-year forward rate measure is typically well correlated to our estimates of the 10-year term premium in the US, Germany and the UK (Chart 9). This correlation likely reflects the level of certainty bond investors have over the likely future path of real interest rates. When there is more uncertainty about how high rates will eventually go to in a tightening cycle, a higher term premium is required. The opposite is true during periods of very low and stable interest rates. Chart 8Drivers Of US Term Premia Pointing Upward​​​​​​ Chart 9Bond Term Premia Positively Correlated To Real Rate Expectations​​​​​​ Chart 10Global Yield Curves Are Too Flat Versus Real Policy Rates Currently, the estimated 10-year US term premium is increasing alongside a rising market-implied path for the real fed funds rate. We anticipate these trends will continue as the Fed lift rates over the next couple of years, boosting longer-term Treasury yields and potentially putting some steepening pressure on the US Treasury curve (or at least limiting the degree of flattening as the Fed tightens). Markets believe that the neutral real rate (r*) is negative Historically, yield curve slopes for government bonds were well correlated to the level of real interest rates, measured as the central bank policy rate minus headline inflation. That relationship has broken down in the US, with the Treasury curve flattening in the face of soaring US inflation and an unchanged fed funds rate (Chart 10). Similar dynamics can also be seen in the German and UK yield curves. The most plausible reason for such a dramatic shift in the relationship between curve slopes and real policy rates is that bond investors now believe that the neutral real interest rate, a.k.a. “r-star”, is negative … and perhaps deeply so. The New York Fed has produced estimates of the US r-star dating back to the 1960s. The gap between the real fed funds rate and that r-star estimate has typically been fairly well correlated to the slope of the Treasury curve (Chart 11). When the real fed funds rate is below r-star, indicating that the policy is accommodative, the Treasury curve is usually steepening, and vice versa. Under this framework, the recent flattening trend of the Treasury curve would indicate that policy is actually getting tighter, despite the falling, and deeply negative, real fed funds rate of -5.4% (deflated by core inflation). Chart 11UST Curve Slope Is Positively Correlated To The 'Real Policy Gap' The last known estimate of r-star from the New York Fed was 0%, but no update has been provided for almost two years. Blame the pandemic for that. The sharp lockdown-fueled collapse in US GDP growth in 2020, and the rapid recovery in growth as the economy reopened, made it impossible to estimate the the “neutral” level of real interest rates given such massive swings in demand that were not related to monetary policy. One way to try and “back out” the implicit pricing of r-star currently embedded in US Treasury yields is to estimate a model linking the gap between the real fed funds rate and r-star to the slope of the Treasury curve. We did just that, with the results presented in Chart 12. This model estimates the “Real Policy Gap”, or r-star minus the real fed funds rate, as a function of the 2/10 Treasury curve slope. In other words, the model shows the Real Policy Gap that is consistent with the current slope of the curve. Chart 12Current UST Yield Curve Makes Slope Sense ... If The Fed Followed The Taylor Rule With 7% Inflation The model estimates that the current 2/10 curve slope is consistent with a Real Policy Gap of 96bps. With US core CPI inflation currently at 5%, and assuming r-star is still 0% as per the last New York Fed estimate, the fed funds rate would have to rise to 4% to justify the current slope of the 2/10 curve. While that may sound like an implausibly large increase in the funds rate, similar results are produced using straightforward Taylor Rules.2 We can also use our Real Policy Gap model to infer the level of inflation that is consistent with a Gap of 96bps, for various combinations of the funds rate and r-star. Those are shown in Table 1. Assuming the funds rate rises in line with current market expectations to 1.7% and r-star remains close to 0%, the current slope of the 2/10 Treasury curve suggests a fall in US inflation to just around 3% - still above the Fed’s inflation target - from the current 5%. Table 1The UST Curve Slope Has Already Discounted A Big Drop In US Inflation We see this as the most plausible reason for the relatively flat level of the 2/10 US Treasury curve. Markets expect somewhat lower US inflation and a moderate rise in the funds rate over the next couple of years, making the real funds rate less negative but not pushing it above a negative r-star expectation. This would suggest upside risk for US Treasury yields, and potential bearish steepening pressure, as markets come to realize that the neutral real fed funds rate is actually positive, not negative. Fight The Forwards, Stay In US Treasury Curve Steepeners While it may sound counter-intuitive with the Fed set to begin a rate hiking cycle, we continue to see better value in tactically positioning in US Treasury curve steepening trades. Specifically, we are keeping our recommended trade in our Tactical Overlay on page 19, where we are long a 2-year Treasury bullet versus a duration-neutral barbell of cash (a 3-month US Treasury bill) and a 10-year Treasury bond. The trade is currently underwater, but we see good reasons to expect the performance to rebound over the next few months. The front end of the curve now discounts more hikes than we expect will unfold in 2022, which should limit further increases in the 2-year Treasury yield. At the same time, the 10-year yield looks too low relative to the expected cyclical peak for the fed funds rate (Chart 13). One way we can assess this is by comparing 5-year/5-year forward Treasury rates to survey estimates of the longer run, or terminal, fed funds rate. The median FOMC forecast (or “dot”) for the terminal funds rate is 2.5%, the median terminal rate forecast from the New York Fed’s Survey of Primary Dealers is 2.25% and the median terminal rate forecast from the New York Fed’s Survey of Market Participants is 2%. This sets a range of estimates of the longer-run terminal rate of 2-2.5%, in line with the current expectations of the BCA Research bond services. The current 5-year/5-year forward Treasury rate is 2.0%, at the low end of that range. We see those forwards rising to the upper part of that 2-2.5% range by the end of 2022, which will push the 10-year Treasury yield toward our year-end target of 2.25%. Chart 13The 5-Year/5-Year UST Forward Rate Is Too Low​​​​​​ Chart 14Stay In UST Curve Steepeners, Even With Fed Liftoff Imminent​​​​​​ Some of our colleagues within the BCA family see the longer-term neutral funds rate as considerably higher than survey estimates, perhaps as high as 3-4%. We are sympathetic to that view, but it will take signs of US economic resiliency in the face of rate hikes before bond investors – and more importantly, the Fed – arrive at that conclusion. This would make steepening trades more attractive on a strategic, or medium-term, basis as the market realizes that the Fed is further behind the policy curve (i.e. the funds rate even further below a higher terminal rate) than previously envisioned. For now, we do not see the US Treasury curve flattening at the pace discounted in the Treasury forward curve over the next 3-6 months (Chart 14, top panel). However, this will be more of a carry trade by betting against the forwards over time. A bearish steepening of the Treasury curve with a swift upward move in the 10-year Treasury yield is less likely with bond investor/trader positioning already quite short (bottom two panels).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com       Footnotes 1      The term premium estimates shown here are derived from our own in-house framework. For those familiar with the various term premium estimates on the 10-year US Treasury yield produced by the Fed, our estimates are currently in line with those produced by the ACM model and the Kim & Wright model. 2     A fun US Taylor Rule calculator, which can be used to generate Taylor Rules under a variety of assumptions, is available on the Atlanta Fed’s website here. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The Software and Services Industry is undergoing a fundamental transformation in its business model catalyzed by a momentous migration of software applications to the cloud and broad-based digitization of the economy. This shift is accompanied by displacement of the traditional on-prem license and support model with a more lucrative cloud-based subscription model.  While on-prem software sales are contracting, cloud revenue is growing in double digits. As a result, the industry enjoys spectacular margins and earnings growth. Its earnings have also proven to be resilient across the business cycle because software and IT services increase companies’ productivity in good times and bad. Rising rates are a headwind, but a temporary one. Margins Will Continue To Expand Bottom Line: The Software and Services industry group is an all-weather industry with resilient earnings and strong growth throughout the business cycle. It is also in the epicenter of technological innovation: Migration to the cloud and digital transformation enhance the industry’s growth and profitability.  We continue recommending both a tactical and a structural overweight. Feature Performance Technology stocks found themselves in the eye of this month’s market rout. After falling 19% from its peak, the NASDAQ is now firmly in correction territory. The Technology sector is down 11%, while the Software and Services industry group is down 10% (Chart 1). In the “Are We There Yet?” report published last week, we posited that it is not yet the right time to bottom fish: While the Technology sector appears oversold, macroeconomic headwinds from the imminent monetary tightening and a slowdown in demand for technology goods and services may prolong the pain. The interplay of valuations and fundamentals for the sector is not yet favorable. While we are underweight the Technology sector, thanks to our underweight positions in Semiconductors and Hardware and Equipment, we remain overweight Software and Services (S&S). In this report, we will conduct a “deep dive” into S&S and reevaluate our positioning (Table 1). Although S&S is down more than 10% from the peak,  it has outperformed the S&P 500 by 88% since 2011 (Chart 2). The million-dollar question we will try to answer is whether this outperformance continues over the tactical and structural time horizons. Chart 1Software And Services Outperformed Other Tech Industries Chart 2S&S Outperformed The S&P 500 By 88% Over The Past 10 Years Table 1Performance Sneak Preview: We maintain our overweight of the Software and Services sector thanks to positive market trends, the all-weather nature of the industry, and resilient earnings. Industry Group Composition The Software And Services Industry Group Is Top Heavy The S&P 500 Software and Services industry group is the largest in the Technology sector and is 48% of the sector market cap. The industry group is split between Software, which is about two-thirds of its market cap, and IT Services, which is one-third (Chart 3). Just like other technology industries, it is dominated by one of the FAANGs+M, Microsoft in this case, which makes up 42% of the industry group index weight. The top 10 constituents out of 36 comprise 80% of the industry’s weight (Table 2). During the current pullback, the S&S industry group has fallen by more than 10%, cushioned by the performance of its larger players. But this masks the pain of the smaller and less profitable constituents, which have fallen by more than 30% (Chart 4). Chart 3Software Dwarfs IT Services Chart 4Some Smaller Constituents Have Fallen More Than 15% YTD Table 2S&S Industry Is Dominated By A Handful Of Successful Companies However, market dominance runs much deeper than just market capitalization: Microsoft, Adobe, Salesforce, and Oracle account for 87% of the Software Industry revenue, while Visa, Mastercard, Accenture, and PayPal generate 42% of the IT Services industry revenue. Larger industry players are also more profitable thanks to the high operating leverage the industry enjoys. Clearly, just a few companies drive sales and earnings growth, valuations, and performance. On the bright side, these are some of the most successful US technology companies, and their size is their competitive moat. We believe that the industry group is in “good hands.” Key Trends Cloud Migration Following the success of offshoring the US manufacturing base to China that allowed corporations to reduce labor costs, companies are now experimenting with outsourcing other key infrastructure elements. This time, however, the migration is happening to digital cloud platforms. Instead of investing in pricey servers and other hardware assets, corporations have the choice of going with Software-as-a-Service (SaaS), Platform-as-a-Service (PaaS), or Infrastructure-as-a-Service (IaaS) solutions offered by the tech titans. Not only are cloud solutions more cost-effective, but they also offer the convenience and flexibility to scale corporate hardware infrastructure by simply purchasing more or less computational power. COVID-19 lockdowns and the migration of the white-collar workforce towards remote work have motivated companies to transition their technology and operations to the cloud, and have acted as a catalyst for “digital offshoring.” Digital Transformation Digital transformation is in many ways similar to cloud migration. Essentially, it represents broader software penetration into the US economy. Whether it is a manufacturing production or customer relationship management process, wider adoption of software allows for a more efficient business solution via automation and process optimization. Airbnb and Uber are the poster children of digital transformation. While some industries have already undergone digital transformation, there are notable areas which lag behind. For instance, banks’ failure to modernize their digital infrastructure to speed up transactions and to increase overall user convenience has arguably led to the development of the crypto space as an alternative to the slow-evolving traditional financial institutions. The broader implication is that there are still major sectors in the economy that are yet to ramp up automation and increase efficiencies via digital transformation, meaning that there is a healthy demand pipeline for the tech companies. Types Of Software And Services Companies Software: Migration To The Cloud Is A Key Driver Of Growth In the past, classifying software companies was a relatively straightforward exercise: They were divided into system software vs. application software. System software included such categories as operating systems for PCs, and other hardware and database software. Application software covered Enterprise Resource Planning (ERP), Customer Relationship Management (CRM), Communications and Collaborations, etc. However, over time, the industry landscape has changed, first by the mergers that blurred the distinction across these lines, and lately, thanks to ubiquitous migration to the cloud model and digitization of the economy. Therefore, it is most practical to classify software companies by their type of business model, i.e., legacy license and support model, or cloud-based, or hybrid.  Pure cloud-first: These companies derive 100% of their sales from the cloud model – Salesforce.com (CRM), ServiceNow (Now), and Twilio (TWLO) are among the biggest winners. Cloud/license hybrid: These are companies that derive 50%+ of their sales from the cloud, such as Microsoft (MSFT), Atlassian (TEAM), Autodesk (ADSK), and Adobe (ADBE). Legacy license and support model (aka On-Premises): Constellation Software (CSU), Citrix Systems (CTSX) – these companies are likely to struggle to grow organically. Types Of Cloud Application Services The cloud-based business model in turn can be classified under three different types of service: Software-as-a-Service (SaaS), Infrastructure-as-a-Service (IaaS), or Platform-as-a-Service (PaaS). Software-as-a-Service: Customers configure and access a web-based application operated by a SaaS provider over the internet. Salesforce.com, Workday (DAY), ServiceNow, and Oracle are some of the most established players. Infrastructure-as-a-Service: This service gives customers access to virtual storage and servers over the internet, enabling them to develop and run any application just as if it were running in their own data center. Amazon’s AWS, Microsoft’s Azure, and IBM are the key competitors in this space. Platform-as-a-Service: This service occupies a middle ground between SaaS and IaaS, i.e. between a full-fledged app that can be used “out-of-the-box” and a “raw server and storage” instance, making the customer responsible for installing and configuring its own “full stack.” PaaS offerings tend to be less standardized. Salesforce.com, Microsoft, and Oracle are the leaders. IDC projects the continued strength of this segment and expects it to grow at an annualized rate of 29.7% over the next five years. The following table from Microsoft presents a perfect explanation of the different software service models (Table 3). Table 3Differences In Cloud Computing Service Models License And Support Vs. Cloud Subscription Model Growth Rates Broad-based migration to the cloud is shifting the industry’s revenue composition, with accelerating bifurcation between cloud and on-prem models: Cloud subscription revenue is replacing the traditional license and support model. As a result, legacy on-prem revenue has recently been contracting, and once the last of the legacy enterprise applications are retired, it will be fully replaced by cloud revenue. According to estimates by CFRA,1  the software industry grew by 4% in 2021, with a 22% year-on-year increase in cloud subscription revenue, which now constitutes 37% of total industry revenue, and a 3% decline in traditional software revenue. The surge in cloud growth is likely to continue, thanks to the accelerating pace of digital transformation. This trend is also promulgated by some of the largest players, such as Microsoft, whose cloud subscription revenue now constitutes more than half of the overall revenue and is an engine of growth in the software space. Strong cloud revenue growth is not just a function of recruiting new users but is also supported by the proliferation of new cloud apps and upgrades to the existing ones.  Importantly, the cloud subscription model is also more profitable than the license model, whose EBITDA margins rarely exceed 40%. Cloud-based services take longer to become profitable but have much higher operating leverage: Once profitable, cloud and hybrid companies often have operating margins around 50-60%.  Software is one of the most resilient technology industries, performing equally well in a growing economy and during downturns: Subscription pricing is sticky, and switching costs are high. As a result, companies, which derive a large share of their revenue from the cloud, have stable and predictable sales. Once clients are onboarded, cloud providers may also be able to exercise their pricing power. IT Services IT services is a smaller segment of the Software and Services industry group and is a hodge-podge of different companies that provide a wide range of services from IT consulting to FinTech. The following is a brief description of the key categories: IT Consulting: The S&P 500 IT Consulting companies are Accenture, Gartner, and Cognizant.  Companies offer Professional advice in IT, management, HR, logistics, and many others. Since the pandemic, these companies’ key focus is on assisting their clients with digital transformation and improving companies’ operations. This industry is one of the key beneficiaries of accelerated migration to the cloud and has enjoyed exponential growth over the past decade. Its revenue stream is highly resilient, as even during economic downturns, clients are seeking advice on the best ways to navigate an uncertain market environment. Outsourcing: Companies such as ADP and Paychex provide HR and business services solutions for mid-sized and small companies. Their services cover payroll, benefits, retirement, and insurance services.   This industry has been growing its sales and profits at a healthy clip over the past few years. Now it is focused on modernizing itself by moving its own operations to the cloud and deploying Artificial Intelligence to improve operations. These companies are also undergoing digital transformation and are moving towards the SaaS model. Financial Transaction Services: This is a FinTech industry that includes card and payment processors, such as Visa, Mastercard, and PayPal, and each of these players operates their own proprietary payment networks.  Digital payments and the wide acceptance of e-commerce drive this space. Lately, these companies have been at the forefront of the adoption of digital currencies as viable payment options. Payment companies are among the earliest adopters of the cloud, and their business model is best described as Transaction-processing-as-a-service. These are highly profitable companies that consistently generate an operating margin above 60%. Key Industry Drivers Software Enhances Productivity And Improves Profitability Broadly speaking, the Software and Services industry group is considered a defensive holding owing to the resiliency of its earnings (Chart 5). Software enhances productivity: During economic downturns, it helps reduce costs, and during expansions, it helps overcome capacity constraints and labor shortages. While pandemic labor shortages and lockdowns produced a spike in productivity, more recently it has been falling, which has warranted a year-over-year increase in software investment (Chart 6). Chart 5S&S Earnings Are Resilient Across The Business Cycle Chart 6Investing In Software Improves Productivity Further, both labor shortages and rising wages are prompting companies to redesign their operations to contain costs and preserve margins. To do so, many are accelerating investments in Capex and automation, much of which is achieved through investment in software and IT services, replacing both labor and capital.  According to CFRA, “software is no longer used to manage a means of production, but rather IS means of production .” Software-related Capex is not only garnering a larger slice of tech spending budgets but also of the overall Capex pie (Chart 7). Chart 7Share Of Software In Overall Capex Has Been Rising Steadily Macroeconomic Backdrop Imminent Rate Hikes Tighter monetary policy and runaway inflation are at the fore of investors’ minds and, arguably, a cause of the current market rout.  Software stocks have outperformed the other long-duration technology stocks. To gauge the reaction of S&S to the upcoming rate hike, we have repeated an exercise we conducted for the Technology sector last week – historical performance of the industry six months before and after the first rate hike (Chart 8).   Clearly, industry returns fall two to three months before the first rate hike, but eventually recover once a new monetary regime is priced in. The year-to-date correction of the software stocks is textbook behavior. Chart 8S&S Underperforms Before The First Rate Hike Software And Services Is A Global Industry – Beware Of A Strong Dollar The Technology sector is one of the most global sectors in the S&P 500 and derives 40% of sales from abroad; similarly, Software and Services has a broad international footprint. As US rates trend higher, and the interest rate differential favors the US vs. other countries, the USD is likely to appreciate further. With a stronger dollar, products of US software firms are more expensive to foreigners, which may have a dampening effect on demand. The US firms’ profitability has also been hit by an unfavorable translation from foreign currency back to the USD. Historically, the path of the dollar and the returns of S&S were inversely correlated (Chart 9). Chart 9Historically, Stronger Dollar Has Been A Headwind For The Industry The redeeming grace is that, as we mentioned before, software subscription revenue is sticky, and switching costs for customers are high. As such, we expect the adverse effect on demand to be minor. Fundamentals Sales Growth According to Grandview Research , the business software and services market is expected to grow at a compound annualized rate of 11.3% from 2021 to 2028. This strong growth is underpinned by the robust pace of enterprise application cloud migration and digital transformation, which see no end in sight. The street expects the Software and Services industry to grow on par with the Technology sector at just under 20% over the next 12 months, and growth is slowing off high levels.  The pandemic has shifted forward some of the spending on software, as companies rushed to adjust to remote work.  However, the industry continues to grow at a healthy clip (Chart 10). Chart 10Sales Growth Is Slowing Labor Costs Are Contained For Now The S&S companies first and foremost rely on the talent and ingenuity of their workforce to deliver cutting-edge technological solutions. Wages are one of the largest expenses in the industry. Recent increases in salaries accompanied by labor shortages and “the great resignation” are bound to cut into the margins of these companies. So far, software and services companies have been able to counter the trend (Chart 11) by deploying creative solutions, offering their employees a wide range of perks, and throwing their net wide in search of talent by offering remote work.   Chart 11Industry Labor Costs Have Been Contained Resilient Earnings Growth For the reasons discussed above, S&S earnings growth is remarkably resilient and stable throughout the business cycle (Chart 12). Currently, earnings expectations of S&S over the next 12 months exceed growth expectations for both the Technology sector and the S&P 500. Over the next 12 months, S&S earnings are expected to grow at 14% compared to 8.6% for the S&P 500 (Table 4). Chart 12S&S EPS Growth Bests The Tech Sector And The S&P 500 Table 4Earnings Growth Vs. Valuations Despite the slowdown in sales growth and the pick-up in labor costs, EBITDA margins have exceeded the previous peak, and are projected to trend higher towards 40% over the course of the year (Chart 13). Expecting a growth slowdown, analysts have been revising earnings expectations down for S&S companies, but by now the downgrading process has run its course, and the bar is set low (Chart 14). Chart 13Margins Will Continue To Expand Chart 14Downgrades Are Bottoming   Valuations Since the S&S industry group’s earnings are expected to grow faster than the earnings of the Tech sector and the S&P 500, it is not surprising that it trades with a 44% premium to the S&P 500 on a forward earnings basis – a steep mark-up. The current correction has taken some froth off the industry’s valuations , with multiples contracting by 3.9 points. Even after the correction, the sector appears overvalued (Chart 15). Adjusting for expected 12-month EPS growth, S&S appears more attractively valued and trades with a discount both to tech and the broad market (Table 4). It is also important to note that the industry group is home to a plethora of quite a few smaller companies, which tend to be more expensive and more volatile: Chart 16 plots companies’ forward earnings multiples against their weight in the industry group.   Chart 15Valuations Are Still Dear... Chart 16Significant Valuation Dispersion Among The Constituents Technicals Recently, the BCA Technical Indicator has moved into the oversold territory, indicating investor capitulation. This means that this bar is cleared, and from a technical standpoint alone, Software and Services is a buy (Chart 17). Chart 17... But Technicals Indicate That S&S Is Oversold Investment Implications We are both tactically and structurally bullish on the Software and Services industry group. Tactically Bullish The Software and Services industry group is an all-weather industry with an unprecedented combination of both earnings resiliency and strong growth throughout the business cycle. It is also undergoing a fundamental transformation in its business model catalyzed by a ubiquitous shift in software applications to the cloud, accompanied by displacement of the traditional on-prem license and support model with a more lucrative subscription model. The industry is expected to grow earnings in double digits and expand margins, unhindered by rising labor costs. Rising rates are certainly a headwind, but hopefully a temporary one. Froth has come off valuations, and a new monetary regime is gradually getting priced in. According to the technical indicator, the sector is oversold. On balance, we have a positive outlook on the industry group (Table 5) and maintain our overweight position. Table 5Software And Services Scorecard Structurally Bullish Our long-held belief is that the broader push to the cloud, augmented reality, AI, cybersecurity, and autonomous driving, which are all software dependent, are not fads but are here to stay. Software and Services are at the epicenter of technological innovation and are home to some of the best American companies.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     CFRA, Industry Surveys, Software, July 2021 Recommended Allocation

Highlights The selloff in equities since the start of the year marks a long overdue correction rather than the start of a bear market. Stocks often suffer a period of indigestion when bond yields rise suddenly, but usually bounce back as long as yields do not move into economically restrictive territory. BCA’s bond strategists expect the 10-year yield to rise to 2%-to-2.25% by the end of the year, which is well below the level that could trigger a recession. While valuations in the US remain stretched, they are much more favorable abroad. Investors should overweight non-US markets, value stocks, and small caps in 2022. Go long homebuilders versus the S&P 500. US homebuilders are trading at only 6.5-times forward earnings and will benefit from tight housing supply conditions and a moderation in input costs. FAQ On Recent Market Action The selloff in stocks since the start of the year has garnered a lot of attention. In this week’s report, we address some of the key questions clients are asking.   Q: What do you see as the main reasons for the equity selloff? A: At the start of the year, the S&P 500 had gone 61 straight weeks without experiencing a 6% drawdown, the third longest stretch over the past two decades. Stocks were ripe for a pullback. The backup in bond yields provided a catalyst for the sellers to come out. Not surprisingly, growth stocks fell hardest, as they are most vulnerable to changes in the long-term discount rate. At last count, the S&P 500 Growth index was down 13.7% YTD, compared to 4.1% for the Value index. Our research has found that stocks often suffer a period of indigestion when bond yields rise suddenly, but usually bounce back as long as yields do not move into economically restrictive territory (Table 1). BCA’s bond strategists expect the 10-year yield to rise to 2%-to-2.25% by the end of the year, which is well below the level that could trigger a recession. Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Should Recover Historically, equity bear markets have coincided with recessions (Chart 1). Corrections can occur outside of recessionary periods, but for stocks to go down and stay down, corporate earnings need to fall. That almost never happens unless there is a major economic downturn (Chart 2). In fact, the only time in the last 50 years the US stock market fell by more than 20% outside of a recessionary environment was in October 1987. Chart 1Recessions And Bear Markets Tend To Go Hand In Hand Chart 2Business Cycles Drive Earnings Chart 3The Bull-Bear Ratio Is Below Its Pandemic Lows It is impossible to know when this correction will end. However, considering that the bull-bear spread in this week’s AAII survey fell below the trough reached both in March 2020 and December 2018, our guess is that it will be sooner rather than later (Chart 3). With global growth likely to remain solid, equity prices should rise. Q: What gives you confidence that growth will hold up? A: Households are sitting on a lot of excess savings – $2.3 trillion in the US and a similar amount abroad. That is a lot of dry powder. Banks are also actively looking to expand credit, as the recent easing in lending standards demonstrates (Chart 4). Leading indicators of capital spending are at buoyant levels (Chart 5). Chart 4US Banks Are Easing Lending Standards Chart 5The Outlook For US Capex Is Bright It is striking how well the global economy has handled the Omicron wave. While service PMIs have come down, manufacturing PMIs have remained firm. In fact, the euro area manufacturing PMI reached 59 in January versus expectations of 57.5. It was the strongest manufacturing print for the region since August. The manufacturing PMI also ticked up slightly in Japan. The China Caixin/Markit PMI and the official PMI published by the National Bureau of Statistics also ticked higher. After dipping below zero last August, the Citi global economic surprise index has swung back into positive territory (Chart 6). Chart 6The Omicron Wave Did Not Drag Down The Global Economy Markets are also not pricing in much of a growth slowdown (Chart 7). Growth-sensitive industrial stocks have outperformed the overall index by 1.1% in the US so far this year. EM equities have outperformed the global benchmark by 5.9%. The Bloomberg Commodity Spot index has risen 7.2%. Credit spreads have barely increased. Chart 7Markets Are Not Discounting Much Of A Growth Slowdown   Q: What is your early read on the earnings season? A: Nothing spectacular, but certainly not bad enough to justify the steep drop in equity prices. According to Refinitiv, of the 145 S&P 500 companies that have reported Q4 earnings, 79% have beat analyst expectations while 19% reported earnings below expectations. Usually, 66% of companies report earnings above analyst estimates, while 20% miss expectations. In aggregate, the reported earnings are coming in 3.2% above estimates, slightly lower than the historic average of 4.1%. Guidance has been lackluster. However, outside of a few tech names like Netflix, earnings disappointments have generally been driven by higher-than-expected expenses, rather than weaker sales. Overall EPS estimates for 2022 have climbed 0.4% in the US and by 1.1% in foreign markets since the start of the year (Chart 8).   Q: To the extent that the Fed is trying to engineer tighter financial conditions, doesn’t this imply that stocks must continue falling? A: That would be true if the Fed really did want to tighten financial conditions, either via lower stock prices, a stronger dollar, higher bond yields, or wider credit spreads. However, we do not think that this is what the Fed wants. Despite all the chatter about inflation, the 5-year/5-year forward TIPS breakeven inflation rate has fallen to 2.05%, which is 25 basis points below the bottom end of the Fed’s comfort zone (Chart 9).1 Chart 8Earnings Expectations Have Not Been Revised Lower Chart 9Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Chart 10The Terminal Fed Funds Rate Seen At 2%-2.5% Chart 11The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% Remember that the Fed’s estimate of the neutral rate, R*, is very low. The Fed thinks it will only be able to raise rates to 2.5% during this tightening cycle, which would barely bring real rates into positive territory (Chart 10). The market does not think the Fed will be able to raise rates to even 2% (Chart 11). The last thing the Fed wants to do is inadvertently invert the yield curve. In the past, an inverted yield curve has reliably predicted a recession (Chart 12). Chart 12A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) The Fed is about to start raising rates and shrinking its balance sheet not because it wants to slow growth, but because it wants to maintain its credibility. While the Fed will never admit it, it is very much attuned to the direction in which the political winds are blowing. The rise in inflation, and the Fed’s failure to predict it, has been embarrassing for the FOMC. Doing nothing is no longer an option. However, doing “something” does not necessarily imply having to raise rates more than the market is already discounting. Contrary to the consensus view that the Fed has turned hawkish, we think that the main takeaway from this week’s FOMC meeting is that Jay Powell, aka Nimble Jay, wants more flexibility in how the Fed conducts monetary policy. This makes perfect sense, as layer upon layer of forward guidance merely served to confuse market participants while unnecessarily tying the Fed’s hands.   Q: How confident are you that inflation will fall without a meaningful tightening in financial conditions? A: If we are talking about a horizon of 2-to-3 years, not very confident. As we discussed two weeks ago in a report entitled The New Neutral, the interest rate consistent with stable inflation and full employment is substantially higher than either the Fed believes or the market is pricing in. This means that the Fed is likely to keep rates too low for too long. However, if we are talking about a 12-month horizon, there is a high probability that inflation will fall dramatically, even if monetary policy stays very accommodative. Today’s inflation is largely driven by rising durable goods prices. Durables are the one category of the CPI basket where prices usually fall over time, so this is not a sustainable source of inflation (Chart 13). As demand shifts back from goods to services and supply bottlenecks abate, durable goods inflation will wane. Chart 14 shows that the price indices for a number of prominent categories of goods – including new and used vehicles, furniture and furnishings, building supplies, and IT equipment – are well above their trendlines. Not only is inflation in these categories likely to fall, but it is apt to turn negative, as the absolute level of prices reverts back to trend. This will put significant downward pressure on inflation. Chart 13Durable Goods Prices Are The Main Driver Of Inflation Chart 14Some Of These Prices Will Fall Outright Chart 15Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Granted, service inflation will accelerate this year as the labor market continues to tighten. However, rising service inflation is unlikely to offset falling goods inflation. While wage growth has accelerated, wage pressures have been concentrated at the bottom end of the wage distribution (Chart 15). According to the Census Household Pulse Survey, a record 8.75 million workers – many of them in relatively low-paid service jobs – were not working in the second week of January due to pandemic-related reasons (Chart 16). As the Omicron wave fades, most of these workers will re-enter the labor force. This should help boost labor participation among low-wage workers, which has recovered much less than for higher paid workers (Chart 17).   Chart 16The Pandemic Is Still Affecting Labor Supply Chart 17Employment In Low-Wage Industries Has Not Fully Recovered Q: Tensions between Ukraine and Russia have risen to a fever pitch. Could this destabilize global markets? Chart 18Valuations Matter For Long-Term Returns A: In a note published earlier today, Matt Gertken, BCA’s Chief Geopolitical Strategist, increased his odds that Russia will invade Ukraine from 50% to 75%. However, of that 75% war risk, he gives only 10% odds to Russia invading and conquering all of Ukraine. A much more likely scenario is one where Russia invades Donbas and perhaps a few other regions in Eastern or Southern Ukraine where there are large Russian-speaking populations and/or valuable coastal territory. While such a limited incursion would still invite sanctions from the West, Matt does not think that Russia will retaliate by cutting off oil and natural gas exports to Europe. Not only would such a retaliation deprive Russia of its main source of export earnings, but it could lead to a hostile response from countries such as Germany which so far have pushed for a more measured approach than the US has championed.   Q: Valuations are still very stretched. Even if the conflict in Ukraine does not spiral out of control and the goldilocks macroeconomic scenario of above-trend global growth and falling inflation comes to pass, hasn’t much of the good news already been discounted? A: US stocks are quite pricey. Both the Shiller PE ratio and households’ allocations to equities point to near-zero total returns for stocks over a 10-year horizon (Chart 18). That said, valuations are not a useful timing tool. The business cycle, rather than valuations, tends to dictate the path of stocks over medium-term horizons of 6-to-12 months (Chart 19). Chart 19AThe Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) Chart 19BThe Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) Moreover, stocks are not expensive everywhere. While US equities trade at 20.8-times forward earnings, non-US stocks trade at a more respectable 14.1-times. The valuation gap is even more extreme based on other measures such as normalized earnings, price-to-book, and price-to-sales (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) In terms of equity styles, both small caps and value stocks trade at a substantial discount to large caps and growth stocks (Chart 21). We recommend that investors overweight these cheaper areas of the market in 2022. Trade Recommendation: Go Long US Homebuilders Versus The S&P 500 US homebuilder stocks have fallen by 19.4% since December 10th. Beyond the general market malaise, worries about rising mortgage rates and soaring input costs have weighed on the sector. Yet, current valuations more than adequately discount these risks. The sector trades at 6.5-times forward earnings, a steep discount to the S&P 500. Whereas demand for new homes is near record high levels according to the National Association of Home Builders (NAHB) survey, the homeowner vacancy rate is at a multi-decade low. The supply of recently completed new homes is half of what it was on the eve of the pandemic (Chart 22). With demand continuing to outstrip supply, home prices will maintain their upward trend. As building material prices stabilize and worries about an overly aggressive Fed recede, homebuilder stocks will rally. Chart 21Value Stocks And Small Caps Are Cheap Chart 22US Homebuilders Looking Attractive Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  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%. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Feature Is the worst over for US and EM equities? Clearly, the risk-reward of stocks has somewhat improved, given they are no longer overbought and some bad news has already been priced in. However, conditions for a durable bottom and a sustainable and lasting rally do not yet exist. In the case of the S&P 500, our capitulation indicator has not yet reached the lows that marked the major bottoms of the past 12 years (Chart 1). Chart 1US Stocks Have Not Reached Their Selling Climax Yet Chart 2Components Of US Equity Capitulation Indicator None of its four components – the advance/decline line, momentum, breadth and investor sentiment – are back to their lows of 2010, 2011, 2015-16 and 2018 (Chart 2). In the past three cases, the S&P 500 corrected by 17-20%. A correction of this magnitude is our base case for the S&P 500 at the moment. The S&P drawdown has so far been half of this. US inflation and the Fed’s policy remain the key headwinds to US share prices. Core consumer price inflation is substantially above the Fed’s preferred range (2-2.25%) and wage growth is accelerating. As a result, the Fed will lose credibility if it does not sound ready to hike interest rates materially. The US equity market is vulnerable to such a not-dovish stance from the Fed because it is still very expensive. Inflation has also become a political problem. One reason Biden’s popularity has been sliding in the polls is the rapid pace of consumer price increases. Heading into the mid-term elections in the fall, the White House and the Democrats will not oppose the Fed raising interest rates to fight inflation. Overall, BCA’s Emerging Markets Strategy team believes markets/investors are underestimating inflation risks in the US. Core inflation will not drop below 3% unless the economy slows down and employment/wages slump. High and rising trimmed-mean and median CPI measures suggest inflation is broad-based. Normalization in supply-side factors will not be enough to lower core inflation below 3%. Importantly, the median and trimmed-mean core inflation measures strip out goods and services that post abnormal fluctuations. Their elevated readings corroborate that inflation is genuine and broad-based. Hence, pressure on the Fed to tighten will remain substantial. This is bad news for a still overvalued US stock market. Chart 3EM EPS Is Set To Dissapoint Concerning EM equities and currencies, economic growth in EM will disappoint. Chart 3 suggests that EM corporate profits are set to deteriorate materially in the coming six months or so. Besides, investor sentiment on EM equities is not downbeat – it is neutral (Chart 28 below). From a contrarian perspective, there is not yet a case to buy EM stocks in absolute terms. China’s business cycle recovery is still several months away. In other EM countries, monetary policy has tightened substantially, real interest rates remain high, or the banking system is too unhealthy to support growth. Finally, fiscal policy will be slightly tight this year in the majority of EM. As domestic demand in China and in mainstream EMs disappoint and the Fed does not do a dovish pivot soon, EM currencies will resume their depreciation versus the US dollar. Chart 4 shows that China’s credit and fiscal impulse leads EM currency cycles and is presently pointing to more EM currency depreciation. Charts 32 and 33 (below) are pointing to further greenback strength. Finally, EM growth disappointments and a strong greenback will pressure EM fixed income markets. EM high-yield (HY) credit – both sovereign and corporate – has been selling off, but investment-grade (IG) credit has been holding up (Chart 5). This is a sign that investors have been reluctant to offload EM IG credit and points to lingering positive sentiment on EM and lack of capitulation. Sluggish EM growth and an appreciating US dollar are headwinds for EM credit markets. Chart 4EM Currencies Remain At Risk Chart 5EM Credit Markets: The Selloff Will Broaden Bottom Line: We continue to recommend a defensive strategy for absolute return investors. For global equity portfolios, we recommend underweighting EM and the US, and overweighting Europe and Japan. The path of least resistance for the US dollar is up for now. The charts on the following pages are the most important ones for investors today. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com US Stocks Have Not Reached Their Selling Climax Yet Even though only 17% of the NASDAQ’s stocks are above their 200-day moving average, the same measure for the NYSE index is 38%, well above its previous lows. Besides, the NYSE’s advance/decline line has broken down, signifying a broadening equity rout. Finally, the US median stock has broken below its 200-day moving average after going sideways for 9-12 months. When such a profile occurs, the sell-off lasts more than a couple of weeks. Chart 6 Chart 7 Chart 8 Chart 9 Non-US Stocks Are Not Oversold Yet Neither global ex-US nor EM stocks are very oversold. Global ex-US and European share prices in SDR terms have been moving sideways for about 9-12 months prior to breaking down recently. Such a breakdown means a weakness in share prices that will likely last for a while. Chart 10 Chart 11 Chart 12 Chart 13 Growth Stocks Have Broken Down Various indexes of growth/TMT stocks have broken below their moving averages that have served as a support since spring 2020. This along with the fact that US interest rates will likely rise suggests that the bull market in growth stocks is either over or in for a prolonged hibernation. Chart 14 Chart 15 Chart 16 Chart 17 Is FAANGM A Bubble? In the past 12 years, US FAANGM stocks rose as much as the previous bubbles. When those bubbles peaked, their prices did not move sideways but rather collapsed. We do not assert that US FAANGM stocks will drop by more than 35% (we simply do not know). The point we would like to emphasize is that the bull market is over for now. At best, US growth stocks will likely be in a trading range in the coming 12-24 months.  Chart 18 Chart 19 US Share Prices And Corporate Margins: Defying Gravity? From a very long-term perspective, the US equity market is rather overextended. Share prices in real terms are almost two standard deviations above their time trend. Similarly, corporate profits in real terms are also very elevated, not least in their reflection of record-high profit margins. The key questions for US equity investors are: (1) how persistent/sticky core inflation will be; and (2) how low corporate profit margins will drop. Wages are the key to both inflation and corporate margins. We believe wage growth will accelerate materially. That will be bad for the outlook of inflation and corporate profit margins, although it will be good news for corporate top lines. Chart 20 Chart 21 The Levels of EM Share Prices And Corporate Profits Have Been Flat For 12 years Contrary to the US, EM share prices are not overextended – they have been flat in absolute terms for the past 12 years. The reason for such dismal performance has been stagnant corporate profits. The latter have been flat-to-down in real terms for the past 12-14 years. A breakout in EM share prices in absolute terms will require their EPS entering a secular uptrend. While this is not impossible this decade, it is not imminent. Chart 22 Chart 23 Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Based on a cyclically-adjusted P/E (CAPE) ratio, EM stocks are close to their fair value. In contrast, based on the same measure, US equities are very overvalued. As a result, the relative CAPE ratio of EM versus the US is at a record low. Hence, on a multi-year horizon, odds are that EM share prices will outperform their US peers. In a nutshell, EM ex-China, Korea, Taiwan currencies are also close to their fair value. We will be looking to upgrade EM in the coming months. Chart 24 Chart 25 Chart 26 Chart 27 Investors Are Not Bearish On EM And Europe One missing factor to upgrade EM (non-US markets in general) is investor sentiment. Sentiment is neutral on EM stocks and is fairly upbeat on Europe. In brief, a capitulation has also not yet occurred in non-US markets. On the whole, the current EM sell-off will likely linger until sentiment becomes downbeat. Chart 28 Chart 29 Directional Indicators For EM Stocks Points To More Downside The cross rate between SEK (a pro-cyclical currency) and CHF (a defensive one) moves in tandem with EM share prices. The same holds for the NZD versus the USD. The rationale is as follows: all of these currencies correlate with the global business cycle and global risk-on/off trends. Presently, the SEK/CHF cross and the NZD point to lower EM share prices. Chart 30 Chart 31 The US Dollar Is To Rally Further The Fed’s willingness (for now) to hike rates is positive for the greenback. The trend in relative TIPS yields between the US and Germany heralds further USD strength against the euro. Also, the cross rate between SEK (a pro-cyclical currency) and CHF (a defensive one) entails more upside in the broad trade-weighted US dollar. Chart 32 Chart 33 Worrisome Market Profiles Several markets such as EM non-TMT share prices, Korean tech stocks, the Chinese onshore CSI300 stock index and silver prices have all failed to break above their 200-day moving averages and are now relapsing. Such a profile is often consistent with new cyclical lows in these markets. Chart 34 Chart 35 Chart 36 Chart 37 China’s Liquidity And Credit Cycles Even though China has heightened the pace of monetary easing, it will take several months before its credit impulse rebounds. On average, it takes about six months for reductions in the required reserve ratio (liquidity injections) to produce a meaningful recovery in the credit impulse. So far, the excess reserve ratio has stabilized but not improved. This means the credit impulse will continue stabilizing in the coming months, but a major rise is unlikely in the near term. In turn, the credit cycle leads share prices by several months. All in all, a risk window for China-related plays remains open in the coming months. Chart 38 Chart 39   Footnotes