Policy

Highlights The odds of a Goldilocks outcome for the US economy increased somewhat in August, but the risks of a US recession over the coming year remain quite elevated. We continue to recommend that investors stay neutrally positioned towards equities within a global multi-asset portfolio. The disinflationary impulse from the July US CPI report is less compelling than it seems, in that it appears to have been mostly driven by declining energy prices. It is far from clear that energy prices will continue to decline over the coming months and are, in fact, likely to rise even if an Iranian deal takes place. This implies that investors may have jumped the gun in pricing in substantial disinflation and sharply higher odds of a Goldilocks economic outcome. The OIS curve is implying a reasonable path for the Fed funds rate for the remainder of this year, but it is too low 12 months from now based on the Fed’s median rate expectation for year-end 2023. This suggests that a further upward adjustment in the OIS curve is likely warranted, and that a modestly short duration stance is appropriate. Investors believe that the rate hike path priced into the OIS curve would not be recessionary, because short-term inflation expectations are pricing in a very substantial slowdown in headline inflation. From the perspective of market participants, this would both raise the recessionary threshold for interest rates (via stronger real wages) and could potentially allow the Fed to reduce interest rates closer to its (very likely wrong) estimate of neutral. We agree that the odds of a recession will decline if headline inflation does fall below 4% over the coming year, but it is not yet clear that this will occur. And if it does, the resulting improvement in real wages would ultimately allow the Fed to raise interest rates to a higher level before short-circuiting the economic expansion. As such, we expect real long-maturity government bond yields to rise meaningfully in a scenario where real wages recover significantly and a recession is avoided, which will put heavy pressure on equity multiples. This underscores that stock prices face risks in both a recessionary and non-recessionary environment. There are arguments pointing to a decline in the dollar beyond the near term, even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. Stay neutral for now, but look for opportunities to short the dollar beyond the coming few months. Jumping The Gun On Goldilocks The odds of a Goldilocks outcome for the US economy over the coming six to nine months increased somewhat in August. The July CPI report presented some evidence of supply-side and pandemic-related disinflation (Chart I-1), and we saw more resilient manufacturing production in the US – even after excluding the automotive sector – than many manufacturing indicators have been indicating (Chart I-2). In addition, the regional Fed manufacturing index in the especially manufacturing-sensitive state of Pennsylvania surprised significantly to the upside in July, although this was at least somewhat offset by a collapse in the New York and Dallas Fed’s general business conditions indexes (Chart I-3). Chart I-1There Is Now Some Evidence Of Supply-Side & Pandemic-Related Disinflation In The US There Is Now Some Evidence Of Supply-Side & Pandemic-Related Disinflation In The US There Is Now Some Evidence Of Supply-Side & Pandemic-Related Disinflation In The US Chart I-2US Manufacturing Production Has Been More Resilient Than Surveys Would Have Suggested US Manufacturing Production Has Been More Resilient Than Surveys Would Have Suggested US Manufacturing Production Has Been More Resilient Than Surveys Would Have Suggested Against the backdrop of significant recessionary risks, and a debate about whether negative growth in the first half of the year already constitutes a recession in the US, these developments have been positive. The Atlanta Fed’s GDPNow model is pointing to positive (albeit below-trend) growth of 1.4% in Q3, which is consistent with consensus forecasts. The Atlanta Fed’s model is also forecasting the strongest real consumption growth since Q4 2021 (Chart I-4). Equity investors responded to incrementally lower recession odds and a slower pace of inflation by bidding up the S&P 500 from roughly 3800 at the beginning of July to over 4200 in August. Chart I-3Mixed Messages From The Regional Fed Indicators Mixed Messages From The Regional Fed Indicators Mixed Messages From The Regional Fed Indicators Chart I-4The Atlanta Fed GDPNow Model Is Pointing To Positive Growth And Resilient Consumption In Q3 September 2022 September 2022   However, several other developments over the past month continue to highlight that the risks of a US recession over the coming year are quite elevated, which supports our recommendation that investors stay neutrally positioned towards equities within a global multi-asset portfolio: The August flash PMIs were fairly negative, especially for the services sector. The August flash S&P Global manufacturing PMI rose in Germany, but it fell in the US, France, and the UK. Services PMIs declined significantly in all four countries, especially in the US where survey participants noted that “hikes in interest rates and inflation dampened customer spending as disposable incomes were squeezed.” Survey respondents also noted that “new orders contracted at the steepest pace for over two years, as companies highlighted greater client hesitancy in placing new work.” Chart I-5The Conference Board's LEI Is Very Weak The Conference Board's LEI Is Very Weak The Conference Board's LEI Is Very Weak The Conference Board’s leading economic indicator dropped for a fifth month in a row in July, which has always been associated with a US recession (based on the indicator’s current construction). Chart I-5 highlights that the indicator’s market-based and real economy components are both very weak, and that the Conference Board’s coincident indicator has now fallen below its 12-month moving average. While the Philly Fed manufacturing index picked up in July, the new orders component of the regional Fed manufacturing PMIs broadly sank further into contractionary territory (Chart I-6). Chart I-6The Regional Fed New Orders Components Are Very Weak The Regional Fed New Orders Components Are Very Weak The Regional Fed New Orders Components Are Very Weak The Atlanta Fed model shown in Chart I-4 is pointing to a second quarter of negative growth from real residential investment, a component of GDP that reliably peaks in advance of economic contractions.1 Job openings are now pointing to a potential rise in unemployment. The relationship between job openings and unemployment is currently subject to heavy debate, as discussed in a recent report by my colleague Ryan Swift.2 However, abstracting from a theoretical discussion about movements along or shifts in the Beveridge curve, investors should note that the empirical record is fairly clear – Chart I-7 highlights that falling job vacancies occurred alongside a significant rise in the level of unemployment during the last two recessions. We acknowledge that the relationship has seen some deviations since 2018/2019, so this may highlight that a larger decline in job openings will be required for unemployment to trend higher. A 10% rise in the level of unemployment relative to its 12-month moving average has always been associated with a recession, implying that a sustained decline in job openings to 10M or lower would represent a likely recessionary signal – even if that recession proves to be a mild one (see Section 2 of this month’s report). Chart I-7Declining Job Openings Are Pointing To Potentially Higher Unemployment Declining Job Openings Are Pointing To Potentially Higher Unemployment Declining Job Openings Are Pointing To Potentially Higher Unemployment Table I-1 highlights that the disinflationary impulse from the July CPI report is less compelling than it seems, in that it appears to have been mostly driven by declining energy prices (particularly gasoline and fuel oil). Outside of the clear impact that falling fuel prices had on airline fares, there is not yet compelling evidence that core inflation is decelerating due to easing supply-side and pandemic-related effects, or due to slowing demand. As we will discuss below, it is far from clear that energy prices will continue to decline over the coming months and are, in fact, likely to rise even if an Iranian deal takes place. This implies that investors may have jumped the gun in pricing in substantial disinflation and sharply higher odds of a Goldilocks economic outcome. Table I-1The Disinflationary Impulse From The July CPI Report Is Less Compelling Than It Seems September 2022 September 2022 Inflation And The Fed As we discuss in Section 2 of our report, recessions occur because monetary policy becomes tight, a significant non-policy shock to aggregate demand or supply occurs, or some combination of both develops. We do not believe that monetary policy is currently restrictive on its own (Chart I-8), and we have not yet concluded that a US recession is inevitable. But when combined with the speed of adjustment in interest rates, the fact that real wages have fallen sharply (Chart I-9), and the fact that the Fed is determined to see inflation quickly return to target levels, it is clear that the odds of a recession over the coming 12-18 months remain elevated. Chart I-8Absent Declining Real Wages, The Current Level Of Interest Rates Would Not Be Restrictive Absent Declining Real Wages, The Current Level Of Interest Rates Would Not Be Restrictive Absent Declining Real Wages, The Current Level Of Interest Rates Would Not Be Restrictive Chart I-9But Real Wages Are Declining, And The Pace Of Tightening Has Been Extraordinarily Rapid But Real Wages Are Declining, And The Pace Of Tightening Has Been Extraordinarily Rapid But Real Wages Are Declining, And The Pace Of Tightening Has Been Extraordinarily Rapid Many investors do not appear to fully appreciate the fact that the Fed will continue to tighten policy until it sees clear and unequivocal signs that inflation is easing. Importantly, the minutes of the July FOMC meeting highlighted that this is likely to be true even if unambiguous signs of easing supply-side and pandemic-related inflation present themselves. During the July meeting, FOMC participants noted that “though some inflation reduction might come through improving global supply chains or drops in the prices of fuel and other commodities, some of the heavy lifting would also have to come by imposing higher borrowing costs on households and businesses”. They also emphasized that “a slowing in aggregate demand would play an important role in reducing inflation pressures”. The upshot is that the Fed was aware before the July CPI report that energy-related inflation might fall, but also understood that they would still have to tighten enough to slow aggregate demand to reduce underlying inflationary pressures. It is true that investors are pricing in additional rate hikes from the Fed, but there are two caveats for investors to consider. The first is that while the OIS curve is implying a reasonable path for the Fed funds rate for the remainder of this year, it is too low 12 months from now based on the Fed’s median rate expectation for year-end 2023 (Chart I-10). This suggests that a further upward adjustment in the OIS curve is likely warranted. Second, and more importantly, investors appear to be making the assumption that the rate hikes already built into the OIS curve will not be recessionary. Investors are making this assumption because short-term inflation expectations are pricing in a very substantial slowdown in headline inflation (Chart I-11), which would both raise the recessionary threshold for interest rates (via stronger real wages) and could potentially allow the Fed to reduce interest rates closer to its (very likely wrong) estimate of neutral. Chart I-10A Further Upward Adjustment In The OIS Curve Is Likely Warranted A Further Upward Adjustment In The OIS Curve Is Likely Warranted A Further Upward Adjustment In The OIS Curve Is Likely Warranted Chart I-11Short-Term Inflation Expectations Are Pricing In A Massive Deceleration In Headline Inflation Short-Term Inflation Expectations Are Pricing In A Massive Deceleration In Headline Inflation Short-Term Inflation Expectations Are Pricing In A Massive Deceleration In Headline Inflation We agree with investors that the odds of a recession will decline significantly, ceteris paribus, if headline inflation does drop below 4% over the coming year. But we noted above that it is not yet clear that this will occur. In addition, we disagree with investors that this would result in a reduction in short-term interest rates, because this belief is based on the view that monetary policy is currently in restrictive territory even without the negative impact of sharply lower real wages. Absent the negative real wage effect, our view is that monetary policy would still be stimulative at current interest rates, which is why we believe that the 2023 portion of the OIS curve is too dovish in a non-recessionary scenario. The Outlook for Stocks The equity market rally that began in early July has been based on the assumption that significant supply-side and pandemic-related disinflation is now a fait accompli. If it is, then the odds of a recession over the coming year are indeed meaningfully lower, and the risk to corporate profits is less than feared. We noted above that investors may have jumped the gun in pricing in substantial disinflation and sharply lower odds of a US recession. But even in a scenario in which the odds of recession do come in significantly, stocks still face risks from a significant rise in real bond yields. Chart I-12Long-Maturity TIPS Yields Would Likely Rise In A Non-Recessionary Scenario, Compressing Equity Multiples Long-Maturity TIPS Yields Would Likely Rise In A Non-Recessionary Scenario, Compressing Equity Multiples Long-Maturity TIPS Yields Would Likely Rise In A Non-Recessionary Scenario, Compressing Equity Multiples Investors have been focused on very elevated inflation as the driver of both rising inflation expectations and rising real bond yields, and have assumed that a meaningful slowdown in inflation (as forecast by short-term measures of inflation expectations) implies that the Fed funds rate will return to the Fed’s estimate of neutral. This belief, along with a lower projected Fed funds rate in 2024 than 2023 in the FOMC’s participant forecasts, is the basis for the 2023 “pivot” currently priced into the OIS curve. Given that the Fed funds rate has already reached the Fed’s neutral rate estimate, there is a meaningful chance that this estimate will be revised upwards by the Fed or challenged by investors if economic activity improves in response to a decline in inflation and a corresponding rise in real wages. Such a scenario would highlight to investors that the Fed’s estimate of neutral is likely too low, which would imply a significant increase in real 10-year TIPS yields (which are currently 160 basis points below their pre-2008 average). Chart I-12 highlights the impact that a rise in real long-maturity bond yields could have on equities, even in a non-recessionary scenario where 12-month forward earnings per share grows 8% over the coming year. A rise in 10-year TIPS yields to 1.5% by the middle of 2023 would cause a 16% contraction in the 12-month forward P/E ratio and a 10% decline in stock prices, assuming an unchanged 12-month forward equity risk premium (ERP). It is possible that the ERP could decline in a rising bond yield scenario. Chart I-13 highlights that the ERP is indeed negatively correlated with real bond yields (in part due to the methods that we use to calculate it). The counterpoint is that there are a number of risks that equity investors should be compensated for today that did not exist in the late 1990s or early 2000s, especially the risks of populist policies in many advanced economies and major geopolitical events (as Russia’s invasion of Ukraine recently highlighted). Chart I-14 illustrates that, since 1960, a long-term version of the equity risk premium, calculated using trailing earnings and our adaptive expectations proxy to deflate long-maturity bond yields, has been fairly well explained by the Misery Index (the sum of the unemployment and headline inflation rates). However, the chart also shows that the ERP has been structurally higher over the past decade than the Misery Index would have predicted. It is unclear if this is due to a riskier environment or the negative ERP/real yield correlation that we noted. Chart I-13The Equity Risk Premium Could Come Down As Bond Yields Rise, But That Is Not Guaranteed The Equity Risk Premium Could Come Down As Bond Yields Rise, But That Is Not Guaranteed The Equity Risk Premium Could Come Down As Bond Yields Rise, But That Is Not Guaranteed Chart I-14A Structurally Higher ERP Over The Past Decade Could Represent Needed Compensation For Structural Risks A Structurally Higher ERP Over The Past Decade Could Represent Needed Compensation For Structural Risks A Structurally Higher ERP Over The Past Decade Could Represent Needed Compensation For Structural Risks The conclusion is that investors do not yet appear to have a basis to bet on a declining ERP in a rising bond yield environment, underscoring that even a non-recessionary scenario poses a risk to stock prices. It is worth noting that this second risk facing stocks has essentially been caused by the Fed because of its maintenance of a very low neutral rate estimate that we feel is no longer economically justified. Bond Market Prospects Chart I-15Investors Should Stay Modestly Short Duration, For Now Investors Should Stay Modestly Short Duration, For Now Investors Should Stay Modestly Short Duration, For Now Over the past few months, the Bank Credit Analyst service has continued to recommend that investors maintain a modestly short duration stance even as we recommended reducing equity exposure. The recent rise in the 10-year Treasury yield back to 3% has validated that view (Chart I-15), and reinforces our view that there is significant upside risk to long-maturity bond yields in a non-recessionary scenario. Our expectation that the Fed will raise interest rates to a higher level over the next year than the OIS curve is currently discounting also argues for a modestly short stance, based on BCA’s “Golden Rule” framework. The “Golden Rule” states that investors should set their overall bond portfolio duration based on how their own 12-month fed funds rate expectations differ from the expectations that are priced into the market. As we detail in Section 2 of our report, the Fed has always cut interest rates in response to a recession in the post-WWII environment, so we would certainly recommend a long duration stance if a recession emerges. But given our view that a recession is still a risk rather than a likely event, we feel that a modestly short duration stance is currently appropriate. Chart I-16US Corporate Bond Value Has Improved, But Not Enough To Trump The Cycle US Corporate Bond Value Has Improved, But Not Enough To Trump The Cycle US Corporate Bond Value Has Improved, But Not Enough To Trump The Cycle As noted above in our discussion of the risks facing stock prices in a non-recessionary scenario, falling inflation that is not associated with a recession will ironically be a bearish signal for long-maturity bonds, because it means that the Fed will have greater capacity to raise interest rates without ending the recovery. The short end of the yield curve could be flat or move modestly lower in response to a significant easing in inflation, but the long end of the curve would be at serious risk of moving higher. We are thus very likely to recommend a short duration stance in response to solid evidence of true supply-side and pandemic-related disinflation, assuming it emerges outside of the context of a recession. Within the credit space, the rise in US corporate bond spreads since the start of the year has meaningfully improved the value of investment- and speculative-grade corporate bonds (Chart I-16), but not so much that it justifies a positive stance towards these assets relative to government bonds given the risks facing the US economy. We continue to recommend an underweight stance towards investment-grade and a neutral stance towards speculative-grade within a fixed-income portfolio. The Outlook For Energy Prices Chart I-17The EU's Oil Embargo Will Cause Russian Oil Production To Tank The EU's Oil Embargo Will Cause Russian Oil Production To Tank The EU's Oil Embargo Will Cause Russian Oil Production To Tank The likely path of commodity prices, particularly that of oil, is an extremely important determinant of whether the US is likely to experience a recession over the coming year. We are among those who have downplayed the significance of oil price shocks in driving contractions in economic output over the past two decades,3 but the current situation is unique given the role that very elevated inflation has played in driving real wages lower. In a recent Strategy Report from our Commodity & Energy Strategy service, my colleague Robert P. Ryan underscored the impact that the European Union’s embargo of Russian oil will likely have on the energy market. If fully implemented, ~ 2.3mm barrels/day of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. EU, UK and US shipping insurance and reinsurance sanctions are also scheduled to be implemented in December, which means that “surplus” Russian oil production cannot be fully reoriented to other countries. Chart I-17 presents the likely impact on Russia’s crude oil output, namely a ~ 2mm barrels/day decline in oil output by the end of next year – nearly equal to the amount of oil set to be embargoed. Our base case view remains that supply and demand in the oil market will remain relatively balanced going into the winter, but the removal from the market of Russian oil production because of the various EU embargoes – even if it is offset by the return of 1mm b/d of Iranian exports on the back of a deal with the US – will ultimately push crude oil prices higher and inventories lower (Chart I-18). The price impact of this event could happen earlier than the immediate supply/demand balance would suggest, if investors have not fully priced in the extent of the decline in Russian oil production that our commodity team is forecasting. Our commodity team’s forecast serves as an important reminder that the economic consequences of Russia’s invasion of Ukraine may not be fully behind us. It also highlights that the recent disinflation observed in the US, which was mostly driven by lower energy prices in July, may not be sustained. Chart I-19 highlights what could happen to US gasoline prices based on the path for oil shown in Chart I-18, and how that forecast is sharply at odds with the current gasoline futures curve. Chart I-20 highlights that US gasoline stocks are currently below their 5-year average; the last time this occurred was in Q1 2021, which was an environment of rising gasoline prices to levels that were higher than what would usually be implied by crude oil prices. Chart I-18Oil Prices Are More Likely To Rise Than Fall Oil Prices Are More Likely To Rise Than Fall Oil Prices Are More Likely To Rise Than Fall Chart I-19Higher Oil Prices Would Cause Gasoline Prices To Deviate Significantly From Market Expectations Higher Oil Prices Would Cause Gasoline Prices To Deviate Significantly From Market Expectations Higher Oil Prices Would Cause Gasoline Prices To Deviate Significantly From Market Expectations Chart I-20Gasoline Stocks Are Low In The US, Underscoring The Upside Risk To Prices Gasoline Stocks Are Low In The US, Underscoring The Upside Risk To Prices Gasoline Stocks Are Low In The US, Underscoring The Upside Risk To Prices The upshot is that our commodity team expects oil prices to move higher over the coming 6-12 months, under the assumption that the EU’s embargo against Russian oil moves forward as announced. This poses a clear threat to imminent supply-side and pandemic-related disinflation, and underscores the risks to a Goldilocks economic outcome over the coming few months. The Dollar: Value, Technical Conditions, And The Cycle Chart I-21The Dollar Is Reliably Countercyclical, But It Has Registered Outsized Gains Over The Past Year The Dollar Is Reliably Countercyclical, But It Has Registered Outsized Gains Over The Past Year The Dollar Is Reliably Countercyclical, But It Has Registered Outsized Gains Over The Past Year The US dollar moved higher over the past month, after first retreating from its mid-July high for the year. We tempered our view about the likelihood of a falling dollar over the near term in last month’s report, but from a bigger picture perspective we have been surprised by the degree of dollar strength this year. The US dollar is a reliably countercyclical currency, so clearly some of the dollar’s strength has been the result of weakness in risky asset prices (Chart I-21). But the bottom panel of Chart I-21 highlights that the broad trade-weighted dollar has performed even better over the past year than returns to the S&P 500 would have implied, underscoring that the magnitude of the dollar’s strength has been atypical. The last two times that the US dollar performed substantially better than the trend in risky assets would have implied were in 2012 and 2015, years in which euro area breakup risk was a driving force in markets. Alongside the fact that EURUSD has fallen below parity and USDEUR has outperformed even more than the broad trade-weighted dollar has, “excess” dollar returns point strongly to Europe’s energy woes in the aftermath of Russia’s invasion of Ukraine as the key driver of outsized broad dollar strength. Chart I-22 highlights that European natural gas prices have exceeded the level that we had forecasted would occur in a complete cutoff scenario, meaning that Europe’s energy crunch is likely happening now, rather than in the winter. However, even considering the negative economic outlook facing the euro area, there are arguments pointing to a decline in the dollar beyond the near term – even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. First, Chart I-23 highlights that EURUSD has undershot what the trend in relative real interest rates would suggest, which has historically led changes in the euro. This implies that the euro has declined partly because of the introduction of a sizeable risk premium, which may dissipate after the winter. Chart I-22The Euro Has Been Heavily Impacted By Europe's Energy Crunch The Euro Has Been Heavily Impacted By Europe's Energy Crunch The Euro Has Been Heavily Impacted By Europe's Energy Crunch Chart I-23EURUSD Has Undershot What The Trend In Relative Real Interest Rates Would Suggest EURUSD Has Undershot What The Trend In Relative Real Interest Rates Would Suggest EURUSD Has Undershot What The Trend In Relative Real Interest Rates Would Suggest Second, Chart I-24 highlights that the US dollar is extremely overbought and is technically extended to a point that has historically been associated with reversals in the broad dollar trend. Finally, Chart I-25 highlights that the US dollar is extraordinarily expensive based on our valuation models, underscoring that an eventual decline in the dollar may be quite severe. We agree that valuation is not usually an effective market timing tool, but investors should place a greater weight on valuation measures as they are stretched further. Based either on our models or a more traditional PPP approach, the degree of US dollar overvaluation is extreme – arguing for a bearish bias on a 6-12 month timeline barring an unambiguous move towards recession in the US. Chart I-24US Dollar And Indicator The US Dollar Is Heavily Overbought US Dollar And Indicator The US Dollar Is Heavily Overbought US Dollar And Indicator The US Dollar Is Heavily Overbought Chart I-25The US Dollar Is Extremely Expensive The US Dollar Is Extremely Expensive The US Dollar Is Extremely Expensive         Investment Conclusions Considering the economic developments over the past month and the reaction of financial markets, the takeaway for investors seems clear. Market participants have eagerly shifted towards the Goldilocks economic and financial market outcome, based on (so far) incomplete evidence of supply-side and pandemic-related disinflation that has predominantly been driven by declining energy prices. Given significant potential upside risks to oil and US gasoline prices over the coming few months, investors should wait for more durable signs of significant disinflation before downgrading the odds of a US recession over the coming year. We would certainly recommend cutting global equity exposure to underweight were we to determine that the US is likely to experience an imminent recession, but the avoidance of a recession does not necessarily suggest that an overweight stance is warranted. Sharply lower inflation would reduce the odds of a recession, but it would also raise real wages and would ultimately allow the Fed to raise interest rates to a higher level before short-circuiting the economic expansion. As such, we expect real long-maturity government bond yields to rise meaningfully in a scenario where real wages recover significantly and a recession is avoided, which will put meaningful pressure on equity multiples. Barring a decline in the equity risk premium, US stocks could face a loss on the order of 10% over the coming year in such a scenario (even under the assumption of positive earnings growth), reinforcing our view that a neutral stance towards global equities is currently appropriate. In addition to a neutral global asset allocation stance, we recommend that investors maintain a neutral regional equity position and a neutral stance towards cyclicals versus defensives, although we do recommend a modest overweight towards value stocks given our view that a modestly short duration stance is appropriate. Although we recommend a neutral stance towards USD over the next few months, we also see ample scope for a decline in the dollar beyond the near term – even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. We believe that there are upside risks to energy prices, which our Commodity & Energy Strategy service recommends playing via the iShares GSCI Commodity Dynamic Roll Strategy (COMT) ETF. As a final point, we remain cognizant of the fact that financial markets rarely trend sideways over 6-to-12 month periods. We continue to regard a neutral global asset allocation stance as a temporary stepping stone either to a further downgrade of risky assets to underweight, or to an increase in risky asset exposure back to a high-conviction overweight. The latter is still possible, especially if we see unequivocal signs of a substantial and broad-based slowdown in the US headline inflation rate, and if long-maturity real bond yields are well-behaved in response or if we see clear signs of a declining equity risk premium. Thus, investors should note that additional changes to our recommended cyclical allocation may occur over the coming few months, in response to incoming data, our assessment of the likely implications for monetary policy, and the response of long-maturity government bond yields.   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst August 25, 2022 Next Report: September 29, 2022 II. The Fed Funds Rate, Bond Yields, And The Next US Recession The risk of a US recession has increased sharply over the past several months. We have not yet concluded that a recession over the coming year is inevitable, but substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. The increased risk of a contraction has caused investors to ponder what the next recession might look like. One very important question concerns the likely behavior of short-term interest rates during the next recession, especially if it occurs sooner rather than later. The historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition, there are several arguments pointing to the next US recession being a mild one. For fixed-income investors, the implication is that investors should not overstay their welcome in a long-duration position during the next US recession, and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. Over the past several months, investors have been faced with a sharp increase in the odds of a US recession. Gauging the risk of a recession has featured prominently in our recent reports, and we have concluded, for now, that a US recession over the coming year is not yet inevitable. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Economic expansions do not last forever. This means that the US economy will eventually succumb to a recession at some point over the coming few years. One very important question for investors concerns the likely behavior of short-term interest rates during the next recession, especially if a contraction occurs sooner rather than later. A key aspect of this question is whether the Fed is likely to be forced back towards a zero or negative interest rate policy, and whether it will need to employ asset purchases as part of its stabilization efforts as it has during the last two recessions. If so, long-maturity bond yields are likely to fall significantly during the next recession; if not, investors may be surprised by how modestly long-maturity yields decline. In this report, we examine the historical record of short-term interest rates during recessions and discuss whether the next US recession is likely to be severe or mild. We conclude that the next US recession is more likely to be mild than severe, and that the 10-year Treasury yield is unlikely to fall below 2% during the recession (or fall below this level for very long). In the case of a more severe recession driven by unanchored inflation expectations, the implications would be clearly bearish for bonds. Within a fixed-income portfolio, one conclusion of our analysis is that investors should not overstay their welcome in a long-duration position during the next recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. The Historical Recessionary Path Of Short-Term Interest Rates When projecting how the Fed funds rate is likely to evolve during the next US recession, most investors typically look to the average decline in short-term interest rates during previous recessions as a guide. Based on that approach, Table II-1 highlights that the Fed would likely have to cut rates into negative territory if a recession occurred over the coming 12-18 months, unless it is able to hike interest rates significantly more over the coming year than the market is currently expecting and the FOMC itself is projecting. But in our view, focusing on the historical recessionary decline in interest rates from their peak is not the right approach, because it ignores the fact that recessions typically occur when monetary policy is tight. If a recession occurs within the next 18 months, it will have happened in large part because of a collapse in real wage growth, not just because of the increase in interest rates that has occurred. Chart II-1 highlights that short-term interest rates remain well below potential GDP growth, highlighting that monetary policy would still be easy today – despite the quick pace of increase in short rates – if real wages were growing rather than contracting sharply. In our view, the right approach is to examine how much short-term interest rates have typically fallen during recessions relative to potential or average historical GDP growth. This method captures the degree to which monetary policy easing has typically been required relative to neutral levels to catalyze an economic recovery. Table II-1Based Only On The Historical Decline In Short-Term Interest Rates, The Fed Would Ostensibly Have To Cut Rates Into Negative Territory During The Next Recession September 2022 September 2022 Chart II-1Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Based on this approach, Chart II-2 highlights that the Fed might have to cut the target range for the Fed funds rate to 0-0.25% during the next recession, but there are some examples (like the 1990-1991 recession) that point to a cut to just 0.25-0.5%. The goal of this exercise is not to be specific about the exact level to which the Fed will have to cut the Fed funds rate, but rather whether the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases is likely. Chart II-2The Fed May Have To Cut To Zero During The Next Recession, But Probably Not Into Negative Territory September 2022 September 2022 Structural bond bulls might note that there are five recessions in the post-war era that could potentially point to that outcome based on Chart II-2. However, these episodes involved circumstances that we doubt would be present during the next US recession, especially if one were to emerge over the coming 12-18 months. The 1950s Recessions The recessions of 1953-54 and 1957-58 were fairly sizeable based on the total rise in the unemployment rate, but the monetary policy stance at that time was wildly stimulative in a way that is very unlikely to repeat itself today. In the 1950s, the level of interest rates was still an artifact of WWII (with the Treasury-Fed accord having only been agreed upon in March 1951). Monetary policy was both overly responsive to a period of pent-up disinflation following the initial burst of government spending associated with the Korean war and insufficiently responsive to a strongly positive output gap (Chart II-3). This was meaningfully compounded by a poor understanding of the size of the output gap at that time; the deviation of the unemployment rate from its 10-year average was significantly smaller than its deviation from today’s estimate of NAIRU (Chart II-4). In sum, the economic and monetary policy conditions that existed in the 1950s and that contributed to an interest rate level that was well below the prevailing rate of economic growth do not exist today. As such, we strongly doubt that the Fed’s response to the next US recession would resemble what occurred during that decade. Chart II-3We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s Chart II-4Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates   1973-1975 The recession that began in 1973 occurred because of a huge energy shock that proved to be stagflationary in the true sense of the word. Excluding the 2020 recession, this was the third largest rise in the unemployment rate of any recession since WWII, following 2008/2009 and the 1981/1982 recessions. There are some parallels between this recession and the current economic environment, but the stability of inflation expectations so far does not point to a truly stagflationary outcome. As such, we do not see the 1973-74 recession as a reasonable parallel to today’s environment. In addition, manufacturing employment – which was heavily impacted by the permanent rise in oil prices due to the sector’s energy intensity – stood at 24% of total nonfarm employment in 1973, compared with 8% today. Finally, the weight of food and energy as a share of total consumer spending today is roughly half of what it was during the 1970s (Chart II-5). 2001 Of the five recessions potentially implying that the Fed may have to cut interest rates into negative territory during the next US recession, the 2001 recession is the most relevant parallel to today. It was a modern recession in which the Fed maintained very easy monetary policy for a significant amount of time, in response to concerns about a significant tightening in financial conditions and the impact of prior corporate sector excesses on aggregate demand. The total rise in the unemployment rate during this recession was not very large, but it took some time for the unemployment rate to return to NAIRU. Still, even though this justified a later liftoff, a Taylor rule approach makes it clear that the Fed overstimulated the economy in response to the recession – a view that is reinforced by the enormous rise in household debt that fueled the housing market bubble during that period (Chart II-6). The Fed was very concerned about the negative wealth effects of the bursting of the equity market bubble, which had been caused by a massive decline in the equity risk premium in the second half of the 1990s. These conditions are simply not present today. Chart II-5Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Chart II-6The Fed Clearly Overstimulated In Response To The 2001 Recession The Fed Clearly Overstimulated In Response To The 2001 Recession The Fed Clearly Overstimulated In Response To The 2001 Recession 2008/2009 Chart II-7A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario Chart II-2 highlighted that the Fed would have to cut interest rates to -1% were the 2008/2009 recession to repeat itself, but we judge that to be a totally implausible scenario given the improvement in US household sector balance sheets and financial sector health since the global financial crisis (Chart II-7). As we discuss below, the next US recession is likely to be meaningfully less severe than the 2008/2009 and 2020 recessions, which we believe carries important significance for the path of interest rates and the response of long-maturity bond yields. The bottom line for investors is that, based on the historical experience of rate cuts during recessions, the Fed may end up cutting interest rates back to or close to the zero lower bound in response to the next recession. But the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seems quite unlikely unless the recession is severe, which we do not expect. Will The Next US Recession Be Severe Or Mild? Chart II-8The Most Severe US Recessions Have Had Aggravating Factors That Do Not Appear To Be Present Today September 2022 September 2022 How drastically the Fed will be forced to cut interest rates during the next recession will be driven by its severity. Chart II-8 presents the total rise in the unemployment rate during post-WWII recessions (excluding 2020), in order to gauge whether the factors that have led to severe recessions in the past are likely to be present during the next contraction in output. From our perspective, the most severe US recessions in the post-WWII era have been driven by factors that are very unlikely to repeat themselves in the current environment. We noted above that a repeat of the 2008/2009 recession is a totally implausible scenario, leaving the 1981-1982, 1973-1975, and 1950s recessions as potential severe recession analogues. In three of these four cases we see clear signs of an aggravating factor that we do not (yet) believe will be present during the next US recession. Chart II-9Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s In the 1981-1982 recession, the unemployment rate rose significantly as the Federal Reserve confronted the fact that inflation expectations had become severely unanchored to the upside, causing a persistent wage/price spiral. While unanchored inflation expectations is a risk today, so far the evidence suggests that both households and market participants expect that currently elevated inflation will not persist over the long run (Chart II-9). If inflation expectations do become unanchored to the upside at some point over the coming 12-18 months (or beyond), we are very likely to change our view about the severity of the next recession. However, this would be a bond bearish outcome (at least initially), as it would imply sharply higher yields at both the short and long end of the yield curve in order to tame inflation and re-anchor inflation expectations. As noted above, in the 1973-74 recession, the unexpected and permanent rise in oil prices and outright energy shortages rendered a significant amount of capital and labor uneconomic, which is different than what has been occurring during the pandemic. Were the recent rise in natural gas prices to be permanent and no alternatives available, Europe’s current energy situation would be more reminiscent of the 1973-1974 recession than the pandemic-driven price pressures and supply shortages affecting the US and other developed economies. Chart II-10The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year Finally, while the 1957-58 recession appears to be somewhat of an anomaly driven by a mix of factors, the 1953-54 recession was clearly exacerbated by a sharp slowdown in government spending following the end of the Korean war. It is true that the US is currently experiencing fiscal drag (Chart II-10), but this has occurred against the backdrop of a strong labor market, and IMF forecasts imply that the drag will be significantly smaller over the coming year than what the US is currently experiencing. There are several additional points suggesting that the next US recession will be comparatively mild: Chart II-11The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) Chart II-11 highlights that the milder recessions, those which have seen the unemployment rate rise by less than 3% from their previous low, have generally been the recessions that appear to have simply been triggered by monetary policy becoming tight or nearly tight. This would likely be the case during the next US recession. In the lead up to the 1970, 1990-91, and 2001 recessions, short-term interest rates approached or exceeded either potential growth or the rolling 10-year average growth rate of nominal GDP. The 1960-61 recession stands out slightly as an exception to this rule, in that interest rates were still moderately easy, which is based on our definition of the equilibrium short-term interest rate. But interest rates had risen close to 400 basis points from 1958 to 1960 (suggesting a change in addition to a level effect of interest rates on aggregate demand), and it is notable that the 60-61 recession was the mildest in post-war history, based on the total rise in the unemployment rate. Chart II-12Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession We argued in Section 1 of our report that monetary policy is not currently restrictive on its own, and that the recessionary risk currently facing the US is the result of a combination of the speed of adjustment in interest rates, the fact that real wages have fallen sharply, and the fact that the Fed is determined to see inflation quickly return to target levels. However, what this also highlights is that a recession would likely cause a rise in real wages via a significant slowdown in inflation (at least for a time); this would likely help stabilize aggregate demand and cause a comparatively mild rise in the unemployment rate. While the odds and magnitude of this effect are difficult to quantify, the fact that the labor market has been so tight over the past year and that the participation rate has yet to recover to its pre-pandemic levels suggests that some firms may be reluctant to shed labor during a recession (Chart II-12), suggesting that the total rise in unemployment in the next recession could be relatively small. Finally, Chart II-13 shows that the excess savings that have accumulated over the course of the pandemic, now primarily the result of reduced spending on services, dwarf the magnitude of precautionary savings that were generated in the prior three recessions as a % of GDP. We agree that the savings rate would likely still rise during the next recession, but the existence of excess savings implies that the rise in the savings rate may be surprisingly small – which would, in turn, imply a comparatively mild rise in the unemployment rate. We noted above that the household sector has deleveraged significantly, which is strong evidence against an outsized or long-lasting decline in consumer spending as a possible driver of an above-average rise in the unemployment rate during the next recession. One question that we often receive from clients is whether excessive corporate sector leverage could cause a more severe decline in economic activity once a recession emerges. Chart II-14 illustrates that the answer is “probably not.” The chart presents one estimate of the US nonfinancial corporate sector debt service ratio, based on national accounts data. The chart highlights that the current debt burden for the nonfinancial corporate sector is very low, underscoring that elevated corporate sector debt would not likely act as an aggravating factor driving an outsized rise in the unemployment rate were a recession to occur today. The chart also shows that even if the 10-year Treasury yield were to rise to 4% and corporate bond spreads were to widen in the lead up to a recession, the nonfinancial corporate sector debt service burden would rise to a lower peak than seen in the last three recessions. One key risk to a mild recession view is a scenario in which inflation does not return to or below the Fed’s target during the recession. In that kind of environment, the Fed would not likely cut interest rates to as low a level as they have in the past relative to potential growth. But the historical record is clear that recessions cause a deceleration in inflation, and if a recession emerges over the coming 12-18 months it will likely happen after supply-side and pandemic-related disinflation has already occurred. That means that inflation is likely to move back to or below the Fed’s target in a recessionary environment. We should note that this assessment differs somewhat from the scenario described by my former colleague Martin Barnes, who wrote a guest report on inflation published in our July Bank Credit Analyst.4 Chart II-13Today’s Pandemic-Related Excess Savings Dwarf Precautionary Savings During The Prior Three Recessions September 2022 September 2022 Chart II-14US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment   Long-Maturity Bond Yields And The Next US Recession What does our analysis imply for long-maturity bond yields and the duration call over the coming few years? In order to judge what is likely to happen to long-maturity bond yields in a recession scenario over the coming 12-18 months, we first project the fair value of the 5-year Treasury yield based on the following hypothetical circumstances: The onset of recession in March 2023 and a peak in the Fed funds rate at a target range of 3.75-4%. A recession duration of eight months, over which time the Fed steadily cuts the policy rate to 0-0.25%. An initial Fed rate hike in September 2024, nine months following the end of the recession, consistent with a relatively short return of the unemployment rate to NAIRU as an expansion takes hold. A rate hike pace of eight quarter-point hikes per year, with the Fed again raising rates to a peak of 4% A longer-term average Fed funds rate of 3%, which we regard as a low estimate. Chart II-15The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario Chart II-15 highlights the fair value path for the 5-year Treasury yield in this scenario. Not surprisingly, the fair value today is lower than the current level of the 5-year yield, highlighting that a shift to a long duration stance will be warranted at some point over the coming year if the US economy enters a non-technical, typical income-statement recession. However, the chart also highlights that a long duration position is not likely to be warranted for very long, given that the lowest level of the 5-year fair value path is substantially higher than it was in 2020 and 2021 and is also higher than its 10-year average. Chart II-16 reveals the importance of forecasting the near-term path of interest rates when predicting the likely behavior of long-maturity bond yields. Even though near- and long-term interest rate expectations should be at least somewhat differentiated, the chart highlights that the real 5-year/5-year forward Treasury yield is very closely explained by the real 5-year Treasury yield and a 3-year lag of our adaptive inflation expectations model (which is highly consistent with BCA’s Golden Rule of bond investing framework). Chart II-16 shows that long-maturity bond yields should be higher than they are based on the current level of real 5-year yields and lagged inflation expectations, underscoring the point that we made in Section 1 of our report that significant upside risk exists for long-maturity bond yields in a non-recessionary outcome over the coming year. In a recessionary outcome, it is clear that bond yields will fall as the Fed cuts interest rates, as Chart II-15 demonstrated. But, Chart II-17 highlights that during recessions, there is little precedent for a negative 5-10 yield curve slope outside of the context of the persistently high inflation environment of the late 1960s and 1970s. Applying that template to the fair value path that we showed in Chart II-15 suggests that the 10-year Treasury yield will not fall below 2% during the next recession. As we noted in our August report,5 a 10-year Treasury yield decline to 2% would result in significant performance for long-maturity bonds, but it would not end the structural bear market in bonds that began two years ago – a fact that we suspect would be very surprising to bond-bullish investors. Chart II-165-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward 5-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward 5-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward Chart II-17There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession It is true that bond yields may deviate from the fair value levels shown in Chart II-15 if investors expect a different outcome for the path of the Fed funds rate than we described. However, it is worth noting that changes in our assumed post-recession peak Fed funds rate and the long-term average do not substantially change the outcome shown in Chart II-15. If investors instead assume that the Fed funds rate will peak at 3% during the next expansion, that lowers the fair value path for the 5-year yield by approximately 5 basis points. Changing the long-term average Fed funds rate to 2.4%, the Fed’s current neutral rate expectation, would reduce it by about 25 basis points. These levels would still be significantly above the lows reached in 2011-2013 and in 2020, underscoring that the length of the recession and the speed at which the Fed begins to raise interest rates will be far more important determinants of the path of US Treasury yields. We strongly suspect that investors will recognize that a comparatively mild recession will not result in the same hyper-accomodative monetary policy stance that occurred during the past two recessions, implying that long-maturity bond yields will have less downside during the next recession than may be currently recognized. Investment Conclusions As we have presented, the historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition to this, there are several arguments pointing to the next US recession being a mild one. In a mild recession scenario, we doubt that the 10-year Treasury yield would fall below 2%, or fall below this level for very long. For fixed-income investors, while bond yields will fall for a time if a recession emerges, the implication is that investors should not overstay their welcome in a long-duration position during the recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. We noted in our July report that if a recession occurred within the coming 6-12 months, that the S&P 500 would likely fall to 3100, even if the recession were average. A mild recession may see the S&P 500 decline less severely than this, but stocks are still likely to incur significant losses during the next recession unless investors price in a much shallower path for short-term interest rates than we believe will be warranted. As noted in Section 1 of our report, we have not yet concluded that a US recession is inevitable over the coming 6-12 months. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Additional changes to our recommended cyclical allocation may thus occur over the coming few months, in response to incoming data, our assessment of the likely implications for monetary policy, and the response of long-maturity government bond yields. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts In contrast to the recent rally in equities, BCA’s equity indicators continue to paint a bearish outlook for stock prices. Our Monetary, Technical, and Speculative indicators have stopped falling, but they remain very weak. Meanwhile, the recent rally has pushed our valuation indicator back towards a level indicating stocks are considerably overvalued. While it is still a risk and not yet a likely event, the odds of a US recession over the next 12 months remain elevated. We maintain a neutral stance for stocks versus bonds over the coming year. Forward earnings are no longer being revised up, but bottom-up analysts’ expectations for earnings are likely still too optimistic. Although earnings growth will be positive over the coming year if a US recession is avoided, it will be in the mid-to-low single-digits given ongoing pressure on profit margins. Within a global equity portfolio, we maintain a neutral stance on cyclicals versus defensives, small caps versus large, and a neutral stance on regional equity allocation. We recommend a modest overweight towards value versus growth stocks, given our recommendation of a modestly short duration stance within a global fixed-income portfolio. Commodity prices have stopped falling, and our composite technical indicator now highlights that commodities are oversold. Our base-case view is that oil prices are likely to rise over the coming 12-months, barring a US recession. Global food prices have come down in the wake of deal between Russia and Ukraine to allow the latter to resume its agricultural exports. But the recent surge in European natural gas prices suggests that global food inflation may remain elevated, given that natural gas is used in the production of fertilizer. Ongoing weakness in the Chinese property market argues for a neutral stance towards industrial metals, until compelling signs of a more aggressive policy response emerge. US and global LEIs have now fallen into negative territory, underscoring that the risk of a global recession is elevated. Some indicators are easing back towards positive territory, such as our global LEI Diffusion Index and our US Financial Conditions Index, but it is not yet clear if they are heralding a reacceleration in economic activity or merely a less intense pace of decline. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators Chart III-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Footnotes 1     Please see The Bank Credit Analyst "Is The US Housing Market Signaling An Imminent Recession?" dated May 26, 2022, available at bca.bcaresearch.com 2     Please see US Bond Strategy "The Great Soft Landing Debate," dated August 2, 2022, available at usbs.bcaresearch.com 3    Please see The Bank Credit Analyst "April 2022," dated March 31, 2022, available at bca.bcaresearch.com 4    Please see The Bank Credit Analyst "Inflation Whipsaw Ahead," dated June 30, 2022, available at bca.bcaresearch.com 5    Please see The Bank Credit Analyst "August 2022," dated July 28, 2022, available at bca.bcaresearch.com

Executive Summary US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins China needs lower interest rates and a weaker currency to battle deflationary pressures. In the US, the main problem is elevated inflation. This heralds higher interest rates and a stronger currency. Hence, the Chinese yuan will depreciate against the greenback. When the RMB weakens versus the US dollar, commodity prices usually fall, and EM currencies and asset prices struggle. Faced with surging unit labor costs, US companies will continue to raise their prices to protect their profit margins and profitability. This will lead to one of the following two possible scenarios in the months ahead. Scenario 1: If customers are willing to pay considerably higher prices, nominal sales will remain robust, profits will not collapse, and a recession is unlikely. However, this also implies that the Fed will have to tighten policy by more than what is currently priced in by markets. Scenario 2: If customers push back against higher prices and curtail their purchases, then the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink, and their profits will plunge.  In both scenarios, the outlook for stocks is poor. However, one key difference is that scenario 1 is bearish for US Treasurys while scenario 2 is bond bullish. Bottom Line: On the one hand, the US has a genuine inflation problem. The upshot is that the Fed cannot pivot too early. The Fed’s hawkish rhetoric will support the US dollar. A strong greenback is bad for EM financial markets. On the other hand, the Chinese economy and global trade are experiencing deflation/recession dynamics. Cyclical assets underperform and the US dollar generally appreciates in this environment. This is also a toxic backdrop for EM financial markets.   Financial markets have been caught in contradictions. The reason is that investors cannot decide if the global economy is heading into a recession with deflationary forces prevailing, or whether a goldilocks economy or a period of inflation or stagflation will emerge in the foreseeable future. There are also plenty of contradictory data to support all the above scenarios.  As such, financial markets are volatile, swinging wildly as market participants absorb new economic data points. The S&P 500 index has rebounded from its 3-year moving average, which had previously served as a major support (Chart 1). Yet, the rebound has faltered at its 200-day moving average. Its failure to break decisively above this 200-day moving average entails that a new cyclical rally is not yet in the cards. Chart 1The S&P 500 Is Stuck Between Technical Resistance And Support Lines The S&P 500 Is Stuck Between Technical Resistance And Support Lines The S&P 500 Is Stuck Between Technical Resistance And Support Lines The S&P 500 index will remain between these resistance and support lines until investors make up their minds about the economic outlook. The EM equity index has been unable to rebound strongly alongside US stocks. A major technical support that held up in the 1998, 2001, 2002, 2008, 2015 and 2020 bear markets is about 15% below the current level (Chart 2). Hence, we recommend that investors remain on the sidelines of EM stocks. Chart 2EM Share Prices Are Still 15% Above Their Long-Term Technical Support Level EM Share Prices Are Still 15% Above Their Long-Term Technical Support Level EM Share Prices Are Still 15% Above Their Long-Term Technical Support Level BCA’s Emerging Markets Strategy team’s macro themes and views remain as follows: Related Report  Emerging Markets StrategyCharts That Matter In China, the main economic risk is deflation and the continuation of underwhelming economic growth. Core and service consumer price inflation are both below 1% and property prices are deflating. Falling prices amid high debt levels is a recipe for debt deflation. We discussed the government’s stimulus – including measures enacted for the property market – in the August 11 report. The latest announcement about the RMB 1 trillion stimulus does not change our analysis. In fact, we expected an additional RMB 1.5 trillion in local government bond issuance for the remainder of the current year. Yet, the government authorized only an additional RMB 0.5 trillion. This is substantially below what had been expected by analysts and commentators in recent months.   In Chinese and China-related financial markets, a recession/deflation framework remains appropriate. Onshore interest rates will drop further, the yuan will depreciate more, and Chinese stocks and China related plays will continue experiencing growth/profit headwinds. Meanwhile, the US economy has been experiencing stagflation this year. Chart 3 shows that even though the nominal value of final sales has expanded by 8-10%, sales and output have stagnated in real terms (close to zero growth). Hence, nominal sales and corporate profits have so far held up because companies have been able to raise prices by 8-9.5% (Chart 4). Is this bullish for the stock market? Not really. Chart 3US Stagflation: Strong Nominal Growth, But Small In Real Terms US Stagflation: Strong Nominal Growth, But Small In Real Terms US Stagflation: Strong Nominal Growth, But Small In Real Terms Chart 4US Corporate Profits Have Held Up Because Of Pricing Power/Inflation US Corporate Profits Have Held Up Because Of Pricing Power/Inflation US Corporate Profits Have Held Up Because Of Pricing Power/Inflation The fact that companies have been able to raise their selling prices at this rapid pace implies that the Fed cannot stop hiking rates. Besides, US wages and unit labor costs are surging (Chart 9 below). The implication is that inflation will be entrenched and core inflation will not drop quickly and significantly enough to allow the Fed to pivot anytime soon. Overall, US economic data releases have been consistent with our view that although real growth is slowing, the US economy is experiencing elevated inflations, i.e., a stagflationary environment. Critically, wages and inflation lag the business cycle and are also very slow moving variables. Hence, US core inflation will not drop below 4% quickly enough to provide relief for the Fed and markets. Is a US recession imminent? It depends. One thing we are certain of is that faced with surging unit labor costs, US companies will attempt to raise their prices to protect their profit margins and profitability. Our proxy for US corporate profit margins signals that they are already rolling over (Chart 5). Hence, business owners and CEOs will attempt to raise selling prices further. Chart 5US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins This will lead to one of two possible scenarios for the US economy in the months ahead. Scenario 1: If customers (households and businesses) are willing to pay considerably higher prices, nominal sales will remain very robust, and profits will not collapse, reducing the likelihood of a recession. Yet, this means that inflation will become even more entrenched, and employees will continue to demand higher wages. A wage-price spiral will persist. The Fed will have to raise rates much more than what is currently priced in financial markets. This is negative for US share prices. Scenario 2: If customers push back against higher prices and curtail their purchases, output volume will relapse, i.e., the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink (prices received will rise much less than unit labor costs) and profits will plunge.  Suffering a profit squeeze, companies will lay off employees, wage growth will decelerate, and high inflation will be extinguished. In this scenario, bond yields will drop significantly but plunging corporate profits will weigh on share prices. We are not certain which of these two scenarios will prevail: it is hard to determine the point at which US consumers will push back against rising prices. Nevertheless, it is notable that in both scenarios, the outlook for stocks is poor.   Finally, as we have repeatedly written, global trade is about to contract. Charts 10-18 below elaborate on this theme. This is disinflationary/recessionary. Investment Conclusions On the one hand, the Chinese economy and global trade are experiencing deflation/recession dynamics. Cyclical assets struggle and the US dollar does well in this environment. This constitutes a toxic backdrop for EM financial markets. On the other hand, the US has a genuine inflation problem. The upshot is that the Fed cannot pivot too early. The Fed’s hawkish rhetoric will support the US dollar. A strong greenback is also bad for EM financial markets. Thus, we do not see any reason to alter our negative view on EM equities, credit and currencies. Investors should continue underweighting EM in global equity and credit portfolios. Local currency bonds offer value, but further currency depreciation and more rate hikes remain a risk to domestic bonds. We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN and IDR. In addition, we recommend shorting HUF vs. CZK, KRW vs. JPY, and BRL vs. MXN.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Messages From Various US High-Beta / Cyclical Stock Prices US high-beta consumer discretionary, industrials, tech and early cyclical stocks have not yet broken out. The rebounds in high-beta tech and industrials have been rather muted. We are watching these and many other market signs and technical indicators to gauge if the recent rebounds can turn into a cyclical bull market. Chart 6 Messages From Various US High-Beta / Cyclical Stock Prices Messages From Various US High-Beta / Cyclical Stock Prices Chart 7 Messages From Various US High-Beta / Cyclical Stock Prices Messages From Various US High-Beta / Cyclical Stock Prices Falling Global Trade + Sticky US Inflation = US Dollar Overshot On the one hand, US household spending on goods ex-autos is already contracting and will drop further. The same is true for EU demand. The reasons are excessive consumption of goods over the past two years and shrinking household real disposable income. As a result, global trade is set to shrink, which is positive for the US dollar. On the other hand, surging US unit labor costs entail that core CPI will be very sticky at levels well above the Fed’s target. Hence, the Fed will likely maintain its hawkish bias for now, which is also bullish for the greenback. In short, the US dollar will continue overshooting.  Chart 8 Falling Global Trade + Sticky US Inflation = US Dollar Overshot Falling Global Trade + Sticky US Inflation = US Dollar Overshot Chart 9 Falling Global Trade + Sticky US Inflation = US Dollar Overshot Falling Global Trade + Sticky US Inflation = US Dollar Overshot Chinese Exports Will Contract, And Imports Will Fail To Recover Chinese export volume growth has come to a halt. Shrinking imports of inputs used for re-export (imports for processing trade) are pointing to an imminent contraction in the mainland’s exports. Further, Chinese import volumes have been contracting for the past 12 months. The value of imports has not plunged only because of high commodity prices. As commodity prices drop, import values will converge to the downside with import volumes. This is negative for economies/industries selling to China. Chart 10 Chinese Exports Will Contract, And Imports Will Fail to Recover Chinese Exports Will Contract, And Imports Will Fail to Recover Chart 11 Chinese Exports Will Contract, And Imports Will Fail to Recover Chinese Exports Will Contract, And Imports Will Fail to Recover Global Manufacturing / Trade Downtrend Is Intact China buys a lot of inputs from Taiwan that are used in its exports. That is why the mainland’s imports from Taiwan lead the global trade cycle. This is presently heralding a considerable deterioration in global trade.  In addition, falling freight rates and depreciating Emerging Asian (ex-China) currencies are all currently pointing to a further underperformance of global cyclicals versus defensive sectors. Chart 12 Global Manufacturing / Trade Downtrend Is Intact Global Manufacturing / Trade Downtrend Is Intact Chart 13 Global Manufacturing / Trade Downtrend Is Intact Global Manufacturing / Trade Downtrend Is Intact Chart 14 Global Manufacturing / Trade Downtrend Is Intact Global Manufacturing / Trade Downtrend Is Intact Taiwan Is A Canary In A Coal Mine Taiwanese manufacturing companies have seen their export orders plunge and their customer inventories surge. This has occurred in its overall manufacturing and semiconductor companies.  This corroborates our thesis that global export volumes will contract in the coming months. Chart 15 Taiwan Is A Canary In A Coal Mine Taiwan Is A Canary In A Coal Mine Chart 16 Taiwan Is A Canary In A Coal Mine Taiwan Is A Canary In A Coal Mine Korean Exporters Are Struggling Korean export companies are experience the same dynamics as their Taiwanese peers. Semiconductor prices and sales are falling hard in Korea. Export volume growth has come to a halt and will soon shrink. Chart 17 Korean Exporters Are Struggling Korean Exporters Are Struggling Chart 18 Korean Exporters Are Struggling Korean Exporters Are Struggling EM Equities: Cheap And Unloved? The EM cyclically adjusted P/E (CAPE) ratio has fallen to one standard deviation below its mean. Based on this measure, EM stocks are currently as cheap as they were at their bottoms in 2020, 2015 and 2008. EM share prices in USD deflated by US CPI are now at two standard deviations below their long-term time-trend. This is as bad as it got when EM stocks bottomed in the previous bear markets. The reason for EM stocks poor performance and such “cheapness” is corporate profits. EM EPS in USD has been flat, i.e., posting zero growth in the past 15 years. Besides, EM narrow money (M1) growth points to further EM EPS contraction in the months ahead. Chart 19 EM Equities: Cheap And Unloved? EM Equities: Cheap And Unloved? Chart 20 EM Equities: Cheap And Unloved? EM Equities: Cheap And Unloved? Chart 21 EM Equities: Cheap And Unloved? EM Equities: Cheap And Unloved? Chart 22 EM Equities: Cheap And Unloved? EM Equities: Cheap And Unloved? Commodity Prices Remain At Risk China needs lower interest rates and a weaker currency to battle deflationary pressures. In the US, the problem is inflation, which heralds higher interest rates and a stronger currency to fight rising prices. Hence, the yuan will depreciate versus the greenback. When the RMB depreciates versus the US dollar, commodity prices usually fall. Further, commodity currencies (an average of AUD, NZD and CAD) continue drafting lower. This indicator correlates with commodity prices and also presages further relapse in resource prices. Chart 23 Commodity Prices Remain At Risk Commodity Prices Remain At Risk Chart 24 Commodity Prices Remain At Risk Commodity Prices Remain At Risk Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chinese crude oil imports have been contracting for almost a year. Global (including US) demand for gasoline has relapsed. Meantime, Russia’s oil and oil product exports have fallen only by a mere 5% from their January level. This explains why oil prices have recently fallen. Oil lags business cycles: its consumption will shrink as global growth downshifts. However, geopolitics remain a wild card. Hence, we are uncertain about the near-term outlook for oil prices. That said, oil has made a major top and any rebound will fail to last much longer or push prices above recent highs. Chart 25 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chart 26 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chart 27 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chart 28 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations What Is Next For The Chinese RMB? The Chinese yuan will continue depreciating versus the US dollar. China needs lower interest rates and a weaker currency to battle deflationary pressures. While currency is moderately cheap, exchange rates tend to overshoot/undershoot and can remain cheap/expensive for a while. The CNY/USD has technically broken down. Interestingly, the periods of RMB depreciation coincide with deteriorating global US dollar liquidity and, in turn, poor performance by EM assets and commodities. Chart 29 What Is Next For The Chinese RMB? What Is Next For The Chinese RMB? Chart 30 What Is Next For The Chinese RMB? What Is Next For The Chinese RMB? Chart 31 What Is Next For The Chinese RMB? What Is Next For The Chinese RMB? Stay Put On Chinese Equities Odds are rising that Chinese platform companies will likely be delisted from the US as we have argued for some time. Hence, international investors will continue dampening US-listed Chinese stocks. The outlook for China’s economic recovery and profits is downbeat. This will weigh on non-TMT stocks and A shares. Within the Chinese equity universe, we continue to recommend the long A-shares / short Investable stocks strategy, a position we initiated on March 4, 2021. Chart 32 Stay Put On Chinese Equities Stay Put On Chinese Equities Chart 33 Stay Put On Chinese Equities Stay Put On Chinese Equities Chart 34 Stay Put On Chinese Equities Stay Put On Chinese Equities Chart 35 Stay Put On Chinese Equities Stay Put On Chinese Equities Messages For Stocks From Corporate Bonds Historically, rising US and EM corporate bond yields led to a selloff in US and EM share prices, respectively. Corporate bond yields are the cost of capital that matters for equities. Unless US and EM corporate bond yields start falling on a sustainable basis, their share prices will struggle. Corporate bond yields could increase because of either rising US Treasury yields or widening credit spreads. Chart 36 Messages For Stocks From Corporate Bonds Messages For Stocks From Corporate Bonds Chart 37 Messages For Stocks From Corporate Bonds Messages For Stocks From Corporate Bonds EM Currencies And Fixed-Income: An Unfinished Adjustment The profiles of EM FX and credit spreads suggest that their adjustment might not be complete. We expect further EM currency depreciation and renewed EM credit spread widening. EM domestic bond yields have risen significantly and offer value. However, if and as US TIPS yields rise and/or EM currencies continue to depreciate, local bond yields are unlikely to fall. To recommend buying EM local bonds aggressively, we need to change our view on the US dollar. Chart 38 EM Currencies And Fixed-Income: An Unfinished Adjustment EM Currencies And Fixed-Income: An Unfinished Adjustment Chart 39 EM Currencies And Fixed-Income: An Unfinished Adjustment EM Currencies And Fixed-Income: An Unfinished Adjustment Chart 40 EM Currencies And Fixed-Income: An Unfinished Adjustment EM Currencies And Fixed-Income: An Unfinished Adjustment Chart 41 EM Currencies And Fixed-Income: An Unfinished Adjustment EM Currencies And Fixed-Income: An Unfinished Adjustment   Footnotes Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Executive Summary Upgrade Euro Area ILBs To Overweight Upgrade Euro Area ILBs To Overweight Upgrade Euro Area ILBs To Overweight Inflation breakevens have stabilized in the US, where gasoline prices have fallen, but have reaccelerated in the UK and euro area, where natural gas prices have exploded. Inflation breakevens have declined in Canada, potentially due to markets starting to discount a rapid decline in Canadian house price inflation. Our suite of global breakeven models shows that US and Canadian 10-year breakevens are too low, while euro area and UK breakevens are too high. When adjusted for market expectations for the future stance of monetary policies, expressed as the slope of nominal bond yield curves, only the UK stands out with a “conflicted” combination of too-high breakevens and an inverted nominal Gilt curve. Bottom Line: Upgrade inflation-linked bonds to overweight in the euro area (Germany, France, Italy), while downgrading Canadian linkers to underweight. Stay underweight UK linkers, with the Bank of England on course to tip the UK into a deep recession. Maintain a neutral stance on US TIPS, but look to upgrade if the Fed signals a less hawkish path for US monetary policy. Feature Chart 1Intensifying Inflation Worries In Europe Intensifying Inflation Worries In Europe Intensifying Inflation Worries In Europe Inflation-linked bonds (ILBs) have played a useful role for fixed income investors looking to protect their portfolios from the pernicious effects of the current era of high inflation. The rising inflation tide had been lifting all global ILB boats. Given the global nature of the brief deflationary shock from the global COVID lockdowns in 2020, and the persistent inflationary shock of the policy-induced recovery from the pandemic, ILB yields – and breakeven spreads versus nominal bonds – have tended to be positively correlated between countries. Now, some interesting divergences have started to appear between market-based inflation expectations (ILB breakevens or CPI swaps) at the country level. Most notably, inflation expectations have been climbing in the euro area and UK, while staying more stable – below the 2022 peak - in the US (Chart 1). In smaller ILB markets like Canada and Australia, breakevens have rolled over and remain at levels consistent with central bank inflation targets even in the fact of high realized inflation. Amid signs of easing inflation pressures from the commodity and traded goods spaces, and with global central banks now in full-blown tightening cycles to try and rein in overshooting inflation, ILB markets are likely to continue being less correlated. Being selective with ILB allocations at the country level, both on the long and short side of the market, will provide better relative return opportunities for bond investors over the next 6-12 months. To assess where those ILB opportunities lie within the developed market universe, we must first go over what is happening with various measures of inflation expectations in each country. A Country-By-Country Tour Of The Recent Dynamics Of Inflation Expectations US Chart 2Lower Gas Prices, Lower US Inflation Expectations Lower Gas Prices, Lower US Inflation Expectations Lower Gas Prices, Lower US Inflation Expectations In the US, the correlation with inflation expectations and gasoline prices remains quite strong (Chart 2). That has been the case when gas prices were soaring, but the correlation works in both directions. The US national gasoline price has fallen by 22% since the peak on June 13, according to the American Automobile Association. Lower gas prices have helped ease consumer inflation expectations. The July reading of the New York Fed’s Survey of Consumer Expectations showed a dip in the 1-year-ahead inflation expectation to 6.2% from 6.8% in June. The 5-year-ahead inflation expectation, which was introduced to the New York Fed survey back in January, fell sharply in July to 2.3% from 2.8% in June (and from a peak of 3% back in March). The fall in US survey-based inflation is also mirrored in lower TIPS breakevens. The 10-year TIPS breakeven fell from 2.76% at the peak of the national gasoline price in mid-June to a low of 2.29% on July 7. The 10-year breakeven has since recovered to 2.58%, but is still below the levels at the time of the peak in gas prices – and considerably lower than the cyclical peak of 3.02% reached in April. The 2-year TIPS breakeven has fallen even more, down from 4.93% to 2.87% since the April peak. UK Chart 3A Historic Energy Price Shock In The UK A Historic Energy Price Shock In The UK A Historic Energy Price Shock In The UK The UK inflation story has been heavily focused on the historic surge in energy prices. UK headline CPI inflation reached double-digit territory in July, climbing to 10.1% on a year-over-year basis, with the energy component of the CPI rising by a staggering 58%. Within that energy component, natural gas prices have been a huge driver, with the gas component of the CPI index up 96% year-over-year in July (Chart 3). Yet despite the relentless climb in energy prices, and the well-publicized “cost of living crisis” with high inflation rates in many non-energy sectors of the UK economy, survey-based measures of UK inflation expectations have stopped rising. The medium-term (5-10 years ahead) inflation expectation from the Citigroup/YouGov survey of UK consumers fell to 3.8% in July, down from the 4.4% peak reached back in March. Even shorter-term inflation expectations have stabilized in the face of rising energy costs (bottom panel). The dip in survey-based inflation expectations as of the July surveys may only be that – a dip – with the 10-year breakeven rate on index-linked Gilts having climbed from 3.8% to 4.2% so far in August. It’s also possible that the household inflation surveys are picking up the impact from the recent slowing of global goods price inflation (and easing global supply chain disruptions). More likely, in our view, UK households are starting to factor in the impact of BoE monetary tightening and an imminent UK recession – one that the BoE is now forecasting – on future inflation. Euro Area Chart 4European Inflation Expectations On The Rise European Inflation Expectations On The Rise European Inflation Expectations On The Rise In the euro area, inflation expectations are finally responding to the steady climb in realized inflation evident across the region. Headline CPI inflation in the region climbed to 8.9% in July, the highest reading since the inception of the euro in 1999. The inflation has been concentrated in a few sectors, with four percentage points of that 8.9% coming from energy prices and another two percentage points coming from food, tobacco and alcohol. Core inflation (excluding food and energy) was 4.0% in July, less alarming than the headline number but still double the ECB’s inflation target of 2%. The ECB now produces its own survey of consumer inflation expectations, which it has been conducting without publishing the results since April 2020. The ECB started publishing the survey this month, as part of a broader Consumer Expectations Survey that also asks questions on topics like future economic growth and the health of labor markets. The most recent survey in June showed that 1-year-ahead inflation expectations were 5%, and 3-year-ahead were 2.8% (Chart 4). Both measures have risen sharply since February – the month before the Russian invasion of Ukraine that triggered the spike in oil and European natural gas prices – when the 1-year-ahead and 3-year-ahead measures were 3.2% and 2.1%, respectively. Euro area market-based inflation expectations are a little more subdued than those from the ECB’s consumer survey. The 5-year breakeven inflation rate on German ILBs is now at 3.4%, while the 10-year breakeven is at 2.5%. A similar message comes from European inflation swaps, with the 5-year measure at 3.4% and the 10-year measure at 2.8%. Canada Chart 5A Housing-Driven Peak In Canadian Inflation Expectations? A Housing-Driven Peak In Canadian Inflation Expectations? A Housing-Driven Peak In Canadian Inflation Expectations? In Canada, realized inflation is still elevated, but may be peaking. Headline CPI inflation was 7.6% in July, down from 8.1% in June, although this came almost entirely from lower energy inflation. Measures of underlying inflation produced by the Bank of Canada (BoC) also stabilized in July, with the trimmed CPI inflation measure ticking down from 5.4% from 5.5% in June (Chart 5). The latest read on survey-based inflation expectations from the BoC’s quarterly Consumer Expectations Survey for Q2/2022 showed a pickup in the 1-year-ahead measure (from 5.1% in Q1 to 6.8%), 2-year-ahead measure (from 4.6% in Q1 to 5%) and 5-year-ahead measure (from 3.2% to 4%). All of those measures are well above the latest readings on market-based inflation expectations from Canadian ILBs, a.k.a. Real Return Bonds, with the 5-year breakeven at 2.2% and 10-year breakeven at 2.1%. Market liquidity is always a factor in the relatively small Canadian Real Return Bond market, yet it is somewhat surprising that breakevens are so low compared with realized and survey-based inflation. The aggressive tightening so far by the BoC, including a whopping 100bp rate hike last month and more expected over the next year, may be playing a role in dampening inflation breakevens – especially with the BoC’s tightening already having an impact on the Canadian housing market. National house price inflation, which tends to lead overall headline CPI inflation by around one year, was 14.2% in July, down from the 2022 peak of 18.8% (top panel). Australia Chart 6Inflation Expectations Remain Moderate In Australia & Japan Inflation Expectations Remain Moderate In Australia & Japan Inflation Expectations Remain Moderate In Australia & Japan In Australia, headline CPI inflation reached 6.1% in Q2/2022, up from 5.1% in Q1/2022, while the median inflation rate was 4.2%. While energy costs were a big contributor to the rise in overall inflation, the pickup was fairly broad-based with notable increases in the inflation rates related to housing (both house prices and furniture prices). Survey-based measures of inflation expectations in Australia focus on more shorter time horizons, thus they are highly correlated to current realized inflation. On that note, the Melbourne University measure of 1-year-ahead consumer inflation expectations soared from 4.9% in Q1/2022 to 6.2% in Q2/2022, while the early read on Q3/2022 2-year-ahead inflation expectations from the Union Officials survey rose to 4.1% from 3.5% in the previous quarter (Chart 6). Market-based inflation expectations are relatively subdued given the high readings of realized inflation and shorter-term survey-based inflation expectations. The 10-year Australian ILB breakeven is now at 1.9%, while the 5-year/5-year forward CPI swap rate is at 2.4%. The aggressive RBA tightening in 2022, with the Cash Rate having increased 175bps over the last four policy meetings, may be playing a role in holding down ILB breakevens. The relatively moderate pace of wage gains in Australia, with the Wage Price Index climbing 2.6% year-over-year in Q2, may also be weighing on ILB breakevens (middle panel). Japan There is not much exciting to say on the inflation front in Japan. The core (excluding fresh food) CPI inflation rate targeted by the Bank of Japan (BoJ) did hit a 7-year of 2.4% in July, but the core CPI measure more in line with international standards (excluding fresh food and energy) was only 1.2% in July (bottom panel). That was the strongest reading since 2015 but still well below the BoJ’s 2% inflation target. Survey-based consumer inflation expectations from the BoJ’s Opinion Survey showed a noticeable increase in Q2/2022, with the 5-year-ahead measure rising to 5% from 3% in Q1. This is obviously well above realized Japanese inflation, although the same survey showed that Japanese consumers believed that the current inflation rate was also 5%. Market-based Japanese inflation expectations are well below the BoJ survey-based measure, but in line with realized core inflation with the 2-year and 10-year CPI swap rates at 1.22% and 0.9%, respectively. The Message From Our Inflation Breakeven Valuation Models Chart 7A Diminished Case For Overweighting Inflation-Linked Bonds A Diminished Case For Overweighting Inflation-Linked Bonds A Diminished Case For Overweighting Inflation-Linked Bonds From an overall global perspective, the case for favoring ILBs versus nominal government bonds across all countries is less intriguing today than was the case in 2021 and early 2022 (Chart 7). Commodity price inflation is slowing rapidly alongside decelerating global growth. This is true both for oil and especially for non-oil commodities, with the CRB Raw Industrials index now falling on a year-over-year basis (middle panel). Supply chain disruptions on goods prices are easing, which is evident in lower rates of goods inflation in the US and other countries. Given the divergences evident between realized inflation, expected inflation and monetary policy outlook outlined in our tour of global inflation expectations, there may be better opportunities to selectively allocate to ILBs on a country-by-country basis. One tool to help us identify such opportunities is our suite of inflation breakeven fair value models. The models are all constructed in a similar fashion, determining the fair value of 10-year ILB breakevens as a function of the same two factors for each country: The underlying trend in realized inflation, defined as the five-year moving average of headline CPI inflation. This forms the medium-term “anchor” for breakevens. The year-over-year percentage change in the Brent oil price, denominated in local currency terms for each country. This attempts to capture cyclical trends around that medium-term anchor based on movements in oil and currencies. We have breakeven fair value models for eight developed market countries, which are shown in the next four pages of this report. The list of countries includes the US (Chart 8), the UK (Chart 9), France (Chart 10), Germany (Chart 11), Italy (Chart 12), Canada (Chart 13), Australia (Chart 14) and Japan (Chart 15). Chart 8Our US 10-Year Inflation Breakeven Model Our US 10-Year Inflation Breakeven Model Our US 10-Year Inflation Breakeven Model ​​​​​​ Chart 9Our UK 10-Year Inflation Breakeven Model Our UK 10-Year Inflation Breakeven Model Our UK 10-Year Inflation Breakeven Model ​​​​​​ Chart 10Our France 10-Year Inflation Breakeven Model Our France 10-Year Inflation Breakeven Model Our France 10-Year Inflation Breakeven Model ​​​​​​ Chart 11Our Germany 10-Year Inflation Breakeven Model Our Germany 10-Year Inflation Breakeven Model Our Germany 10-Year Inflation Breakeven Model ​​​​​​ Chart 12Our Italy 10-Year Inflation Breakeven Model Our Italy 10-Year Inflation Breakeven Model Our Italy 10-Year Inflation Breakeven Model ​​​​​​ Chart 13Our Canada 10-Year Inflation Breakeven Model Our Canada 10-Year Inflation Breakeven Model Our Canada 10-Year Inflation Breakeven Model ​​​​​ Chart 14Our Australia 10-Year Inflation Breakeven Model Our Australia 10-Year Inflation Breakeven Model Our Australia 10-Year Inflation Breakeven Model ​​​​​ Chart 15Our Japan 10-Year Inflation Breakeven Model Our Japan 10-Year Inflation Breakeven Model Our Japan 10-Year Inflation Breakeven Model ​​​​​ Full disclosure: we decided last year to de-emphasize our breakeven fair value models after the 2020 COVID recession and, more importantly, the sharp global economic recovery in 2021 from the pandemic shock. The rapid acceleration of oil prices – up 2-3 times in all countries - triggered by that recovery created some wild swings in the estimated breakeven fair value. Today, with oil inflation at more “normal” levels below 100%, we have greater confidence in using the models once again in our strategic thinking on ILBs. The broad conclusions from the models are the following: 10-year inflation breakevens are too low in the US, Canada and Germany 10-year inflation breakevens are too high in the UK and Italy 10-year inflation breakevens are fairly valued in France, Japan and Australia. Taken at face value, our models would suggest overweighting ILBs in the US, Canada and Germany and underweighting ILBs in the UK (and staying neutral on France, Japan and Australia) as part of a new regional ILB diversification strategy. However, there is an additional element to consider when assessing the attractiveness of inflation breakevens at the macro level – the expected stance of monetary policy. ILB inflation breakevens often represent a market-based “report card” on the appropriateness of a central bank’s monetary policy. If monetary settings are deemed to be overly stimulative, the markets will price in higher expected inflation and wider breakevens. The opposite holds true if policy is deemed to be too restrictive, leading to reduced expected inflation and narrower breakevens. Thus, any regional ILB allocation strategy should not only use fair value assessments, but also a monetary policy “filter”. In Chart 16, we show a scatter graph plotting the latest deviations from fair value of 10-year breakevens from our eight country fair value models on the x-axis, and the cumulative amount of expected interest rate increases discounted in overnight index swap (OIS) curves for each country on the y-axis. For the latter, we define this as the peak in rates discounted in 2023 (which is the case for all the countries) minus the trough in policy rates at the start of the current monetary tightening cycle (which is near 0% for all the countries). Chart 16No Clear Link Between Rate Hikes & Breakeven Valuations A Regional Diversification Strategy For Inflation-Linked Bonds A Regional Diversification Strategy For Inflation-Linked Bonds The idea behind the chart is that inflation breakeven valuations should be inversely correlated to the amount of monetary tightening expected by markets. Too many rate hikes would result in markets discounting lower breakevens, and vice versa. However, there is no reliable relationship evident in the chart. For example, the OIS curves are discounting roughly similar levels of cumulative tightening in the US, UK, Canada and Australia, yet ILB breakeven valuations are very different between those countries. In Chart 17, we show a slightly different version of that scatter graph, this time plotting the ILB breakeven fair values versus the slope of the 2-year/10-year nominal government bond yield curve for all eight countries. The logic here is that the slope of the yield curve represents the bond market’s assessment of the appropriateness of future monetary policy. When policy is deemed to be too tight – with an expected peak in rates above what the market believes to be the neutral rate – the yield curve will be flat or even inverted, as markets discount slowing growth in the future and, eventually, lower inflation. Chart 17A Stronger Link Between Yield Curves & Breakeven Valuations A Regional Diversification Strategy For Inflation-Linked Bonds A Regional Diversification Strategy For Inflation-Linked Bonds There is a clear positive relationship between yield curve slope and inflation expectations evident in the new chart. This provides some evidence justifying adding a monetary policy filter to a regional ILB allocation strategy. Related Report  Global Fixed Income StrategyDovish Central Bank Pivots Will Come Later Than You Think Under this framework, US and Canadian breakevens trading below fair value is consistent with the inverted yield curves in both countries, with markets now discounting a restrictive level of future interest rates that would dampen inflation expectations. The fair value of Australian and Japanese breakevens also appears in line with the slope of the yield curves in those countries. In terms of divergences, the overvaluation of UK breakevens is inconsistent with the inverted nominal Gilt curve, while the three euro area countries should have somewhat higher breakevens (trading more richly to fair value) given the relatively steeper slope of their yield curves. Investment Conclusions Chart 18Upgrade Euro Area ILBs To Overweight Upgrade Euro Area ILBs To Overweight Upgrade Euro Area ILBs To Overweight After surveying our ILB breakeven fair value models, and cross-checking them versus trends in survey-based inflation expectations and our own assessment of future monetary policies, we arrive at the following country allocations within our new regional ILB strategy: Neutral on US TIPS, despite the attractive valuations. However, look to upgrade if the Fed signals a less hawkish path for US monetary policy (not our base case) or if breakevens fall even further below fair value without more deeper US Treasury curve inversion. Underweight UK ILBs. Breakevens are overshooting due to the near-term inflation risk from soaring energy prices – an outcome that will force the BoE to deliver an even tighter monetary policy, with a more deeply inverted yield curve, that will drive the UK into a disinflationary recession. Underweight Canadian ILBs, despite the attractive valuations. Canadian inflation has likely peaked, and the BoC is engineering a disinflationary downturn in the Canadian housing market with aggressive rate hikes that will maintain an inverted yield curve. Overweight German, French and Italian ILBs. The ECB is likely to deliver fewer rate hikes than markets are discounting, keeping the euro area yield curves relatively steep versus the curves of other developed countries. This also provides a better way to play the near-term inflationary upside from overshooting natural gas prices in Europe than overweighting UK ILBs, with the BoE expected to be much more hawkish than the ECB (Chart 18). Neutral Australia and Japan. Underlying inflation momentum is slower than in the other regions, while breakeven valuations are neutral and not out of line with the expected stance of monetary policy. We are incorporating this new regional ILB strategy into our Model Bond Portfolio, which can be seen on pages 18-20. The changes from current allocations involve upgrades to Germany, France and Italy to overweight, and a downgrade of Canada to underweight.   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 A Regional Diversification Strategy For Inflation-Linked Bonds A Regional Diversification Strategy For Inflation-Linked Bonds The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) A Regional Diversification Strategy For Inflation-Linked Bonds A Regional Diversification Strategy For Inflation-Linked Bonds

Listen to a short summary of this report.     Executive Summary Euro Bulls Are Evaporating Euro Bulls Are Evaporating Euro Bulls Are Evaporating The euro is likely to undershoot in the near term, as the winter months approach and economic volatility in Europe rises. However, much of the euro’s troubles are well understood and discounted by financial markets. This suggests a floor closer to parity for the EUR/USD. Unlike many other developed economies, the fiscal drag in the eurozone is likely to be minimal for the rest of this year and early next year. The forces pressuring equilibrium rates lower in the periphery are slowly dissipating. That should lift the neutral rate of interest in the entire eurozone. China’s zero Covid-19 policy along with property market troubles has weighed heavily on the euro, but that could change. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Long EUR/GBP 0.846 2021-10-15 -0.13 Short EUR/JPY 141.20 2022-07-07 2.46 Bottom Line: The euro tends to be largely driven by pro-cyclical flows, which will be a positive when risk sentiment picks up. Meanwhile, making a structural case for the euro is easy when it comes to valuation. According to our in-house PPP models, an investor who buys the euro today can expect to make 6% a year over the next decade, should the euro mean revert to fair value and beyond. Our current stance is more measured because investors could see capitulation selling in the coming months. Feature Chart 1Two Decades After The Creation Of The Euro Two Decades After The Creation Of The Euro Two Decades After The Creation Of The Euro The creation of the euro was an ambitious project. It began with a simple idea – let’s create the biggest monetary union and everything else will follow, not least, economic might. Over the last two decades, the euro has survived, but its ambitions have been jolted by various crises. Today, the euro is sitting around where it was at the initiation of the project (Chart 1). That has been a tremendous loss in real purchasing power for many of its citizens. Given that we are back to square one, this report examines the prospects for the euro from the lens of its original ambitions, while navigating the economic and geopolitical landscape today. Surviving The Winter Chart 2A European Recession Is Well Priced In A European Recession Is Well Priced In A European Recession Is Well Priced In Winter will be tough for eurozone citizens. But how tough? In our view, less than what the euro is pricing in. According to the ZEW sentiment index, the eurozone manufacturing PMI should be around 45 today, but sits at 49.8. The euro, which has been tracking the ZEW index tick-for-tick has already priced in a deep recession, worse than the 2020 episode (Chart 2). Bloomberg GDP growth consensus forecasts for the eurozone are still penciling in 2.8% growth for 2022, down from a high of 4%. For 2023, forecasts have hit a low of 0.8%. It is certainly possible that euro area growth undershoots this level, which will cause a knee jerk sell off in the euro. However, much of the euro’s troubles are well understood and discounted by financial markets. Natural gas storage is already close to 80%, the EU’s target, to help the eurozone navigate the winter. Coal plants are firing on all cylinders, and Germany has decided to delay the closure of its nuclear power plants. It is true that electricity prices are soaring, but part of the story has been weather-related, notably a heat wave across Europe, falling water levels along the Rhine that has delayed coal shipments, and lower wind speeds that have affected renewable energy generation. France is also having problems with nuclear power generation, due to little availability of water for cooling reactors. Looking ahead, energy markets are already discounting a steep fall in prices from the winter energy cliff (Chart 3). If that turns out to be true, it will be a welcome fillip for eurozone growth. First, it will ease the need for the ECB to tighten policy aggressively, and second, it will boost real incomes, which will support spending. This is not being discussed in financial markets today. Chart 3AFutures Markets Suggest The Energy Crunch Will Ebb Futures Markets Suggest The Energy Crunch Will Ebb Futures Markets Suggest The Energy Crunch Will Ebb Chart 3CFutures Markets Suggest The Energy Crunch Will Ebb Futures Markets Suggest The Energy Crunch Will Ebb Futures Markets Suggest The Energy Crunch Will Ebb Chart 3BFutures Markets Suggest The Energy Crunch Will Ebb Futures Markets Suggest The Energy Crunch Will Ebb Futures Markets Suggest The Energy Crunch Will Ebb Fiscal Policy To The Rescue? Unlike many other developed economies, the fiscal drag in the eurozone is likely to be minimal for the rest of this year and early next year (Chart 4). As funds from the next generation EU plan are being disbursed into strategic sectors, including renewable energy, Europe’s productive capital base will also improve. This is likely to have a huge multiplier effect on European growth. Chart 4AThe Fiscal Drag In The Eurozone Could Be Minimal The Fiscal Drag In The Eurozone Could Be Minimal The Fiscal Drag In The Eurozone Could Be Minimal Chart 4BThe Fiscal Drag In The Eurozone Could Be Minimal The Fiscal Drag In The Eurozone Could Be Minimal The Fiscal Drag In The Eurozone Could Be Minimal Taking a bigger-picture view, what has become evident in recent years is stronger solidarity among eurozone countries, both economically and politically. Related Report  Foreign Exchange StrategyMonth In Review: Inflation Is Still Accelerating Globally Economically, the standard dilemma for the eurozone was that interest rates were too low for the most productive nation, Germany, but too expensive for others, such as Spain and Italy. As such, the euro was often caught in a tug of war between a rising equilibrium rate of interest for Germany, but a very low neutral rate for the peripheral countries. The good news is that for the eurozone, a lot of this internal rupture has been partly resolved. Labor market reforms have seen unit labor costs in Greece, Ireland, Portugal and Spain collectively contract since 2008. This has effectively eliminated the competitiveness gap with Germany, accumulated over the last two decades (Chart 5). Italy remains saddled with a rigid and less productive workforce, but the overall adjustments have still come a long way to close a key fissure plaguing the common currency area. The result has been a collapse in peripheral borrowing spreads, relative to Germany (Chart 6). Ergo, interest payments as a share of GDP are now manageable. It is true that Italy remains a basket case but the ECB’s Transmission Protection Instrument (TPI) will ensure that peripheral spreads remain well contained and a liquidity crisis (in Italy) does not morph into a solvency one. Chart 5The Periphery Is Now Competitive The Periphery Is Now Competitive The Periphery Is Now Competitive Chart 6Peripheral Spreads Are Still Contained In Real Terms Peripheral Spreads Are Still Contained In Real Terms Peripheral Spreads Are Still Contained In Real Terms Beyond the adjustment in competitiveness, productivity among eurozone countries might also converge. Our European Investment Strategy colleagues suggest that the neutral rate is still wide between Germany and the periphery. That said, gross fixed capital formation in the periphery has been surging relative to core eurozone members (Chart 7). If this capital is deployed in the right sectors, it will have two profound impacts. First, the neutral rate of interest in the eurozone will be lifted from artificially low levels. The proverbial saying is that a chain is only as strong as its weakest link. This means that if the forces pressuring equilibrium rates lower in the periphery are slowly dissipating, that should lift the neutral rate of interest in the entire eurozone. Over a cyclical horizon, this should be unequivocally bullish for the euro. Second, and more importantly, economic solidarity among eurozone members will help ensure the survival of the euro, over the next decade and beyond. Chart 7The Periphery Could Become More Productive The Periphery Could Become More Productive The Periphery Could Become More Productive Trading The Euro The above analysis suggests long-term investors should be buying the euro today. However, the long run can be a very long time to be offside. Our trading strategy is as follows: Over the next 6 months, stay neutral to short the euro. The economic landscape for the eurozone remains fraught with risk. This is a typical recipe for a currency to undershoot. Eurozone banks are very sensitive to economic conditions in the eurozone, and ultimately the performance of the euro, and the signal from bank shares remains negative (Chart 8). Chart 8European Banks Are Not Part Of The Agenda Watch Eurozone Banks European Banks Are Not Part Of The Agenda Watch Eurozone Banks European Banks Are Not Part Of The Agenda Watch Eurozone Banks Investors have been cutting their forecasts for the euro but have not yet capitulated. Bets are that the euro will be at 1.10 by the end of next year, and 14% higher in two years. A bottom will be established when investors cut their forecasts below current spot prices (Chart 9). This corroborates with data from net speculative positions that have yet to hit rock bottom.  Chart 9Euro Bulls Are Evaporating Euro Bulls Are Evaporating Euro Bulls Are Evaporating Real interest rates in the euro area are still plunging across the curve, relative to the US. The two-year real yield has hit a cyclical low. Five-year, 10-year and 30-year real yields are also falling. Historically, the euro tends to trend higher when interest rate differentials are moving in favor of the eurozone (Chart 10). Chart 10AReal Rates Are Dropping In The Euro Area Real Rates Are Dropping In The Euro Area Real Rates Are Dropping In The Euro Area Chart 10BReal Rates Are Dropping In The Euro Area Real Rates Are Dropping In The Euro Area Real Rates Are Dropping In The Euro Area Hedging costs have risen tremendously, as the forward market (like investors) is already pricing in an appreciation in the euro. The embedded two-year return for EUR investors is circa 4%, in line with the carry costs (Chart 11). In real terms, the returns are closer to 9% to compensate for much higher inflation expectations in the eurozone. Higher hedging costs will dissuade foreign investors from gobbling up European assets on a hedged basis. Chart 11A 5% Rally In The Euro Is Already Anticipated A 5% Rally In The Euro Is Already Anticipated A 5% Rally In The Euro Is Already Anticipated In short, the euro is likely to enter a capitulation phase. Our sense is that that it will push EUR/USD below parity, towards 0.98. Below that level, we believe the risk/reward profile will become much more attractive for both short- and longer-term investors. Signals From External Demand Chart 12The Euro Is Increasingly Dependant On Chinese Data The Euro Is Increasingly Dependant On Chinese Data The Euro Is Increasingly Dependant On Chinese Data The eurozone is a very open economy. Exports of goods and services represented 51% of euro area GDP in 2021. This means that what happens with external demand, especially in the US, the UK and China, matters for European growth (Chart 12). Of all its major export partners, China is the biggest question mark. China’s zero Covid-19 policy along with property market troubles has weighed heavily on the euro. Historically, the Chinese credit impulse has been a good coincident indicator for EUR/USD. Lately, that relationship has decoupled (Chart 13A). We favor the view that the credit transmission mechanism in China is merely delayed, rather than broken. For one, a rising Chinese credit impulse usually leads European exports, and this time should be no different. Chinese bond markets are also becoming more liberalized, and as such are a key signal for financial conditions in China. For over a decade, easing financial conditions have usually been a good signal that import demand is about to improve (Chart 13B). This is good news for European export demand. The bottom line is that investors are currently too pessimistic on Europe’s growth prospects at a time when a few green shoots are emerging for external demand. That may not save the euro in the near term but will be a welcome fillip for euro bulls when it does undershoot. Chart 13AThe Muse For The Euro Is Chinese Data The Muse For The Euro Is Chinese Data The Muse For The Euro Is Chinese Data Chart 13BThe Muse For The Euro Is Chinese Data The Muse For The Euro Is Chinese Data The Muse For The Euro Is Chinese Data Concluding Thoughts Chart 14The Goldilocks Case For The Euro The Goldilocks Case For The Euro The Goldilocks Case For The Euro The euro tends to be largely driven by pro-cyclical flows. Fortunately for investors, European equities remain unloved, given that they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Analysts are aggressively revising up their earnings estimates for eurozone equities, relative to the US. They might be wrong in the near term, but over a 9-to-12-month horizon, this has been a good leading indicator for the euro.  Making a structural case for the euro is easy when it comes to valuation. According to our in-house PPP models, an investor who buys the euro today can expect to make 6% a year over the next decade, should the euro mean revert to fair value and beyond (Chart 14). Meanwhile, beyond the winter months, inflation could come crashing back to earth in the eurozone, which will provide underlying support for the fair value of the currency. Our near-term stance is more measured because investors are only neutral the euro, and risk reversals are not yet at a nadir. This is particularly relevant given that Europe still has a war in its backyard, with the potential of generating more market volatility ahead. Given this confluence of factors, we have chosen to play euro via two channels: Long EUR/GBP: As we argued last week, the UK has a bigger stagflation problem compared to the eurozone. This trade is also a bet on improving economic fundamentals between the eurozone and the UK, as well as a bet on policy convergence between the two economies. Short EUR/JPY: The yen is even cheaper than the euro. In a risk-off environment, EUR/JPY will sell off. In a risk-on environment, the yen can still benefit since it is oversold. Meanwhile, investors remain bullish EUR/JPY. Long EUR/USD: We will go long the euro if it breaks below 0.98.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Listen to a short summary of this report.     Executive Summary Back From The Future: An Investor’s Almanac Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis Stocks will rally over the next six months as recession risks abate but then begin to swoon as it becomes clear the Fed will not cut rates in 2023. A second wave of inflation will begin in mid-2023, forcing the Fed to raise rates to 5%. The 10-year US Treasury yield will rise above 4%. While financial conditions are currently not tight enough to induce a recession, they will be by the end of next year. In the past, the US unemployment rate has gone through a 20-to-22 month bottoming phase. This suggests that a recession will start in early 2024. The US dollar will soften over the next six months but then get a second wind as the Fed is forced to turn hawkish again. Over the long haul, the dollar will weaken, reflecting today’s extremely stretched valuations.   Bottom Line: Investors should remain tactically overweight global equities but look to turn defensive early next year. Somewhere in Hilbert Space I have long believed that anything that can possibly happen in financial markets (as well as in life) will happen. Sometimes, however, it is useful to focus on a “base case” or “modal” outcome of what the world will look like. In this week’s report, we do just that, describing the evolution of the global economy from the perspective of someone who has already seen the future unfold. September 2022 – Goldilocks! US headline inflation continues to decline thanks to lower food and gasoline prices (Chart 1). Supply-chain bottlenecks ease, as evidenced by falling transportation costs and faster delivery times (Chart 2). Most measures of economic activity bottom out and then begin to rebound. The surge in bond yields earlier in 2022 pushed down aggregate demand, but with yields having temporarily stabilized, demand growth returns to trend. The S&P 500 moves up to 4,400. Chart 1ALower Food And Gasoline Prices Will Drag Down Headline Inflation (I) Lower Food And Gasoline Prices Will Drag Down Headline Inflation (I) Lower Food And Gasoline Prices Will Drag Down Headline Inflation (I) Chart 1BLower Food And Gasoline Prices Will Drag Down Headline Inflation (II) Lower Food And Gasoline Prices Will Drag Down Headline Inflation (II) Lower Food And Gasoline Prices Will Drag Down Headline Inflation (II)   October 2022 – Europe’s Prospects of Avoiding a Deep Freeze Improve: Economic shocks are most damaging when they come out of the blue. With about half a year to prepare for a cut-off of Russian gas, the EU responds with uncharacteristic haste: Coal-fired electricity production ramps up; the planned closure of Germany’s nuclear power plants is postponed; the French government boosts nuclear capacity, which had been running at less than 50% earlier in 2022; and, for its part, the Dutch government agrees to raise output from the massive Groningen natural gas field after the EU commits to establishing a fund to compensate the surrounding community for any damage from increased seismic activity. EUR/USD rallies to 1.06.  November 2022 – Divided Congress and Trump 2.0: In line with pre-election polling, the Democrats retain the Senate but lose the House (Chart 3). Markets largely ignore the outcome. To no one’s surprise, Donald Trump announces his candidacy for the 2024 election. Over the following months, however, the former president has trouble rekindling the magic of his 2016 bid. His attacks on his main rival, Florida governor Ron DeSantis, fall flat. At one rally in early 2023, Trump’s claim that “Ron is no better than Jeb” is greeted with boos. Chart 2Supply-Chain Pressures Are Easing Supply-Chain Pressures Are Easing Supply-Chain Pressures Are Easing Chart 3Democrats Will Lose The House But Retain The Senate Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis   December 2022 – China’s “At Least One Child Policy”: The 20th Party Congress takes place against the backdrop of strict Covid restrictions and a flailing housing market. In addition to reaffirming his Common Prosperity Initiative, President Xi stresses the need for actions that promote “family formation.” The number of births declined by nearly 30% between 2019 and 2021 and all indications suggest that the birth rate fell further in 2022 (Chart 4). Importantly for investors, Xi says that housing policy should focus not on boosting demand but increasing supply, even if this comes at the expense of lower property prices down the road. Base metal prices rally on the news. Chart 4China's Baby Bust China's Baby Bust China's Baby Bust January 2023 – Putin Declares Victory: Faced with continued resistance by Ukrainian forces – which now have wider access to advanced western military technology – Putin declares that Russia’s objectives in Ukraine have been met. Following the playbook in Crimea and the Donbass, he orders referenda to be held in Zaporizhia, Kherson, and parts of Kharkiv, asking the local populations if they wish to join Russia. The legitimacy of the referenda is immediately rejected by the Ukrainian government and the EU. Nevertheless, the Russian military advance halts. While the West pledges to maintain sanctions against Russia, the geopolitical risk premium in oil prices decreases. February 2023 – Credit Spreads Narrow Further: At the worst point for credit in early July 2022, US high-yield spreads were pricing in a default rate of 8.1% over the following 12 months (Chart 5). By late August, the expected default rate has fallen to 5.2%, and by January 2023, it has dropped to 4.5%. Perceived default risks decline even more in Europe, where the economy is on the cusp of a V-shaped recovery following the prior year’s energy crunch. Chart 5The Spread-Implied Default Rate Has Room To Fall If Recession Fears Abate The Spread-Implied Default Rate Has Room To Fall If Recession Fears Abate The Spread-Implied Default Rate Has Room To Fall If Recession Fears Abate March 2023 – Wages: The New Core CPI? US inflation continues to drop, but a heated debate erupts over whether this merely reflects the unwinding of various pandemic-related dislocations or whether it marks true progress in cooling down the economy. Those who argue that higher interest rates are cooling demand point to the decline in job openings. Skeptics retort that the drop in job openings has been matched by rising employment (Chart 6). To the extent that firms have been converting openings into new jobs, the skeptics conclude that labor demand has not declined. In a series of comments, Jay Powell stresses the need to focus on wage growth as a key barometer of underlying inflationary pressures. Given that wage growth remains elevated, market participants regard this as a hawkish signal (Chart 7). The 10-year Treasury yield rises to 3.2%. The DXY index, having swooned from over 108 in July 2022 to just under 100 in February 2023, moves back to 102. After hitting a 52-week high of 4,689 the prior month, the S&P 500 drops back below 4,500. Chart 6Drop In Job Openings Is Matched By Rise In Employment Drop In Job Openings Is Matched By Rise In Employment Drop In Job Openings Is Matched By Rise In Employment Chart 7Wage Growth Remains Strong Wage Growth Remains Strong Wage Growth Remains Strong   April 2023 – Covid Erupts Across China: After successfully holding back Covid for over three years, the dam breaks. When lockdowns fail to suppress the outbreak, the government shifts to a mitigation strategy, requiring all elderly and unvaccinated people to isolate at home. It helps that China’s new mRNA vaccines, launched in late 2022, prove to be successful. By early 2023, China also has sufficient supplies of Pfizer’s Paxlovid anti-viral drug. Nevertheless, the outbreak in China temporarily leads to renewed supply-chain bottlenecks. May 2023 – Biden Confirms He Will Stand for Re-Election: Saying he is “fit as a fiddle,” President Biden confirms that he will seek a second term in office. Little does he know that the US will be in a recession during most of his re-election campaign. Chart 8Consumer Confidence And Real Wages Tend To Move Together Consumer Confidence And Real Wages Tend To Move Together Consumer Confidence And Real Wages Tend To Move Together June 2023 – Inflation: The Second Wave Begins: The decline in inflation between mid-2022 and mid-2023 sows the seeds of its own demise. As prices at the pump and in the grocery store decline, real wage growth turns positive. Consumer confidence recovers (Chart 8). Household spending, which never weakened that much to begin with, surges. The economy starts to overheat again, leading to higher inflation. After having paused raising rates at 3.5% in early 2023, the Fed indicates that further hikes may be necessary. The DXY index strengthens to 104. The S&P 500 dips to 4,300. July 2023 – Tech Stock Malaise: Higher bond yields weigh on tech stocks. Making matters worse, investors start to worry that many of the most popular US tech names have gone “ex-growth.” The evolution of tech companies often follows three stages. In the first stage, when the founders are in charge, the company grows fast thanks to the introduction of new, highly innovative products or services. In the second stage, as the tech company matures, the founders often cede control to professional managers. Company profits continue to grow quickly, but less because of innovation and more because the professional managers are able to squeeze money from the firm’s customers. In the third stage, with all the low-lying fruits already picked, the company succumbs to bureaucratic inertia. As 2023 wears on, it becomes apparent that many US tech titans are entering this third stage. August 2023 – Long-term Inflation Expectations Move Up: Unlike in 2021-22, when long-term inflation expectations remained well anchored in the face of rising realized inflation, the second inflation wave in 2023 is accompanied by a clear rise in long-term inflation expectations. Consumer expectations of inflation 5-to-10 years out in the University of Michigan survey jump to 3.5%. Whereas back in August 2022, the OIS curve was discounting 100 basis points of Fed easing starting in early 2023, it now discounts rate hikes over the remainder of 2023 (Chart 9). The 10-year yield rises to 3.8%. The 10-year TIPS yield spikes to 1.2%, as investors price in a higher real terminal rate. The S&P 500 drops to 4,200. The financial press is awash with comparisons to the early 1980s (Chart 10). Chart 9The Markets Expect The Fed To Cut Rates By Over 100 Basis Points Starting In 2023 The Markets Expect The Fed To Cut Rates By Over 100 Basis Points Starting In 2023 The Markets Expect The Fed To Cut Rates By Over 100 Basis Points Starting In 2023 Chart 10The Early-1980s Playbook The Early-1980s Playbook The Early-1980s Playbook October 2023 – Hawks in Charge: After a second round of tightening, featuring three successive 50 basis-point hikes, the Fed funds rate reaches a cycle peak of 5%. The 10-year Treasury yield gets up to as high as 4.28%. The 10-year TIPS yield hits 1.62%. The DXY index rises to 106. The S&P 500 falls to 4,050. November 2023 – Housing Stumbles: With mortgage yields back above 6%, the US housing market weakens anew. The fallout from rising global bond yields is far worse in some smaller developed economies such as Canada, Australia, and New Zealand, where home price valuations are more stretched (Chart 11). Chart 11Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets January 2024 – Unemployment Starts to Rise: After moving sideways since March 2022, the US unemployment rate suddenly jumps 0.2 percentage points to 3.6%, with payrolls contracting for the first time since the start of the pandemic. The 22-month stretch of a flat unemployment rate is broadly in line with the historic average (Table 1). Table 1In Past Cycles, The Unemployment Rate Has Moved Sideways For Nearly Two Years Before A Recession Began Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis February 2024 – The US Recession Begins: Although there was considerable debate about whether the US was entering a recession at the time, in early 2025, the NBER would end up declaring that February 2024 marked the start of the recession. The 10-year yield falls back below 4% while the S&P 500 drops to 3,700. Lower bond yields are no longer protecting stocks.  March 2024 – The Fed Remains in Neutral: Jay Powell says further rate hikes are unwarranted in light of the weakening economy, but with core inflation still running at 3.5%, the Fed is in no position to ease. April 2024 – The Global Recession Intensifies: The US unemployment rate rises to 4.7%. The economic downdraft is especially sharp in America’s neighbor to the north, where the Canadian housing market is in shambles. Back in June 2022, the Canadian 10-year yield was 21 basis points above the US yield. By April 2024, it is 45 basis points below. Europe and Japan also fall into recession. Commodity prices continue to drop, with Brent oil hitting $60/bbl. May 2024 – The Fed Cuts Rates: Reversing its position from just two months earlier, the Federal Reserve cuts rates for the first time since March 2020, lowering the Fed funds rate from 5% to 4.5%. The Fed funds rate will ultimately bottom at 2.5%, below the range of 3.5%-to-4% that most economists will eventually recognize as neutral. August 2024 – Republican National Convention: Unwilling to spend much of his own money on the campaign, and with most donations flowing to DeSantis, Trump’s bid to reclaim the White House fizzles. While the former president never formally bows out of the race, the last few months of his primary campaign end up being a nostalgia tour of his past accomplishments, interspersed with complaints about all the ways that he has been wronged. In the end, though, Trump makes a lasting imprint on the Republican party. During his acceptance speech, in typical Trumpian style, Ron DeSantis attacks Joe Biden for “eating ice cream while the economy burns” and declares, to thunderous applause, that “Americans are sick and tired of having woke nonsense hurled in their faces and then being dared to deny it at the risk of losing their jobs.” Chart 12The Dollar Is Very Overvalued The Dollar Is Very Overvalued The Dollar Is Very Overvalued October 2024 – The Stock Market Hits Bottom: While the unemployment rate continues to rise for another 12 months, ultimately reaching 6.4%, the S&P troughs at 3,200. The 10-year Treasury yield settles at 3.1% before starting to drift higher. The US dollar, which began to weaken anew after the Fed starts cutting rates, enters a prolonged bear market. As in past cycles, the dollar is unable to defy the gravitational force from extremely stretched valuations (Chart 12). November 2024 – President DeSantis: Against the backdrop of rising unemployment, uncomfortably high inflation, and a sinking stock market, Ron DeSantis cruises to victory in the 2024 presidential election. Unlike Trump, DeSantis deemphasizes corporate tax cuts and deregulation during his presidency, focusing instead on cultural issues. With the Democrats still committed to progressive causes, big US corporations discover that for the first time in modern history, neither of the two major political parties are willing to champion their interests. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter Global Investment Strategy View Matrix Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis Special Trade Recommendations Current MacroQuant Model Scores Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis      

Executive Summary More Regional Divergences Within Our Global LEI More Regional Divergences Within Our Global LEI More Regional Divergences Within Our Global LEI The BCA global leading economic indicator (LEI) is still in a downtrend, but its diffusion index – which tends to lead the overall global LEI at major cyclical turning points – has crept higher since bottoming in January. The diffusion index is rising in part because of very marginal increases in the LEIs of a few countries, but there have been more decisive increases in the LEIs of two major countries outside the developed world – China and Brazil. There is not yet enough evidence pointing to a true bottoming of the BCA global LEI anytime soon, but an improvement in the LEI diffusion index above 50 (i.e. a majority of countries with a rising LEI) would be a more convincing signal that global growth momentum is set to rebound. Bottom Line: Given the uncertain message on growth from our global LEI, and with inflation rates still too high for central banks to pivot dovishly, we recommend staying close to neutral on overall global fixed income duration and modestly defensive on overall spread product exposure. Feature Investors can be forgiven for being a bit confused by some conflicting messages in recent global economic data. For example, US real GDP contracted in both the first and second quarter of this year – a so-called “technical recession” – and consumer confidence is at multi-decade lows, yet the US unemployment rate fell to 3.5%, the lowest level since 1969, in July. A similar story is playing out across the Atlantic, where a historic surge in energy prices was supposed to have already tipped the euro area into recession, yet real GDP expanded in both Q1 and Q2 at an above-trend pace and unemployment continues to decline. At times like the present, when market narratives do not always line up with hard data, we always believe it important to look within our vast suite of indicators to help clear the fog. One of our most trusted growth indicators, the BCA Global Leading Economic Indicator (LEI), is still falling and, thus, signaling a continued deceleration of global growth over at least the next 6-9 months. However, there are some signs of more optimistic news embedded within our global LEI stemming from outside the developed economies, which could be a potential early sign of a bottoming in global growth momentum. In this report, we dig deeper into the guts of our global LEI to assess the odds of an imminent turning point in the LEI and, eventually, global growth. This has important implications for global bond yields, which are likely to remain rangebound until there is greater clarity on global growth momentum (and inflation downside momentum). What Leads The Leading Indicator? The BCA global LEI is a composite index that combines the LEIs of 23 individual countries using GDP weights. The underlying list of countries differs from that of the widely followed OECD LEI, which is comprised of data from 33 countries but with a heavy weighting on developed market economies. The overall OECD LEI excludes important exporting countries such as Taiwan and Singapore, which are highly sensitive to changes in global growth. Most importantly, the OECD LEI omits the world’s largest economy, China. For our global LEI, we prefer to use a smaller set of countries but one that includes China and a bigger weighting on emerging market (EM) economies. For most of the nations in our global LEI, we do use the country-level LEIs produced by the OECD.1 That also includes several large and important non-OECD EM countries for which the OECD calculates LEIs - a list that includes China, Brazil, India, Russia, Indonesia and South Africa. For a few selected countries, however, we use the following data: US, Korea, Taiwan and Singapore: LEIs produced by national government data sources or, in the case of the US, the Conference Board. Argentina, Malaysia and Thailand: LEIs are produced in-house at BCA, a necessary step given the lack of domestically-produced LEIs in those countries at the time our global LEI was first constructed. We find that our global LEI leads global real GDP growth by around six months, and leads global industrial production growth by around twelve months (Chart 1). Chart 1A Gloomy Message From Our Global LEI A Gloomy Message From Our Global LEI A Gloomy Message From Our Global LEI The latest reading on the global LEI from July is pointing to a further deceleration of global GDP into a “growth recession” where GDP is expanding slower than the pace of potential global GDP growth (less than 2%). The global LEI is also pointing to an outright contraction of global industrial production, a path also signaled by the JPMorgan global manufacturing PMI index which hit a two-year low of 51.1 – closing in on the 50 level that signifies expanding industrial activity – in July. Chart 2A Ray Of Hope On Global Growth? A Ray Of Hope On Global Growth? A Ray Of Hope On Global Growth? The momentum of our global LEI is largely influenced by its breadth. Specifically, we have found that when a growing share of countries within the global LEI have individual LEIs that are rising, the overall LEI will eventually follow suit. Thus, the diffusion index of our global LEI, which measures the percentage share of countries with rising individual LEIs, is itself a fairly good leading indicator of the global LEI at major cyclical turning points. We may be approaching such a turning point, as our global LEI diffusion index has increased from a low of 9 back in January of this year to the level of 30 in July (Chart 2). In past business cycles, the diffusion index has tended to lead the global LEI by around 6-9 months, which suggests that a bottom in the actual global LEI could occur sometime in the next few months – although that outcome is conditional on the magnitude of the rise in the diffusion index. In the top half of Table 1, we list previous episodes since 1980 where the global PMI diffusion index followed a similar path to that seen in 2022 – bottoming out below 10 and then rising to at least 30. We identified nine such episodes. In the table, we also show the subsequent change in the level of the global LEI after the increase in the diffusion index. Table 1Global LEI Diffusion Index Greater Than 50 Typically Signals LEI Uptrend A Hint Of Recovery In The BCA Global Leading Economic Indicator? A Hint Of Recovery In The BCA Global Leading Economic Indicator? The historical experience shows that an increase in the diffusion index to 30 was only enough to trigger a decisive rebound in the global LEI over a 6-12 month horizon in the 2000-01 and 2008 episodes. In several episodes, the global LEI actually contracted despite the pickup in the diffusion index. Related Report  Global Fixed Income StrategyDovish Central Bank Pivots Will Come Later Than You Think In the bottom half of Table 1, we run the same analysis but define the episodes as when the diffusion index rose from a low below 10 to at least 50. Unsurprisingly, periods when at least half of the countries have a rising LEI tend to result more frequently in the overall global LEI entering an uptrend within one year – although the two most recent episodes in 2010 and 2018-19 were notable exceptions. Bottom Line: After looking at past experience, the latest pickup in the global LEI diffusion index has not been by enough to confidently forecast a rebound in the LEI – and, eventually, faster global growth. No Broad-Based Improvement In Our Global LEI When grouping the countries within our global LEI by geographical region, it is clear that there is still no sign of improvement in North America or Europe, but some signs of bottoming in Asia and Latin America (Chart 3). Typically, the regional LEIs tend to be very positively correlated during major cyclical moves in the overall LEI, with no one region being particularly better than the others at consistently leading the global business cycle. Chart 3More Regional Divergences Within Our Global LEI More Regional Divergences Within Our Global LEI More Regional Divergences Within Our Global LEI ​​​​​ Table 2Country Weightings In Our Global LEI A Hint Of Recovery In The BCA Global Leading Economic Indicator? A Hint Of Recovery In The BCA Global Leading Economic Indicator? Of course, the global LEI is a GDP-weighted index that is dominated by the US and China (Table 2). When looking at individual country LEIs, the recent improvement in the LEI diffusion index looks less impressive. Some countries, like the UK and Korea, have only seen a tiny fractional uptick in the most recent LEI reading – moves small enough to qualify as statistical noise, even though the tiniest of positive moves still register as an “increase” when calculating the diffusion index. When looking at all the individual country LEIs within our global LEI, only two countries stand out as having meaningful increases over the past few months – China and Brazil (Chart 4). In the case of China, the idea that there could be signs of improving growth runs counter to the broad swath of recent data that highlight slowing momentum of Chinese consumer spending, business investment and residential construction. However, the production-focused components of the OECD’s China LEI, which we use in our global LEI, have shown some improvement of late (Chart 5). For example, motor vehicle production grew at a 32% year-over-year rate in July according to the OECD’s data, while total construction activity (based on OECD aggregates of production by industry) rose 9% year-over-year. Chart 4LEI Improvement In China & Brazil, Sluggish Elsewhere LEI Improvement In China & Brazil, Sluggish Elsewhere LEI Improvement In China & Brazil, Sluggish Elsewhere ​​​​​ Chart 5Improvement In Some Components Of The OECD's China LEI Improvement In Some Components Of The OECD's China LEI Improvement In Some Components Of The OECD's China LEI ​​​​​ The OECD’s LEI methodology is designed to include the minimum number of data series to optimize the fit of the LEI to the growth rate of each country’s industrial production index, which does lead to some peculiar series being included in the LEIs. However, there are signs of a potential rebound in Chinese economic growth evident in indicators preferred by our emerging market strategists, like the change in overall credit and fiscal spending as a share of GDP, a.k.a. the credit and fiscal impulse (Chart 6). The latter has shown a modest improvement that is hinting at faster Chinese growth in 2023, similar to the OECD’s China LEI. Turning to Brazil, the improvement in the OECD’s LEI there is focused on more survey-based data, like confidence among manufacturers and expectations on the demand for services. However, some hard data that the OECD includes in its Brazil LEI, namely net exports to Europe, have also shown clear improvement (Chart 7). Chart 6China Credit/Fiscal Impulse Signaling A Growth Rebound China Credit/Fiscal Impulse Signaling A Growth Rebound China Credit/Fiscal Impulse Signaling A Growth Rebound Bottom Line: The modest improvement in our global LEI diffusion index is even less than meets the eye, as only China and Brazil have seen LEI increases that are meaningfully greater than zero. Chart 7Improvement In Many Components Of The OECD's Brazil LEI Improvement In Many Components Of The OECD's Brazil LEI Improvement In Many Components Of The OECD's Brazil LEI ​​​​​ Investing Around The Global LEI Chart 8Global Financial Conditions Not Signaling An LEI Rebound Global Financial Conditions Not Signaling An LEI Rebound Global Financial Conditions Not Signaling An LEI Rebound Investors spend a sizeable chunk of their time focused on the future growth outlook to make investment decisions. This would, presumably, give leading economic indicators a useful role in any investment process. However, when looking at the relationship between our global LEI and the returns on risk assets like equities and corporate credit, the correlation is highly coincident (Chart 8). In other words, risk assets are themselves leading indicators of future economic growth – so much so that equity indices are often included as a component of the leading indicators of individual countries. On that front, the recent rebound in global equity markets, and the pullback in global credit spreads from the mid-June peak, could be signaling a more stable growth outlook that would be reflected in a bottoming of our global LEI. However, the monetary policy cycle matters, as evidenced by the correlation between the shape of government bond yield curves and our global LEI (bottom panel). That relationship is less strong than that of the LEI and equity/credit returns, but there are very few examples where yield curves are flat, or even inverted as is now the case in the US, and leading indicators are rising. Chart 9Stay Neutral On Overall Duration Exposure Stay Neutral On Overall Duration Exposure Stay Neutral On Overall Duration Exposure In the current environment where more central banks are worrying more about overshooting inflation than slowing growth, a turnaround in our global LEI will be difficult to achieve until inflation is much closer to central bank target levels, allowing policymakers to loosen policy and steepen yield curves. We do not expect such a scenario to unfold over at least the next 12-18 months, given broad-based entrenched inflation pressures in global services and labor markets. While leading indicators may not be of much value in forecasting risk assets, we do find value in using them to forecast moves in government bond yields. Regular readers of BCA Research Global Fixed Income Strategy will be familiar with our Global Duration Indicator, comprised of growth-focused measures that have historically had a leading relationship to the momentum (annual change) in developed market bond yields (Chart 9). The Duration Indicator contains both the global LEI and its diffusion index, as well as the ZEW expectations indices for the US and Europe. Three of those four indicators remain at depressed levels suggesting waning bond yield momentum. Overshooting global inflation has weakened the correlation between bond yield momentum and our Duration Indicator over the past year. However, with global commodity and goods inflation now clearly decelerating, we expect bond momentum to begin tracking growth dynamics more closely again. This leads us to expect bond yields to remain trapped in ranges over at least the balance of 2022, defined most prominently by the 10-year US Treasury yield trading between 2.5% and 3%. Bottom Line: Given the uncertain message on growth from our global LEI, and with inflation rates still too high for central banks to pivot dovishly, we recommend staying close to neutral on overall global fixed income duration and modestly defensive on overall spread product exposure.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1   Details on how the OECD calculates the individual country leading economic indicators can be found here: http://www.oecd.org/sdd/leading-indicators/compositeleadingindicatorsclifrequentlyaskedquestionsfaqs.htm\   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark A Hint Of Recovery In The BCA Global Leading Economic Indicator? A Hint Of Recovery In The BCA Global Leading Economic Indicator? The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) A Hint Of Recovery In The BCA Global Leading Economic Indicator? A Hint Of Recovery In The BCA Global Leading Economic Indicator?

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (August 16 at 10:00 AM EDT, 15:00 PM BST, 16:00 PM CEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist Treasury Index Returns Spread Product Returns

Executive Summary US Deficits Will Rise Before They Fall No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation The Inflation Reduction Act combined with the Chips and Science Act will add $88 billion to the budget deficit through FY2027. The two bills would only reduce the deficit by $11.1 billion by 2031. The deficit that year will be $2 trillion.    Hence Congress’s latest actions add to the deficit in the short run and are effectively deficit-neutral over the long run. That is not disinflationary.  Gridlock is still the likeliest outcome of the midterm elections. That is disinflationary for 2023-24 because fiscal policy freezes. Whether gridlock will persist after 2024 is unknown. Federal investments in US computer chips and renewable energy could enhance productivity over the long run. That could well be disinflationary … but the magnitude and timing are unknown. Overall, US social spending, industrial spending, defense spending, and government intervention are rising as the nation-state responds to social unrest and geopolitical conflict. Inflation will depend on many things, but this policy trend is not disinflationary. Close Recommendation (Tactical) Closing Level CLOSING DATE Return Long US Treasuries Vs. TIPS 1.3768 AUG 12, 2022 1.53%   Bottom Line: Close long US Treasuries relative to TIPS. But stay long the US dollar. Biden’s legislative victories underscore our strategic themes of Limited Big Government and Peak Polarization – and are not disinflationary.  Feature President Biden’s approval rating ticked up to 40% after a series of policy wins, including the passage of the Inflation Reduction Act and the Chips and Science Act. These bills reinforce our strategic theme of Limited Big Government, i.e. a rising role for the state within the US’s free market context. When Biden unveiled his anti-inflation agenda back in June we argued that his only real options to reduce inflation before the midterm elections hinged on other people: namely the Federal Reserve, the Saudis, the Iranians, and also Capitol Hill. With regard to Congress, we expected Democrats to pass a budget reconciliation bill. We saw that they were repackaging this bill as an “inflation reduction” measure to improve their election prospects. But we argued that it would not fight inflation in any substantive way.1 Now that the bill is on the way to Biden’s desk, it is only fair to ask: What will be the impact? Will it reduce inflation or not? The short version is no. The bill does not stand alone but is part of the Biden administration’s “last-ditch effort” to pass two major bills before the midterms. These two laws are deficit-neutral at best but slightly stimulative in the short run – and hence marginally inflationary. These laws could prove disinflationary over the long run, as investments in semiconductors and renewable energy should drive innovation. But that is hard to predict. We are optimistic on that front but for the foreseeable future the effects are neutral or inflationary. To understand this view, we need to review BCA’s stance on inflation overall and then discuss the legislation. The BCA View On Inflation BCA sees this year’s inflationary bout as both a cyclical and a structural phenomenon. The cyclical rise in inflation stemmed from the pandemic and the ensuing economic stimulus. This cycle is peaking now. Commodity prices are moderating and goods spending has fallen two-thirds of the way back to where it stood prior to the pandemic, suggesting that inflation will take a step back. At very least inflation has stopped skyrocketing (Chart 1). Yet the structural drivers of inflation will persist. Chart 1Inflation Rolls Over ... For Now Inflation Rolls Over ... For Now Inflation Rolls Over ... For Now The long-term inflation thesis hinges first and foremost on global population trends. Fewer prime-age workers as a share of the population means that the price of a prime-age worker goes up. It also hinges on the decline in the global glut of savings, the rise of mercantilism and trade protectionism (i.e. hypo-globalization), and the conclusion of household deleveraging in the wake of the 2008 crisis. Structurally looser fiscal policy – soft budgets – also plays a role. The decay of the liberal world order since 2008 financial crisis entails that western governments face the combined threats of social unrest at home and great power competition abroad. These governments’ answer is to take a more active role in the economy to appease popular wrath, improve energy security, and bulk up national defense. The result will be larger deficits. Larger budget deficits reduce the savings available to the private sector and constrain future supply, feeding into inflation. The result is that, in the United States, the neutral rate of interest will likely prove to be higher than expected, monetary conditions will be looser than expected in real terms, and hence the economy will overheat. At least until central banks and fiscal authorities impose austerity.  Bottom Line: Inflation is a cyclical and structural phenomenon in the United States. Cyclically inflation is starting to moderate as various factors from the pandemic and fiscal stimulus wear off. But structurally inflation will be a persistent problem due to population aging, the end of the savings glut, hypo-globalization, geopolitical conflict, and a rising government role in the economy. New Laws Do Not Cut The Deficit Until 2027 At Best Now we can put the Biden administration’s policy into context. The stagflationary cyclical backdrop poses a severe challenge for the ruling Democratic Party. Midterm elections are only three months away and yet headline inflation is still running at 8.5% and core inflation is rising unabated at 5.9% year-on-year. The median voter suffers from high inflation in the form of falling real income and wages. Yet the Democratic legislative agenda has focused on increasing spending, which adds to inflation.  If US gasoline prices continue to moderate, the median household’s inflation expectations will come down – and that is a positive short-term development for Democrats (Chart 2). That is why President Biden went to Saudi Arabia with his tail between his legs to beg for more crude oil production. That is why he is trying to do a deal with Iran too (though there our view is pessimistic). That is why he has urged Europe to wait until after the midterm to implement full oil sanctions on Russia. Hence also the Senate repackaged the -$4 trillion “Build Back Better” spending splurge as a +$300 billion “Inflation Reduction” fiscal reform. But will the Inflation Reduction Act truly reduce inflation? Will it affect the cyclical or structural drivers mentioned above?  Chart 2Inflation Expectations Moderating Inflation Expectations Moderating Inflation Expectations Moderating The title of the bill alone should prompt investors to be skeptical. The bill does not meaningfully reduce budget deficits. According to the Democratic Party it will generate $300 billion in savings over 10 years, mostly as a result of capping drug costs that Medicare pays to hospitals on behalf of about 64 million Americans. However, the Committee for a Responsible Federal Budget provides a more realistic scenario in which the savings amount to $160 billion, or about half as much as advertised (Table 1).2 The CBO estimates the bill will reduce the budget deficit by $100 billion over 10 years, one third of the official selling point. Table 1What Is Inside The Inflation Reduction Act Of 2022? No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Table 2 shows the CBO’s baseline estimates of the US budget deficit outlook as of July 2021, May 2022, and August 2022 (i.e. the latter with the new legislation). The trend line with the reconciliation bill is virtually indistinguishable from the May estimate (Chart 3). Table 2US Budget Balance Projections Before/After The Inflation Reduction Act No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Chart 3What Deficit Reduction? No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Table 3 shows the specific change in the budget deficit for each year, illustrated in Chart 4. The bill modestly reduces the deficit in 2023 but increases the deficit in subsequent years until 2028. When the bill’s savings peak at $41 billion in 2031, they will shave off 2% of the $2 trillion deficit. Table 3Change In US Deficit Due To Inflation Reduction Act And Chips And Science Act No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation In other words, the deficit reduction will not occur until after the 2028 election – by which time it will be swamped by other political and economic factors. In addition, the bipartisan Chips and Science Act will add $47.5 billion to the budget deficit through FY2026 and $79.3 billion through FY2031. Combining them shows that Congress is still adding to spending despite today’s 5.9% core inflation reading – while delaying the miniscule deficit reduction until the latter part of the decade. Credit should be given to the Democrats for offsetting their new spending with revenue increases. But in realistic terms Congress’s latest actions are deficit-neutral at best. The question was how to pay for the desired spending rather than how to impose budget consolidation. Austerity is politically impractical in the context of left-wing and right-wing populism. Chart 4US Deficits Will Rise Before They Fall No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation The new fiscal spending makes sense given the strategic predicament that the US faces. But it should flag to investors that the only real fiscal discipline on the horizon will come after the midterm election, when Congress is gridlocked and fiscal policy is basically frozen. Bottom Line: The Inflation Reduction Act combined with the Chips and Science Act will add about $88 billion to the budget deficit through FY2027. The two bills only reduce the growth of the budget deficit by $11.1 billion by 2031. They will not reduce investors’ inflation expectations over the next five years. Cyclical inflation expectations will fall for other reasons – such as Fed rate hikes, the slowdown in global growth, and looming gridlock. Reducing Drug Prices And EV Prices Is Not Generally Disinflationary What about the sector effects of the Inflation Reduction Act? Could they be disinflationary? The bill raises a minimum corporate tax rate of 15% to pay for renewable energy subsidies, it bulks up the Internal Revenue Service’s tax collecting capabilities to pay for an expansion of Obamacare subsidies, and it empowers Medicare to negotiate pharmaceutical prices, creating revenue savings for the federal government.   Theoretically caps on drug prices will push prices down, while subsidies to buy electric vehicles (EV) will incentivize Americans to buy those cars and expand the domestic EV supply chain. Hence Democrats can at least claim to be reducing drug price inflation and arguably EV price inflation. Drug price caps are popular and could increase social stability. Electric car subsidies are less popular but tap into demands for domestic manufacturing and action on climate change. Neither will generate substantial opposition in the voting booth. However, the general level of prices will not fall as a result of these sector-specific interventions. Spending on motor vehicles is around 4.2% of total personal consumption expenditure (Chart 5, first panel). Spending on prescription drugs is around 3.2% of total personal consumption expenditure (Chart 5, second panel). Hence the bill could at maximum affect 7.4% of total consumer spending. But only certain drugs will face price caps and only EVs will be subsidized, so the effect is even narrower than that. Spending on cars grew by 1.7% between 2003-20, in line with economic growth. Drug spending grew faster, in line with an aging society, at 2.9% over the same period (Chart 6). Normally the contribution to inflation is negligible for cars but higher-than-average for drugs. True, after Covid-19 car prices surged while drug prices fell below average, but that process should normalize (Chart 7).  Chart 5The Role Of Cars And Drugs In Inflation The Role Of Cars And Drugs In Inflation The Role Of Cars And Drugs In Inflation Chart 6Growth Of Car And Drug Spending Growth Of Car And Drug Spending Growth Of Car And Drug Spending Chart 7Change In Car And Drug Prices Change In Car And Drug Prices Change In Car And Drug Prices Only 20 drugs will be eligible for Medicare negotiation per year. The top 20 drugs amount to around 18% of the pharmaceutical market. The new government-negotiated prices will begin to take effect in 2027. The effect will be to dampen domestic manufacturers’ incentive to produce generics, leading to supply constraints or substitution effects (e.g. imports). Hence overall drug prices will not fall as much as expected. The US lacks universal healthcare coverage, so price controls represent an economic transfer between corporations or between corporations and government – not between corporations and consumers. Capping drug prices will benefit insurers directly and consumers only indirectly. The profit will change from the hands of Big Pharma to Big Insurance (managed healthcare providers) (Chart 8). Incidentally big insurers will also benefit from the bill’s expansion of the Obamacare subsidies. Of course, Obamacare enrollees will see a marginal increase in disposable income – especially lower-income individuals, who have a higher propensity to consume. This is positive from the perspective of social stability but likely to be inflationary, not disinflationary. Lower insurance premiums mean more spending cash. Chart 8Big Insurance Versus Big Pharma Big Insurance Versus Big Pharma Big Insurance Versus Big Pharma As for the bill’s green subsidies, EVs account for about 5.6% of cars sold. Subsidies will encourage the production of EVs and accelerate the growth of EV market share. The point is to make EV prices competitive with other cars since EVs are more costly to make, especially if they are to be made domestically. Non-EVs may have to lower their prices but, as we have seen, car inflation is not a major contributor to general inflation, at least not in normal times. Of course, no electric vehicles will qualify for the new rebate immediately. The law requires a large share of qualifying electric cars to be manufactured in North America, or at least not to be produced in “countries of concern” such as China. China is still the leader in making critical components of EVs, especially batteries. Such policies are not conducive to the most efficient manufacturing methods and lowest consumer prices. Rather they seek to shift supply chains to allied countries or to “onshore” them within the United States for strategic reasons, even at a higher cost to consumers. As such the new law reflects the US’s newfound populism, economic nationalism, industrial policy, and trade protectionism. It epitomizes the connection between great power competition and hypo-globalization, prioritizing supply chain resilience at the expense of economic efficiency. That makes sense from a national security point of view but is not likely to be disinflationary – quite the opposite. The bipartisan Chips and Science Act will dovetail with these measures to revive US industrial policy, steer capital into priority projects, and encourage domestic investment. This law and the climate change subsidies are federal investments that should boost productivity and enhance the supply side of the economy. We are optimistic over the long run regarding the productivity enhancements that could accrue from the government’s historic shift to re-initiate these kinds of investments. The space program in the 1960s may be too optimistic but it is still analogous. The US is already in the midst of Cold War II.  If a major breakthrough in renewable energy eventually occurs that is tied to investments from the Inflation Reduction Act, then it will justify the bill’s anti-inflation moniker. But that remains to be seen. In the meantime, these investments will quicken US economic activity when the economy is already at full employment and inflation is running hot. Bottom Line: Cars do not contribute much to inflation in normal times and this bill gives subsidies to make electric cars in the US, which is not optimal for costs. Drugs contribute positively to inflation but Medicare caps will not lower drug prices until 2027 and general price effects are debatable. Overall, social unrest and great power competition are leading to greater government involvement in the economy, which is marginally inflationary. Economic Slowdown Is Disinflationary What will be the effect of this legislation on the midterm election campaign? Economic sentiment improved over the past month, even among Republicans. That led to a drop in polarization for the right reasons, i.e. a resilient economy, rather than the wrong reasons, i.e. the universal loathing of inflation (Chart 9). Polarization will stay near peak levels during the 2022-24 election campaign but the bipartisan Chips Act, the Biden administration’s adoption of hawkish foreign policy on trade and China, and the administration’s attempt to pursue at least a deficit-neutral approach to the budget reinforce our “Peak Polarization” theme. Long-term US policy consensus is developing beneath the still extreme polarization in the short term. Business activity is improving, which has contributed to the equity rally on the basis that the Fed is achieving a “soft landing” (Chart 10). We expect a hard landing due to the combination of negative macro and geopolitical factors but the latest data brings a positive surprise. Chart 9Economic Sentiment Ticks Up ... Even Among Republicans Economic Sentiment Ticks Up ... Even Among Republicans Economic Sentiment Ticks Up ... Even Among Republicans Chart 10Business Activity Improves Business Activity Improves Business Activity Improves In the short term, Biden and the Democrats will benefit from passing legislation (“getting things done”) and piggybacking on the fact that inflation is rolling over and the economy is showing some positive surprises. Biden’s approval rating is showing signs of stabilizing, albeit at a low level (Chart 11). The two parties are neck and neck in congressional ballot, with Democrats taking back the lead again from Republicans (Chart 12). If this trend continues it will mitigate the Democrats’ losses in the midterms. The Senate is competitive. Chart 11Biden’s Approval Will Perk Up At Least Somewhat No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Chart 12US Parties Neck And Neck In Generic Congressional Ballot No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation If inflation rolls over, real wages will improve, which will boost consumer confidence and, if it comes by October, could  help the Democrats further (Chart 13). Chart 13Uptick In Real Wage Would Boost Consumer Confidence Uptick In Real Wage Would Boost Consumer Confidence Uptick In Real Wage Would Boost Consumer Confidence Still, Democrats are likely to lose the House of Representatives in the midterms, as the ruling party usually loses seats and Democrats only have a five-seat margin. In other words, we would fade the emerging “Blue Sweep” risk (i.e. risk that Democrats keep control of both houses of Congress). A sweep is possible but unlikely, especially because many of Biden’s foreign policy problems can still come back to haunt him before the midterm. Two consecutive quarters of negative GDP growth usually results in an official recession. The jury is still out. Bankruptcies are ticking up and unemployment has nowhere to go but up (Chart 14). The stagflationary environment will probably persist through the midterm. Biden will face a rocky road to re-election. Chart 14Yet Unemployment And Bankruptcy Will Rise Yet Unemployment And Bankruptcy Will Rise Yet Unemployment And Bankruptcy Will Rise Investment Takeaways Inflation expectations began to roll over due to the global slowdown, the drop in commodity prices, and the Fed’s rate hikes, but structural factors suggest inflation will remain a problem over the long run. The Inflation Reduction Act will not be implemented in time to have any effect on prices in 2022. It will slightly reduce the budget deficit next year but expand the deficit from FY2024-27. Combined with the Chips and Science Act the effect is slightly stimulative or inflationary until FY2028 at earliest.   The bill increases policy uncertainty ahead of the midterms. Democrats will be able to take credit for any moderation of inflation through October and hence the election will become more competitive. But the election outcome is still highly likely to be congressional gridlock. Gridlock is disinflationary in 2023-24 because it implies that fiscal policy will shift to neutral – or even that real deficit reduction will occur if Biden compromises with a partially or wholly Republican congress. Structurally the US suffers from an imbalance of savings and investment. The global savings glut more than filled the gap and prevented inflation for several decades. Now the society is aging, the savings glut is depleting, globalization is retreating, and governments need to maintain spending to address high domestic and foreign challenges. US policy is forming a new consensus (“Peak Polarization”) that includes a larger role for government within the US context (“Limited Big Government”) in order to fight against social instability and geopolitical threats. The result is inflationary or at least not disinflationary. A high-tech and/or green energy productivity boom is possible and would combat the structural drivers of inflation. We are optimistic but the disinflationary impact is not forthcoming immediately and much remains to be seen.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com   Footnotes 1     Specifically we argued that the bill would be “mildly stimulating for the economy (i.e. inflationary) and none of the supply-side improvements would reduce inflation in time for the midterms.” We also implied that the act would probably not correct the US’s long-term rise in budget deficits as a share of GDP. 2     The difference has to do with the Affordable Care Act (Obamacare). Obamacare subsidies were expanded during the pandemic. The reconciliation bill will spend about $100 billion on extending the subsidies by three years. But it will be politically difficult for future congresses to revoke these subsidies. Hence the CBO assumes they will become permanent.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Table A3US Political Capital Index No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Chart A1Presidential Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Chart A2Senate Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort  Table A4House Election Model Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5APolitical Capital: White House And Congress No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Table A5BPolitical Capital: Household And Business Sentiment No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Table A5CPolitical Capital: The Economy And Markets No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation  

Executive Summary Then And Now Then And Now Then And Now Investors are fixated on inflation; for now, the peak in US CPI is a positive for global stocks. However, this tailwind could easily transform into fear if inflation becomes deflation. The risk of deflation is greater than investors currently appreciate. In the early 1920s, the policy-driven inflation of World War One quickly morphed into a violent deflationary shock, which prompted a severe bear market. Even in the absence of the gold standard, many contemporary factors parallel those that were apparent before 1921. As a result, if commodity prices do not stabilize by year-end, investors will start to worry about deflation. This fear could prompt another sell-off in stocks, which would be particularly painful in Europe. Buy protection against deflation while it is cheap by selling EUR/JPY. Continue to favor defensive over cyclical equities. Bottom Line: The deflation risk for 2023 is greater than the investment community currently appreciates. While it remains a tail risk, it is an underpriced one. As a result, investors should use the current rebound in stocks to buy protection against deflation.     Last week, the NASDAQ entered a new bull market following a decline in US inflation. European stocks have rallied too, albeit considerably less so, only rising 12.5% since their July 5th low. We have participated in this rally, having taken a more constructive view on European equities and other risk assets since our return from a trip visiting clients in Europe. Related Report  European Investment StrategyQuestions From The Road The decline in US inflation is likely to remain a tailwind for global equities in the near future. The pandemic-related factors that spiked inflation in the past quarters are ebbing, and commodity inflation is decreasing. However, BCA’s US bond strategists expect this window to be short-lived. Labor market tightness and strong rents suggest that core CPI will stabilize around 4%. Nonetheless, as long as this window is open, stocks should remain bid. Investors expecting the demise of this current rebound continue to pin their view on stubborn inflation. While sticky inflation is an undeniable risk, it is a threat well understood by the market. However, another danger lurks, which is much less appreciated by investors: deflation. Investors currently underestimate its odds, when deflation could prove even more damaging to the market than sticky inflation. Remembering 1921 Chart 1The 1921 Bear Market The 1921 Bear Market The 1921 Bear Market The most famous period of deflation in US economic history is the Great Depression. This is not, however, an appropriate parallel. The 1921 recession, at which time deflation hit a historical low of 16% per annum, is the more direct potential equivalent to today. It was accompanied by a 47% crash in the market that brought the Shiller P/E to five (Chart 1, top panel). At the end of WWI, the stock market experienced a rapid rally, with the Dow Jones jumping 58% from its low in March 1918 to its peak in November 1919. In that time frame, inflation was robust, with headline CPI averaging 16% between 1917 and 1920. Inflation was high because of a combination of factors: The war had forced a substantial loosening of fiscal policy with the Federal debt rising from 2.7% of GDP in 1916, before the entry of the US in the conflict, to 32.9% in 1921. The money supply experienced an unprecedented surge. At the beginning of the war, the US was a neutral party and European powers purchased large quantities of US goods. The resulting trade surplus pushed the US stock of gold from $1.5bn in 1914 to $2.6bn in 1920. Meanwhile, to help finance the government’s wartime expenditures, the newly created Federal Reserve expanded its banknote issuance and its claims on the banking system, which meant that Fed money rose from 21% of high-power money in April 1917 to 59% by November 1918. As a result of these two concurrent trends, the money supply doubled between 1916 and June 1920. The Fed was slow to remove the accommodation. The New York discount rate, which had fallen from 6% to 4% as war broke out in Europe, was only increased to 4.75% in the Spring of 1918 and stayed there until January 1920. The global economy was facing potent supply constraints. Large swaths of the European capital stock had been destroyed by the war, at the same time as the US economy had been redesigned to supply military goods, not consumer goods. As a result, inflation remained perky in 1919 and 1920, despite the end of the conflict. The fiscal and monetary supports suddenly ended in 1920, and the economy entered a vicious contraction that caused industrial production to plunge by 36% in 1921 and deflation to hit 16% (Chart 1, second and third panel). The fiscal easing suddenly shifted toward fiscal rectitude under the administration of Warren Harding, which greatly hurt domestic demand in 1921. Additionally, the inflow of gold from the war period morphed into outflow, as European powers enjoyed trade surpluses after their currencies fell 60% to 30% against the dollar between 1919 and the start of 1921. Moreover, the Fed increased the discount rate to 6% in 1920 and cut back the ratio of Fed money to gold, which caused M2 to swing from a 20% growth annual growth rate in Q1 1920 to a 7% contraction in Q3 1921. Simultaneously, corporate borrowing rates soared (Chart 1, fourth and fifth panel) The shock of stagflation and the associated deep output contraction caused the Dow Jones to collapse by 47% from late 1919 to August 1921. The market only stabilized once deflationary pressures ebbed, after the Fed had cut back the discount rate to 6% and around the same time when commodity prices began to firm up. By the end of the bear market, the reconstituted S&P 500 was trading at a cyclically-adjusted P/E of 5.2, and profits had fallen 81% from their 1916 peak. Bottom Line: The 1921 bear market was one of the most violent of the twentieth century. It was caused by an economic contraction and deep deflation that engulfed the US economy after the monetary and fiscal support of WWI had been removed. It only ended once deflationary forces began to ebb, after commodity prices found a floor. What Are The Parallels? At first glance, the parallels between 1921 and today seem negligible. Yes, inflation was raging in 1920, but deflation was a direct consequence of the gold standard that forced a rapid contraction in high-powered money, especially as gold fled the US in 1921. Chart 2Inflationary Fiscal And Monetary Policy Inflationary Fiscal And Monetary Policy Inflationary Fiscal And Monetary Policy The similarities, however, are remarkable too. As a result of the COVID-19 pandemic, the economy was subjected to similar conditions as that of the US around WWI. The US economy witnessed a massive explosion of fiscal stimulus that pushed the Federal deficit from 5% in 2019, to 10% and 6% of GDP in 2020 and 2021, respectively. Moreover, the Federal Reserve generated extremely accommodative monetary conditions during and after the pandemic, when its balance sheet more than doubled and M2 grew by 41% (Chart 2). Additionally, the global economy has witnessed extraordinary supply-side disruptions that have added to inflationary pressures created by the extreme push to aggregate demand from fiscal and monetary policy.1 Chart 3The Money Supply Is Contracting The Money Supply Is Contracting The Money Supply Is Contracting However, as in 1921, these forces are moving in the opposite direction. The fiscal thrust in the US was deeply negative in 2021 and 2022, when fiscal policy subtracted 4% and 2% from GDP growth, respectively. Moreover, the Fed’s policy tightening campaign is exceptionally aggressive. The Fed has increased rates by 2.25% in five months, and, based on the OIS curve, will push up interest rates by an additional 1.3% by the year-end (Chart 3). As a result, the recent contraction in M2 has further to run, even if the US economy is not constrained by its golden tethers (Chart 3, bottom panel). Between 1920 and 1921, investors had trouble judging how far the Fed would tolerate money contraction, which is again the case. Chart 4The Dollar Is Deflationary The Dollar Is Deflationary The Dollar Is Deflationary While the gold standard has been dissolved, the recent wave of dollar strength creates deflationary forces that are similar to the bullion anchor in the 1920s. In the US, the strength in the dollar is limiting imported inflation. US import prices have rolled over, a trend likely to continue. Once converted in USD, Chinese PPI is almost contracting today, which is no small matter when China is the marginal supplier of goods for the world (Chart 4). A strong dollar is deflationary for the global economy, not just that of the US. A rising greenback hurts commodity prices and also tightens global liquidity conditions. Already, the dollar-based liquidity is contracting and EM FX reserves – which are a form of high-powered money similar to gold flows in the 1920s – are tanking, even after adjusting for the confiscation of Russian reserves in the wake of the Ukrainian conflict (Chart 4, bottom panel). To defend their currencies as the dollar rallies, EM central banks are forced to tighten policy, which hurts their domestic economies. This phenomenon is also visible in advanced economies. The weak euro has played a role inching the ECB toward aggressive rate hikes, while the Riksbank and the Swiss National Bank are both lifting interest rates to fight the inflationary impact of their currencies falling against the greenback. Global supply constraints are also defusing. The price of shipping commodities and goods around the world is declining meaningfully (Chart 5). Meanwhile, deliveries by suppliers are accelerating globally, which is contributing to a very rapid easing of our indicator of US Supply Constraints (Chart 5, bottom panel). Beyond these parallels with the early 1920s, demand is already weakening globally. Hampered by the current rise in living costs, households have begun to reduce the volume of goods they purchase, while companies have maintained robust production schedules. As a result, inventories are swelling around the world (Chart 6). Historically, the best cure for elevated inventories is lower prices. Chart 5Easing Supply Constraints Easing Supply Constraints Easing Supply Constraints Chart 6Inventories And Weak Demand Are Deflationary Inventories And Weak Demand Are Deflationary Inventories And Weak Demand Are Deflationary Bottom Line: There is no guarantee that deflation will become the prevailing force in the global economy. However, the risk is there—and this threat is woefully underappreciated by the investment community. At this current juncture, investors are welcoming lower commodity prices as they take the edge off ebullient inflation. However, if commodity prices do not stabilize by year-end, then investors will begin to worry about deflation. As the 1921 experience showed, deflation is very painful for stocks because it is so negative for profits. While the absence of the gold standard means that the deep deflation of 1921 is extremely unlikely, a period of deflation would nonetheless have a very negative impact on stocks, since they trade at 29 times cyclically-adjusted earnings, not 6.2 times, as was the case in November 1919. What Does This Mean For European Assets? A bout of global deflation would be especially painful for European equities. European equities are more cyclical than their US counterparts, which means that they often underperform when global growth is weak and global export prices of manufactured goods are falling (Chart 7). In other words, a deflationary shock in the US would be felt more acutely in the European market than in that of the US. Additionally, the euro would likely weaken further. Already, the European money impulse (the change in M1 flows) is contracting, which augurs poorly for European economic activity (Chart 8). The addition of a deflationary shock to the weak domestic backdrop would prompt further outflows from Europe, which would hurt the euro even more. Chart 7European Stocks Hate Deflationary Busts European Stocks Hate Deflationary Busts European Stocks Hate Deflationary Busts Chart 8European Activity Is Weak European Activity Is Weak European Activity Is Weak Chart 9A Value Trap? A Value Trap? A Value Trap? Finally, with respect to the European cyclicals-to-defensive ratio, our Combined Mechanical Valuation Indicator suggests that European cyclicals have purged their overvaluation relative to their defensive counterparts (Chart 9). However, in previous deflationary outbreaks such as those in 1921 or the 1930s, cyclicals deeply underperformed defensive equities, no matter how cheap they became. This time around, we would expect the same outcome from cyclicals. Moreover, even if investors do not price in a deflationary risk early next year, European cyclicals remain hampered by the deceleration in the Chinese economy and the energy rationing that will hit Europe this winter. As a result, we continue to fade any rebound in the European cyclicals-to-defensives ratio. Bottom Line: Even if a deflationary shock is a risk that is more likely to emanate from the US, European markets will not be immune. The European economy is already weak, and the cyclicality of European equities creates greater vulnerability to deflation. Thus, while deflation in 2023 is a tail risk, investors should use the current rebound in global risk assets to buy protection cheaply. Selling EUR/JPY and favoring defensive European markets continue to make sense in light of this risk.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1Another similarity is that the Spanish Flu was decimating the population from late WWI to 1921.   Tactical Recommendations Cyclical Recommendations Structural Recommendations

Listen to a short summary of this report.     Executive Summary Significant Savings Provide A Moat Around Consumers Significant Savings Provide A Moat Around Consumers Significant Savings Provide A Moat Around Consumers Three mega moats will protect the US economy over the next 12 months: 1) A high number of job openings; 2) Significant pent-up demand; and 3) Strong Fed credibility, which has kept bond yields from rising more than they otherwise would have in response to higher inflation. Ironically, a recession will only occur when investors start believing that a recession will not occur. Without more economic optimism, real yields will not rise into restrictive territory. The double-dip 1980/82 recessions, the 1990-91 recession, the 2001 recession, and the 2007-09 Great Recession were all preceded by an almost identical 21-to-23-month period of a flat unemployment rate. The unemployment rate has been fairly stable since March when it hit 3.6%. Given the three moats, we suspect that it will move sideways well into next year. At that point, the trajectory of inflation will determine the path for the unemployment rate and the broader economy. Inflation will fall significantly over the coming months thanks to lower food and energy prices and easing supply-chain pressures. However, falling inflation could sow the seeds of its own demise. As prices at the pump and the grocery store decline, real wage growth will turn positive. This will bolster consumer confidence, leading to more spending, and ultimately, a reacceleration in core inflation.​​​​ Bottom Line: Stocks will rise over the next six months as recession risks abate, but then decline over the subsequent six months as it becomes clear that the Fed has no intention of cutting rates in 2023 and may even need to raise them further. On balance, we recommend a neutral exposure to global equities over a 12-month horizon.   Don’t Bet on a US Recession Just Yet Many investors continue to expect the US economy to slip into recession this year. The OIS curve is discounting over 100 basis points in rate cuts starting in 2023, something that would probably only happen in a recessionary environment (Chart 1). In contrast to the consensus view, we think that the US will avoid a recession. This is good news for stocks in the near term because it means that earnings estimates, which have already fallen meaningfully this year, are unlikely to be cut any further (Chart 2). It is bad news for stocks down the road because it means that rather than cutting rates in 2023, the Fed could very well have to raise them. Chart 1Investors Expect Fed Tightening To Give Way To An Easing Cycle In 2023 Investors Expect Fed Tightening To Give Way To An Easing Cycle In 2023 Investors Expect Fed Tightening To Give Way To An Easing Cycle In 2023 Image These two conflicting considerations lead us to expect stocks to rise over the next six months but then to fall over the subsequent six months. As such, we recommend an above-benchmark exposure to global equities over a short-term tactical horizon but a neutral exposure over a 12-month horizon. Three mega moats will protect the US economy over the next 12 months: 1) A high number of job openings; 2) Significant pent-up demand; and 3) Strong Fed credibility, which has kept bond yields from rising more than they otherwise would have in response to higher inflation. Let’s explore each in turn.   Moat #1: A High Number of Job Openings While job openings have fallen over the past few months, they are still very high by historic standards (Chart 3). In June, there were 1.8 job openings for every unemployed worker, up from 1.2 in February 2020. At the peak of the dotcom bubble, there were 1.1 job openings per unemployed worker. A high job openings rate means that many workers who lose their jobs will have little difficulty finding new ones. This should keep the unemployment rate from rising significantly as labor demand cools on the back of higher interest rates. Some investors have argued that the ease with which companies can advertise for workers these days has artificially boosted reported job openings. We are skeptical of this claim. For one thing, it does not explain why the number of job openings has risen dramatically over the past two years since, presumably, the cost of job advertising has not changed that much. Moreover, the Bureau of Labor Statistics bases its estimates of job openings not on a tabulation of online job postings but on a formal survey of firms. For a job opening to be counted, a firm must have a specific position that it is seeking to fill within the next 30 days. This rules out general job postings for positions that may not exist. We are also skeptical of claims that increased layoffs could significantly push up “frictional” unemployment, a form of unemployment stemming from the time it takes workers to move from one job to another. There is a great deal of churn in the US labor market (Chart 4). In a typical month, net flows in and out of employment represent less than 10% of gross flows. In June, for example, US firms hired 6.4 million workers. On the flipside “separations” totaled 5.9 million in June, 71% of which represented workers quitting their jobs. Chart 3A 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 4Labor Market Churn Tends To Increase As Unemployment Falls Labor Market Churn Tends To Increase As Unemployment Falls Labor Market Churn Tends To Increase As Unemployment Falls   In fact, total separations (and hence frictional unemployment) tend to rise when the labor market strengthens since that is when workers feel the most emboldened to quit. The reason that the unemployment rate increases during recessions is not because laid-off workers need time to find a new job but because there are simply not enough new jobs available. Fortunately, that is not much of a problem today.   Moat #2: Significant Pent-Up Demand US households have accumulated $2.2 trillion (9% of GDP) of excess savings since the start of the pandemic, most of which reside in highly liquid bank deposits (Chart 5). Admittedly, most of these savings are skewed towards middle- and upper-income households who tend to spend less out of every dollar of income than the poor (Chart 6). Nevertheless, even the top 10% of income earners spend about 80% of their income (Chart 7). This suggests that most of these excess savings will be deployed, supporting consumption in the process. Chart 5Significant Savings Provide A Moat Around Consumers Significant Savings Provide A Moat Around Consumers Significant Savings Provide A Moat Around Consumers Chart 6Unlike The Poor, Middle-To-Upper Income Households Still Hold Much Of Their Pandemic Savings Unlike The Poor, Middle-To-Upper Income Households Still Hold Much Of Their Pandemic Savings Unlike The Poor, Middle-To-Upper Income Households Still Hold Much Of Their Pandemic Savings Some commentators have argued that high inventories will restrain production, even if consumer spending remains buoyant. We doubt that will happen. While retail inventories have risen of late, the retail inventory-to-sales ratio is still near all-time lows (Chart 8). Moreover, real retail sales have returned to their pre-pandemic trend (Chart 9A). Overall goods spending is still above trend, but has retraced two-thirds of its pandemic surge with little ill-effect on the labor market (Chart 9B). Chart 7Even The Wealthy Spend Most Of Their Income Three Mega Moats Around The US Economy Three Mega Moats Around The US Economy Chart 8Retail Inventory-To-Sales Ratios Have Rebounded, But Remain Low Retail Inventory-To-Sales Ratios Have Rebounded, But Remain Low Retail Inventory-To-Sales Ratios Have Rebounded, But Remain Low Chart 9ASpending On Goods Has Been Normalizing (I) Spending On Goods Has Been Normalizing (I) Spending On Goods Has Been Normalizing (I) Chart 9BSpending On Goods Has Been Normalizing (II) Spending On Goods Has Been Normalizing (II) Spending On Goods Has Been Normalizing (II) The latest capex intention surveys point to a deceleration in business investment (Chart 10). Nevertheless, we doubt that capex will decline by very much. Following the dotcom boom, core capital goods orders moved sideways for two decades (Chart 11). The average age of the nonresidential capital stock rose by over two years during this period (Chart 12). Excluding investment in intellectual property, business capex as a share of GDP is barely higher now than it was during the Great Recession. Not only is there a dire need to replenish the existing capital stock, but there is an urgent need to invest in new energy infrastructure and increased domestic manufacturing capacity. Chart 10Capex Intentions Have Dipped Capex Intentions Have Dipped Capex Intentions Have Dipped Chart 11Capex Has Been Moribund For The Past Two Decades (I) Capex Has Been Moribund For The Past Two Decades (I) Capex Has Been Moribund For The Past Two Decades (I) With regards to residential investment, the homeowner vacancy rate has fallen to a record low. The average age of US homes stands at 31 years, the highest since 1948. Chart 13 shows that housing activity has weakened somewhat less than one would have expected based on the significant increase in mortgage rates in the first six months of 2022. Given the recent stabilization in mortgage rates, the chart suggests that housing activity should rebound by the end of the year. Chart 12Capex Has Been Moribund For The Past Two Decades (II) Capex Has Been Moribund For The Past Two Decades (II) Capex Has Been Moribund For The Past Two Decades (II) Chart 13Housing Activity Should Rebound On The Back Of Low Vacancy Rates, An Aging Housing Stock, And Stabilizing Mortgage Rates Housing Activity Should Rebound On The Back Of Low Vacancy Rates, An Aging Housing Stock, And Stabilizing Mortgage Rates Housing Activity Should Rebound On The Back Of Low Vacancy Rates, An Aging Housing Stock, And Stabilizing Mortgage Rates Moat #3: Strong Fed Credibility Even though headline inflation is running at over 8% and most measures of core inflation are in the vicinity of 5%-to-6%, the 10-year bond yield still stands at 2.87%. Two things help explain why bond yields have failed to keep up with inflation. First, investors regard the Fed’s commitment to bringing down inflation as highly credible. The TIPS market is pricing in a rapid decline in inflation over the next two years (Chart 14). The widely-followed 5-year, 5-year forward TIPS inflation breakeven rate is still near the bottom end of the Fed’s comfort zone. Chart 14AWell-Anchored Long-Term Inflation Expectations Have Kept Bond Yields From Rising More Than They Would Have Otherwise Three Mega Moats Around The US Economy Three Mega Moats Around The US Economy Chart 14BWell-Anchored Long-Term Inflation Expectations Have Kept Bond Yields From Rising More Than They Would Have Otherwise Well-Anchored Long-Term Inflation Expectations Have Kept Bond Yields From Rising More Than They Would Have Otherwise Well-Anchored Long-Term Inflation Expectations Have Kept Bond Yields From Rising More Than They Would Have Otherwise Households tend to agree with the market’s assessment. While households expect inflation to average over 5% over the next 12 months, they expect it to fall to 2.9% over the long term. As Chart 15 illustrates, expected inflation 5-to-10 years out in the University of Michigan survey is in line with where it was between the mid-1990s and 2015. This is a major difference from the early 1980s, when households expected inflation to remain near 10%. Back then, Paul Volcker had to engineer a deep recession in order to bring long-term inflation expectations back down to acceptable levels. Such pain is unlikely to be necessary today. Chart 15Households Expect Inflation To Come Back Down Households Expect Inflation To Come Back Down Households Expect Inflation To Come Back Down Chart 16Markets Think That The Real Neutral Rate Is Low Markets Think That The Real Neutral Rate Is Low Markets Think That The Real Neutral Rate Is Low The second factor that is suppressing bond yields is the market’s perception that the real neutral rate of interest is quite low. The 5-year, 5-year TIPS yield – a good proxy for the market’s estimate of the real neutral rate – currently stands at 0.40%, well below its pre-GFC average of 2.5% (Chart 16). Ironically, a recession will only occur when investors start believing that a recession will not occur. Without more economic optimism, real yields will not rise into restrictive territory. When Will the Moats Dry Up? The US unemployment rate is a mean-reverting series. When unemployment is very low, it is more likely to rise than to fall. And when the unemployment rate starts rising, it keeps rising. In the post-war era, the US has never avoided a recession when the unemployment rate has risen by more than one-third of a percentage point over a three-month period (Chart 17). Chart 17When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising ​​​​​With the unemployment rate falling to a 53-year low of 3.5% in July, it is safe to say that we are in the late stages of the business-cycle expansion. When will the unemployment rate move decisively higher? While it is impossible to say with certainty, history does offer some clues. Remarkably, the double-dip 1980/82 recessions, the 1990-91 recession, the 2001 recession, and the 2007-09 Great Recession were all preceded by an almost identical 21-to-23-month period of a flat unemployment rate (Chart 18 and Table 1). Coincidentally, the Covid-19 recession was also preceded by 22 months of a stable unemployment rate. To the extent that the economy was not showing much strain going into the pandemic, it is reasonable to assume that the unemployment rate would have continued to move sideways for most of 2020 had the virus never emerged. Chart 18The Bottoming Phase Of The Unemployment Rate Has Only Begun The Bottoming Phase Of The Unemployment Rate Has Only Begun The Bottoming Phase Of The Unemployment Rate Has Only Begun Image Inflation is the Key The unemployment rate has been fairly stable since March when it hit 3.6%. Given the three moats discussed in this report, we suspect that it will move sideways well into next year. At that point, the trajectory of inflation will determine the path of the unemployment rate and the broader economy. As this week’s better-than-expected July CPI report foreshadows, inflation will fall significantly over the coming months, thanks to lower food and energy prices and easing supply-chain pressures. The GSCI Agricultural Index has dropped 24% from its highs and is now below where it was before Russia’s invasion of Ukraine (Chart 19). Retail gasoline prices have fallen 19% since June, with the futures market pointing to a substantial further decline over the next 12 months. In general, there is an extremely strong correlation between the change in gasoline prices and headline inflation (Chart 20). Supplier delivery times have also dropped sharply (Chart 21). Chart 19Agricultural Prices Have Started Falling Agricultural Prices Have Started Falling Agricultural Prices Have Started Falling Chart 20Headline Inflation Tends To Track Gasoline Prices Headline Inflation Tends To Track Gasoline Prices Headline Inflation Tends To Track Gasoline Prices Falling inflation could sow the seeds of its own demise, however. As prices at the pump and the grocery store decline, real wage growth will turn positive. That will bolster consumer confidence, leading to more spending (Chart 22). Core inflation, which is likely to decrease only modestly over the coming months, will start to accelerate in 2023, prompting the Fed to turn hawkish again. Stocks will falter at that point. Chart 21Supplier Delivery Times Have Declined Supplier Delivery Times Have Declined Supplier Delivery Times Have Declined Chart 22Falling 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 Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn and Twitter     Global Investment Strategy View Matrix Three Mega Moats Around The US Economy Three Mega Moats Around The US Economy Special Trade Recommendations Current MacroQuant Model Scores Three Mega Moats Around The US Economy Three Mega Moats Around The US Economy