Fixed Income

Executive Summary High profile economists Larry Summers and Olivier Blanchard have recently cast doubt on the Federal Reserve’s claim that a soft landing is possible for the US economy. We explore the arguments from both sides of the debate and conclude that the economic data will likely support the Fed’s soft landing thesis during the next six months. However, the unemployment rate will rise more significantly as we move deeper into 2023 and the Fed continues to run a restrictive monetary policy. This report also provides an update on our recommended portfolio duration and high-yield positioning, and suggests a tweak to our recommended positioning across the Treasury curve. Specifically, we advise clients to enter a duration-matched position long the 5/30 barbell and short the 10-year bullet. The Beveridge Curve Peak Fed Funds? Peak Fed Funds? Bottom Line: Investors should keep portfolio duration close to benchmark and maintain a neutral (3 out of 5) allocation to high-yield bonds. Investors should also exit positions long the 2-year bullet versus a duration-matched cash/5 barbell and enter a position long a 5/30 barbell versus the 10-year bullet. Feature This week’s report digs into a recent macro debate between two high profile economists – Larry Summers and Olivier Blanchard – and the Federal Reserve about whether a “soft landing” is possible for the US economy. We summarize the debate below and offer our own thoughts on its implications for investment strategy. But first, we provide a quick update on our recent thinking about US bond portfolio construction, including a change to our recommended yield curve positioning. Positioning Update Portfolio Duration In recent reports we have written that we would reduce our recommended portfolio duration stance from “at benchmark” to “below benchmark” if the 10-year Treasury yield falls to 2.5% or if core inflation converges to our 4%-5% estimate of its underlying trend (Chart 1).1 The 10-year yield came close to hitting our 2.5% trigger last week but then quickly reversed course. It moved even higher after Friday’s extremely strong employment report, and it now sits at 2.78%. We are sticking with our plan. Despite July’s blockbuster job gains, trends in both initial and continuing jobless claims suggest that the unemployment rate is more likely to rise than fall during the next few months (Chart 2). Supply chain indicators also point toward falling inflation (Chart 2, bottom panel). Against this backdrop, it wouldn’t be too surprising to see bond yields experience another downleg. Chart 1Stay Neutral For Now Stay Neutral For Now Stay Neutral For Now Chart 2Unemployment Has Bottomed Unemployment Has Bottomed Unemployment Has Bottomed High-Yield Turning to credit, we continue to recommend an underweight allocation to spread product (including investment grade corporate bonds) versus Treasuries, but with a slightly higher allocation (neutral) to high-yield. We think that high-yield spreads can tighten in the near-term as recession fears are allayed and inflation rolls over. However, the medium-to-long run macro environment is negative for spread product and we will be quick to reduce junk exposure if spreads reach their 2017-19 average (Chart 3) or if core inflation converges with our 4%-5% estimate of trend. Chart 3Tracking The Junk Rally Tracking The Junk Rally Tracking The Junk Rally Treasury Curve Chart 4Buy A 5/30 Flattener Buy A 5/30 Flattener Buy A 5/30 Flattener Finally, this week we tweak our recommended yield curve positioning by closing our prior recommendation: long 2-year bullet versus duration-matched cash/5 barbell, and by initiating a new trade: long 5/30 barbell versus a duration-matched 10-year bullet. We only initiated that 2 over cash/5 trade a couple weeks ago on the view that 2/5 Treasury curve inversions don’t tend to last very long.2 However, it has since become clear that our timing was premature. In fact, we probably shouldn’t anticipate a significant 2/5 steepening until the Fed’s tightening cycle is near its end, which we do not believe to be the case. Instead, we recommend that investors shift into a duration-matched position that is overweight a 5/30 barbell versus the 10-year bullet. This trade offers a positive yield differential of 16 bps (Chart 4) and will profit from a flattening of the 5-year/30-year Treasury slope. The 5/30 slope has steepened in recent weeks, but further steepening is only likely to occur near the end of a Fed tightening cycle. Given that we see significant further tightening ahead, it’s much more likely that the 5/30 slope will fall to zero or even turn negative (Chart 4, top panel). The Battle Of The Beveridge Curves Our battle begins with a speech from Fed Governor Christopher Waller that was given back in May.3 In that speech, Waller made the case for why the large number of job vacancies gave him “reason to hope that policy tightening in current circumstances can tame inflation without causing a sharp increase in unemployment.” Waller’s argument was based on the historical relationship between the job vacancy rate and the unemployment rate, a relationship known as the Beveridge Curve (Chart 5). In essence, Waller’s argument for a “soft landing” boils down to the observation that the Beveridge Curve shown in Chart 5 has shifted up since the pandemic. That is, since March 2020 we have consistently seen more job vacancies for any given unemployment rate. His contention is that, as economic activity slows, rather than moving to the right along the Beveridge Curve, the curve will shift down toward its pre-pandemic level. In other words, the job vacancy rate will decline significantly without a large uptick in the unemployment rate. Chart 5The Beveridge Curve The Great Soft Landing Debate The Great Soft Landing Debate Objection! In a paper published this month, Olivier Blanchard, Alex Domash and Larry Summers (BDS) take issue with Waller’s claims from two different angles, a theoretical one and an empirical one.4 First, from a theoretical perspective, BDS describe three factors that lead to either movements along the Beveridge Curve or shifts in the curve itself. 1) Economic Activity. Stronger economic activity leads to more job vacancies and a lower unemployment rate. In other words, a shift to the left along the Beveridge Curve, illustrated as the journey from point A to point B in Chart 6. Chart 6An Illustrated Beveridge Curve The Great Soft Landing Debate The Great Soft Landing Debate 2) Matching Efficiency. If available jobs are a worse match for the skills of the unemployed labor force, then it will lead to a higher job vacancy rate for any given unemployment rate. In other words, a shift up in the Beveridge Curve from point B to point C in Chart 6. 3) Reallocation Intensity. If people switch jobs more frequently, then there will also tend to be more vacancies for any given level of unemployment. Again, this would shift the Beveridge Curve up from point B to point C in Chart 6. Using a model and data from the JOLTS survey, BDS attempt to decompose how much of these three factors have contributed to the current positioning of the Beveridge Curve. The authors estimate that economic activity has increased significantly since the end of 2019, but also that the labor market’s matching efficiency has declined, and that reallocation intensity has increased (Chart 7). Chart 7An Illustrated Beveridge Curve An Illustrated Beveridge Curve An Illustrated Beveridge Curve   While monetary tightening can weaken economic activity, it cannot change the labor market’s matching efficiency or its reallocation intensity. Therefore, the authors argue, unless matching efficiency and reallocation intensity naturally revert to their pre-COVID levels, weaker economic activity will manifest as a movement to the right along the post-2020 Beveridge Curve, leading to a higher unemployment rate. This, in our view, is the crux of the “soft landing” debate. Are the recent changes in labor market matching efficiency and reallocation intensity temporary or permanent? Next, we move to BDS’ empirical arguments. The authors construct a time series of the job vacancy rate going back to the 1950s and then examine changes in both the job vacancy rate and the unemployment rate following cyclical peaks in the vacancy rate. Their results show that a falling job vacancy rate almost always coincides with a rising unemployment rate (Table 1). In other words, if history is any guide, it is very unlikely that the Fed will be able to push the job vacancy rate down without seeing an increase in unemployment. Table 1Average Change In The Unemployment Rate And The Vacancy Rate After A Peak In The Vacancy Rate The Great Soft Landing Debate The Great Soft Landing Debate That said, the authors’ results also reveal a dynamic known as the Beveridge Loop. Notice in Table 1 that a drop in the vacancy rate leads to a much smaller increase in the unemployment rate during the first six months following the vacancy rate peak than it does during the first 12 months or first 24 months. In other words, there is some empirical validity to Fed Governor Waller’s argument that the early impact of Fed tightening will be felt primarily through a falling job vacancy rate. The 2018/19 Example We can illustrate the Beveridge Loop with a recent example, one that interestingly was not included in BDS’ empirical analysis. The job vacancy rate peaked in November 2018 and then trended lower until the pandemic struck in early 2020. Interestingly, this 2018-19 drop in the job vacancy rate occurred alongside a modest decline in the unemployment rate. Chart 8 shows what the Beveridge Curve looked like during this period. Notice that, rather than moving back to its January 2018 point in a straight line, the Beveridge Curve formed a loop after peaking in November 2018. Chart 8The 2018/19 Beveridge Loop The Great Soft Landing Debate The Great Soft Landing Debate What allowed the labor market to achieve this “soft landing” in 2018/19? The most likely answer is that labor force participation rose significantly during this period (Chart 9). The influx of workers into the labor force allowed the unemployment rate to keep falling even as continuing unemployment claims bottomed out. Chart 9The 2018/19 Soft Landing The 2018/19 Soft Landing The 2018/19 Soft Landing The BCA Verdict Our view is that the incoming economic data will appear to validate the Fed’s “soft landing” view during the next six months, but that the unemployment rate will start to rise more significantly as we move deeper into 2023. As we have stated in prior reports, a significant increase in the unemployment rate will eventually be required to tame inflation, but that increase likely won’t occur as soon as many market participants expect.5 In essence, we anticipate a large Beveridge Loop. A loop that, in fact, appears to already be forming (Chart 5). We have shown that the empirical evidence supports the idea that a Beveridge Loop will occur during the early stages of a slowdown. Further, theory and empirical evidence demonstrate that the Beveridge Curve is convex. This suggests that the Beveridge Loop could be particularly large in this cycle given that the vacancy rate is starting from such a high level. Perhaps the bigger question, though, is whether the Beveridge Curve will re-converge with its pre-pandemic level during the next 6-12 months. On this question we side more with Blanchard, Domas and Summers. While we think that matching efficiency can continue to improve along its current trend (Chart 7, panel 2), the widespread adoption of work-from-home suggests that the labor market has probably experienced a permanent increase in reallocation intensity. On matching efficiency, the best evidence for continued improvement comes from a breakdown of employment by industry (Table 2). Notice that the three sectors (other than government) that have experienced the greatest job losses since the pandemic – Health Care, Leisure & Hospitality and Other Services – also have three of the highest job openings rates. This suggests that there shouldn’t be a permanent friction between matching those missing workers to available jobs. Table 2Employment By Industry The Great Soft Landing Debate The Great Soft Landing Debate Finally, working from our 2018/19 example, we can assess the likelihood that an increase in labor force participation will cushion the upside in the unemployment rate. Here, we see some potential for the prime age participation rate to rise back to its pre-COVID level, but the re-entry of recently retired workers over the age of 55 is more in doubt. Overall, it’s highly unlikely that the overall participation rate will re-gain its pre-pandemic level (Chart 10). Chart 10Labor Force Participation Labor Force Participation Labor Force Participation The bottom line is that the next six months will likely look more like a soft landing than a hard one. The job vacancy rate will fall quickly and the unemployment rate will stay relatively low, causing the Beveridge Curve to form a large loop. However, the Beveridge Curve will not revert to its pre-COVID level any time soon. As we move deeper into 2023, the Beveridge Curve will stop looping and the unemployment rate will rise significantly.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Recession Now Or Recession Later?”, dated July 26, 2022. 2 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Low Conviction US Bond Market”, dated July 12, 2022. 3https://www.federalreserve.gov/newsevents/speech/files/waller20220530a.pdf 4https://www.piie.com/publications/policy-briefs/bad-news-fed-beveridge-space#:~:text=The%20Federal%20Reserve%20seeks%20to,together%20and%20remain%20unlikely%20now. 5 Please see US Bond Strategy Weekly Report, “Three Conjectures About The US Economy”, dated July 19, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Counterpoint’s August schedule: Next week, I am travelling to see clients in Australia, New Zealand, and Singapore, so we will send you a report on China’s 20th National Party Congress written by our Chief Geopolitical Strategist, Matt Gertken. Given that the outlook for the $100 trillion Chinese real estate market is crucial for the global economy and markets, Matt’s insights will be very interesting. Then on August 18, I will host the monthly Counterpoint webcast, which I hope you can join. We will then take a week’s summer holiday and return with a report on September 1. Executive Summary In the topsy-turvy recession of 2022, real wages have collapsed. This means profits have stayed resilient and firms have not laid off workers. Making this recession a ‘cost of living crisis’ rather than a ‘jobs crisis’. If inflation comes down slowly, then the ‘cost of living crisis’ will persist. But if inflation comes down quickly while wage inflation remains sticky, firms will lay off workers to protect their profits, turning the ‘cost of living crisis’ into a ‘jobs crisis’. Either way, this will keep a choke on consumer spending, and particularly the spending on goods, which is likely to remain in recession. Meanwhile, until mortgage rates move meaningfully lower, housing investment will also remain in recession.  The double choke on growth means that the bear market in the 30-year T-bond is likely over. This suggests that the bear market in stock market valuations is also over, but that ‘cyclical value’ is now vulnerable to profit downgrades. Hence, equity investors should stick with ‘defensive growth’, specifically healthcare and biotech. Fractal trading watchlist: GBP/USD and Hungarian versus Polish bonds. In The 2008 Recession, Real Wage Rates ##br##Went Up So Employment Went Down… In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... …But In The 2022 Recession, Real Wage Rates##br##Went Down So Employment Went Up! ...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! ...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! Bottom Line: The bear market in the 30-year T-bond and stock market valuations is likely over, but equity investors should stick with ‘defensive growth’, specifically healthcare and biotech. Feature The US economy has just contracted for two consecutive quarters, meeting the rule-of-thumb definition of a recession. Other major economies are likely to follow. Yet many economists and strategists are in denial. This cannot be a ‘proper’ recession, they say, because the economy remains at full employment. But the recession-deniers are wrong. It is a recession, albeit it is a ‘topsy-turvy’ recession in which employment remains high (so far) because real wage rates have collapsed, circumventing the need for lay-offs. This contrasts with a typical recession when real wage rates remain high, forcing the need for lay-offs.1 The Topsy-Turvy Recession Of 2022 When do firms lay off workers? The answer is, when they need to protect their profits. Profits are nothing more than revenues minus costs, and in a typical recession revenues slow much faster than the firms’ biggest cost, the wage bill. In this event, the only way that firms can protect their profits is to lay off workers. Chart I-1 confirms that every time that nominal sales have shrunk relative to wage rates, the unemployment rate has gone up. Without exception. Chart I-1Unemployment Goes Up Whenever Firms' Wage Rates Rise Faster Than Their Revenues... Unemployment Goes Up Whenever Firms' Wage Rates Rise Faster Than Their Revenues... Unemployment Goes Up Whenever Firms' Wage Rates Rise Faster Than Their Revenues... But what happens during a recession in which nominal sales do not shrink relative to wage rates? In this event, profits stay resilient, so firms do not need to lay off workers. Welcome to the topsy-turvy recession of 2022! In the topsy-turvy recession of 2022, there has been much greater inflation in consumer prices and nominal sales than in nominal wage rates (Chart I-2). The result is that real wage rates have collapsed, profits have stayed resilient, and firms have not needed to lay off workers… so far. Chart I-2...But In The 2022 Recession, Wage Rates Have Risen Slower Than Revenues, So Unemployment Hasn't Gone Up ...But In The 2022 Recession, Wage Rates Have Risen Slower Than Revenues, So Unemployment Hasn't Gone Up ...But In The 2022 Recession, Wage Rates Have Risen Slower Than Revenues, So Unemployment Hasn't Gone Up In a typical recession, the pain falls on the minority of workers who lose their jobs, as well as on profits. Paradoxically, for the majority that keep their jobs, real wages go up. This is because sticky wage inflation tends to hold up more than collapsing price inflation. For example, in the 2008 recession, the real wage rate surged by 4 percent (Chart I-3), and in the 2020 recession it rose by 2 percent. Chart I-3In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... Yet in the 2022 recession, the real wage rate has shrunk by 4 percent, meaning that the pain of the recession has fallen on all of us (Chart I-4). In one sense therefore, this recession is ‘fairer’ because ‘we’re all in it together’. This is confirmed by the current malaise being characterised not as a ‘jobs crisis’, but as a ‘cost of living crisis’. In another sense though, the recession is unfair because the pain has not been shared by corporate profits, which have remained resilient… so far. Chart I-4...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! ...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! ...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! The crucial question is, what happens next? Using the US as our template, wage rates are growing at 5-6 percent, and this growth rate is typically stickier than sales growth. Assuming inflation drifts lower, nominal sales growth will also drift lower from its current 7 percent clip, meaning that it could soon dip below sticky wage growth. Once the growth in firms’ revenues has dipped below that in nominal wage rates, profits will finally keel over. To repeat, profits are nothing more than revenues minus costs, where the biggest cost is the wage bill (Chart I-5).2 Chart I-5Profits Are Nothing More Than Revenues Minus Costs Profits Are Nothing More Than Revenues Minus Costs Profits Are Nothing More Than Revenues Minus Costs At this point, the downturn will become more conventional. To protect profits, firms will be forced to lay off workers who will bear the pain of the downturn alongside falling profits. Meanwhile, with inflation easing, real wage growth for the majority that keep their jobs will turn positive. But to repeat, this is the typical pattern in a recession. Accelerating real wage rates are entirely consistent with a contracting economy as we witnessed in both 2008 and 2020.  As Two Huge Imbalances Correct, Demand Will Be Pegged Back All of this assumes that real demand will remain under pressure, so the question is what is pegging back real demand? The answer is: corrections in two huge imbalances in the global economy. A breakdown of the -1.3 percent contraction in the US economy reveals these two corrections:3   Spending on goods, which contributed -1.2 percent Housing investment, which contributed -0.7 percent. These corrections are not over. As we presciently explained back in February in A Massive Economic Imbalance, Staring Us In The Face: “The pandemic overspend on goods constitutes one of the greatest imbalances in economic history. An overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend. The pandemic overspend on goods constitutes one of the greatest imbalances in economic history. This unfortunate asymmetry means that the recent overspend on goods at the expense of services makes the economy vulnerable to a recession. And the risk is exacerbated by central banks’ intentions to hike rates in response to inflation” (Chart I-6). Chart I-6The Pandemic Overspend On Goods Constitutes One Of The Greatest Imbalances In Economic History The Pandemic Overspend On Goods Constitutes One Of The Greatest Imbalances In Economic History The Pandemic Overspend On Goods Constitutes One Of The Greatest Imbalances In Economic History Then, in The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting, we identified a second major imbalance that is starting to correct. Specifically, the global housing boom of the past decade, which has doubled the worth of global real estate to $370 trillion, was predicated on ultra-low mortgage rates that made buying a home more attractive than renting. But in many parts of the world now, buying a home has become more expensive than renting (Chart I-7). Disappearing US and European homebuyers combined with a flood of home-sellers will weigh on home prices and housing investment – at least until policymakers are forced to bring down mortgage rates (Chart I-8 and Chart I-9). Chart I-7Buying A Home Has Become More Expensive Than Renting! Buying A Home Has Become More Expensive Than Renting! Buying A Home Has Become More Expensive Than Renting! Chart I-8Homebuyers Have Disappeared... Homebuyers Have Disappeared... Homebuyers Have Disappeared... Chart I-9...While Home-Sellers Are Flooding The Market ...While Home-Sellers Are Flooding The Market ...While Home-Sellers Are Flooding The Market Meanwhile, as Chinese policymakers try and gently let the air out of the $100 trillion Chinese real estate market, a collapse in Chinese property development and construction activity will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. More Investment Conclusions In addition to the long-term investment conclusions just described, we can draw some shorter-term conclusions: If inflation comes down slowly, then the current ‘cost of living crisis’, which is pummelling everyone’s real incomes, will persist. But if inflation comes down quickly while wage inflation remains sticky, firms will be forced to lay off workers to protect their profits, turning the ‘cost of living crisis’ into a ‘jobs crisis’. Either way, this will keep a choke on consumer spending, and particularly the spending on goods, which is likely to remain in recession. Meanwhile, until mortgage rates move meaningfully lower, housing investment will also remain in recession.  Equityinvestors should stick with ‘defensive growth’, specifically healthcare and biotech. This double choke on growth is likely to keep a lid on ultra-long bond yields, even if central banks need to hike short-term rates more than expected to slay inflation. Our proprietary fractal analysis confirms that the sell-off in the 30-year T-bond is likely over (Chart I-10). Chart I-10The Bear Market In The 30-Year T-Bond Is Likely Over The Bear Market In The 30-Year T-Bond Is Likely Over The Bear Market In The 30-Year T-Bond Is Likely Over For the stock market, this suggests that the valuation bear market is now over, but that ‘cyclical value’ sectors are now vulnerable to profit downgrades. Hence, equity investors should stick with ‘defensive growth’, specifically healthcare and biotech. Fractal Trading Watchlist This week we noticed that the sudden 20 percent collapse of Hungarian versus Polish 10-year bonds, has reached the point of short-term fractal fragility that suggests an imminent rebound. Hence, we are adding this to our watchlist. Go long GBP/USD. But our trade is GBP/USD. UK political risk is diminishing, the BoE is likely to be as, or more, hawkish than the Fed, and the 260-day fractal structure of GBP/USD is at the point of fragility that has signalled major turning points in 2014, 15, 16, 18 and 21 (Chart I-11). Accordingly the recommendation is long GBP/USD, setting the profit target and symmetrical stop-loss at 5 percent.   Chart I-11Go Long GBP/USD Go Long GBP/USD Go Long GBP/USD Go Long GBP/USD Go Long GBP/USD Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Chart 1CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point   Chart 2Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Chart 3Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Chart 4US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 5CAD/SEK Is Reversing CAD/SEK Is Reversing CAD/SEK Is Reversing Chart 6Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Chart 7The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended Chart 8The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended Chart 9FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 10Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 11The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 12The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 13Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 14German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse Chart 15Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 16ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 18The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 19A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 21Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 22Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 23Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 24USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 25The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 26A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 27US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 28The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The best measure of wage rates is the employment cost index (ECI) because it includes all forms of compensation including benefits and bonuses. 2  In fact, stock market profits are even more cyclical because, as well as wages, there are other sticky deductions from revenues such as interest and taxes. 3 All expressed as annualised rates. Fractal Trading System Fractal Trades Welcome To The Topsy-Turvy Recession Of 2022! Welcome To The Topsy-Turvy Recession Of 2022! Welcome To The Topsy-Turvy Recession Of 2022! Welcome To The Topsy-Turvy Recession Of 2022! 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Government bond yields worldwide are falling due to fears of a global recession that will lead to monetary easing in 2023. This pricing is too optimistic with inflation likely to remain well above central bank targets next year. Even though US real GDP contracted modestly in the first half of 2022, the broader flow of US economic data is more consistent with an economy that is slowing substantially but not yet in recession. The Fed welcomes sharply slower growth to deal with high inflation, but will not unwind the 2022 rate hikes as quickly as markets expect given sticky core/wage inflation. The Fed rate cuts now discounted for 2023 will likely not be delivered. No Major Recessionary Signal From Global Yield Curves … Yet No Major Recessionary Signal From Global Yield Curves . . . Yet No Major Recessionary Signal From Global Yield Curves . . . Yet Bottom Line: Falling global bond yields have helped stabilize risk assets – a path that will eventually lead to a rebound in yields if easier financial conditions help avoid a deep recession. Stay neutral overall duration exposure in global bond portfolios. The Great Recession Debate Begins Global bond yields have seen substantial declines over the past few weeks, as the market narrative has quickly changed from surging inflation and rate hikes to imminent recession and eventual rate cuts (Chart 1). The truth is somewhere in the middle, with global inflation in the process of peaking and global growth slowing rapidly but not yet in full-blown recession. Related Report  Global Fixed Income StrategyMixed Messages & Range-Bound Bond Yields Bond markets are expecting central banks, most importantly the Fed, to quickly abandon the fight against high inflation for a new battle to tackle decelerating economic growth. The problem for investors is that weaker growth is needed – and, indeed, welcomed by policymakers - to create economic slack to help bring down elevated inflation. There is little evidence of such a disinflationary slack being created, with unemployment rates still near cyclical lows in the US, Europe and most of the developed world. The link between longer-term bond yields and shorter-term interest rate expectations remains strong in an environment of very flat government yield curves. For example, in the US, the 10-year Treasury yield has fallen from a peak of 3.47% in mid-June to 2.67% at the end of July. Over the same period, the 1-month interest rate, two-years ahead priced into the US overnight index swap (OIS) curve fell from a peak of 3.1% to 2.1% (Chart 2). Chart 1A Downward Adjustment Of Interest Rate Expectations A Downward Adjustment Of Interest Rate Expectations A Downward Adjustment Of Interest Rate Expectations ​​​​​​ Chart 2A Lower Trajectory For Rates Priced In As Growth Slows A Lower Trajectory For Rates Priced In As Growth Slows A Lower Trajectory For Rates Priced In As Growth Slows ​​​​​​ An even more dramatic decline in yields has been seen in Europe. The 10-year German Bund yield has fallen from a mid-June peak of 1.75% to 0.83% at the end of July, while the 1-month/2-year forward European OIS rate fell from 2.5% to 1.1%. The 2-year German yield, most sensitive to ECB rate hike expectations, also fell dramatically from 1.15% to 0.24%. There have also been substantial declines in bond yields and rate expectations in the UK, Canada and Australia over the past six weeks. As central banks continue to raise policy rates towards levels perceived to be at least neutral, if not mildly restrictive, there should a stronger correlation between future rate hike expectations and longer-term bond yields. Put another way, yield curves tend to flatten and eventually invert as policymakers move rates to levels that should slow growth and, eventually, reduce inflation. Currently, the “global” 2-year/10-year government bond yield curve, using Bloomberg Global Treasury index data, is slightly inverted at -13bps (Chart 3). More deeper curve inversions typically precede major contractions in global growth and equity prices. Chart 3No Major Recessionary Signal From Global Yield Curves . . . Yet No Major Recessionary Signal From Global Yield Curves . . . Yet No Major Recessionary Signal From Global Yield Curves . . . Yet At the moment, global equities have performed in line with deeper curve inversions and contracting growth, with the MSCI World equity index down -7% on a year-over-year basis (bottom panel). Yet actual global growth is not yet in contraction. Global industrial production, while slowing, is still growing at a +3% year-over-year rate. The global manufacturing PMI remains above 50, indicative of a still-expanding manufacturing sector. Euro area, which is widely believed to already be in recession, saw real GDP growth (non-annualized) of +0.5% and +0.7%, respectively, in Q1 and Q2 of this year. Meanwhile, US real GDP shrank modestly over the first half of 2022, down only -0.6% (non-annualized) over Q1 and Q2, but with no corroborating evidence of recession from the labor market with the headline unemployment rate falling from 4.0% to 3.6% over that same period. Further adding to the confusing mix of signals between yield curves and growth is that the curve inversion at the global level is not yet evident across all countries. For example, the 2-year/10-year curve is inverted in the US and Canada, countries where central banks have been more aggressive on hiking rates in 2022 (Chart 4A) Yet in both countries, there have only been moderate declines in leading economic indicators and composite PMIs (combining manufacturing and services). In contrast, the 2-year/10-year curve in Germany and the UK – where the ECB and Bank of England have delivered fewer rates than the Fed and Bank of Canada – remains positively sloped but with similar moderate declines in leading economic indicators and composite PMIs to those seen in the US and Canada (Chart 4B). Chart 4AA Policy-Driven Slowdown In North America A Policy-Driven Slowdown In North America A Policy-Driven Slowdown In North America ​​​​​​ Chart 4BAn Energy-Driven Slowdown In Europe An Energy-Driven Slowdown In Europe An Energy-Driven Slowdown In Europe ​​​​​​ Chart 5Central Banks Cannot Pivot Dovishly Against This Backdrop Central Banks Cannot Pivot Dovishly Against This Backdrop Central Banks Cannot Pivot Dovishly Against This Backdrop The deceleration of growth seen so far in this countries is nowhere near enough for central banks to begin contemplating a pivot away from hawkish rate hikes in 2022 to dovish rate cuts in 2023/24, as markets are now discounting. Inflation rates remain far too elevated, and labor markets remain far too tight, for policymakers to switch from the brake pedal to the gas pedal (Chart 5). This exposes global bond yields to a rebound from recent lows as central banks disappoint the market’s growing belief that policymakers’ focus will turn to growth from inflation. The language from recent central bank policy decisions, from the ECB’s 50bp hike on July 21 to the Fed’s 75bp hike last week to yesterday’s 50bp hike by the Reserve Bank of Australia, has been consistent, calling for a continued need to tighten policy. All three central banks essentially abandoned forward guidance, but described future rate moves as being “data dependent”, particularly inflation data. There is likely to be some relief from elevated inflation rates over the next few months. There have already been substantial declines in the growth of commodity prices, with the CRB Raw Industrials index now contracting in year-over-year terms (Chart 6). Global shipping costs and supplier delivery times have also declined, as evidence of some easing of supply chain disruptions that is helping bring down goods inflation. Yet given the starting point of such high headline inflation rates – at or above 9% in the US, UK and euro area – it is unlikely that there will be enough disinflation from the commodity/goods space to quickly bring inflation down by enough for central banks to breathe easier. This is especially true given that stickier domestically generated inflation stemming from wages and services will remain well above central bank targets over at least the next year, or at least until there is a substantial increase in slack-producing unemployment (i.e. a recession). What does all this mean for our view on the direction of global bond yields? We still see the current environment as more consistent with broad trading ranges for yields, rather than the start of a new major downtrend or uptrend. Europe was the one exception to this view, given how markets were pricing in a rise in ECB policy rates that was too aggressive, but even that has now corrected after the dramatic collapse in core European yields from the mid-June peak. Our Global Duration Indicator has been calling for a loss of cyclical upward momentum of bond yields in the latter half of 2022, which is now starting to play out (Chart 7). That indicator is focused on growth indicators like our global leading economic indicator and the ZEW expectations index for the US and Europe, all of which have been declining for the past several months. Chart 6Global Inflation Is Peaking Global Inflation Is Peaking Global Inflation Is Peaking ​​​​​ Chart 7Stay Neutral On Global Duration Exposure Stay Neutral On Global Duration Exposure Stay Neutral On Global Duration Exposure ​​​​​​ However, there is a potential note of economic optimism from another key component of the Global Duration Indicator - the diffusion index of our global leading economic indicator, which measures the number of countries with rising leading indicators versus those with falling ones. That diffusion index has hooked up as the leading economic indicators of some important countries that are typically leveraged to global growth – China, Japan, Brazil, Korea and Malaysia – have started to move higher. If this trend continues in the months ahead, our Duration Indicator may signal a reacceleration of global bond yield momentum in the first half of 2023 as the global growth outlook improves. Bottom Line: Bond markets are overreacting to slowing global growth momentum by pricing in a quick reversal of 2022 rate hikes in 2023 across the developed world. Do not chase bond yields lower. The Fed Will Respond To Inflation Before Recession The Q2/2022 US GDP report showed an annualized decline of -0.9%, following on the annualized -1.6% fall in Q1 real GDP (Chart 8). This fulfills the so-called “technical definition” of a recession widely cited by the financial media. However, the official arbiters of recession dating – the National Bureau of Economic Research, or NBER – use a broader list of data to identify recessions that focus on income growth, employment and industrial production. None of those indicators contracted in the first half of the year, when the GDP-defined recession allegedly took place. We are sympathetic to the view that the US has not yet entered recession. However, recession odds are increasing, with many reliable cyclical data series slowing to a pace that has preceded past recessions. In Chart 9, we show a “cycle-on-cycle” comparison of the latest readings on some highly cyclical US economic data with readings from past recessions dating back to the late 1970s. In the chart, the data series are lined up such that the vertical line represents the NBER-designated start date of each recession, starting with the 1979/80 recession up to the 2008 recession. We show both the average path for each series across all of those recessions (the dotted line) and the range of outcomes from each recession (the shaded zone). Given the unique nature of the 2020 COVID recession, which was limited to just one quarter of collapsing activity due to pandemic lockdowns rather than typical business cycle forces, we did not include that episode in this chart. Chart 8No US Growth In H1/2022 No US Growth In H1/2022 No US Growth In H1/2022 The selected variables in this cycle-on-cycle analysis are: The year-over-year growth of the Conference Board leading economic indicator The ISM manufacturing index The University Of Michigan consumer expectations index The year-over-year growth of housing starts The year-over-year growth rate of non-financial (top-down) corporate profits. Chart 9The US Is Definitely Flirting With Recession The US Is Definitely Flirting With Recession The US Is Definitely Flirting With Recession ​​​​​ All five series selected have slowed over past several months, consistent with the run-up to previous recessions. However, in terms of timing, not all of the indicators shown are at levels that would be consistent with the US already being in a recession, as the real GDP contractions in Q1 and Q2 would suggest. Typically, the ISM index falls below 50 at the start of the recession, while the growth in the leading indicator turns negative about six months before the start of the recession. The current readings on both are still modestly above levels seen at the start of those past recessions. Corporate profit growth typically contracts for a full year ahead of recessions, and the latest complete reading available from Q1 was still showing positive, albeit slowing, growth. Chart 10The Fed Is OK With This Outcome, Given High Inflation The Fed Is OK With This Outcome, Given High Inflation The Fed Is OK With This Outcome, Given High Inflation Some of the indicators shown are looking recessionary. The current contraction in the growth of housing starts is in line with the timing from the average of past recessions. The same can be said for falling consumer expectations, although the latest decline is particularly severe compared to past recessions. From the point of view of investors, the semantics over the “official” declaration of a recession are irrelevant. There has already been a major pullback in US equity markets and widening of US corporate credit spreads as investors have priced in substantially slower growth – and the Fed tightening that is helping engineer that economic outcome. The pullback in risk assets has tightened US financial conditions, exacerbating the hit to business and consumer confidence from high inflation and declining real incomes (Chart 10). Equity and credit markets did stage healthy recoveries in the month of June as markets began to price out Fed rate hikes in response to the US potentially entering recession. However, Fed rate hikes have already flattened the US Treasury curve, which has raised the odds of a US recession NEXT year. According to the New York Fed’s recession probability model, the current spread between the 10-year US Treasury yield and the 3-month US Treasury bill rate of 23bps translates to a 26% probability of a US recession occurring one year from now (Chart 11). That model uses data going back to the 1960s, which includes the Volcker-era Fed tightenings in the 1970s that resulted in dramatic increases in real US interest rates and steep inversions of the US Treasury curve. Using the post-1980 range of recession probabilities, ranging from 0-50%, the latest 26% probability is more like a 50/50 bet on a 2023 US recession. Chart 11A US Recession Is More Likely In 2023, Says The UST Curve A US Recession Is More Likely In 2023, Says The UST Curve A US Recession Is More Likely In 2023, Says The UST Curve The Fed will need to continue delivering rate hikes until there is evidence that core inflation has peaked and will begin the path of falling back to the Fed’s 2% target. That is certainly not a story for 2022, or even for 2023, given the rapid acceleration of US wage growth (Chart 12). If the Fed were to begin pivoting away from rate hikes now, with the Atlanta Fed Wage Tracker and the Employment Cost Index accelerating at a 5-7% pace, the result would be an unwanted increase in inflation expectations. Chart 12The Fed Must Stay Hawkish With Labor Costs Still Accelerating The Fed Must Stay Hawkish With Labor Costs Still Accelerating The Fed Must Stay Hawkish With Labor Costs Still Accelerating The Fed is fighting hard to regain the inflation-fighting credibility lost in 2022 when “Team Transitory” ruled the FOMC and policy did not respond to rapidly rising inflation. The Fed’s aggressive rate hikes in 2022 have helped restore some of that credibility with bond markets, judging by the pullback in longer-term CPI-based TIPS breakevens seen in recent months, which are now back in line with the 2.3-2.5% range we have deemed consistent with the Fed’s 2% PCE inflation target (Chart 13). The evidence from survey-based measures of inflation expectations is a bit mixed, but still consistent with improved Fed credibility. The New York Fed’s Consumer Survey shows 1-year-ahead inflation expectations still elevated at 6.8%, but the 3-year-ahead expectation has drifted back below 4% (bottom panel). The University of Michigan 5-10 year consumer inflation expectation is even lower, falling to 2.8% in July from 3.1% in June. The Fed will not risk those hard-earned declines in longer-term inflation expectations by turning dovish too quickly – especially as it is not year clear if the US is even in a recession. Investors betting on a dovish pivot by the Fed before year end, leading to substantial rate cuts in 2023, are likely to be disappointed. In our view, this is setting up a potential opportunity to reduce US duration exposure to position for a rebound in Treasury yields. However, a meaningful increase in yields will be difficult to achieve, as yields are still adjusting to downside data surprises and duration positioning among investors is still below benchmark, according to the JPMorgan client duration survey (Chart 14). We suggest staying neutral on US duration exposure, for now, until the technical backdrop becomes more conducive to higher yields. Chart 13Mixed Messages On US Inflation Expectations Mixed Messages On US Inflation Expectations Mixed Messages On US Inflation Expectations ​​​​​ Chart 14Stay Neutral On US Duration - For Now Stay Neutral On US Duration - For Now Stay Neutral On US Duration - For Now ​​​​​ Bottom Line: US recession odds have increased, but the economy is not yet in recession. The Fed welcomes sharply slower growth to deal with high inflation, but will not unwind the 2022 rate hikes as quickly as markets expect given sticky core/wage inflation. The Fed rate cuts now discounted for 2023 will likely not be delivered. Treasury yields are more likely to stay rangebound over the next 3-6 months than move lower.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Dovish Central Bank Pivots Will Come Later Than You Think Dovish Central Bank Pivots Will Come Later Than You Think The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Dovish Central Bank Pivots Will Come Later Than You Think Dovish Central Bank Pivots Will Come Later Than You Think

Listen to a short summary of this report.     Executive Summary Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Following last week’s sharp post-FOMC rally, we shifted our 12-month equity recommendation from overweight to neutral. We expect stock prices to rise further during the remainder of the year as US recession risks abate, but then to give up most of their gains early next year as it becomes clear that the Fed has no intention of cutting rates and may even need to raise rates. We have more conviction that US growth will hold up over the next 12 months than we do that inflation will fall as fast as the Fed expects or the breakevens imply. These varying degrees of conviction stem from the same reason: The neutral rate of interest in the US is higher than widely believed. A high neutral rate implies that it may take significant monetary tightening to slow the economy. That reduces the risk of a recession in the near term, but it raises the risk that inflation will remain elevated. A recession is now our base case for the euro area. However, we expect the European economy to bounce back early next year, as gas supplies increase and fiscal policy turns more stimulative. The euro has significant upside over the long haul. Bottom Line: Stocks will continue to recover over the coming months before facing renewed pressure early next year. We are retaining our tactical (3-month) overweight on global equities but are shifting our 12-month recommendation to neutral. Taking Some Chips Off the Table Following last week’s sharp post-FOMC rally, we shifted our cyclical 12-month equity recommendation from overweight to neutral. This note lays out the key considerations in a Q&A format.   Q: Have any of your underlying views about the economy changed recently or has the market simply moved towards pricing in your benign outlook? A: Mainly the latter. While we continue to see a higher-than-normal risk of a US recession over the next 12 months, our baseline (60% odds) remains no recession.   Q: Many would say that we are in a recession already. A: While two consecutive quarters of negative growth does not officially constitute a recession, it is correct to say that every time real GDP has contracted for two quarters in a row, the NBER has ultimately deemed that episode a recession (Chart 1). Chart 1In The Past, Two Consecutive Quarters Of Negative Growth Have Always Coincided With A Recession In The Past, Two Consecutive Quarters Of Negative Growth Have Always Coincided With A Recession In The Past, Two Consecutive Quarters Of Negative Growth Have Always Coincided With A Recession That said, one should keep two things in mind. First, preliminary GDP estimates are subject to significant revisions. According to our calculations, there is a 35% chance that real GDP growth in Q2 will ultimately be revised into positive territory (Chart 2). Even Q1 may eventually show positive growth. Real Gross Domestic Income (GDI), which conceptually should equal GDP, rose by 1.8% in Q1. Chart 2After Further Revisions, It Is Possible That GDP Growth Ends Up Being Positive In Q2 2022 Shifting Into Neutral: A Q&A Shifting Into Neutral: A Q&A Second, every single US recession has seen an increase in the unemployment rate (Chart 3). So far, that has not happened, and there is good reason to think it will not happen for some time: There are 1.8 job openings per unemployed worker (Chart 4). For the foreseeable future, most people who lose their jobs will be able to walk across the street to find a new one. Chart 3Recessions And Spikes In The Unemployment Rate Go Hand-In-Hand Recessions And Spikes In The Unemployment Rate Go Hand-In-Hand Recessions And Spikes In The Unemployment Rate Go Hand-In-Hand Chart 4A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market   Chart 5Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Q: Aren’t other measures of economic activity such as the ISM, consumer confidence, and homebuilder sentiment all signaling that a major slowdown is in progress? A: They are but we should take them with a grain of salt. The composition of consumer spending is shifting from goods to services. This is weighing on manufacturing output. As Chart 5 shows, goods spending has already retraced two-thirds of its pandemic surge, with no ill effects on the labor market. Consumer confidence tends to closely track real wages (Chart 6). Despite an extraordinarily tight labor market, real wages have been shrinking all year. As supply-chain bottlenecks abate, inflation will fall, allowing real wages to rise. This will bolster consumer confidence and spending. Falling gasoline prices will also boost disposable incomes. Prices at the pump have fallen for seven straight weeks and the futures market is pointing to further declines in the months ahead (Chart 7). Chart 6Falling Inflation Will Boost Real Wages And Consumer Confidence Falling Inflation Will Boost Real Wages And Consumer Confidence Falling Inflation Will Boost Real Wages And Consumer Confidence Chart 7The Futures Market Points To Further Declines In Gasoline Prices The Futures Market Points To Further Declines In Gasoline Prices The Futures Market Points To Further Declines In Gasoline Prices It is also critical to remember that the Fed is trying to slow the economy by tightening monetary policy. At the start of the year, investors expected the Fed funds rate to be 0.9% in early 2023. Today, they expect it to be 3.4% (Chart 8). Chart 8Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Chart 9Housing Activity Should Recover Now That Mortgage Rates Have Stabilized Housing Activity Should Recover Now That Mortgage Rates Have Stabilized Housing Activity Should Recover Now That Mortgage Rates Have Stabilized   Rising rate expectations curb aggregate demand. This temporarily leads to lower growth. However, once rate expectations stabilize – and demand resets to a lower level – growth will tend to return to trend. The 6-month mortgage yield impulse has already turned up. This suggests that housing and other interest-rate sensitive parts of the economy will begin to recover by the end of the year (Chart 9). Admittedly, if the unemployment rate rises in response to lower aggregate demand, this could set off a vicious circle where higher unemployment leads to less spending, leading to even higher unemployment. However, as noted above, given that the current starting point is one where labor demand already exceeds labor supply by a wide margin, the odds of a such a labor market doom loop are much lower than during past downturns.   Q: Does the question of whether we officially enter a recession or not really matter that much? A: It is a matter of degree. As Chart 10 shows, macroeconomic factors are by far the most important determinant of equity returns over medium-term horizons of about 12 months. As a rule of thumb, bear markets almost always coincide with recessions (Chart 11). Chart 10Macro Forces Are An Important Driver Of Equity Returns On Cyclical Horizons Macro Forces Are An Important Driver Of Equity Returns On Cyclical Horizons (I) Macro Forces Are An Important Driver Of Equity Returns On Cyclical Horizons (I) Chart 11Equity Bear Markets And Recessions Go Hand-In-Hand Equity Bear Markets And Recessions Go Hand-In-Hand Equity Bear Markets And Recessions Go Hand-In-Hand   Chart 12Soaring Energy Prices Have Boosted Earnings Estimates This Year Soaring Energy Prices Have Boosted Earnings Estimates This Year Soaring Energy Prices Have Boosted Earnings Estimates This Year Q: Are you surprised that earnings estimates have not come down faster this year as economic risks have intensified? A: Most analysts have not baked in a recession in their forecasts, so from that perspective, if our baseline scenario of no recession does not pan out, earnings estimates will almost certainly come down (Chart 12). That said, the bar for major downward earnings revisions is quite high. This is partly because we think that if a recession does occur, it is likely to be a mild one. It is also because earnings are reported in nominal terms. In contrast to real GDP, nominal GDP grew by 6.6% in Q1 and 7.8% in Q2.   Q: Let’s turn to interest rates. Why do you think the Fed will not cut rates next year as markets are discounting? A: It all boils down to the neutral rate of interest. In past reports, we made the case that the neutral rate in the US is higher than widely believed. The fact that job vacancies are so plentiful provides strong evidence in favor of our thesis. If the neutral rate were low, the labor market would not have overheated. But it did, implying that monetary policy must have been exceptionally accommodative. The good news for investors is that a high neutral rate implies that the Fed is unlikely to induce a recession by raising rates in accordance with its dot plot. That reduces the risk of a recession in the near term. The bad news is that a high neutral rate will essentially preclude the Fed from cutting rates next year. The economy will simply be too strong for that. Worse still, if the Fed is too slow in bringing rates to neutral, inflation – which is likely to fall over the coming months as supply-chain pressures ease – could reaccelerate at some point next year. That could force the Fed to start hiking rates again.   Chart 13Real Yields Have Scope To Rise Further Real Yields Have Scope To Rise Further Real Yields Have Scope To Rise Further Q: What is your estimate for the neutral rate in the US? A: In the past, we have written that the neutral rate in the US is around 3.5%-to-4%. However, I must admit, I’m not a big fan of this formulation. Real rates matter more for economic growth than nominal rates, and long-term rates matter more than short-term rates. Thus, a better question is what level of real long-term bond yields is consistent with stable inflation and full employment. Based on research we have published in the past, my best bet is that the neutral long-term real bond yield is between 1.5%-and-2%. That is substantially above the 10-year TIPS yield (0.27%) and the 30-year TIPS yield (0.79%) (Chart 13). Given that the yield curve is inverted, the Fed may have to raise policy rates well above 4% in order to drag up the long end of the curve. It is a bit like how oil traders say you need to lift spot crude prices in order to push up long-term futures prices when the oil curve is backwardated.   Chart 14Investors Expect Inflation To Fall Rapidly Over The Next Few Years Shifting Into Neutral: A Q&A Shifting Into Neutral: A Q&A Q: So presumably then, you would favor a short duration position in fixed-income portfolios? A: Yes, if the whole yield curve shifts higher, you will lose a lot less money in short-term bonds than in long-term bonds. Relatedly, we would overweight TIPS versus nominal bonds. The TIPS market is pricing in a very rapid decline in inflation over the next few years (Chart 14). The widely followed 5-year, 5-year forward TIPS inflation breakeven rate is trading at 2.28%, toward the bottom end of the Fed’s comfort zone of 2.3%-to-2.5%.1   Q: What about credit? A: US high-yield bonds are pricing in a default rate of 6.1% over the next 12 months. This is up from an expected default rate of 3.8% at the start of the year and is significantly higher than the trailing 12-month default rate of 1.4%. In a typical recession, high-yield default rates rise above 8% (Chart 15). Thus, spreads would probably increase if the US entered a recession. That said, it is important to keep in mind that many corporate borrowers took advantage of very low long-term yields over the past few years to extend the maturity of their debt. Only 7% of US high-yield debt, and less than 1% of investment-grade debt, held in corporate credit ETFs matures in less than two years. This suggests that the default cycle, if it were to occur, would be less intense and more elongated than previous ones. Chart 15High-Yield Bonds Are Pricing In Higher Default Rates High-Yield Bonds Are Pricing In Higher Default Rates High-Yield Bonds Are Pricing In Higher Default Rates On balance, we recommend a modest overweight to high-yield bonds within fixed-income portfolios.   Chart 16High Energy Prices Are Weighing On The European Economy High Energy Prices Are Weighing On The European Economy High Energy Prices Are Weighing On The European Economy Q: Let’s turn to non-US markets. The dollar has strengthened a lot against the euro this year as the economic climate in Europe has soured. Can Europe avoid a recession? A: Probably not. European natural gas prices are back near record highs and business surveys increasingly point to recession (Chart 16). That said, the nature of Europe’s recession could turn out to be quite different from what many expect. There are a few useful parallels between the predicament Europe finds itself in now and what the global economy experienced early on during the pandemic. Just like the Novel coronavirus, as it was called back then, represented an external shock to the global economy, the partial cut-off in Russian energy flows represents an external shock to the European economy. Policymakers in advanced economies responded to the pandemic by showering their economies with various income-support measures. European governments will react similarly to the energy crunch. In fact, the political incentive to respond generously is even greater this time around because the last thing European leaders want is for Putin to succeed in his efforts to destabilize the region. For its part, the ECB will set an extremely low bar for buying Italian bonds and the debt of other vulnerable economies. Just like the world eventually deployed vaccines, Europe is taking steps to inoculate itself from its dangerous addiction to Russian energy. The official REPowerEU plan seeks to displace two-thirds of Russian natural gas imports by the end of the year. While some aspects of the plan are probably too optimistic, others may not be optimistic enough. For example, the plan does not envision increased energy production from coal-fired plants, which is something that even the German Green Party has now signed on to. The euro is trading near parity to the dollar because investors expect growth in the common-currency bloc to remain depressed for an extended period of time. If investors start to price in a more forceful recovery, the euro will rally.   Q: China’s economy remains in the doldrums. Could that undermine your sanguine view on the global economy? A: China’s PMI data disappointed in July, as anxiety over the zero-Covid policy and a sagging property market continued to weigh on activity (Chart 17). We do not expect any change to the zero-Covid policy until the conclusion of the Twentieth Party Congress later this year. After that, the government is likely to ease restrictions, which will help to reignite growth. Chart 17The Zero-Covid Policy And Slumping Property Market Are Weighing On Chinese Economic Activity The Zero-Covid Policy And Slumping Property Market Are Weighing On Chinese Economic Activity The Zero-Covid Policy And Slumping Property Market Are Weighing On Chinese Economic Activity Chart 18China Faces A Structural Decline In The Demand For Housing China Faces A Structural Decline In The Demand For Housing China Faces A Structural Decline In The Demand For Housing The property market has probably entered a secular downturn (Chart 18). If a weakening property market were to cause a banking crisis, similar to what happened in the US and parts of Europe in 2008, this would destabilize the global economy. However, we doubt that this will happen given the control the government has over the banking system. In contrast, a soft landing for the Chinese real estate market might turn out to be a welcome development for the global economy, as less Chinese property investment would keep a lid on commodity prices, thus helping to ease inflationary pressures. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn & Twitter   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 2.3%-to-2.5%. View Matrix Image Special Trade Recommendations Current MacroQuant Model Scores Shifting Into Neutral: A Q&A Shifting Into Neutral: A Q&A

Highlights Chart 1Are Expectations Too Dovish? Are Expectations Too Dovish? Are Expectations Too Dovish? ​​​ The bond market is now priced for the fed funds rate to peak at 3.44% in January and then head back down to 2.79% by the end of 2023 (Chart 1). We strongly push back against the idea that the Fed will be cutting rates in 2023. While inflation will fall during the next few months, strong wage growth suggests that it will be sticky above the Fed’s 2% target for some time. What’s more, comments from yesterday’s ISM PMI release show that “companies continue to hire at strong rates”. Our sense is that it will be difficult to push the unemployment rate up significantly even as economic activity slows. Given that inflation is likely to fall during the next few months, we recommend keeping portfolio duration ‘at benchmark’ for the time being. However, we are now actively looking for an opportunity to reduce portfolio duration and we could change our recommended allocation in the near term. Stay tuned. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance Don't Bet On A Fed Pivot Don't Bet On A Fed Pivot Table 3A Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* Don't Bet On A Fed Pivot Don't Bet On A Fed Pivot Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview ​​​​​ Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 109 basis points in July, bringing year-to-date excess returns up to -274 bps. The average index option-adjusted spread tightened 11 bps on the month and it currently sits at 144 bps. Similarly, our quality-adjusted 12-month breakeven spread moved down to its 54th percentile since 1995 (Chart 2). A report from a few months ago made the case for why investors should underweight investment grade corporate bonds on a 6-12 month investment horizon.1 The main rationale for this recommendation is that the slope of the Treasury curve suggests that the credit cycle is in its late stages. Corporate bond performance tends to be weak during periods when the yield curve is very flat or inverted. Despite our underweight 6-12 month investment stance, we wouldn’t be surprised to see spreads narrow further during the next couple of months as inflation finally shows signs of rolling over. That said, the persistent removal of monetary accommodation and inverted yield curve will limit how much spreads can compress. A recent report dug deeper into the corporate bond space and concluded that investment grade-rated Energy bonds offer exceptional value on a 6-12 month horizon.2 That report also concluded that long maturity investment grade corporates are attractively priced relative to short maturity bonds. High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 434 basis points in July, bringing year-to-date excess returns up to -493 bps. The average index option-adjusted spread tightened 100 bps on the month to reach 469 bps, 100 bps above the 2017-19 average and 62 bps below the 2018 peak. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – moved lower in July. It currently sits at 6.2% (Chart 3). As is the case with investment grade, there’s a good chance that high-yield spreads can continue their relief rally during the next couple of months as inflation falls. Due to the flatness of the yield curve, we think it will be difficult for spreads to move below the average seen during the last tightening cycle (2017-19). However, even a move back to average 2017-19 levels would equate to roughly 5% of excess return for the junk index if it is realized over a six month period. This potential return is the main reason to prefer high-yield over investment grade in a US bond portfolio. While we maintain a neutral (3 out of 5) allocation to high-yield for now, we will be inclined to downgrade the sector if spreads tighten to the 2017-19 average or if core inflation falls back to 4%.3 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 129 basis points in July, bringing year-to-date excess returns up to -44 bps. We discussed the outlook for Agency MBS in a recent report.4  We noted that MBS’s poor performance in 2021 and early-2022 was driven by duration extension. Fewer homeowners refinanced their loans as mortgage rates rose, and the MBS index’s average duration increased (Chart 4). But now, the index’s duration extension is at its end. The average convexity of the MBS index is close to zero (panel 3), meaning that duration is now insensitive to changes in rates. This is because hardly any homeowners have the incentive to refinance at current mortgage rates. The implication is that excess MBS returns will be stronger going forward. That said, we still don’t see enough value in MBS spreads to increase our recommended allocation. The average index spread for conventional 30-year Agency MBS remains close to its lowest level since 2000 (panel 4). At the coupon level, we observe that low-coupon MBS have much higher duration than high-coupon MBS and that convexity is close to zero for the entire coupon stack. This makes the relative coupon trade a direct play on bond yields. We had been recommending that investors favor low-coupon (1.5%-2.5%) MBS over high-coupon (3%-4.5%) MBS to take advantage of falling bond yields (bottom panel). Now that bond yields have fallen, we think it is wise to take profits on this position and shift to a neutral allocation across the coupon stack. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview Emerging Market bonds outperformed the duration-equivalent Treasury index by 31 basis points in July, bringing year-to-date excess returns up to -708 bps. EM Sovereigns outperformed the Treasury benchmark by 155 bps on the month, bringing year-to-date excess returns up to -784 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 45 bps, dragging year-to-date excess returns down to -659 bps. The EM Sovereign Index outperformed the duration-equivalent US corporate bond index by 53 bps in July. The yield differential between EM sovereigns and duration-matched US corporates remains negative (Chart 5). As such, we continue to recommend a maximum underweight allocation to EM sovereigns. The EM Corporate & Quasi-Sovereign Index underperformed duration-matched US corporates by 116 bps in July. The index continues to offer a significant yield advantage versus duration-matched US corporates (panel 4). As such, we continue to recommend a neutral (3 out of 5) allocation to the sector. EM currencies continue to struggle versus the US dollar (bottom panel), and depreciating exchange rates will continue to act as a headwind for USD-denominated EM bond performance. Our Emerging Market Strategy service expects continued near-term weakness in EM currencies.5 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 2 basis points in July, dragging year-to-date excess returns down to -169 bps (before adjusting for the tax advantage). We view the municipal bond sector as better placed than most to cope with the recent bout of spread volatility. As we noted in a recent report, state & local government revenue growth has been strong, but governments have been slow to hire.6 The result is that net state & local government savings are incredibly high (Chart 6) and it will take some time to deplete those coffers, even as economic growth slows and federal fiscal thrust turns to drag. On the valuation front, munis have cheapened up relative to both Treasuries and corporates during the past few months. The 10-year Aaa Muni / Treasury yield ratio is currently 85%, up significantly from its 2021 trough of 55%. The yield ratio between 12-17 year munis and duration-matched corporate bonds is also up significantly off its lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation Municipal bonds and duration-matched US corporates is 89%. The same measure for 17-year+ Revenue bonds stands at 95%, just below parity even without considering municipal debt’s tax advantage. Treasury Curve: Buy 2-Year Bullet Versus Cash/5 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened out to the 10-year maturity point in July. The 2-year/10-year Treasury slope flattened 28 bps on the month while the 5-year/30-year slope steepened 17 bps. The 2/10 and 5/30 slopes now stand at -22 bps and +30 bps, respectively. We closed our position long the 5-year bullet versus a duration-matched 2/10 barbell in a recent report.7 The reason for the move is that the 5-year note no longer offers a yield advantage versus the 2/10 barbell. That 2/5/10 butterfly spread has continued to compress during the past three weeks, and it now sits at -10 bps (Chart 7). In that same report we initiated a new recommendation: buy the 2-year bullet versus a duration-matched barbell consisting of cash and the 5-year note. This position offers a much more attractive yield advantage of 51 bps (bottom panel). Our new position will deliver strong returns if the 2-year/5-year Treasury slope steepens, something that is likely to occur if the market prices out the rate cuts that are currently discounted for next year. This would be in line with our base case expectation. However, if our base case is wrong and a deep recession forces the Fed to cut rates during the next 6-12 months, then our position should also benefit from a bull-steepening of the 2/5 slope. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 270 basis points in July, bringing year-to-date excess returns up to +256 bps. The 10-year TIPS breakeven inflation rate rose 20 bps on the month, moving back above the Fed’s 2.3% - 2.5% comfort zone (Chart 8). Meanwhile, our TIPS Breakeven Valuation Indicator now shows that TIPS are modestly cheap versus nominals (panel 2). We upgraded TIPS from underweight to neutral in a recent report.8 In that report we noted that TIPS valuation had improved considerably in recent months as the cost of inflation compensation embedded in the market trended down. For example, the 1-year CPI swap rate currently sits at 3.94%, down from a peak of 5.9% in June. Given our expectation that core inflation will be sticky around 4%, the cost of inflation compensation looks a lot more compelling than it did even a month ago. We also closed our long-standing recommendation to short 2-year TIPS in a report published two weeks ago.9 We made this change after the 2-year TIPS yield moved into positive territory for the first time since 2020, up from a 2021 low of -3.07% (bottom panel). We are not yet ready to upgrade TIPS to overweight, despite much improved valuation, because headline inflation is much more likely to trend lower than higher during the next few months. That said, if current valuations persist, we will likely be looking to upgrade TIPS once more before the end of the year.  ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 10 basis points in July, dragging year-to-date excess returns down to -52 bps. Aaa-rated ABS underperformed by 10 bps on the month, dragging year-to-date excess returns down to -43 bps. Non-Aaa ABS underperformed by 11 bps on the month, dragging year-to-date excess returns down to -104 bps. During the past two years, substantial federal government support for household incomes caused US households to build up an extremely large buffer of excess savings. Nowhere is this more evident than in the steep drop in the amount of outstanding credit card debt that was witnessed in 2020 and 2021 (Chart 9). In 2022, consumers have started to re-lever. The personal savings rate was just 5.1% in June and the amount of outstanding credit card debt has recovered to its pre-COVID level (bottom panel). But while household balance sheets are starting to deteriorate, they remain exceptionally strong in level terms. In other words, it will be some time before we see enough deterioration to cause a meaningful uptick in consumer credit delinquencies. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in July, bringing year-to-date excess returns up to -175 bps. Aaa Non-Agency CMBS outperformed Treasuries by 18 bps on the month, bringing year-to-date excess returns up to -123 bps. Non-Aaa Non-Agency CMBS outperformed by 22 bps on the month, bringing year-to-date excess returns up to -319 bps. CMBS spreads remain wide compared to other similarly risky spread products and are currently slightly above their historic averages. Further, last week’s Q2 GDP report confirmed that commercial real estate (CRE) investment remains weak (Chart 10). Weak investment will continue to support CRE price appreciation which will benefit CMBS spreads. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 24 bps in July, dragging year-to-date excess returns down to -15 bps. The average index option-adjusted spread widened 9 bps on the month. It currently sits at 54 bps, close to its long-term average (bottom panel). Agency CMBS spreads also continue to look attractive compared to other similarly risky spread products. Stay overweight.  Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 78 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Don't Bet On A Fed Pivot Don't Bet On A Fed Pivot Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of July 29, 2022) Don't Bet On A Fed Pivot Don't Bet On A Fed Pivot Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of July 29, 2022) Don't Bet On A Fed Pivot Don't Bet On A Fed Pivot Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 34 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 34 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Don't Bet On A Fed Pivot Don't Bet On A Fed Pivot Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of July 29, 2022) Don't Bet On A Fed Pivot Don't Bet On A Fed Pivot Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 2 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 3 For more details on this call please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 4 Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 5 Please see Emerging Markets Strategy Charts That Matter, “Beware Of Another Downleg In Risk Assets”, dated June 30, 2022. 6 Please see US Bond Strategy Weekly Report, “Echoes Of 2018”, dated May 24, 2022. 7 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Low Conviction US Bond Market”, dated July 12, 2022. 8 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Low Conviction US Bond Market”, dated July 12, 2022. 9 Please see US Bond Strategy Weekly Report, “Three Conjectures About The US Economy”, dated July 19, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Dear client, There will be no regular bulletin from the European Investment Strategy team next week to allow us to take some time off. We will return to our regular publishing schedule on August 15, 2022. Kind regards, The European Investment Strategy team   Executive Summary Global Headwinds For Europe Global Headwinds For Europe Global Headwinds For Europe Ahead of our summer break, we review our EIS main themes for the remainder of the year. We expect European growth to be poor in the latter half of 2022, but a recession toward the new year will be shallow. European inflation is set to crest in the fall. While the ECB will only modestly underwhelm the current €STR curve pricing, the TPI will be activated. European equities have entered a bottoming process, but cyclicals will continue to underperform defensive equities in the short-term. European investment grade credit is more attractive than local equities and US investment grade debt. The euro is also in a bottoming process, but near-term downside risk remains considerable. Bottom Line: European stocks are in the process of forming a bottom; yet, the economic softness will prevent cyclical shares from outperforming their defensive counterparts. Additionally, European IG debt offers more attractive risk-adjusted returns than equities in the near-term. Finally, the euro still faces potent front-loaded headwinds, despite a seductive long-term outlook.   The month of August is starting, which often corresponds to a period of lower volumes on the markets, since a large percentage of the financial industry goes on vacation for the summer. This year, those vacations are even more merited than usual, as the first seven months of the year have been particularly tumultuous. Chart 1Deteriorating European Growth Deteriorating European Growth Deteriorating European Growth So far, the European economy has experienced a rare set of consecutive shocks. First, inflation has jumped to its highest level since the euro was introduced 23 years ago. This inflationary shock, however, does not reflect booming demand, as it is accompanied by a sharp economic growth slowdown and thus has a strong connotation of stagflation. PMIs have fallen below the 50 boom/bust line and the growth expectations component of the Ifo survey is now firmly at recessionary levels (Chart 1). Ultimately, what Europe faces is an inward shift in the supply curve caused by a sudden curtailment of energy flows from Russia. Chart 2A Tough First Half of 2022 A Tough First Half of 2022 A Tough First Half of 2022 Second, and largely because of this inflationary shock, the policy backdrop is in upheaval. On July 21, 2022, the ECB increased interest rates for the first time in eleven years and delivered its first 50 bps hike in more than two decades. At last, negative interest rates are not the determinant feature of Eurozone rates. Yet, despite the end of this longstanding policy distortion, the euro cannot catch a break and has tested parity. Meanwhile, German yields hit 1.9% in June, inflicting a YTD loss of 13% on their holders, and Italian spreads have blown up, raising the specter of financial fragmentation in Europe (Chart 2). Third, the environment has also been rough for equity investors. The pan-European Euro STOXX and the Eurozone Euro STOXX 50 have entered into bear markets, falling 23% and 24% respectively from their January 5 peak to their trough on July 5, 2022 (Chart 2, bottom panel). At this juncture, we will review our main themes for the remainder of the year, which also gives us an opportunity to align our recommendations with our core views.  Key Views For The Remainder Of The Year We continue to expect European growth in the latter half of the year to be weak, probably around 0%. Too many hurdles are mounting. We continue to witness signs that global growth is deteriorating. The slowdown in manufacturing activity is not a phenomenon unique to Europe. Global inventories are rising in the manufacturing and retail sectors, which is likely to reduce global industrial production in the coming quarters. As a result, global trade and European exports are set to weaken further (Chart 3). Moreover, the global credit impulse is contracting rapidly in response to tightening monetary conditions. This, too, will weigh on global trade, and thus, on export-oriented nations like Europe. Chart 3Global Headwinds For Europe Global Headwinds For Europe Global Headwinds For Europe Chart 4Households Aren't Alright Households Aren't Alright Households Aren't Alright Inside Europe, the household sector’s malaise is deepening further, as highlighted by crashing consumer confidence (Chart 4). This degeneration reflects the hit to real income caused by elevated inflation, but it has been compounded by rising borrowing costs and falling financial asset prices. Chart 5Running Out Of Gas Running Out Of Gas Running Out Of Gas Meanwhile, the risks from the energy market remain most salient and could even force a contraction in output somewhere between Q4 2022 and Q1 2023. Russian natural gas flows are minimal and are unlikely to rebound enough to allow for the hoped-for build-up in natural gas inventories by the winter (Chart 5). As a result, to keep the lights on, European countries will have to rely on a combination of coal power and energy cuts. Nonetheless, BCA’s commodity and energy strategists estimate that the 14GW of coal-fired generation capacity announced so far and the 15% cut in demand pushed by the European Commission will allow Europe to limp along this winter and avoid the nightmare scenarios delineated by the Bundesbank four months ago.   Ultimately, we expect European economic activity to rebound rapidly in the second quarter of 2023. European governments will not sit idly by when their economies are suffering from a major drag caused by a conflict. Households and the sectors that will be most affected by energy rationing (industrials, such as chemicals and cement) will receive help. Thus, fiscal policy will remain accommodative. Moreover, any production curtailed during the winter will be postponed, which means that activity will likely rebound sharply once the weather warms up. On the inflation front, we continue to see a peak in inflation in the coming months. Commodity inflation is peaking and supply-side constraints are ebbing, which will lessen overall inflation (Chart 6). Additionally, the current weakening demand in Europe, tighter financial conditions, and slowing money supply growth are all consistent with a slowdown in inflation (Chart 7). Chart 6Weaker Commodity Inflation Weaker Commodity Inflation Weaker Commodity Inflation Chart 7Domestic Conditions Becoming Disinflationary Domestic Conditions Becoming Disinflationary Domestic Conditions Becoming Disinflationary Regarding monetary policy, the ECB wants to hike — and hike it will. Our base case scenario calls for a 50bps hike in September, but risks are skewed to the downside because of the weakening economic activity. We also expect two 25bps interest rate increases in October and December, which is somewhat under the €STR curve pricing, but only marginally so (Chart 8). However, we do expect the Transmission Protection Instrument (TPI) to be activated in the fall to facilitate higher policy rates because of the vast difference in r-star between Germany and the periphery.  Chart 8A Tad To High A Tad To High A Tad To High For government bonds, since we foresee a small dovish surprise by the ECB as well as lower inflation, we anticipate slightly more downside for German Bund yields for the rest of the year. Italian government bonds remain risky in the near-term as market participants test the ECB’s resolve regarding the TPI and Italian politics remain in a state of flux. However, the eventual ECB purchases render them an attractive bet in medium- to long-term portfolios. Despite the slowdown in activity, European equities have already entered a bottoming process. They are cheap and their multiples are already consistent with deep stagflation fears (Chart 9, top panel). Moreover, earnings revisions are already contracting (Chart 9, bottom panel). The collapse in the euro, however, is providing a potent counterweight to economic weaknesses and is allowing European firms to beat analyst expectations. This positive view on the aggregate stock level does not translate yet into an overweight stance on cyclical equities versus defensive ones. Lower inflation and potentially lower global yields help defensive stocks, not cyclical ones. Meanwhile, the Chinese economy continues to struggle with the impact of Beijing’s zero-COVID policy and the disarray in the housing market. These forces suggest that European cyclicals could suffer further underperformance in the coming months (Chart 10), especially if European activity and global trade remain under stress. Additionally, the risks caused by the energy market will continue to warrant a discount in European cyclical equities. Chart 9The Bottoming Process For Stock Has Begun The Bottoming Process For Stock Has Begun The Bottoming Process For Stock Has Begun Chart 10Cyclicals Are Still Handicapped Cyclicals Are Still Handicapped Cyclicals Are Still Handicapped Chart 11IG Prices In A Recession Already IG Prices In A Recession Already IG Prices In A Recession Already European credit, especially investment-grade corporate, offers more appealing risk-adjusted returns than equities. Valuations in the IG space are clearly discounting a severe recession, with the 12-month breakeven spreads in their 80th historical percentile (Chart 11). Meanwhile, the combination of shallower than-once-feared recession with continued fiscal support and further ECB buying will help spreads narrow. As a result, we continue to favor IG to increase risk exposure in Europe. We also favor European IG debt over their US counterparts, especially on a USD hedge basis. The euro remains at a complex juncture. As we wrote three weeks ago, EUR/USD is increasingly attractive for long-term holders. It is cheap and a turnaround in growth next year will help this pro-cyclical currency. However, in the near-term, the euro must cope with the negative impact of China’s growth weakness, Europe’s more pronounced recession risk relative to the US, and the evolving threat of a severe energy crunch. As a result, we continue to see a very fat left tail in EUR/USD in the near-term and prefer the CHF to other European currencies as a vehicle to garner exposure to Europe. Bottom Line: European growth will remain challenged in the near-term, but a severe recession will be avoided. With inflation also peaking this fall, European stocks are in the process of forming a bottom; yet, economic softness will prevent cyclical shares from outperforming their defensive counterparts. Additionally, European IG debt offers more attractive risk-adjusted returns than equities in the near-term. Finally, the euro still faces potent front-loaded headwinds, despite a seductive long-term outlook. Consequently, investors should favor the CHF to gain exposure to European currencies. House Cleaning We take this opportunity to restate our view for the remainder of the year, and to clean up our recommendation and focus on those most aligned with the aforementioned views. The trades from our rotation framework are not impacted, as they are not linked to our key views. Tactical Trades We keep the following tactical trades on the books: Neutral stance on cyclicals relative to defensives: This trade is aligned with our worries that weak global growth will continue to hurt the performance of cyclical equities. Long German / short Italian industrials: This is an uncorrelated trade that benefits from the extreme valuation discount of German industrials relative to their southern counterparts. Moreover, the German economy is faring better than that of Italy, while German financial and monetary conditions are looser than those in Italy. Long Swiss equities / short Eurozone defensives: This is another uncorrelated trade. Swiss stocks are pricey and defensive. However, they are less exposed to the energy rationing this winter than their Eurozone counterparts. Moreover, this position is an implicit bet on a weaker EUR/CHF. Long / short basket based on Combined Mechanical Valuation Indicator: This is another uncorrelated trade, based strictly on the most extreme signals from our CMVI methodology. It is a risk averse approach that focuses on buying assets discounting the worst outcome and buying those pricing in some excessively optimistic scenarios. Short European tech firms / long European healthcare shares: This is a defensive trade that seeks to avoid taking a directional bet on the performance of high duration stocks relative to the market. It corresponds to our worry about cyclicals relative to defensives Combined Mechanical Valuation Indicator Top 20: This position is similar to our country-selected CMVI trade, but here, it picks the most extreme signals in terms of valuation among 2,000+ sectoral trades across nine European countries. Short European consumer discretionary / long telecom services: This is another defensive trade that is supported by valuations and that benefits from the negative impact on real household income of inflation. It will also gain if energy prices additionally increase and further hurt discretionary spending. Overweight Spanish and Italian bonds: This position has now become a cyclical bet. Italian and Spanish bonds could suffer some additional near-term volatility; however, the upcoming activation of the ECB’s TPI will cause these spreads to widen, offering investors the opportunity to enjoy a much higher yield than Bunds and capital gains as well. Long Eurozone Investment Grade corporate: We are moving this position to become a cyclical trade. It is a direct bet on our positive stance on European IG corporates. Sell EUR/JPY: This trade is a play on the near-term downside risk to the euro. Cyclical Trades: We keep the following cyclical trades on the books: Underweight French consumer discretionary stocks relative to the French equity benchmark: The overbought and expensive status of the entire French stock benchmark comes from the consumer discretionary sector. These stocks are treated as growth stocks; however, the decline in global consumer confidence is historically associated with a vanishing premium for this sector. Long Swedish Industrials / short Eurozone and US industrials: This is a sector neutral trade that avoids overexposure to cyclicals. Instead, it takes advantage of the fact that Swedish industrials have a higher return on assets and profit margins than that of their competitors in the Eurozone and the US. Moreover, the SEK is particularly cheap, which boosts the competitiveness of Swedish industrial equities. Favor Eurozone aerospace & defense stocks relative to the benchmark: Defense stocks are our favorite sector at the moment. They benefit from both European re-armament and from the need for power projection in a multipolar world. Favor Eurozone aerospace & defense stocks relative to industrials: Industrials are likely to see their valuation premium diminish once inflation recedes. They currently trade as an inflation hedge because of their comparatively robust pricing power. Meanwhile, defense equities benefit from the structural tailwind described above. Favor Spanish over Italian equities: Spain’s competitiveness has improved considerably relative to the rest of the Eurozone, notably relative to Italy. Importantly, Spain’s political risk is currently lower than that of Italy. Underweight German Bunds within European fixed-income portfolios: This trade is similar to our overweight stance on Italian and Spanish bonds. Overweight Gilts within European fixed-income portfolios: The British economy is weak, which constraints the ability of the BoE to push up rates as much as what is priced into the SONIA curve. Short EUR/SEK: This trade is being move to a structural position. The Swedish economy is more cyclical than that of Europe, but Sweden is less at risk than the Eurozone from Russia’s energy curtailments. Moreover, Swedish returns on assets are superior to those of the Euro Area, which is positive for the currency on a long-term basis. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary Italy’s right-wing alliance, led by Brothers of Italy, will likely outperform in  the upcoming election. The new government will prioritize the economy, posing a risk to the EU’s united front against Russia. It is conducive to an eventual ceasefire, which is marginally positive for risk assets in 2023. We recommend investors underweight Italian assets on a tactical basis. China’s political risks will remain elevated until Xi consolidates power this fall, positive news will come after, if at all. Geopolitical risk in the Taiwan Strait will remain high and persistent until China and the US reach a new understanding. Separately, we are booking a 9% gain on our long US equities relative to UAE equities trade. Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Tactical Recommendation Inception Date Return LONG US / UAE EQUITIES (CLOSED) 2022-03-11 9.0% Bottom Line: Italy’s political turmoil suggests a more pragmatic policy toward Russia going forward. Europe’s energy cutoff will also motivate governments to negotiate with Russia. Feature In this report we update our GeoRisk Indicators, with a special focus on Italy’s newest political turmoil. Italy Over the past several months, we have argued that Italy was a source of political risk within the European Union and that the market underestimated the probability of an early Italian election. In the past two weeks, this forecast has become a reality (Chart 1). Chart 1Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator The grand coalition under Prime Minister Mario Draghi had fulfilled its two main purposes – to distribute EU recovery funds and secure an establishment politician in the Italian presidency. At the same time, headline inflation hit 8.5% in June, the highest since 1986, even as the Italian and global economy slowed down, Italian government bonds sold off, and Russia induced an energy crisis. The stagflationary economic environment is biting hard and the different coalition members are looking to their individual interests ahead of election season. On July 14, Giuseppe Conte, the former prime minister, pulled its populist Five Star Movement (M5S) out of Mario Draghi’s national unity government, triggering a new round of political turmoil in Italy. Draghi’s first resignation was rejected by Italian President Mattarella later that day. However, on July 21, the League and Forza Italia also defected from the grand coalition. After Draghi’s plan of reviving the coalition collapsed, President Mattarella accepted his resignation and called for a snap election to be held on September 25, ten months ahead of the original schedule. Based on the latest public opinion polls, right-wing political parties are well-positioned for the upcoming election. The far-right Brothers of Italy is now the front runner in the election race and is expected to win around 23% of the votes. Another far-right party, the League, is the third most popular party, with nearly 15% support despite a drop in support during its time within the grand coalition. In addition, the center-right Forza Italia receives 8.5% of the support. Together, the right-wing conservative bloc amounts to 46.5% of voting intentions. There is still positive momentum for Brothers of Italy to harvest more support given that they are the flag-bearer for anti-incumbent sentiment amid the stagflationary economy. By contrast, the left-wing parties – the Democrats, the Left, and the Greens – only command about 27%. The possibility of an extended left-wing coalition, even with the inclusion of the M5S, is looking slim. On July 25, Enrico Letta, the leader of the Democratic Party, publicly expressed his anger against party leader Giuseppe Conte and ruled out any electoral pact with the M5S because of the recent political chaos they caused. He stressed that the Democratic Party would seek ties with parties that had remained loyal to Draghi’s national unity. However, there are not many parties left for the Democrats to partner with. Apart from the Left and the Greens, the Democrats’ best chance would be the center-left Action Party and Italia Viva, which is led by Matteo Renzi, who served as the secretary of the Democratic Party from 2013 to 2018. However, these four parties are small and will not enable the Democrats to form a government. Courting M5S is the Democrats’ only chance to set up an alternative to the right-wing bloc, but that will require the election to force the two parties together. Related Report  Geopolitical StrategyLe Pen And Other Hurdles (GeoRisk Update) The Democratic Party was the biggest supporter of Draghi’s government, while the Brothers of Italy were the sole major opposition. Thus the September 25 election will be a race between these two major parties. Both are expected to outperform current polling, as they will attract the most supporters from each side. The other right-wing parties, Forza Italia and the League, will at least perform in line with their polling, while the other left-wing parties will underperform. In the meantime, M5S’ popularity will continue to decline – the party is bruised over its role in Draghi’s coalition and divided over how to respond to the Ukraine war. Foreign policy is a major factor in this election. Italy has the highest share of citizens in the Eurozone who support solving the Russia-Ukraine conflict through peaceful dialogue (52% versus the Eurozone average of 35%). Italy has long maintained pragmatic relations with Russia, including the Putin administration, as it imported 40% of its natural gas from there prior to 2022. The EU is struggling to maintain a united front against Russia, and war policy will be a key focal point among the different parties. Draghi and the Democratic Party are the strongest supporters of the EU’s oil embargo on Russia and decision to send arms to support Ukraine. On the other side, the right-wing Forza Italia and the League have been more equivocal due to their traditional friendship with Russia. What’s more important is the stance of the Brothers of Italy on Russia, as it is the largest party now and will probably lead a right-wing government after the election. On July 27, the three right-wing parties struck a deal to officially form an alliance in the upcoming election and whichever party wins the most votes would determine the next prime minister if the alliance wins. This deal puts Giorgia Meloni, the leader of Brothers of Italy, one step closer to becoming Italy’s first female PM. Giorgia Meloni, unlike her right-wing peers, has endorsed Draghi’s hawkish stance towards Russia. Recently, she stressed that Italy would keep sending arms to Ukraine if her party forms a government after the election. However, Meloni’s speech could be a tactical move to win the election more than an unshakeable policy position. First, like the other two right-wing parties, the Brothers of Italy have had close connections with Russia. After the 2018 Russian presidential election, Meloni congratulated Putin and claimed his victory was “the unequivocal will of Russians.” In addition, she is close to Prime Minister Viktor Orban of Hungary and National Rally leader Marine Le Pen of France, both of whom have criticized the EU’s decision to provide military support to Kyiv. Hence her sharp change of stance this year seems calculated to avoid accusations of being pro-Russian. But that does not preclude a more pragmatic approach to Russia once in office. Second, Meloni has compromised other far-right positions to broaden her voter base. She has reversed the party’s original anti-EU stance and claimed it does not seek to leave the EU, as most European anti-establishment parties have had to do in order to make themselves electable. Being the only female in the election race, Meloni also pledged to protect women’s access to safe abortions in Italy, also a softer stance than before. Even if the Brothers of Italy distance themselves from some unpopular right-wing positions, including on Ukraine, they probably cannot form a government on their own. They will need to court Forza Italia and the League. These two parties prefer a more pragmatic approach to Russia and a peaceful resolution to the war. Thus while it will be hard to find a middle ground on the issue of Ukraine, the election will likely prevent Italy from taking a more confrontational stance toward Russia. It will probably do the opposite. Consider the context in which the next Italian government will operate. Russia declared on July 25 that it will further reduce natural gas supplies to Europe through Nord Stream 1, as we expected, bringing pipeline flows to 20% of its full capacity.  Energy prices will go up even as European economic activity and industry will suffer greater strains. If Meloni is elected as the new prime minister this September, she will have to keep talking tough on Russia while simultaneously seeking a solution to soaring energy prices and economic crisis. This solution will be diplomacy – unless Russia seeks to expand its invasion all the way to Moldova. A right-wing victory is the most likely outcome based on opinion polling, the negative cyclical economy, and the underlying structural factors supporting populism in Italy that we have monitored for years. Such a coalition will not be pro-Russian but it will be pragmatic and focused on salvaging Italy’s economy, which means it will be highly inclined toward diplomacy. If Russia halts its military advance – does not attempt to conquer southwestern Ukraine to Moldova – then this point will be greatly reinforced. Italy will become a new veto player within the European Union when it comes to any major new sanctions on Russia. While Europeans will continue diversifying their energy mix away from Russia, it will be much harder for the EU to implement a natural gas embargo in the coming years if Italy as well as Hungary oppose it. Even if we are wrong, and the Democratic Party or other left-wing parties surprise to the upside in the election, the new coalition will most likely have to focus on mitigating the economic crisis and thus pursuing diplomacy with Russia. That is, as long as Russia pushes for a ceasefire after it achieves its military aims in Donetsk, the last holdout within the south-southeastern territories Russia is trying to conquer. Bottom Line: Due to persistent political uncertainty, we recommend investors underweight Italian stocks and bonds at least until a new government takes shape, which could take months even after the election. However, government bonds will remain vulnerable if a right-wing coalition assumes power, since it will pursue loose fiscal policies and will eschew structural reforms. Overall Italy’s early elections will lead to a new government that is focused on short-term economic growth, likely including pragmatism toward Russia. From an investment point of view that will not be a negative development, though much depends on whether Russia expands its invasion or declares victory after Donetsk. Russia Market-based measures of Russian geopolitical risk are rebounding after subsiding from peak levels hit during the invasion of Ukraine in February (Chart 2). Chart 2Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia’s continued tightening of natural gas supplies (and food exports) this week is precisely what we predicted would happen despite a wave of wishful thinking from investors over the past month. The optimists claimed that Russia would resume Nord Stream 1 pipeline flows after a regular “maintenance” period. They also said that Canada’s cooperation in resolving some “technical” issues around turbines would stabilize natural gas supply. The truth is that Russia is seeking to achieve its war aims in Ukraine. Until it has achieved its aims, it will use a range of leverage, including tightening food and energy supplies. Most likely Russia will halt the advance after completing the conquest of the Donbas region and land-bridge to Crimea. Then it will seek to legitimize its conquests through a ceasefire agreement. However, it could launch a new phase of the war to try to take Odessa and Transniestria, which would cement European resolve, even in Italy, and trigger a new round of sanctions. Bottom Line: Russia faces a fork in the road once it completes the conquest of Donetsk. Most likely it will declare victory and start pushing for a ceasefire late this year or early next year. Movement toward a ceasefire would reduce geopolitical risk for global financial markets in 2023. But there is still a substantial risk that Russia could expand the invasion to eastern Moldova, which would escalate the overarching Russia-West conflict and sustain the high level of geopolitical risk for markets. China Chinese political and geopolitical risk will continue to rise and the bounce in Chinese relative equity performance is faltering as we expected (Chart 3). Chart 3China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator China’s leaders will hold their secretive annual meeting at Beidaihe in August ahead of the critical Communist Party national congress this fall. General Secretary Xi Jinping is attempting to cement himself as the paramount leader in China, comparable to Chairman Mao Zedong, transforming China’s governance from that of single-party rule to single-person rule. The reversion to autocratic government is coinciding with a historic economic slowdown consisting of cyclical factors (weak domestic demand, weakening foreign demand, draconian Covid-19 restrictions) and structural factors (labor force contraction, property sector bust, social change and unrest). Both Xi and US President Biden face major domestic political challenges in the coming months with the party congress and the US midterm election. Hence they are holding talks to try to stabilize relations. But we do not think they will succeed. China cannot reject Russia’s strategic overture, while the US cannot afford to re-engage with a China that is partnering with Russia in a challenge to the liberal-democratic world order. In addition, US policies are erratic and the US cannot credibly promise China that it will not pursue a containment strategy even if China offers trade concessions. Bottom Line: China-related political and geopolitical risks will remain very high until at least after the twentieth party congress. At that point we expect President Xi to loosen a range of policies to stabilize the economy and foreign trade relations. These policies may bring positive news in 2023, though China’s biggest macroeconomic and geopolitical problems remain structural in nature and we remain underweight Chinese assets. Taiwan For many years we have warned of a “fourth Taiwan Strait crisis” due to the unsustainable geopolitical situation between China, Taiwan, and the United States. After the war in Ukraine we argued that the US would try to boost its strategic deterrence around Taiwan, since it failed to deter Russia from invading Ukraine, but that the increased commitment to Taiwan would in fact provoke China (Chart 4). Chart 4Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Until the US and China reach a new understanding over Taiwan, we argued that the region would be susceptible to rising tensions and crisis points that would send investors fleeing from risky assets, especially risky regional assets. It is possible that we have arrived at this crisis now, with House Speaker Nancy Pelosi making preparations to visit Taiwan, China pledging “forceful” countermeasures if she does, President Biden suggesting that the US military thinks Pelosi should not visit, and Biden and Xi preparing for a phone conversation. In essence China is giving an ultimatum and setting a new bar, and a very low bar, for taking some kind of action on Taiwan, i.e. the mere visit of a US House speaker, which has happened before (House Speaker Newt Gingrich in 1997). China’s purpose is to lay the groundwork for preventing the US from upgrading Taiwan relations in any more substantial way, whether political or military. If the Biden administration calls off the Pelosi visit, then American relations with Taiwan will have been curtailed, at least for this administration. If Biden goes forward with the visit, then Beijing will need to respond with an aggressive show of force to prevent any future president from repeating the exercise or building on it. And if this show threatens US personnel or security, a full-blown diplomatic or military crisis could ensue. While we doubt it would lead to full-scale war, it could lead to a frightening confrontation. Biden may want to stabilize relations with China, since he is primarily focused on countering Russia, but his options are limited. China cannot save him from inflation but it can solidify the public perception that he is weak. Hence he is more likely to maintain his administration’s hawkish approach. Biden’s approval rating is 38% and his party faces a drubbing in the midterm elections. A confrontation with Russia, China, Iran, or anyone else would likely help his party by producing a public rally around the flag. Any unilateral concessions will merely strengthen Xi’s power consolidation at the party congress, which is detrimental to US interests. Only if the Biden administration pursues a dovish policy of re-engagement that is subsequently confirmed by the 2024 presidential election will there be potential for a substantial US-China economic re-engagement. We are pessimistic. Bottom Line: Taiwan-related geopolitical risk will rise in the short run. If there is a new US-China understanding over Taiwan, then regional and global geopolitical risk will decline over the medium term. But we remain short Taiwanese assets. Investment Takeaways Investors should remain defensively positioned until the US midterm election ends with congressional gridlock; the Chinese party congress is over and Xi Jinping launches a broad pro-growth policy; and Russia starts pushing for a ceasefire in Ukraine. We also expect that markets will need to get over new, unexpected oil supply shocks arising from the failure of US-Iran nuclear negotiations, which remains off the radar and therefore a source of negative surprises. Any US-Iran nuclear deal would be a major positive surprise that postpones this risk for a few years. Having said that, we are booking a 9% gain on our long US versus UAE equity trade for technical reasons. Democrats have reached a deal to pass a budget reconciliation bill in an effort to mitigate midterm election losses. This development reinforces the 65% odds of passage that we have maintained for this bill’s passage in our US Political Strategy reports since last year.   Yushu Ma Research Analyst yushu.ma@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Appendix UK Chart 5UK: GeoRisk Indicator United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator Germany Chart 6Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator France Chart 7France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator Spain Chart 8Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Canada Chart 9Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Australia Chart 10Australia: GeoRisk Indicator Australia: GeoRisk Indicator Australia: GeoRisk Indicator Korea Chart 11Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Brazil Chart 12Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Turkey Chart 13Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator South Africa Chart 14South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades Geopolitical Calendar

Executive Summary If a loss of wealth persists for a year or more, it hurts the economy. The recent $40 trillion slump in global financial wealth is larger than that suffered in the pandemic of 2020, the global financial crisis of 2008, and the dot com bust of 2000-01. Partly countering this slump in global financial wealth is a $20 trillion uplift in global real estate wealth. However, Chinese home prices are already stagnating. And the recent disappearance of US and European homebuyers combined with a flood of home-sellers warns that US and European home prices will cool over the next 6 months. With the loss of wealth likely to persist, it will amplify a global growth slowdown already in train, aided and abetted by central banks that are willing to enter recession to slay inflation. The optimal asset allocation over the next 6-12 months is: overweight bonds, neutral stocks, and underweight commodities. A variation on this theme is: overweight conventional bonds and stocks versus inflation-protected bonds and commodities. Fractal trading watchlist: US telecoms versus utilities, and copper. We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters Bottom Line: On a 6-12 month horizon, overweight bonds, neutral stocks, and underweight commodities. Feature Since the end of last year, the world has lost $40 trillion of financial wealth, evenly split between the crashes in stocks and bonds (Chart I-1). The slump in financial wealth, both in absolute and proportionate terms, is the worst suffered in a generation, larger than that in the pandemic of 2020, the global financial crisis of 2008, and the dot com bust of 2000-01.1 Chart I-1Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Partly countering this $40 trillion slump in global financial wealth is a $20 trillion uplift in global real estate wealth. But in total, the world is still $20 trillion ‘asset poorer’ than at the end of last year. Given that global GDP is around $100 trillion, we can say that we are asset poorer, on average, by about one fifth of our annual income. Does this loss of wealth matter? A Loss Of Wealth Matters If It Persists For A Year Or More Some argue that we shouldn’t worry about the recent slump in our wealth, because we are still wealthier than we were, say, at the start of the pandemic (Chart I-2). Yet this is a facile argument. Whatever loss of wealth we suffer, there is always some point in the past against which we are richer! Chart I-2We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation Another argument is that people do not care about a short-lived dip in their wealth. This argument has more truth to it. For example, in the extreme event of a flash crash, an asset price can drop to zero and then bounce back in the blink of an eyelid. In this case, most people would be oblivious, or unconcerned, by this momentary collapse in their wealth. But people do care if the slump in their wealth becomes more prolonged. How long is prolonged? The answer is, if the slump persists for a year or more. Why a year? Because that is the timeframe over which governments, firms, and households make their income and spending plans. Governments and firms do this formally in their annual budgets that set tax rates, wages, bonuses, and investment spending. Households do it informally, because their wages, bonuses, and taxes – and therefore disposable incomes – also adjust on an annual basis. Into this yearly spending plan will also come any change in wealth experienced over the previous year. For example, firms often do this formally by converting an asset write-down to a deduction from profits, which will then impact the firm’s future spending. This illustrates that what impacts your spending is not the level of your wealth, but the yearly change in your wealth. Spending Is Impacted By The Change In Wealth The intellectual battle here is between Economics and Psychology. The economics textbooks insist that it is the level of your wealth that impacts your spending, whereas the psychology and behavioural finance textbooks insist that it is the change in your wealth that impacts your spending. (Chart I-3and Chart I-4). In my view, the psychologists and behavioural finance guys have nailed this better than the economists, through a theory known as Mental Accounting Bias. Chart I-3The Change And Impulse Of Stock Market Wealth Are Both Negative The Change And Impulse Of Stock Market Wealth Are Both Negative The Change And Impulse Of Stock Market Wealth Are Both Negative Chart I-4The Change And Impulse Of Bond Market Wealth Are Both Negative The Change And Impulse Of Bond Market Wealth Are Both Negative The Change And Impulse Of Bond Market Wealth Are Both Negative Nobel Laureate psychologist Daniel Kahneman points out that we categorise our money into different accounts, which are sometimes physical, sometimes only mental – and that there is a clear hierarchy in our willingness to spend these ‘mental accounts’. Put simply, we are willing to spend our income mental account, but we are much less willing to spend our wealth mental account. Still, wealth can generate income through interest payments and dividends, which we are willing to spend. Clearly, the level of income generated will correlate with the amount of wealth – $10 million of wealth will likely generate much more income than $1 million of wealth. So, economists get the impression that it is the level of wealth that impacts spending, but the truth is that it is the income generated by the wealth that impacts spending.    We are willing to spend our income ‘mental account’, but we are much less willing to spend our wealth ‘mental account’. What about someone like Amazon founder Jeff Bezos who has immense wealth but seemingly negligible income – Mr. Bezos receives only a token salary, and his huge holding of Amazon shares pays no dividend – how then can we explain his largesse? The answer is that Mr. Bezos’ immense wealth generates tens of billions in trading income. So again, it is his income that is driving his spending. Wealth also generates an ‘income substitute’ via capital gains. For example, you should be indifferent between a $100 bond giving you $2 of income, or a $98 zero-coupon bond maturing in one year at $100, giving you $2 of capital gain. In this case the capital gain is simply an income substitute and fully transferred into the spending mental account. Nowhere is this truer than in China, where the straight-line appreciation in house prices through several decades has allowed homeowners to regard a reliable capital gain as an income substitute (Chart I-5). Which justifies rental yields on Chinese housing that are the lowest in the world and lower even than the yield on risk-free cash. In other words, which justifies a stratospheric valuation for Chinese real estate. Image Usually though, we tend to transfer only a proportion of our capital gains or losses into our spending mental account. As described previously, a firm will do this formally by transferring an asset write-down into the income statement. And households will do it informally by transferring some proportion of their yearly change in wealth into their spending mental account. The important conclusion is that spending is impacted by the yearly change in wealth. Meaning that spending growth is impacted by the yearly change in the yearly change in wealth, known as the wealth (1-year) impulse, where a negative impulse implies negative growth. Cracks Appearing In The Housing Market Given the recent slump in financial wealth, the global financial wealth impulse is in deeply negative territory. Yet by far the largest part of our wealth comprises housing, meaning the value of our homes2 (Chart I-6). In China, the recent stagnation of house prices means that the housing wealth impulse has turned negative. Elsewhere in the world though, the recent boom in house prices means that the housing wealth impulse is still positive, meaning a tailwind – albeit a rapidly fading tailwind – to spending (Chart I-7 and Chart I-8). Chart I-6Housing Comprises By Far The Largest Part Of Our Wealth Housing Comprises By Far The Largest Part Of Our Wealth Housing Comprises By Far The Largest Part Of Our Wealth Chart I-7Chinese House Prices Have Stagnated, US House Prices Have Surged The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters Chart I-8The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading In China, the recent stagnation of house prices means that the housing wealth impulse has turned negative. Still, as we explained in The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting, the disappearance of homebuyers combined with a flood of home-sellers is a tried and tested indicator that US and European home prices will cool over the next 6 months. US new home prices have already suffered a significant decline in June (Chart I-9). Some of this is because US homebuilders are building smaller and less expensive homes. Nevertheless, it seems highly likely that the non-China housing wealth impulse will also turn negative later this year. Chart I-9US New Home Prices Fell Sharply In June US New Home Prices Fell Sharply In June US New Home Prices Fell Sharply In June To be clear, the wealth impulse is just one driver of spending growth. Nevertheless, it does have the potential to amplify the growth cycle in either direction. With global growth clearly slowing, and central banks willing to enter recession to slay inflation, the rapidly fading global wealth impulse will amplify the slowdown. Therefore, the optimal asset allocation over the next 6-12 months is: Overweight bonds. Neutral stocks. Underweight commodities. A variation on this theme is: Overweight conventional bonds and stocks versus inflation-protected bonds and commodities. Fractal Trading Watchlist After a 35 percent decline since March, copper has hit a resistance point on its short-term fractal structure, from which it could experience a countertrend move. Hence, we are adding copper to our watchlist. Of note also, the underperformance of US telecoms versus utilities has reached the point of fragility on its 260-day fractal structure that has signalled previous major turning points in 2012, 2014, and 2017 (Chart I-10). Hence, the recommended trade is long US telecoms versus utilities, setting a profit target and symmetrical stop-loss at 8 percent. Chart I-10US Telecoms Versus Utilities Are At A Potential Turnaround US Telecoms Versus Utilities Are At A Potential Turnaround US Telecoms Versus Utilities Are At A Potential Turnaround Fractal Trading Watchlist: New Additions Copper’s Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1     The value of global equities has dropped by $20tn to $80tn, the value of global bonds by $20tn to around $100tn, while the value of global real estate has increased by $20tn to an estimated $370tn. 2     Strictly speaking, housing wealth should be measured net of the mortgage debt that is owed on our homes. But as the wealth impulse is a change of a change, and mortgage debt changes very slowly, it does not matter whether we calculate the impulse from gross or net housing wealth. Chart 1CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point Chart 2Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Chart 3US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 4CAD/SEK Is Reversing CAD/SEK Is Reversing CAD/SEK Is Reversing Chart 5Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Chart 6The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended Chart 7The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended Chart 8FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 9Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 10The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 11The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 12Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 13German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse Chart 14Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 15ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation Chart 16The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 17The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 18A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 19Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 20Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 21Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 22Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 23USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 24The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 25A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 26GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point Chart 27US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 28The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted   Fractal Trading System Fractal Trades The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area     Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed     Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations     Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

US services spending collapsed during the COVID-19 pandemic, and remains significantly below the level that would have prevailed had the pandemic not occurred. This raises the question of whether services consumption will ever return to “normal.” In this report, we address this question by examining the weakest components of services spending, with an eye towards any evidence indicating that this weakness is permanent. A category analysis of services spending highlights that the spending gap currently exists due to a combination of work-from-home trends and evidence of lasting aversion to COVID-19. The latter is unlikely to be permanent, and the former will be partially or fully offset by a permanent increase in substitutable goods spending. In a non-recessionary scenario, our analysis suggests that the US services spending gap will continue to close, which will provide support for overall consumption as goods spending slows in response to weak real wage growth and higher interest rates. The COVID-19 pandemic has been enormously disruptive, socially as well as economically. In the US, a massive shift from services to goods spending represents one of the most significant economic disruptions caused by the pandemic, which persists even today. Chart II-1The Pandemic Caused An Extreme Shift In Spending From Services To Goods The Pandemic Caused An Extreme Shift In Spending From Services To Goods The Pandemic Caused An Extreme Shift In Spending From Services To Goods Chart II-1 presents our best estimate of the real goods and services spending gaps relative to potential GDP, which illustrates how extreme the shift from services to goods has been. The real goods spending gap exploded during the pandemic to a level that had not been seen since the early-1950s, and services spending collapsed in an unprecedented fashion and remains at a level that is lower than at any other point over the past seven decades (aside from the worst of the pandemic itself). Chart II-2 highlights that the overall output and household consumption gaps have not yet turned positive, despite an extremely strong labor market. This underscores that weak services spending is playing a role in depressing consumption, and thus overall economic activity. Chart II-2Weak Services Spending Is Playing A Role In Depressing Consumption Weak Services Spending Is Playing A Role In Depressing Consumption Weak Services Spending Is Playing A Role In Depressing Consumption This persistent weakness in services spending raises the question of whether services consumption will ever return to “normal,” defined as the level of spending that would have likely prevailed had the pandemic never occurred. In this report we address this question by examining the weakest components of services spending, with an eye towards any evidence indicating that this weakness is permanent. We conclude that the services spending gap currently exists due to a combination of WFH trends and evidence of lasting aversion to COVID-19. While the effect of the former may be permanent, we do not believe that the effect of the latter will be. And, in cases where certain categories of services spending are likely to be permanently lower, at least some of this decline in spending is likely to be partially or fully offset by a permanent increase in substitutable goods spending. In a non-recessionary scenario, our analysis suggests that the US services spending gap will continue to close, which will provide support for overall consumption as goods spending slows in response to weak real wage growth and higher interest rates. The Pandemic, Remote Work, And Services Spending During the very early phase of the pandemic, COVID-19 was spreading rapidly in industrialized economies. Following recommended or mandatory stay at home orders from governments in many countries, most office-based businesses rapidly shifted to work-from-home (WFH) arrangements as an emergency response. This, in conjunction with forced closures of “close contact” businesses such as restaurants, entertainment, and travel caused US services spending to collapse. However, by the summer of 2021, many of these pandemic control measures had been significantly eased or lifted in the US. In addition, several national US surveys found many office workers preferred the flexibility afforded by WFH arrangements. Many employers, correspondingly, found that the productivity of their employees did not suffer while working from home, or that it even improved. These findings led many in the business community to conclude that WFH policies are not, in fact, emergency measures that will ultimately be reversed and instead reflect the “new normal” for work. While this “new normal” is still in the process of being defined, it seems fairly clear that some form of hybrid work arrangements will be permanent for many businesses. Chart II-3 presents the Kastle Systems Back to Work Barometer, which reflects keycard swipes in office buildings in the top 10 US cities. The chart highlights that urban office building activity has recovered to less than half of its pre-pandemic level, and that there has been no evidence of a continued uptrend over the past 3 months. Chart II-4 reinforces this point by highlighting that public transit use in major US cities has lagged the recovery in air travel, and also has not substantially changed over the past few months. Chart II-3Urban Office Building Activity Has Recovered To Less Than Half Of Its Pre-Pandemic Level Urban Office Building Activity Has Recovered To Less Than Half Of Its Pre-Pandemic Level Urban Office Building Activity Has Recovered To Less Than Half Of Its Pre-Pandemic Level Chart II-4Urban Public Transit Use Has Lagged The Recovery In Air Travel Urban Public Transit Use Has Lagged The Recovery In Air Travel Urban Public Transit Use Has Lagged The Recovery In Air Travel This underscores that investors have a basis to question whether at least some US services spending may be permanently impaired by the pandemic, as was the case for overall output for several years following the 2008/2009 global financial crisis. To answer this question, we present a detailed review of the most lagging categories of US services spending on pages 8-15, focused on whether WFH trends and/or activity in central business districts can plausibly explain the gap in spending in each category. The US Services Spending Gap: Key Observations And Conclusions As discussed in greater detail below, we make the following observations about the US services spending gap: Among the seven major categories of US services spending, health care accounts for the largest portion of the services spending gap. Reduced health care spending has little to do with work from home trends, and more to do with an aversion to contracting the disease in a healthcare environment and the reluctance to place elderly relatives in nursing homes given the higher risk that COVID presents to those who are older. Some recreation services spending has been impacted by WFH trends and thus may be permanent, but a lingering fear of crowded indoor spaces and still-recovering international tourism appear to be more important drivers of the recreation services spending gap. Some portion of reduced transportation services spending may be permanent (either in whole or in part), as the spending gap in road transportation seems strongly connected to WFH trends. But the sizeable and impactful decline in real spending on motor vehicle leasing is likely to recover as motor vehicle production improves over the coming year, suggesting that transportation services spending will continue to improve over the coming year relative to its pre-pandemic trend even if a spending gap in this category of services spending is permanent or long-lasting. Personal care and clothing services is mostly responsible for the spending gap in other services, and clear WFH effects do suggest that a reduction in spending in this category may be permanent. However, these categories are relatively small, and in some cases have been partially offset by what is likely to be a permanently positive spending gap on equivalent goods. The takeaway for investors is that the services spending gap currently exists due to a combination of WFH trends and evidence of lasting aversion to COVID-19. While some investors may interpret these observations as suggesting that the gap will act as a permanent or long-lasting drag on consumer spending, we disagree for two important reasons. First, we agree that some form of hybrid work arrangements will be permanent for many businesses, and that a spending gap may be permanent or long-lasting for spending categories most closely tied to WFH effects. But this also suggests that the goods-equivalent spending that has occurred as a result of this decline in services spending will also be permanent. In other words, some of the drag that permanent WFH effects will have on overall consumer spending will be offset by a permanent increase in certain categories of goods spending. Chart II-5Some Of The Permanent Drag On Services Spending Will Be Offset By Permanently Higher Goods Spending Some Of The Permanent Drag On Services Spending Will Be Offset By Permanently Higher Goods Spending Some Of The Permanent Drag On Services Spending Will Be Offset By Permanently Higher Goods Spending Chart II-5 highlights the sum of spending for two pairs of clearly substitutable services/goods categories: miscellaneous personal care services plus personal care products, and sporting equipment, supplies, guns, and ammunition plus membership clubs and participant sports centers. The chart highlights that the sum of these four categories is currently above its pre-pandemic trend, highlighting that permanently lower spending in some services categories affected by WFH trends will likely be offset by permanently higher spending in some goods categories. Second, we doubt that a strong aversion to a COVID-19 infection will be permanent, as the endemicity of the disease has yet to be recognized by the public and normalized by political leaders and health professionals. This is especially true given that the availability and awareness of Pfizer’s Paxlovid antiviral therapy is still in its early stages in the US, and remains severely restricted in other developed economies and (for now) essentially unavailable in the emerging world. As an additional point concerning the lingering societal fear of COVID-19, estimates for the likely annual disease burden from “endemic COVID” are now coming into focus. In a recent New York Times opinion piece, the author cited forecasts from a number of medical professionals that endemic COVID-19 will likely infect roughly half of the US population per year, and will kill on the order of 100,000-250,000 Americans annually.1 That compares with roughly 50,000 fatalities over the course of a year from the worst flu season experienced over the past decade, implying that COVID-19 will end up being between 2-5 times as bad over the longer term as worst-case flu. If the disease burden of endemic COVID-19 ends up being on the higher end of that estimate, then it is likely that an aversion to crowded spaces and shared human settings will be permanent. But we suspect that the eventually-widespread availability of Paxlovid – and other treatment options that have yet to be developed – makes it more likely that annual fatalities will be on the lower end of that range. Chart II-6“Endemic COVID” Will Still Be A Significant Killer, But It Will Not Likely Cause A Permanent Fear Of Crowded Spaces August 2022 August 2022 While tragic, a disease with a fatality rate of 30 per 100,000 people (equivalent to 100,000 US deaths per year) will rank behind accidents, chronic lower respiratory diseases (such as bronchitis, emphysema, and asthma), stroke, and just in line with Alzheimer’s disease as a leading cause of death (Chart II-6). It is certainly unwelcome that a new leading cause of death has emerged. But given that COVID-19 will never go away, we doubt that this will be enough to cause a permanent change in public behavior, suggesting that US services spending will return to normal over time. To the extent that some services spending declines are permanent, we expect that to be partially or fully offset by a permanent increase in substitutable goods spending. Investment Conclusions As we discussed in Section 1 of our report, the risk of a US recession is quite elevated. In a non-recessionary scenario, our analysis suggests that the US services spending gap will continue to close, which will provide support for overall consumption as goods spending slows in response to weak real wage growth and higher interest rates. Chart II-7In A Nonrecessionary Scenario, Excess Savings Will Support Services Spending In A Nonrecessionary Scenario, Excess Savings Will Support Services Spending In A Nonrecessionary Scenario, Excess Savings Will Support Services Spending Chart II-7 highlights that the excess savings that have accumulated since the onset of the pandemic – which can be deployed to support spending – have accrued heavily to upper income earners, who are typically responsible for a significant amount of services spending. While it is true that upper income earners have also suffered a significant wealth shock from the combined effect of falling stock and bond prices, we strongly suspect that excess savings and the transition to endemic COVID-19 will support services spending and cause it to move toward the level that would have prevailed had the pandemic not occurred. In a recessionary scenario, we doubt that services spending would fall significantly, given that it is still extraordinarily depressed relative to history. However, some cyclical categories of services spending would decline, and Chart II-1 highlighted that services spending does tend to decline during recessions. The key point for investors is that changes in services spending would not be large enough to cushion a meaningful decline in goods spending were a recession to emerge. While the emergence of a US recession is not yet a foregone conclusion, the risk that it will occur is an important reason supporting our a neutral asset allocation stance. As noted in Section 1 of our report, further signs of an impending recession would cause us to recommend that investors underweight risky assets over the coming 6-12 months. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate Overall Household Consumption Expenditures for Services Household consumption expenditures for services is composed of seven categories of services spending: Housing and Utilities, Health Care, Transportation Services, Recreation Services, Food Services and Accommodations, Financial Services and Insurance, and Other Services. In order to gauge to what degree services spending is likely to be permanently impaired by the COVID-19 pandemic, we estimate the “services spending gap” for each of these seven categories based on the pre-pandemic trend of overall services spending and the pre-pandemic weight of each category (Chart II-8). Chart II-8The Services Spending Gap Is Fairly Broad-Based August 2022 August 2022 Spending fell in all seven services categories during the early phase of the COVID-19 pandemic, but the pace of their respective recoveries has been varied. Spending in many of these sectors has not yet fully recovered relative to its pre-pandemic trend (Charts II-9 and 10), contributing to a spending gap of more than $350 billion real dollars.2 Chart II-8 presents a breakdown of this spending gap by category, and we analyze the drivers of each of these gaps by examining subcategories of services spending on pages 8-15. Our subcategory analysis focuses on areas of services spending that are well below their pre-pandemic level, rather than relative to the hypothetical level of spending that would have prevailed had the pandemic not occurred. This is due to BEA data limitations that prevent us from accurately attributing category spending gaps to subcategories in real terms. Charts II-8-10 underscore that the services spending gap is very broad-based. However, four categories stand out as being particularly impactful: health care, recreation services, transportation services and other services. We discuss the causes of the spending gap in these four categories below, with the goal of determining whether they will likely abate as the pandemic continues to recede, or whether they are likely to be permanent. Chart II-9Four Categories Of Services Spending Stand Out… Four categories Of Services Spending Stand Out... Four categories Of Services Spending Stand Out... Chart II-10…As Being Particularly Impactful Drivers Of The Services Spending Gap ...As Being Particularly Impactful Drivers Of The Services Spending Gap ...As Being Particularly Impactful Drivers Of The Services Spending Gap Health Care Real US personal consumption on health care services is currently $126 billion below our estimate of its pre-pandemic trend, and is currently just below its pre-pandemic level (Chart II-11). “Missing” health care spending accounts for the largest share of the overall spending gap for household consumption expenditures for services. Chart II-11“Missing” Health Care Spending Accounts For A Large Part Of The Overall Services Spending Gap August 2022 August 2022 Health care spending initially experienced a V-shaped recovery following the onset of the pandemic, but the pace of recovery has since slowed. The sectors displaying the most significant deviations from their pre-pandemic levels are physician services, dental services, and nursing home spending (Chart II-12). The gap in spending on hospital, physician, and dental services is clearly related to the COVID-19 pandemic, in the sense that some households likely fear contracting the disease in a healthcare setting (especially given the invasive nature of dental treatments). It is also possible that households have been visiting doctor and dentist offices less frequently due to work-from-home policies, in cases where these offices were located in or adjacent to central business districts. Nursing home spending is very much the outlier in the health care sub-sectors, in the sense that its recovery has been more U-shaped than V-shaped. As the pandemic placed the elderly at great risk, we suspect that many family members decided to remove them from nursing homes (or postpone moving them into a nursing home), due to the concern that a communal living environment significantly increased the risk of COVID exposure. Bottom Line: We strongly doubt that the gap in healthcare services spending is permanent. The increasing availability of Paxlovid should help physician services, dental services, and nursing home spending recover, although it is possible that nursing home spending will be the most lagging of the three. Still, we expect that the health care services spending gap will close meaningfully over the coming year if a US recession is avoided (and possibly even if a recession does occur). Chart II-12Some Households Likely Fear Contracting COVID In A Healthcare Setting Some Households Likely Fear Contracting COVID In A Healthcare Setting Some Households Likely Fear Contracting COVID In A Healthcare Setting Chart II-13Lingering Fears Of Crowded Indoor Spaces And Still Weak Tourism Explain Weak Recreation Services Spending Lingering Fears Of Crowded Indoor Spaces And Still Weak Tourism Explain Weak Recreation Services Spending Lingering Fears Of Crowded Indoor Spaces And Still Weak Tourism Explain Weak Recreation Services Spending Recreation Services Real spending on recreation services is currently $75 billion below its pre-pandemic trend, and remains well below its pre-pandemic level (Chart II-14). Despite only accounting for 6% of household consumption expenditure for services, the sharp decline in spending in certain sub-sectors of recreation services has been large enough to significantly contribute to the overall services spending gap. Chart II-14The Recreation Services Spending Gap: Concerts, Amusement Parks, Movies, And Gyms August 2022 August 2022 Chart II-13 highlights that the sectors most responsible for the gap in recreation services spending are 1) live entertainment excluding sports, 2) amusement parks, campgrounds and related recreational services, 3) motion picture theatres, and 4) membership clubs and participant sports centers. A fairly clear narrative explains large spending gaps in three of these categories. In contrast to real spending on spectator sports, which is currently $9 billion above its pre-pandemic level, movies and concerts tend to be held indoors, underscoring that large spending gaps in these categories likely reflect lingering fears of contracting COVID in crowded indoor spaces. Membership clubs and participant sports centers spending is also explained by the COVID-fear effect, although some of the spending gap in this subcategory may be long-lasting as it is also seemingly related to work-from-home effects (for example, substituting home exercise equipment for gym memberships). Real spending on amusement parks, campgrounds and related recreational services is somewhat more difficult to explain, given that spending on these types of services tend to occur outdoors. In addition, some high-profile examples of amusement parks, such as those maintained by the Walt Disney Company in California and Florida, have seemingly experienced strong attendance compared with pre-pandemic levels. We suspect that weakness in this spending category reflects the fact that international tourism has yet to return to its pre-pandemic level. Over the past 12 months, visitor arrivals to the US, while rising, have been less than 40% of what prevailed prior to the pandemic. Bottom Line: We strongly doubt that a sizeable majority of the recreation services spending gap is permanent. As noted for healthcare spending, the increased availability of Paxlovid should progressively reduce the fear associated with crowded indoor spaces, which we believe will cause the recreation services spending gap to close meaningfully over the coming year if a US recession is avoided. Transportation Services Real spending on transportation services is currently $64 billion below our estimate of its pre-pandemic trend, and remains well below its pre-pandemic level (Chart II-15). Chart II-15Road Transportation And Motor Vehicle Leasing Are The Largest Contributors To The Transportation Services Spending Gap August 2022 August 2022 Similar to recreation services spending, transportation services spending accounts for only 5% of household consumption expenditure for services, but the extent of the decline in certain categories of transportation services spending has significantly contributed to the overall gap in services spending. The sectors responsible for the transportation services spending gap are: road transportation, motor vehicle leasing, motor vehicle maintenance and repair, and parking fees and tolls (Chart II-16). Some of the gap in transportation services spending is related to work-from-home trends, and as such may be permanent (either in whole or in part). The decline in road transportation spending has been heavily driven by a collapse in spending on intercity buses and mass transit, which is strongly connected to reduced office building occupancy in major US cities and also appears to explain reduced spending on parking fees and tolls. In addition, weak motor vehicle maintenance and repair seems strongly correlated with retail and recreation mobility, which remains below its pre-pandemic level. However, reduced spending on motor vehicle leasing accounts for an important portion of the transportation services spending gap, and does not appear to be caused by work-from-home trends. Instead, the decline in leasing seems strongly linked to the decline in motor vehicle inventory that has caused an enormous rise in new and used car prices. As we have discussed at length in previous reports, this decline in vehicle production and sales has been caused by a semiconductor shortage that will eventually abate, underscoring that this subcomponent of transportation services spending will eventually recover. Bottom Line: We expect the transportation services spending gap to close further over the coming year, even if it does not close fully. Some portion of reduced transportation services spending may be permanent (either in whole or in part), but spending on motor vehicle leasing will not be, suggesting that transportation services spending will continue to improve over the coming year relative to its pre-pandemic trend if a contraction in the US economy is avoided. Chart II-16Some Of The Gap In Transportation Services Spending May Be Permanent Some Of The Gap In Transportation Services Spending May Be Permanent Some Of The Gap In Transportation Services Spending May Be Permanent Chart II-17Personal Care And Clothing Services Spending Has Definitely Been Impacted By Work-From-Home Trends Personal Care And Clothing Services Spending Has Definitely Been Impacted By Work-From-Home Trends Personal Care And Clothing Services Spending Has Definitely Been Impacted By Work-From-Home Trends Other Services Other services spending represents a 14% share of household consumption expenditure for services. Real spending on other services is currently $51 billion below our estimate of its pre-pandemic trend, and still below its pre-pandemic level (Chart II-18). In percentage terms, the other services spending gap is smaller than for health care, recreation services, and transportation services, but it is closer in dollar terms because other services spending is a larger expenditure category. Chart II-18Some Other Services Spending Is Higher Than Before The Pandemic, But Personal Care And Clothing Services Is The Laggard August 2022 August 2022 Real spending on other services is below its pre-pandemic level in four subcategories: personal care and clothing services, education services, household maintenance, and social services and religious activities. However, the majority of the spending gap in other services is accounted for by personal care and clothing services (Chart II-17). Some components of personal care and clothing services spending are likely permanently impaired (in whole or in part). Almost all of clothing and footwear services spending is made up by spending on laundry and dry-cleaning services, which remains 12% below its pre-pandemic level and is not exhibiting any meaningful uptrend. In addition, within personal care services, spending on hairdressing salons and personal grooming establishments remains well below its pre-pandemic level, and is only slowly recovering in line with central business district office occupancy. However, one interesting aspect of personal care services spending is that spending on personal care products has increased significantly during the pandemic as spending on miscellaneous personal care services decreased. This suggests that any permanently negative spending gap on personal care and clothing services will be at least partially offset by a permanently positive spending gap on personal care products. Bottom Line: Some of the negative spending gap on other services is likely to be permanent or long-lasting due to persistent work-from-home effects, but at least some of this negative gap will be offset by a permanently positive spending gap on the goods equivalent of these services.   Footnotes 1    New York Times Opinion, Endemic Covid-19 Looks Pretty Brutal, July 20, 2022 2    Please note that all real dollar references in this report refer to chained (2012) dollars.