Sectors

Executive Summary There has never been a modern era recession or sharp slowdown in which the oil price did not collapse. In a recession, the massive destruction of oil demand always overwhelms a tight supply. Across the last six recessions, the median collapse in the oil price was -60 percent, with the best case being -30 percent, and the worst case being -75 percent. Hence, in the coming recession, the oil price is likely headed to $55, with the best case being $85, and the worst case being $30. Investors should short oil, or short oil versus copper. Equity investors should underweight the oil sector versus basic resources and/or industrials and/or banks, and underweight oil-heavy equity markets such as Norway. Fractal trading watchlist: Oil versus industrials, and oil versus banks. Oil Didn’t Get The ‘Everything Sell-Off’ Memo Oil Didn't Get The 'Everything Sell-Off' Memo Oil Didn't Get The 'Everything Sell-Off' Memo Bottom Line: There has never been a modern era recession or sharp slowdown in which the oil price did not collapse, and this time will be no different. Feature We have just witnessed a rare star-alignment. The near-perfect line up of Mercury, Venus, Mars, Jupiter and Saturn in the heavens is a spectacular sight for the early birds who can star gaze through clear skies. And it is a rare event, which last happened in 2004. But investors have just witnessed an even rarer star-alignment. The ‘everything sell-off’ in stocks, bonds, inflation-protected bonds, industrial metals, and gold during the second quarter has happened in only one other calendar quarter out of almost 200. Making it a ‘1 in a 100’ event, which last happened way back in 1981 (Chart I-1 and Chart I-2). Chart I-1The ‘Everything Sell-Off’ In 2022… Oil Didn't Get The 'Everything Sell-Off' Memo Oil Didn't Get The 'Everything Sell-Off' Memo Chart I-2...Last Happened In 1981 ...Last Happened In 1981 ...Last Happened In 1981 As we detailed in our previous reports Markets Echo 1981 When Stagflation Morphed Into Recession and More On 2022-23 = 1981-82 And The Danger Ahead, a once-in-a-generation conjugation connects the ‘1 in a 100’ everything sell-offs in 1981 and 2022. The conjugation is inflation fears, exacerbated by a major war between commodity producing neighbours, and countered by aggressive rate hikes, morph into recession fears. The 1981-82 episode is an excellent blueprint for market action through 2022-23. This makes the 1981-82 episode an excellent blueprint for market action through 2022-23, and we refer readers to the previous reports for the implications for stocks, bonds, equity sectors, and currencies. Oil Didn’t Get The ‘Everything Sell-Off’ Memo But one major investment didn’t get the ‘everything sell-off’ memo. That major investment is crude oil. Even within the commodity space, oil is the outlier. In the second quarter, industrial commodity prices have collapsed: copper, -20 percent; iron ore -25 percent; tin, -40 percent; and lumber, -40 percent. Yet the crude oil price is up, +7 percent, and the obvious explanation is the Russia/Ukraine war (Chart I-3). Chart I-3Oil Didn't Get The 'Everything Sell-Off' Memo Oil Didn't Get The 'Everything Sell-Off' Memo Oil Didn't Get The 'Everything Sell-Off' Memo The Russia/Ukraine war is an important part of the 2022/1981 once-in-a-generation conjugation. In 1981, just as now, the full-scale invasion-led war between two major commodity producing neighbours – Iraq and Iran – disrupted commodity supplies, and thereby added fuel to an already red-hot inflationary fire. When Russia invaded Ukraine earlier this year, the oil price surged by 25 percent. Remarkably, when Iraq invaded Iran in late 1980, the oil price also surged by 25 percent. But by mid-1981, with the global economy slowing, the oil price had given back those gains. Then, as the economy entered recession in early 1982, the oil price slumped to 15 percent below its pre-war level. If 2022-23 follows this blueprint, it would imply the oil price falling to $85/barrel (Chart I-4). Chart I-4If Oil Follows The 1981-82 Blueprint, It Will Tumble To $85 If Oil Follows The 1981-82 Blueprint, It Will Tumble To $85 If Oil Follows The 1981-82 Blueprint, It Will Tumble To $85 There Has Never Been A Recession In Which The Oil Price Did Not Collapse Everybody knows the narrative for the oil price surge this year. In what is putatively a very tight market, the embargo of Russian oil has removed enough supply to put significant upward pressure on the price. The trouble with this story is that Russian oil will find a buyer, even if it requires a discount. Moreover, with the major buyers being China and India, it will be politically and physically impossible to police secondary sanctions. The bottom line is that Russian oil will find its way into the market. There has never been a modern era recession or sharp slowdown in which the oil price did not collapse. But the bigger problem will come from the demand side of the equation when the global economy enters, or even just flirts with, a recession. Put simply, because of massive demand destruction, there has never been a modern era recession or sharp slowdown in which the oil price did not collapse (Chart I-5 - Chart I-10). Chart I-5In The Early 80s Recession, Oil Collapsed By -30 Percent In The Early 80s Recession, Oil Collapsed By -30 Percent In The Early 80s Recession, Oil Collapsed By -30 Percent Chart I-6In The Early 90s Recession, Oil Collapsed By -60 Percent In The Early 90s Recession, Oil Collapsed By -60 Percent In The Early 90s Recession, Oil Collapsed By -60 Percent Chart I-7In The 2000 Dot Com Bust, Oil Collapsed By ##br##-55 Percent In The 2000 Dot Com Bust, Oil Collapsed By -55 Percent In The 2000 Dot Com Bust, Oil Collapsed By -55 Percent Chart I-8In The 2008 Global Financial Crisis, Oil Collapsed By -75 Percent In The 2008 Global Financial Crisis, Oil Collapsed By -75 Percent In The 2008 Global Financial Crisis, Oil Collapsed By -75 Percent Chart I-9In The 2015 EM Recession, Oil Collapsed By ##br##-60 Percent In The 2015 EM Recession, Oil Collapsed By -60 Percent In The 2015 EM Recession, Oil Collapsed By -60 Percent Chart I-10In The 2020 Pandemic, Oil Collapsed By ##br##-75 Percent In The 2020 Pandemic, Oil Collapsed By -75 Percent In The 2020 Pandemic, Oil Collapsed By -75 Percent Furthermore, as we explained in Oil Is The Accessory To The Murder, a preceding surge in the oil price is a remarkably consistent ‘straw that breaks the camel’s back’, tipping an already fragile economy over the brink into recession. Meaning that the oil price ends up in a symmetrical undershoot to its preceding overshoot. The result being a massive drawdown in the oil price in every modern era recession or sharp slowdown. Specifically: Early 80s recession: -30 percent Early 90s recession: -60 percent 2000 dot com bust: -55 percent 2008 global financial crisis: -75 percent 2015 EM recession: -60 percent 2020 pandemic: -75 percent What about the 1970s episode – isn’t this the counterexample in which the oil price remained stubbornly high despite a recession? No, even in the 1974 recession, the oil price fell by -25 percent.  Moreover, the commonly cited explanation for the elevated nominal price of oil through the 70s is a misreading of history. The popular narrative blames OPEC supply cutbacks related to geopolitical events – especially the US support for Israel in the Arab-Israel war of October 1973.  As neat and popular as this narrative is, it ignores the real culprit: the collapse in August 1971 of the Bretton Woods ‘pseudo gold standard’, which severed the fixed link between the US dollar and quantities of commodities. To maintain the real value of oil, OPEC countries were raising the price of crude oil just to play catch up. Meaning that while geopolitical events may have influenced the precise timing and magnitude of price hikes, OPEC countries were just ‘staying even’ with the collapsing real value of the US dollar, in which oil was priced. In terms of gold, in which oil was effectively priced before 1971, the oil price was no higher in 1980 than in 1971! (Chart I-11) Chart I-11Priced In Gold, The Oil Price Was No Higher In 1980 Than in 1971! Priced In Gold, The Oil Price Was No Higher In 1980 Than in 1971! Priced In Gold, The Oil Price Was No Higher In 1980 Than in 1971! Shorting Oil And Oil Plays Will Be Very Rewarding For Patient Investors The four most dangerous words in investment are ‘this time is different’. Today, the oil bulls insist that this time really is different because of an unprecedented structural underinvestment in fossil fuel extraction. Leaving the precariously tight oil market vulnerable to the slightest uptick in demand, or downtick in supply. Maybe. But to reiterate, in a recession, the massive destruction of oil demand always overwhelms a tight supply. In this important regard, this time will not be different. Taking the median drawdown of the last six recessions of 60 percent, and applying it to the post-invasion peak of $130, it implies that, in the coming recession, oil will plunge to $55. In a recession, the massive destruction of oil demand always overwhelms a tight supply. Of course, this is the average of a range of recession outcomes, with the best case being $85 and the worst case being $30. Still, this means that patient investors who short oil can look forward to substantial gains. Alternatively, those who want a hedged position should short oil versus copper – especially as oil versus copper is now at the top of its 25-year trading channel (Chart I-12). Chart I-12Oil Versus Copper Is At The Top Of Its 25-Year Trading Channel Oil Versus Copper Is At The Top Of Its 25-Year Trading Channel Oil Versus Copper Is At The Top Of Its 25-Year Trading Channel Equity investors should underweight the oil sector versus basic resources (Chart I-13) and/or versus industrials and/or versus banks, and underweight oil-heavy stock markets such as Norway (Chart I-14). Chart I-13Underweight Oil Versus Basic Resources Underweight Oil Versus Basic Resources Underweight Oil Versus Basic Resources Chart I-14Underweight Oil-Heavy Stock Markets Such As Norway Underweight Oil-Heavy Stock Markets Such As Norway Underweight Oil-Heavy Stock Markets Such As Norway Suffice to say, these are all correlated trades. They will all work, or they will all not work. But to repeat, this time is never different. Fractal Trading Watchlist Confirming the fundamental arguments to underweight oil plays, the spectacular recent outperformance of oil equities versus both industrials and banks has reached the point of fragility on its 260-day fractal structures that has reliably signalled previous turning points (Chart I-15). Chart I-15The Outperformance Of Oil Versus Industrials Is Exhausted The Outperformance Of Oil Versus Industrials Is Exhausted The Outperformance Of Oil Versus Industrials Is Exhausted We are adding oil versus banks to our watchlist, with this week’s recommendation being to underweight oil versus industrials, setting a profit target and symmetrical stop-loss of 10 percent, with a maximum holding period of 6 months. Fractal Trading Watchlist: New Additions The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted Chart 1BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point   Chart 2Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Chart 3CNY/USD At A Potential Turning Point CNY/USD Has Reversed CNY/USD Has Reversed Chart 4US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 5CAD/SEK Is Vulnerable To Reversal CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 6Financials Versus Industrials Has Reversed Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 7The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 8The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 9FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 10Netherlands' Underperformance Vs. Switzerland Is Ending Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 11The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 12The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 13Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Chart 14German Telecom Outperformance Vulnerable To Reversal AT REVERSAL AT REVERSAL Chart 15Japanese Telecom Outperformance Vulnerable To Reversal AT REVERSAL AT REVERSAL Chart 16The Strong Downtrend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 17The Strong Downtrend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 18A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 19Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 20Norway's Outperformance Has Ended Norway's Outperformance Could End Norway's Outperformance Could End Chart 21Cotton Versus Platinum Has Reversed Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 22Switzerland's Outperformance Vs. Germany Has Ended Fractal Trading Watch List Fractal Trading Watch List Chart 23USD/EUR Is Vulnerable To Reversal The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 24The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 25A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 26GBP/USD At A Potential Turning Point GBP/USD At A Turning Point GBP/USD At A Turning Point Chart 27US Utilities Outperformance Vulnerable To Reversal Fractal Trading Watch List Fractal Trading Watch List Chart 28The Outperformance Of Oil Versus Banks Is Exhausted Fractal Trading Watch List Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Why Oil Is Headed To $55 Why Oil Is Headed To $55 Why Oil Is Headed To $55 Why Oil Is Headed To $55 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Depressing Housing Market And Service Sector Activity Depressing Housing Market And Service Sector Activity Depressing Housing Market And Service Sector Activity May’s economic data ticked up from extremely depressed levels in April, driven by a normalization in the supply chain and a resumption in production. The service sector and housing market continued to shrink on a year-on-year (YOY) basis and sentiment among households and corporates remains lackluster. The rebound in exports growth in May will likely be unsustainable. Chinese exports are set to contract from 2021 as external demand for goods weakens. The rapidly worsening labor market dynamics reinforce households’ unwillingness to consume and hence, will hinder the recovery in household consumption. Although industrial production showed a decent rebound in May, the manufacturing production recovery might be derailed by rolling lockdowns and prolonged logistic bottlenecks. Barring major lockdowns, China’s economy will likely improve in 2H 2022 from the very low base in Q2. That said, the country’s economic recovery faces several challenges and the magnitude of the rebound will be subdued. Bottom Line: The elements for a robust and sustainable recovery in the Chinese economy are not yet in place. The recent rally in the A-share market reflects a mean-reversal to the pre-March lockdown price level, rather than the beginning of a cyclical bull market. Investors should remain cautious on Chinese equities in the next several months. Feature China’s economic data moved up slightly in May from an extremely depressed level in April. A normalization of the supply chain and a resumption of production post-lockdown in Shanghai and other cities led to a modest recovery in business activities. However, indicators from the service sector and housing market continued to shrink on a YOY basis, highlighting persistent weaknesses on the demand side. Chart 1Import Dynamics Reflect Weak Domestic Demand Import Dynamics Reflect Weak Domestic Demand Import Dynamics Reflect Weak Domestic Demand May’s import data also reflects sluggish domestic demand. The increase in imports value from a year ago was largely driven by the elevated prices in energy and agriculture products. China’s imports in May, in volume terms, continued to contract on a YOY basis, albeit improved from its historical low in April (Chart 1). Barring major lockdowns, China’s economy will likely improve in the second half of this year. However, the economic recovery in 2H 2022 will be very subdued due to the following challenges: Downbeat sentiment among households and enterprises; Continued real estate woes; A contraction in exports; Deteriorating labor market conditions; and Risk of rolling lockdowns and persistent logistic bottlenecks. The recent rebound in the A-share market reflects an improvement in investors’ sentiment buttressed by the easing of lockdowns and a resumption of production. In other words, the rebound in Chinese stock prices is probably a mean-reversal to pre-lockdown levels, rather than a sustainable rally (Chart 2). Our cautious view on Chinese equities is also corroborated by the divergence between falling raw industrial prices, which reflect weak China’s growth, and rising Chinese equity prices (Chart 3). Overall, we continue to recommend a neutral stance in Chinese equities within a global portfolio. Chart 2Too Early To Turn Bullish On Chinese Stocks Too Early To Turn Bullish On Chinese Stocks Too Early To Turn Bullish On Chinese Stocks Chart 3Falling Prices In Raw Materials Do Not Signal An Imminent Round In Demand Falling Prices In Raw Materials Do Not Signal An Imminent Round In Demand Falling Prices In Raw Materials Do Not Signal An Imminent Round In Demand   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Downbeat Household And Corporate Sentiment Chart 4Subdued Bank Loan Growth Has Been A Drag On Credit Expansion Subdued Bank Loan Growth Has Been A Drag On Credit Expansion Subdued Bank Loan Growth Has Been A Drag On Credit Expansion Although China’s credit growth improved sequentially in May after a very weak reading in April, the magnitude of May’s credit rebound is much more subdued compared with the months following the first lockdowns in early 2020 (Chart 4). In addition, May’s rebound in credit growth was mainly driven by an acceleration in local government bond issuance. The modest pickup in the credit impulse - calculated as a 12-month change in total social financing (TSF) as a percentage of nominal GDP - is much more muted when excluding local government bond issuance (Chart 5). Furthermore, as noted in our previous report, given that most of the planned local government special purpose bonds (SPBs) will be issued by the end of June, barring any increase in this year’s SPBs quota, the support from local government bond issuance to TSF growth will likely wane significantly in the second half of 2022. Meanwhile, confidence among consumers and businesses remained downbeat through May (Chart 6). The poor private-sector sentiment will continue to dampen credit demand and thus, limit the effectiveness of monetary stimulus. Chart 5The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance Chart 6Gloomy Sentiment Among Chinese Households And Enterprises Gloomy Sentiment Among Chinese Households And Enterprises Gloomy Sentiment Among Chinese Households And Enterprises Private-sector credit demand remains very frail. Household medium- to long-term loans are still contracting from previous month, while bank loans to corporate peers were also weak in May (Chart 7 & 8). Chart 7Depressed Household Loan Demand Depressed Household Loan Demand Depressed Household Loan Demand Chart 8Corporate Demand For Credit Remains Weak Despite Accommodative Monetary Conditions Corporate Demand For Credit Remains Weak Despite Accommodative Monetary Conditions Corporate Demand For Credit Remains Weak Despite Accommodative Monetary Conditions Chart 9Deterioration In Corporate Sentiment Is Also Reflected In Surveys of Business Conditions Deterioration In Corporate Sentiment Is Also Reflected In Surveys of Business Conditions Deterioration In Corporate Sentiment Is Also Reflected In Surveys of Business Conditions On the other hand, corporate bill financing as a portion of new bank loans, although rolled over from April’s record high, remained very elevated through May (Chart 8, bottom panel). Moreover, enterprises’ financing and investment expectations deteriorated further in May (Chart 9).   Persisting Real Estate Woes The near-term outlook for China’s property market remains uninspiring. So far, easing measures in the housing sector have not been successful in reviving home sales and homebuyers’ sentiment. Residential property sales and real estate investment growth ticked up slightly in May after plummeting by 43% and 10% in April, respectively (Chart 10). However, the modest improvement in May does not mark the start of a full-fledged cyclical recovery. High-frequency data show a renewed weakening in floor space sales, particularly in tier-one and tier-two cities, during the first two weeks of June (Chart 11). Chart 10The Slight Improvement In Housing Market Indicators Does Not Signal A Cyclical Recovery The Slight Improvement In Housing Market Indicators Does Not Signal A Cyclical Recovery The Slight Improvement In Housing Market Indicators Does Not Signal A Cyclical Recovery Chart 11Renewed Deterioration In Home Sales In June Renewed Deterioration In Home Sales In June Renewed Deterioration In Home Sales In June Chart 12Real Estate Developers' Decreased Funding Will Further Dampen Housing Construction Activities Real Estate Developers' Decreased Funding Will Further Dampen Housing Construction Activities Real Estate Developers' Decreased Funding Will Further Dampen Housing Construction Activities Funds to real estate developers have been contracting at the fastest rate since data collection began in 1998. The lack of funding for real estate developers will further depress housing construction activities in the near term (Chart 12). Moreover, new home prices, which tend to lead housing starts, started to decrease on a YOY basis in May. This was the first price contraction since 2016. Our housing price diffusion index suggests that home price growth will continue to shrink in the next six to nine months (Chart 13). Many local cities reduced mortgage rates, by anywhere from 15 to more than 100 basis points, after the PBoC lowered mortgage rate floor and the benchmark rate (5-year LPR) in May. However, the average cost of mortgage loans remains higher than households’ income growth, making mortgage borrowing less attractive to ordinary households (Chart 14). Chart 13Housing Prices Are Set To Decline Further In 2H 2022 Housing Prices Are Set To Decline Further In 2H 2022 Housing Prices Are Set To Decline Further In 2H 2022 Chart 14Mortgage Rates Have Dropped, But Still Higher Than Income And Home Price Growth Mortgage Rates Have Dropped, But Still Higher Than Income And Home Price Growth Mortgage Rates Have Dropped, But Still Higher Than Income And Home Price Growth In addition, the widening gap between the average mortgage rate and the pace of housing price appreciation implies that housing has become much less appealing to residents who purchase homes as investment (Chart 14, bottom panel). In short, property purchases will remain weak given neither “to live in” nor investment demand for properties is likely to recover fast. China's Exports Are Set To Contract In 2H 2022 China’s exports rebounded in May from the April low as supply chain interruptions subsided and logistic disruptions began to ease. However, as US and European consumer spending on goods (excluding autos) declines, Chinese shipments will shrink in the months ahead. May’s improvement in suppliers’ delivery times and product inventory subindexes of China’s official Purchasing Managers’ Index (PMI) suggests that logistics were less of a drag on economic activity than in April (Chart 15). In addition, Shanghai and China’s exports freight indexes recovered significantly on a month-over-month basis (Chart 16) with the lifting of lockdown measures. Chart 15Chinese Logistics Pressures Have Eased Slightly In May... Chinese Logistics Pressures Have Eased Slightly In May... Chinese Logistics Pressures Have Eased Slightly In May... Chart 16...And Export Freight Indices Have Rebounded ...And Export Freight Indices Have Rebounded ...And Export Freight Indices Have Rebounded Chart 17Global Demand Is Dwindling Global Demand Is Dwindling Global Demand Is Dwindling Meanwhile, global demand for goods has been weakening. Korean exports volume growth, a bellwether for global trade, has been trending down since late 2021 (Chart 17). Moreover, the US and Euro Area manufacturing PMIs have been falling (Chart 17, bottom panel). Spending in developed economies is shifting from manufactured goods to services. Retail inventories in the US are well above their pre-pandemic trend, suggesting that the demand growth for Chinese goods will dwindle when US retailers start to destock their inventories (Chart 18). Falling US and Euro Area real household disposable income will also reinforce the downward trend in external demand (Chart 19). Therefore, China's exports are set to shrink in the second half of this year. Chart 18Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Chart 19A Contraction in US and Euro Area Household Real Disposable Income A Contraction in US and Euro Area Household Real Disposable Income A Contraction in US and Euro Area Household Real Disposable Income Deteriorating Labor Market Conditions Will Curb Household Consumption Recovery Although improved from April’s extreme low, Chinese retail sales and service activity remained in contractionary territory in May, highlighting sluggish household demand (Chart 20). In addition, the cinema audience, which is used to gauge the impact of the pandemic on the service sector, indicates a further deterioration in the sector’s activity in June (Chart 20, bottom panel). The lackluster consumer demand is also evidenced by soft core and service consumer prices (CPI) in May (Chart 21). Chart 20Chinese Retail Sales And Service Activity Continued To Contract In May Chinese Retail Sales And Service Activity Continued To Contract In May Chinese Retail Sales And Service Activity Continued To Contract In May Chart 21Soft Core And Service CPIs Also Reflect Lackluster Household Demand Soft Core And Service CPIs Also Reflect Lackluster Household Demand Soft Core And Service CPIs Also Reflect Lackluster Household Demand   Labor market conditions have also worsened. Although the nationwide urban survey-based unemployment rate fell moderately in May, the 31-large city surveyed unemployment rate climbed to an all-time high in the 10-year history of this survey. Moreover, employment in the service sector deteriorated to the worst level since mid-2020 (Chart 22). Furthermore, urban new job creation fell into deep shrinkage on a YOY basis, while the unemployment rate among younger workers rose to the highest point since data collection began in 2018 (Chart 23). Chart 22Labor Market Situation Is Worsening Rapidly... Labor Market Situation Is Worsening Rapidly... Labor Market Situation Is Worsening Rapidly... Chart 23...Particularly Among Younger Workers ...Particularly Among Younger Workers ...Particularly Among Younger Workers Chart 24Weak Sentiment On Future Income Contributes To Households' Unwillingness To Consume Weak Sentiment On Future Income Contributes To Households' Unwillingness To Consume Weak Sentiment On Future Income Contributes To Households' Unwillingness To Consume The rapidly worsening labor market dynamics and income prospects reinforce households’ downbeat sentiment (Chart 24). The latter will impede household consumption recovery in the second half of this year.   Production Recovery Faces Risks Of Persistent Logistic Bottlenecks   The uptick in industrial activity in May was due to a lifting of Covid-related lockdown restrictions. Although industrial production showed a decent rebound, underlying data suggest that economic fundamentals remained subdued. Chart 25Industrial Activity Improved Only Slightly In May Industrial Activity Improved Only Slightly In May Industrial Activity Improved Only Slightly In May Chart 26Construction Material Production Continues To Shrink On A YOY Basis Construction Material Production Continues To Shrink On A YOY Basis Construction Material Production Continues To Shrink On A YOY Basis Electricity output remained in contractionary territory through May (Chart 25). Cement and steel output continued shrinking from the same period last year (Chart 26). Moreover, their prices have been falling even though production growth has been waning, which indicates that demand in the construction sector is depressed (Chart 3, bottom panel). Consumer durable goods production also remains well below their levels from a year ago (Chart 27 & 28). Chart 27Auto And Smartphone Production Keeps Decreasing From A Year Ago... Auto And Smartphone Production Keeps Decreasing From A Year Ago... Auto And Smartphone Production Keeps Decreasing From A Year Ago... Chart 28… As Well As Production Of Home Appliances ...As Well As Production Of Home Appliances ...As Well As Production Of Home Appliances Chart 29Prolonged Logistic Bottlenecks Prolonged Logistic Bottlenecks Prolonged Logistic Bottlenecks Chinese manufacturing investment rebounded in May. However, since exports will likely shrink in the second half of this year, it will create a major headwind for manufacturing investment and output. Moreover, China’s manufacturing production will likely be challenged by persistent logistic bottlenecks in 2H 2022. Chinese road freight was still declining in the first three weeks in June from the same period last year as shown in Chart 29. The risk of renewed Covid-induced lockdowns or mobility restrictions are nontrivial since China will maintain its zero-Covid policy at least through the end of this year.   Table 1China Macro Data Summary A Muted Post-Lockdown Recovery Ahead A Muted Post-Lockdown Recovery Ahead Table 2China Financial Market Performance Summary A Muted Post-Lockdown Recovery Ahead A Muted Post-Lockdown Recovery Ahead Footnotes Strategic Themes Cyclical Recommendations

Executive Summary High food and fertilizer prices are at risk of morphing into a full-blown food crisis in several developing countries. Some countries were plagued by severe food insecurity even before the Ukraine war broke out. The Ukraine war has upended two crucial aspects of food security: availability of food grains as well as the availability of fertilizers. A few Middle Eastern and African countries, who are dependent on both imported cereals and crude oil, are experiencing the greatest difficulty. The stock-to-use ratio of food grains is alarmingly low in several countries. Some of them also have high twin deficits (i.e., fiscal and current account deficits) – indicating that governments there would be hard-pressed to provide necessary relief. Several Countries Need To Import Over 90% Of Their Cereal Consumption Are Developing Countries Heading Into Food Crises? Are Developing Countries Heading Into Food Crises? Bottom Line: All aspects considered, we reckon Lebanon, Egypt, Kenya, Peru, Pakistan, and Sri Lanka to be the most at risk of experiencing a food crisis, and consequent socio-political upheaval. Feature Food prices have surged in most parts of the world. In some developing countries however, food inflation is threatening to morph into a food crisis. In the year ahead, high food and fertilizer prices could accentuate food insecurity in several poorer countries − with major socio-political ramifications. In this report, we identify the nations most at risk, especially among countries included in the MSCI Emerging and Frontier Equity Indexes. Our research indicates that Lebanon, Egypt, Kenya, Peru, Pakistan, and Sri Lanka are the most vulnerable to a food crisis, and consequent socio-political upheaval. Food Inflation: In The Stratosphere In a few countries such as Lebanon and Venezuela, food inflation is at a mind-boggling 370% and 200%, respectively. It is abnormally high in many other developing countries as well – including Turkey (92%), Argentina (64%), Iran (49%), Sri Lanka (45%), Ghana (30%), and Egypt (28%). In several other countries such as Colombia, Nigeria, Hungary, Bulgaria, and Kazakhstan, food prices are rising at about 20% or more. That is also the case in war-torn Ukraine and Russia (Chart 1). Chart 1Food Inflation Has Become Extremely Painful In Some Countries Are Developing Countries Heading Into Food Crises? Are Developing Countries Heading Into Food Crises? In a few countries such as Turkey, Pakistan and Sri Lanka, currency depreciation could explain part of the rise in food prices. Chart 2Food Prices Began To Surge Well Before The Ukraine Crisis Food Prices Began To Surge Well Before The Ukraine Crisis Food Prices Began To Surge Well Before The Ukraine Crisis That said, given that only a minor share of all food consumed is imported by these countries, the sharp rise in overall food prices cannot be explained away by currency depreciation alone. Rather, it points to genuine price pressures in domestically grown food. That is also the case in all other countries where food inflation is higher than currency depreciation. Notably, in many of these countries, food inflation was quite high even before the Ukraine war broke out. Indeed, global food grain prices had begun to surge in mid-2020 – well before Russia’s invasion began (Chart 2). And yet, the onset of the Ukraine war and the resulting sanctions and logistics bottlenecks have worsened the situation dramatically. Even though food prices have eased marginally in the past couple of weeks, they are still extremely elevated compared to pre-pandemic levels. More worryingly, many countries are now at risk of experiencing a full-blown food crisis.  Pre-existing Food Insecurity Some developing countries are more susceptible to a food crisis than others. This is because they were already plagued by food insecurity even before the Ukraine war broke out. The x-axis of Chart 3 shows the extent of “severe food insecurity”1 in various developing nations, as per the United Nations’ Food and Agriculture Organization (FAO). Kenya, Nigeria, South Africa and Peru stand out in this respect among the countries included in the MSCI EM & Frontier market equity indexes: as high as 18 to 26% of the total population in these countries experienced severe food insecurity between 2018 and 2020. Chart 3Countries With Pre-Existing Food Insecurity Are More At Risk Are Developing Countries Heading Into Food Crises? Are Developing Countries Heading Into Food Crises? Notably, these countries also happen to have high fiscal deficits; and in some cases, high public debt (Chart 3, y-axis). This leaves their governments with less room to provide necessary relief should an acute food crisis hit their population. Not surprisingly, some of the countries plagued by severe food insecurity are highly dependent on grain imports to meet their domestic demand. The x-axis of Chart 4 shows the cereal import dependency of various countries as a percentage of their cereal intake. Most middle eastern countries such as Lebanon, Jordan, Kuwait, Saudi Arabia and Oman need to import nearly all of their cereal consumptions, as per FAO data. That said, what sets the truly vulnerable cereal importers apart from the rest is that some of them do not have much export earnings to pay for their rising food import bills. For instance, in Lebanon, food imports alone cost two-thirds of its total goods export revenues before the pandemic, according to FAO. For Egypt, Jordan and Kenya, food imports used up over 40% of their export earnings (Chart 4, y-axis). Chart 4Several Countries Need To Import Over 90% Of Their Cereal Consumption Are Developing Countries Heading Into Food Crises? Are Developing Countries Heading Into Food Crises? These figures must have gone up further as food prices have risen significantly in the past two years. If high food prices persist, the balance of payments of these countries will deteriorate further. That, in turn, will negatively affect their currencies and general inflation.  High Oil Prices Adding To The Woes Many oil and gas producers in the Middle East and Africa are also large net importers of food. Current high crude prices, however, are helping them to foot their food bills. But countries who need to import both food and oil and gas are facing a double whammy. Chart 5 shows that several food importers are indeed large net importers of oil and gas too. On this parameter, Lebanon, Pakistan, Jordan and Kenya appear to be facing the most acute pain − their annual food plus net oil import bills are very high, ranging from 60 to 120% of their goods export revenues. Needless to say, if both food and oil prices remain elevated, these nations could face major socio-economic upheavals. Chart 5Countries Which Need To Import Both Food And Fuel Are The Most Distressed Are Developing Countries Heading Into Food Crises? Are Developing Countries Heading Into Food Crises? Chart 6Industrial Metals And Ore Producers Will Face More Pain Going Forward Industrial Metals And Ore Producers Will Face More Pain Going Forward Industrial Metals And Ore Producers Will Face More Pain Going Forward On a separate note, many producers of industrial metals/raw materials such as Chile and Peru may also soon experience more difficulties. The reason is that industrial metal prices have recently rolled over relative to food prices (Chart 6). Going forward, slowing global growth will likely push down industrial metal prices further, robbing these nations of a major source of income. Falling income amid high food prices would hurt the population even more, as the former will also limit the authorities’ ability to provide relief. The Implications Of The Ukraine War Could Linger The Ukraine war has upended the two most crucial aspects of food security: availability of food grains and fertilizers. Notably, the exportable surplus of food and fertilizers in the world are concentrated in only a handful of countries. Russia and Ukraine are key among them. In the case of wheat, 28% of global exports (in volume terms) in 2021 came from Russia (18%) and Ukraine (10%),  as per the FAO. In the case of barley, their share was 24%, and for corn (maize) 12%. Chart 7Grain Prices Have Surged Across The Board Grain Prices Have Surged Across The Board Grain Prices Have Surged Across The Board These two countries are dominant in some oilseed exports as well. Ukraine (37%) and Russia (26%) together held about two-thirds of the global sunflower oil export market share. In the case of rapeseed, Ukraine had about 20% of global export share. Much of these supplies now face severe logistical hurdles. That, in turn, has pushed up grain and edible oil prices globally, hurting all countries whether they are dependent on food imports or not (Chart 7). That said, the countries who are heavily dependent on Russian and Ukrainian supplies are particularly hit hard. Chart 8 shows the import dependency of some countries on Russian and Ukrainian wheat. Turkey, Lebanon and Egypt will have to urgently find alternative suppliers as a very large share of their imports now face uncertainty. The same can be said about Eritrea, Somalia and some former Soviet republics.    In the case of fertilizers, Russia was the largest supplier of nitrogen-based fertilizers2 (the kind that is most heavily used) at 17% of global exports in 2021. The country was also the second largest exporter of potassium-based fertilizer (23%), and the third largest in phosphorus-based fertilizers (16%). Ukraine, however, has not been a big exporter of fertilizers. Just like in the case of wheat, several countries had been highly dependent on Russian fertilizers. Among EM countries, Peru procured 42% of its fertilizer needs from Russia last year. Brazil, Mexico, and Colombia each imported about 22% from Russia. That figure was substantially higher for some other developing countries such as Ghana (37%), Cameroon (47%), and Honduras (50%) (Chart 9). Given the numerous sanctions imposed on a multitude of Russian entities, shipments of Russian fertilizers are now at risk. As such, all these countries need to find substitute suppliers urgently.  Chart 8Russia And Ukraine Supplied Over 80% Of Wheat Imports For Many Countries Are Developing Countries Heading Into Food Crises? Are Developing Countries Heading Into Food Crises? Chart 9Russia Supplied Over 40% Of Fertilizer Imports For Many Countries Are Developing Countries Heading Into Food Crises? Are Developing Countries Heading Into Food Crises?   Notably, it’s not just the logistics/availability issues that fertilizer users must contend with. Prices of fertilizers have also surged by a massive 200 to 300% compared to pre-pandemic levels. The reason for that is sky-high natural gas prices, which is the primary feedstock of (nitrogen-based) fertilizers (Chart 10). Chart 10High Natural Gas Prices Will Keep Fertilizers Expensive High Natural Gas Prices Will Keep Fertilizers Expensive High Natural Gas Prices Will Keep Fertilizers Expensive Since Russia is also a major natural gas producer, the current situation does not bode well for the fertilizer price relief outlook. New western sanctions on Russia and countermeasures by Russia are continuing relentlessly. As such, one can expect that natural gas prices will likely stay elevated for the foreseeable future. That will keep fertilizers expensive. Meanwhile, the scarcity and/or high prices of fertilizers would force farmers in many poor countries to curtail their fertilizer use during the ongoing / upcoming crop season. That in turn would imperil their domestic food production, accentuating overall food scarcity. Where Do Countries’ Food Stocks Stand Now? Chart 11 shows various developing countries’ combined stockpile of food grains (wheat, corn and soybean) relative to their yearly usage (i.e., the stock-to-use ratio). Chart 11The Stock Of Foodgrains Is Precariously Low In Many Countries Are Developing Countries Heading Into Food Crises? Are Developing Countries Heading Into Food Crises? Among the countries who have high cereal import dependency (and, who are not oil producers), the stock-to-use ratio is particularly low for Lebanon, Jordan, Chile, Peru, and Egypt. Since some of the countries with low food stock-to-use ratio are also dependent on imported food and fertilizers, they are even more susceptible to an outright food shortage this year. Lebanon, Egypt and Peru are three such countries among MSCI included ones. If various countries’ stock-to-use figures are juxtaposed with their twin deficits, their wherewithal to provide necessary relief should their food stocks become inadequate can be demonstrated. Chart 12 shows that several countries with a low food stock-to-use ratio are also plagued by high twin deficits, and therefore low capacity to provide relief. Examples are Lebanon, Jordan, Egypt, Nigeria and Venezuela. Chart 12Some Countries With Low Food Stock Have A Low Capacity To Provide Relief Are Developing Countries Heading Into Food Crises? Are Developing Countries Heading Into Food Crises? Food Price Shock: Is It Inflationary Or Deflationary? High food prices can sometimes lead to higher general inflation. The starting point of that is usually household inflation expectations: facing higher grocery prices every day, consumer expectations of future prices become unmoored. That said, whether the higher inflation ‘expectations’ will evolve into higher ‘realized’ inflation depends on households’ (labor) power to negotiate wages. If they are successful to gain higher wages, core inflation also begins to rise in tandem with food inflation, which might eventually lead to a wage-inflation spiral. In most developing nations, however, that does not look to be the case. Wages are rising sharply in only a handful of countries. Moreover, since a very high share of consumer spending in developing countries is accorded to food (25% to 55%), higher food bills are eating substantially into households’ real discretionary spending. That does not bode well for (non-food) corporate earnings. In addition, the central banks in many developing economies are raising interest rates in response to high inflation. All these will likely push many developing economies on the brink of a recession.   Investment Conclusions Currently, most emerging and frontier market nations are facing a deteriorating growth outlook – thanks to tight fiscal and tightening monetary policies domestically, a very strong US dollar, rising global interest rates, and a subpar Chinese recovery. High food and/or fuel prices are additional ‘taxes’ on their economies, and especially for the import-dependent ones. As a result, their growth will be stymied further. The consequence could well be socio-political volatility. Incidentally, the last time global food prices witnessed a major surge (about 40%) was back in 2010. That was soon followed by social upheavals in much of the Middle East (known as the ‘Arab Spring’) and elsewhere in the developing world. In the present episode, food prices have risen by 70% in two years. As mentioned, some of the countries facing food and fertilizer scarcity are also plagued by low grains stocks (relative to requirement) and have weak fiscal and external accounts. Considering all the aspects, we reckon that Lebanon, Jordan, Egypt, Kenya, Peru, Pakistan, and Sri Lanka are most-at-risk of slipping into a food crisis this year and beyond. Incidentally, the Emerging Markets Strategy team holds a bearish view on the near-term performances of EM stocks and bonds. Investors should stay underweight EM relative to global equities and bonds. Absolute return investors should stay on the sidelines. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Sebastian Rodriguez Research Associate sebastian.rodriguez@bcaresearch.com     Footnotes 1     Severe food insecurity refers to missing meals and/or reduced food intake because of financial constraints 2     The three main type of chemical fertilizers are nitrogen-based (urea and ammonia), potassium-based (potash), and phosphorus-based (phosphates).

Executive Summary Small Do Poorly During The Slowdown Phase Will Small Get Even Smaller? Will Small Get Even Smaller? Small Caps are a more cyclical and high-octane version of Large Caps. Small underperforms Large during the slowdown stage of the business cycle. The yield curve is flattening and is close to inversion – a signal that does not bode well for the outperformance of Small vs. Large either. Rising high-yield spreads are a bad omen for the outperformance of small caps. Small caps are incredibly cheap both in real and absolute terms. They are also oversold. The profitability of both small and large companies is under pressure, but small companies have fewer resources and are less resilient. Earnings growth estimates for both Large and Small are unrealistically high and misleading. We expect an earnings recession, and negative earnings growth is likely for both asset classes. Bottom Line: Small caps are a more cyclical, lower quality, high-octane asset class than Large caps and face significant macroeconomic headwinds from slowing economic growth. We recommend underweighting Small relative to Large, despite attractive valuations, until macroeconomic uncertainty dissipates, inflation turns, and earnings deceleration gets priced in. Feature In the front section of our June 6, Style Chart Pack, we upgraded Growth and downgraded Value both to equal weight, making the case that Growth vs Value divergence in performance has likely run its course – with economic growth slowing, companies with strong fundamentals and stable earnings are much more valuable. We also stated that once macroeconomic uncertainty dissipates, we will be able to pounce and shift Growth to overweight, and Value to underweight. In this week’s report, we will revisit our overweight Small/underweight Large allocation – a position that has been bleeding red ink since November. The question on our mind is what to do with an underperforming position – be patient or have losses? We ground this report in an analysis we conducted a year ago in the “Is It A Small World After All” report. Sneak Preview: The macroeconomic backdrop for Small is unfavorable, and its earnings growth is about to decelerate – yet much of the bad news is already priced in. However, Small is unlikely to outperform in a sustainable way until inflation turns, and economic uncertainty dissipates. We shift Small to underweight and Large to overweight. Premise For Our Call Last Fall We will start this report by reviewing the history of the call. We upgraded the allocation of Small vs. Large to overweight, making a case based on valuations, strong earnings growth, and demonstrated ability to outperform under duress. We also relied on the empirical analysis that showed that Small held its own in the environment of rising rates. In the “2022 Outlook” report, we highlighted risks to our call. We quote: ”If economic growth disappoints, and the yield curve continues its relentless flattening, signifying a Fed policy mistake or the onset of another COVID Greek, Small is bound to underperform. Margins are narrow and continued cost pressures, especially surging labor costs, have the potential to dent small caps’ profitability. Yet, on a balance of probabilities of such an outcome vs. attractive valuations and fundamentals, this is a risk we are willing to take.” Unfortunately, most of the risks we highlighted have come to pass. Since October 4, the S&P 600 has underperformed the S&P 500 by 5.5%, with most losses accumulating between December and February  (Chart 1). Small is down 26% off its peak in November, 2021. However, recently its relative performance has stabilized (Table 1). What’s next? Chart 1Small Outperformed On The Back of Post-Covid Recovery, But Has Been Lagging Ever Since Small Outperformed On The Back of Post-Covid Recovery, But Has Been Lagging Ever Since Small Outperformed On The Back of Post-Covid Recovery, But Has Been Lagging Ever Since Table 1Performance Summary Will Small Get Even Smaller? Will Small Get Even Smaller? Small Vs. Large Sector Composition The differences in sector composition of the S&P 500 vs. the S&P 600 have profound implications for relative performance during different stages of the business cycle and various macroeconomic regimes. On a sector level, Small has a higher allocation to Financials, Industrials, and Real Estate, while Large has more weight in Technology and Healthcare (Chart 2). Chart 2Small Vs. Large Sector Breakdown Will Small Get Even Smaller? Will Small Get Even Smaller? By grouping sectors into the cyclical vs. defensive categories, we observe that Small has a lower allocation to Defensives, and a higher allocation to Cyclicals: The Cyclical/Defensive gap between the asset classes is roughly 18%. This also indicates that Small has higher operating leverage than Large. Small is also overweight early cyclical sectors by 8% (Chart 3), which explains the underperformance of small-capitalization stocks at times of strain (corrections, economic contraction, a risk-off environment), as well as the “out-of-the-gate” behavior during recoveries and bear market rallies. Small’s higher weight in Financials increases its sensitivity to the slope of the yield curve. Chart 3Small Vs. Large Style Breakdown Will Small Get Even Smaller? Will Small Get Even Smaller? Bottom Line: Small is a more cyclical and high-octane version of Large. Macroeconomic Backdrop Nothing matters more for the relative performance of Small vs. Large than a macroeconomic backdrop that highlights differences in sector composition, credit quality, and intrinsic profitability of these asset classes. Large Caps Reign During The Slowdown Stage Of The Business Cycle The May inflation surprise has solidified the Fed’s resolve to fight inflation, which it executes by aggressive tightening of monetary conditions. A tighter monetary policy is designed to slow economic growth and curtail demand (Chart 4). As we have written over the past several months, US economic growth is already slowing and is surprising on the downside (Chart 5). Bloomberg consensus expects the economy to grow at 2.5% over the next 12 months, which is a sharp slowdown from 2021. Chart 4Financial Conditions Are Tight... Financial Conditions Are Tight... Financial Conditions Are Tight... Chart 5...And Economic Growth Is Slowing ...And Economic Growth Is Slowing... ...And Economic Growth Is Slowing... Small caps tend to underperform larger companies during the slowdown stage of the business cycle (Chart 6) due to their overweight in Early Cyclicals and shortage of Defensive Growth. In addition, slower economic growth hits smaller and less profitable companies much harder than their larger brethren. Bottom Line: Small underperforms Large during the slowdown stage of the business cycle. Chart 6Small Do Poorly During The Slowdown Phase Will Small Get Even Smaller? Will Small Get Even Smaller? Yield Curve Flattening Is Unfavorable For The Outperformance Of Small Small caps thrive in an environment of accelerating growth, which is a necessary tailwind for smaller, younger, and less profitable companies. A flatter yield curve signals upcoming growth deceleration, which is a drop of poison in the outlook for Small (Chart 7). In addition, small caps have a higher allocation to regional banks, which are extremely sensitive to the shape of the yield curve. The spread between the borrowing rate (the short-term rate on deposits) and the lending rate (on long-term loans) is the source of profitability and determines the bank’s net income margins. Prior empirical analysis validates this: During periods of a flattening yield curve, Small underperformed Large over the following three months (Chart 8). Chart 7Flattening Yield Curve Drags Down Relative Performance Of Small Vs Large Flattening Yield Curve Drags Down Relative Performance Of Small Vs Large Flattening Yield Curve Drags Down Relative Performance Of Small Vs Large Chart 8Small Underperforms When Yield Curve Is Flattening Will Small Get Even Smaller? Will Small Get Even Smaller? Recently the Treasury 10-2Y curve has flattened, coming down from 0.9% in January to 0.1% by the end of June, and is dangerously close to inversion, which is a classical predictor of a looming recession. Bottom Line: The yield curve is flattening and is close to inversion – a signal that does not bode well for the outperformance of Small vs. Large. HY Spreads Also Signal Underperformance Another important signal for Small vs. Large is the direction of change in HY spreads. Small caps are riskier and more leveraged than their large-cap peers (Chart 9). Not surprisingly, they also tend to have lower credit ratings: Indeed, the median rating for a small-cap stock is B+, which falls straight into the high-yield territory. As a result, the fate of small caps is closely tied to that of HY debt and is linked to both its spreads and its default trends. Higher yields and higher defaults would be a sign of distress for the small-cap universe. Therefore, the relative performance of small caps is inversely correlated to HY spreads (Chart 10A). Chart 9Small Caps Are More Leveraged Than Large Caps Small Caps Are More Leveraged Than Large Caps Small Caps Are More Leveraged Than Large Caps Over the past several months, HY spreads have blown out from 2.8% to 5.2% and will continue widening in the near future: As the US economy is edging towards a recession, historically low default rates are likely to rise. Spreads widening off an already high level of 500 bps historically have been followed by relative underperformance of Small over the next three months 60% of the time (Chart 10B). Bottom Line: Rising high yield spreads are a bad omen for the outperformance of small caps. Chart 10ASmall Caps Performance... Small Caps Performance... Small Caps Performance... Chart 10B...Is Inversely Correlated With HY Spreads Will Small Get Even Smaller? Will Small Get Even Smaller? Inflation Regimes Having razor-thin margins, smaller companies hate inflation. Not only do they have difficulty budgeting and planning ahead but also they are often not able to convert sales growth into earnings growth, i.e., their costs may grow faster than their revenues. According to the most recent NFIB survey, 28% of small businesses consider inflation their biggest problem compared to 1-2% in 2019 (Chart 11). The second largest problem is labor quality concerns at 23%. Of course, these two problems are inherently interlinked, igniting a wage-price spiral. Empirical analysis of the relative performance of Small vs. Large in different inflation regimes since 1984 suggests that unless inflation rolls over, Small is likely to continue to underperform (Chart 12). Bottom Line: Small will outperform once inflation turns the corner. Until then, it will lead bear market rallies that will be spurred by hopes of falling inflation and a less hawkish Fed. Chart 11No Comments Needed No Comments Needed No Comments Needed Chart 12Inflation Is A Major Headwind Will Small Get Even Smaller? Will Small Get Even Smaller? Valuations And Fundamentals Small Caps’ Valuations Are At The Lowest Level In A Decade Small caps were very cheap back in October, but they have gotten even cheaper since then. Yet another example of valuation being a poor timing tool: All too often, cheap assets just keep getting cheaper, and expensive assets get more expensive. Currently, small caps trade with a nearly 30% discount to Large both on a forward and on a trailing earnings basis, while historically, a small-cap premium was more of the norm (Table 2). The small caps’ valuations have hit the lowest level in 10 years, both on an absolute and relative basis. The BCA valuations indicator is trading more than two standard deviations below its historical average (Chart 13, top panel). The BCA technical indicator signals oversold conditions (Chart 13, bottom panel). Chart 13Cheap For A Reason Cheap For A Reason Cheap For A Reason Table 2Valuations Summary Will Small Get Even Smaller? Will Small Get Even Smaller? Bottom Line: Small caps are incredibly cheap both in real and absolute terms. They are also oversold. Small-Cap Margins Are Under Pressure Small companies are always less profitable than their large-cap brethren as they lack economies of scale, and many of these companies are either younger or less successful than bigger companies. As a result, the margins of smaller companies are usually about 500 bps lower than those of their larger peers (Chart 14). Having thin margins, small caps don’t have much room for error in dealing with the same challenges larger companies are facing, i.e., rising costs of transportation, raw materials, and energy. Yet, it is the cost of labor, which is stickier than other components and is the largest component of cost structure, that has the potential to dent the profitability of small caps. The NFIB survey shows that 25% of small businesses intend to raise employee wages, which are growing at over 5.5%. It is not surprising, that on a net basis, nearly 25% of small companies reported declining profitability (Chart 15). Therefore, it is unsurprising that margins of Small have also started to contract. Chart 14Margins To Contract Margins To Contract Margins To Contract Chart 15Profits Are Collapsing Profits Are Collapsing Profits Are Collapsing Bottom Line: The profitability of both small and large companies is under pressure, but small companies have fewer resources and are less resilient. Earnings Expectations For Small Have Turned Down, Albeit From High Levels The market expects the S&P 500 and the S&P 600 to grow earnings by 10% and 13% respectively over the next 12 months (Table 3). Small is getting more analyst upgrades than Large (Chart 16). Table 3The Street's Forecasts Will Small Get Even Smaller? Will Small Get Even Smaller? We concluded in the “Is Earnings Recession Likely?” report that earnings expectations are unreasonably high and don’t reconcile with the underlying economic conditions. Slowing economic growth is bound to weigh on earnings growth (Chart 17). We believe that an earnings recession is likely and estimates just do not reflect the reality on the ground and need to come down. Chart 16But Sell-side Analysts Are Optimistic But Sell-side Analysts Are Optimistic But Sell-side Analysts Are Optimistic Chart 17Earnings Have Turned Earnings Have Turned Earnings Have Turned Arguably, small-cap earnings growth will contract more than that of large caps, as Small is a high-octane, high-beta asset class with high exposure to cyclicals and a higher degree of operating leverage. Bottom Line: Earnings growth estimates for both Large and Small are unrealistically high and are misleading. We expect an earnings recession and negative earnings growth is likely for both asset classes. Investment Implications To sum up the analysis, we have put together a Small/Large scorecard (Table 4). Table 4Scorecard Will Small Get Even Smaller? Will Small Get Even Smaller? We conclude that the macroeconomic backdrop is extremely unfavorable for Small compared to Large. Small caps tend to underperform in the environment of slowing growth as lower levels of profitability make this asset class vulnerable in a downturn. Rising high yield spreads and the increasing probability of defaults don’t bode well for Small as it is a lower-quality asset class. Inflation is also a headwind. And last, earnings expectations for both Small and Large are too high and do not reflect the reality on the ground – earnings growth will decelerate, and earnings of Small will contract further than Large. On the positive side, Small is incredibly cheap both in relative and absolute terms. It is also oversold relative to Large. It is fair to conclude that much of the adversity is already priced in, and Small is unlikely to fall much further. On the first whiff of lower inflation, Small will bounce and will outperform Large and other asset classes. However, sustainable outperformance is unlikely until inflation rolls over and monetary conditions stabilize. We believe that for patient investors with a long investment horizon, buying Small at this level is attractive. However, on a tactical basis, we will underweight Small relative to Large until macroeconomic headwinds clear. Bottom Line Small caps are a more cyclical, lower quality, high-octane asset class than Large caps and face significant macroeconomic headwinds from slowing economic growth. Their profitability is also under pressure from rising costs of raw materials and spiraling labor costs. We recommend underweighting Small relative to Large, despite attractive valuations, until macroeconomic uncertainty dissipates, inflation turns, and earnings deceleration gets priced in. We also want to highlight that Small will be a certain leader in the bear market rallies.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation Recommended Allocation: Addendum Will Small Get Even Smaller? Will Small Get Even Smaller?  

Executive Summary Russia Squeezes EU Natural Gas Russia Squeezes EU Natural Gas Russia Squeezes EU Natural Gas Major geopolitical shocks tend to coincide with bear markets, so the market is getting closer to pricing this year’s bad news. But investors are not out of the woods yet. Russia is cutting off Europe’s natural gas supply ahead of this winter in retaliation to Europe’s oil embargo. Europe is sliding toward recession. China is reverting to autocratic rule and suffering a cyclical and structural downshift in growth rates. Only after Xi Jinping consolidates power will the ruling party focus exclusively on economic stabilization. The US can afford to take risks with Russia, opening up the possibility of a direct confrontation between the two giants before the US midterm election. A new strategic equilibrium is not yet at hand. Tactical Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 18.3% Bottom Line: Maintain a defensive posture in the third quarter but look for opportunities to buy oversold assets with long-term macro and policy tailwinds. Feature 2022 is a year of geopolitics and supply shocks. Global investors should remain defensive at least until the Chinese national party congress and US midterm election have passed. More fundamentally, an equilibrium must be established between Russia and NATO and between the US and Iran. Until then supply shocks will destroy demand. Checking Up On Our Three Key Views For 2022 Our three key views for the year are broadly on track: 1.  China’s Reversion To Autocracy: For ten years now, the fall in Chinese potential economic growth has coincided with a rise in neo-Maoist autocracy and foreign policy assertiveness, leading to capital flight, international tensions, and depressed animal spirits (Chart 1). Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Rising incomes provided legitimacy for the Communist Party over the past four decades. Less rapidly rising incomes – and extreme disparities in standards of living – undermine the party and force it to find other sources of public support. Fighting pollution and expanding the social safety net are positives for political stability and potentially for economic productivity. But converting the political system from single-party rule to single-person rule is negative for productivity. Mercantilist trade policy and nationalist security policy are also negative. China’s political crackdown, struggle with Covid-19, waning exports, and deflating property market have led to an abrupt slowdown this year. The government is responding by easing monetary, fiscal, and regulatory policy, though so far with limited effect (Chart 2). Economic policy will not be decisive in the third quarter unless a crash forces the administration to stimulate aggressively. Chart 1China's Slowdown Leads To Maoism, Nationalism China's Slowdown Leads To Maoism, Nationalism China's Slowdown Leads To Maoism, Nationalism ​​​​​​ Chart 2Chinese Policy Easing: Limited Effect So Far Chinese Policy Easing: Limited Effect So Far Chinese Policy Easing: Limited Effect So Far ​​​​​ Chart 3Nascent Rally In Chinese Shares Will Be Dashed Nascent Rally In Chinese Shares Will Be Dashed Nascent Rally In Chinese Shares Will Be Dashed Once General Secretary Xi Jinping secures another five-to-ten years in power at the twentieth national party congress this fall, he will be able to “let 100 flowers bloom,” i.e. ease policy further and focus exclusively on securing the economic recovery in 2023. But policy uncertainty will remain high until then. The party may have to crack down anew to ensure Xi’s power consolidation goes according to plan. China is highly vulnerable to social unrest for both structural and cyclical reasons. The US would jump to slap sanctions on China for human rights abuses. Hence the nascent recovery in Chinese domestic and offshore equities can easily be interrupted until the political reshuffle is over (Chart 3). If China’s economy stabilizes and a recession is avoided, investors will pile into the rally, but over the long run they will still be vulnerable to stranded capital due to Chinese autocracy and US-China cold war. If the Politburo and Politburo Standing Committee are stacked with members of Xi’s faction, as one should expect, then the reduction in policy uncertainty will only be temporary. Autocracy will lead to unpredictable and draconian policy measures – and it cannot solve the problem of a shrinking and overly indebted population. If the Communist Party changes course and stacks the Politburo with Xi’s factional rivals, to prevent China from going down the Maoist, Stalinist, and Putinist route, then global financial markets will cheer. But that outcome is unlikely. Hawkish foreign policy means that China will continue to increase its military threats against Taiwan, while not yet invading outright. Beijing has tightened its grip over Tibet, Xinjiang, and Hong Kong since 2008; Taiwan and the South China Sea are the only critical buffer areas that remain to be subjugated. Taiwan’s midterm elections, US midterms, and China’s party congress will keep uncertainty elevated. Taiwan has underperformed global and emerging market equities as the semiconductor boom and shortage has declined (Chart 4). Hong Kong is vulnerable to another outbreak of social unrest and government repression. Quality of life has deteriorated for the native population. Democracy activists are disaffected and prone to radicalization. Singapore will continue to benefit at Hong Kong’s expense (Chart 5). Chart 4Taiwan Equity Relative Performance Peaked Taiwan Equity Relative Performance Peaked Taiwan Equity Relative Performance Peaked ​​​​​​ Chart 5Hong Kong Faces More Troubles Hong Kong Faces More Troubles Hong Kong Faces More Troubles ​​​​​​ Chart 6Japan Undercuts China Japan Undercuts China Japan Undercuts China China and Japan are likely to engage in clashes in the East China Sea. Beijing’s military modernization, nuclear weapons expansion, and technological development pose a threat to Japanese security. The gradual encirclement of Taiwan jeopardizes Japan’s vital sea lines of communication. Prime Minister Fumio Kishida is well positioned to lead the Liberal Democratic Party into the upper house election on July 10 – he does not need to trigger a diplomatic showdown but he would not suffer from it. Meanwhile China is hungry for foreign distractions and unhappy that Japan is reviving its military and depreciating its currency (Chart 6). A Sino-Japanese crisis cannot be ruled out, especially if the Biden administration looks as if it will lose its nerve in containing China. Financial markets would react negatively, depending on the magnitude of the crisis. North Korea is going back to testing ballistic missiles and likely nuclear weapons. It is expanding its doctrine for the use of such weapons. It could take advantage of China’s and America’s domestic politics to stage aggressive provocations. South Korea, which has a hawkish new president who lacks parliamentary support, is strengthening its deterrence with the United States. These efforts could provoke a negative response from the North. Financial markets will only temporarily react to North Korean provocations unless they are serious enough to elicit military threats from Japan or the United States. China would be happy to offer negotiations to distract the Biden administration from Xi’s power grab. South Korean equities will benefit on a relative basis as China adds more stimulus. 2.  America’s Policy Insularity: President Biden’s net approval rating, at -15%, is now worse than President Trump’s in 2018, when the Republicans suffered a beating in midterm elections (Chart 7). Biden is now fighting inflation to try to salvage the elections for his party. That means US foreign policy will be domestically focused and erratic in the third quarter. Aside from “letting” the Federal Reserve hike rates, Biden’s executive options are limited. Pausing the federal gasoline tax requires congressional approval, and yet if he unilaterally orders tax collectors to stand down, the result will be a $10 billion tax cut – a drop in the bucket. Biden is considering waiving some of former President Trump’s tariffs on China, which he can do on his own. But doing so will hurt his standing in Rust Belt swing states without reducing inflation enough to get a payoff at the voting booth – after all, import prices are growing slower from China than elsewhere (Chart 8). He would also give Xi Jinping a last-minute victory over America that would silence Xi’s critics and cement his dictatorship at the critical hour. Chart 7Democrats Face Shellacking In Midterm Elections Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning ​​​​​​ Chart 8Paring Trump Tariffs Won't Reduce Inflation Much Paring Trump Tariffs Won't Reduce Inflation Much Paring Trump Tariffs Won't Reduce Inflation Much ​​​​​​ Chart 9Only OPEC Can Help Biden - And Help May Come Late Only OPEC Can Help Biden - And Help May Come Late Only OPEC Can Help Biden - And Help May Come Late Biden is offering to lift sanctions on Iran, which would free up 1.3 million barrels of oil per day. But Iran is not being forced to freeze its nuclear program by weak oil prices or Russian and Chinese pressure – quite the opposite. If Biden eases sanctions anyway, prices at the pump may not fall enough to win votes. Hence Biden is traveling to Saudi Arabia to make amends with Crown Prince Mohammed bin Salman. OPEC’s interest lies in producing enough oil to prevent a global recession, not in flooding the market on Biden’s whims to rescue the Democratic Party. Saudi and Emirati production may come but it may not come early in the third quarter. Lifting sanctions on Venezuela is a joke and Libya recently collapsed again (Chart 9). Even in dealing with Russia the Biden administration will exhibit an insular perspective. The US is not immediately threatened, like Europe, so it can afford to take risks, such as selling Ukraine advanced and long-range weapons and providing intelligence used to sink Russian ships. If Russia reacts negatively, a direct US-Russia confrontation will generate a rally around the flag that would help the Democrats, as it did under President John F. Kennedy in 1962 – one of the rare years in which the ruling party minimized its midterm election losses (Chart 10). The Cuban Missile Crisis counted more with voters than the earlier stock market slide. 3.  Petro-States’ Geopolitical Leverage: Oil-producing states have immense geopolitical leverage this year thanks to the commodity cycle. Russia will not be forced to conclude its assault on Ukraine until global energy prices collapse, as occurred in 2014. In fact Russia’s leverage over Europe will be greatly reduced in the coming years since Europe is diversifying away from Russian energy exports. Hence Moscow is cutting natural gas flows to Europe today while it still can (Chart 11). Chart 10Biden Can Afford To Take Risks With Russia Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning ​​​​​​ Chart 11Russia Squeezes EU's Natural Gas Russia Squeezes EU's Natural Gas Russia Squeezes EU's Natural Gas ​​​​​​ Chart 12EU/China Slowdown Will Weigh On World Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning Russia’s objective is to inflict a recession and cause changes in either policy or government in Europe. This will make it easier to conclude a favorable ceasefire in Ukraine. More importantly it will increase the odds that the EU’s 27 members, having suffered the cost of their coal and oil embargo, will fail to agree to a natural gas embargo by 2027 as they intend. Italy, for example, faces an election by June 2023, which could come earlier. The national unity coalition was formed to distribute the EU’s pandemic recovery funds. Now those funds are drying up, the economy is sliding toward recession, and the coalition is cracking. The most popular party is an anti-establishment right-wing party, the Brothers of Italy, which is waiting in the wings and can ally with the populist League, which has some sympathies with Russia. A recession could very easily produce a change in government and a more pragmatic approach to Moscow. The Italian economy is getting squeezed by energy prices and rising interest rates at the same time and cannot withstand the combination very long. A European recession or near-recession will cause further downgrades to global growth, especially when considering the knock-on effects in China, where the slowdown is more pronounced than is likely reported. The US economy is more robust but it will have to be very robust indeed to withstand a recession in Europe and growth recession in China (Chart 12). Russia does not have to retaliate against Finland and Sweden joining NATO until Turkey clears the path for them to join, which may not be until just before the Turkish general election due in June 2023. But imposing a recession on Europe is already retaliation – maybe a government change will produce a new veto against NATO enlargement. Russian retaliation against Lithuania for blocking 50% of its shipments to the Kaliningrad exclave is also forthcoming – unless Lithuania effectively stops enforcing the EU’s sanctions on Russian resources. Russia cannot wage a full-scale attack on the Baltic states without triggering direct hostilities with NATO since they are members of NATO. But it can retaliate in other ways. In a negative scenario Moscow could stage a small “accidental” attack against Lithuania to test NATO. But that would force Biden to uphold his pledge to defend “every inch” of NATO territory. Biden would probably do so by staging a proportionate military response or coordinating with an ally to do it. The target would be the Russian origin of attack or comparable assets in the Baltic Sea, the Black Sea, Ukraine, Belarus, or elsewhere. The result would be a dangerous escalation. Russia could also opt for cyber-attacks or economic warfare – such as squeezing Europe’s natural gas supply further. Ultimately Russia can afford to take greater risks than the US over Kaliningrad, other territories, and its periphery more broadly. That is the difference between Kennedy and Biden – the confrontation is not over Cuba. Russia is also likely to take a page out of Josef Stalin’s playbook and open a new front – not so much in Nicaragua as in the Middle East and North Africa. The US betrayal of the 2015 nuclear deal with Iran opens the opportunity for Russia to strengthen cooperation with Iran, stir up the Iranians’ courage, sell them weapons, and generate a security crisis in the Middle East. The US military would be distracted keeping peace in the Persian Gulf while the Europeans would lose their long-term energy alternative to Russia – and energy prices would rise. The Iranians – who also have leverage during a time of high oil prices – are not inclined to freeze their nuclear program. That would be to trade their long-term regime survival for economic benefits that the next American president can revoke unilaterally. Bottom Line: Xi Jinping is converting China back into an autocracy, the Biden administration lacks options and is willing to have a showdown with Russia, and the Putin administration is trying to inflict a European recession and political upheaval. Stay defensive. Checking Up On Our Strategic Themes For The 2020s As for our long-term themes, the following points are relevant after what we have learned in the second quarter: 1.  Great Power Rivalry: The war in Ukraine has reminded investors of the primacy of national security. In an anarchic international system, if a single great nation pursues power to the neglect of its neighbors’ interests, then its neighbors need to pursue power to defend themselves. Before long every nation is out for itself. At least until a new equilibrium is established. For example, Russia’s decision to neutralize Ukraine by force is driving Germany to abandon its formerly liberal policy of energy cooperation in order to reduce Russia’s energy revenues and avoid feeding its military ambitions. Russia in turn is reducing natural gas exports to weaken Europe’s economy this winter. Germany will re-arm, Finland and Sweden will eventually join NATO, and Russia will underscore its red line against NATO bases or forces in Finland and Sweden. If this red line is violated then a larger war could ensue. Chart 13China Will Shift To Russian Energy China Will Shift To Russian Energy China Will Shift To Russian Energy Until Russia and NATO come to a new understanding, neither Europe nor Russia can be secure. Meanwhile China cannot reject Russia’s turn to the east. China believes it may need to use force to prevent Taiwan independence at some point, so it must prepare for the US and its allies to treat it the same way that they have treated Russia. It must secure energy supply from Russia, Central Asia, and the Middle East via land routes that the US navy cannot blockade (Chart 13). Beijing must also diversify away from the US dollar, lest the Treasury Department freeze its foreign exchange reserves like it did Russia’s. Global investors will see diversification as a sign of China’s exit from the international order and preparation for conflict, which is negative for its economic future. However, the Russo-Chinese alliance presents a historic threat to the US’s security, coming close to the geopolitical nightmare of a unified Eurasia. The US is bound to oppose this development, whether coherently or not, and whether alone or in concert with its allies. After all, the US cannot offer credible security guarantees to negotiate a détente with China or Iran because its domestic divisions are so extreme that its foreign policy can change overnight. Other powers cannot be sure that the US will not suffer a radical domestic policy change or revolution that leads to belligerent foreign policy. Insecurity will drive the US and China apart rather than bringing them together. For example, Russia’s difficulties in Ukraine will encourage Chinese strategists to go back to the drawing board to adjust their plans for military contingencies in Taiwan. But the American lesson from Ukraine is to increase deterrence in Taiwan. That will provoke China and encourage the belief that China cannot wait forever to resolve the Taiwan problem. Until there is a strategic understanding between Russia and NATO, and the US and China, the world will remain in a painful and dangerous transitional phase – a multipolar disequilibrium. Chart 14Hypo-Globalization: Globalizing Less Than Potential Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning 2.  Hypo-Globalization: If national security rises to the fore, then economics becomes a tool of state power. Mercantilism becomes the basis of globalization rather than free market liberalism. Hypo-globalization is the result. The term is fitting because the trade intensity of global growth is not yet in a total free fall (i.e. de-globalization) but merely dropping off from its peaks during the phase of “hyper-globalization” in the 1990s and early 2000s (Chart 14). Hypo-globalization is probably a structural rather than cyclical phenomenon. The EU cannot re-engage with Russia and ease sanctions without rehabilitating Russia’s economy and hence its military capacity – which could enable Russia to attack Europe again. The US and China can try to re-engage but they will fail. Russo-Chinese alliance ensures that the US would be enriching not one but both of its greatest strategic rivals if it reopened its doors to Chinese technology acquisition and intellectual property theft. Iran will see its security in alliance with Russia and China. China has an incentive to develop Iran’s economy so as not to depend solely on Russia and Central Asia. Russia has an incentive to develop Iran’s military capacity so as to deprive Europe of an energy alternative. Both Russia and China wish to deprive the US of strategic hegemony in the Middle East. By contrast the US and EU cannot offer ironclad security guarantees to Iran because of its nuclear ambitions and America’s occasional belligerence. Thus the world can see expanding Russian and Chinese economic integration with Eurasia, and expanding American and European integration with various regions, but it cannot see further European integration with Russia or American integration with China. And ultimately Europe and China will be forced to sever links (Chart 15). Globalization will not cease – it is a multi-millennial trend – but it will slow down. It will be subordinated to national security and mercantilist economic theory. 3.  Populism/Nationalism: In theory, domestic instability can cause introversion or extroversion. But in practice we are seeing extroversion, which is dangerous for global stability (Chart 16). Chart 15Global Economic Disintegration Global Economic Disintegration Global Economic Disintegration ​​​​​​ Chart 16Internal Sources Of Nationalism Internal Sources Of Nationalism Internal Sources Of Nationalism ​​​​​​ Russia’s invasion of Ukraine derived from domestic Russian instability – and instability across the former Soviet space, including Belarus, which the Kremlin feared could suffer a color revolution after the rigged election and mass protests of 2020-21. The reason the northern European countries are rapidly revising their national defense and foreign policies to counter Russia is because they perceive that the threat to their security is driven by factors within the former Soviet sphere that they cannot easily remove. These factors will get worse as a result of the Ukraine war. Russian aggression still poses the risk of spilling out of Ukraine’s borders. China’s Maoist nostalgia and return to autocratic government is also about nationalism. The end of the rapid growth phase of industrialization is giving way to the Asian scourge: debt-deflation. The Communist Party is trying to orchestrate a great leap forward into the next phase of development. But in case that leap fails like the last one, Beijing is promoting “the great rejuvenation of the Chinese nation” and blaming the rest of the world for excluding and containing China. Taiwan, unfortunately, is the last relic of China’s past humiliation at the hands of western imperialists. China will also seek to control the strategic approach to Taiwan, i.e. the South China Sea. China’s claim that the Taiwan Strait is sovereign sea, not international waters, will force the American navy to assert freedom of passage. American efforts to upgrade Taiwan relations and increase deterrence will be perceived as neo-imperialism. The United States, for its part, could also see nationalism convert into international aggression. The US is veering on the brink of a miniature civil war as nationalist forces in the interior of the country struggle with the political establishment in the coastal states. Polarization has abated since 2020, as stagflation has discredited the Democrats. But it is now likely to rebound, making congressional gridlock all but inevitable. A Republican-controlled House will find a reason to impeach President Biden in 2023-24, in hopes of undermining his party and reclaiming the presidency. Another hotly contested election is possible, or worse, a full-blown constitutional crisis. American institutions proved impervious to the attempt of former President Trump and his followers to disrupt the certification of the Electoral College vote. However, security forces will be much more aggressive against rebellions of whatever stripe in future, which could lead to episodes in which social unrest is aggravated by police repression. If the GOP retakes the White House – especially if it is a second-term Trump presidency with a vendetta against political enemies and nothing to lose – then the US will return to aggressive foreign policy, whether directed at China or Iran or both. In short, polarization has contaminated foreign policy such that the most powerful country in the world cannot lead with a steady hand. Over the long run polarization will decline in the face of common foreign enemies but for now the trend vitiates global stability. Chart 17Germany And Japan Rearming Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning It goes without saying that nationalism is also an active force in Iran, where 83-year-old Supreme Leader Ayatollah Khamenei is attempting to ensure the survival of his regime in the face of youthful social unrest and an unclear succession process. If Khamenei takes advantage of the commodity cycle, and American and Israeli disarray, he can make a mad dash for the bomb and try to achieve regime security. But if he does so then nationalism will betray him, since Israel and/or the US are willing to conduct air strikes to uphold the red line against nuclear weaponization. If any more proof of global nationalism is needed, look no further than Germany and Japan, the principal aggressors of World War II. Their pacifist foreign policies have served as the linchpins of the post-war international order. Now they are both pursuing rearmament and a more proactive foreign policy (Chart 17). Nationalism may be very nascent in Germany but it has clearly made a comeback in Japan, which exacerbates China’s fears of containment. The rise of nationalism in India is widely known and reinforces the trend. Bottom Line: Great power rivalry is intensifying because of Russia’s conflict with the West and China’s inability to reject Russia. Hypo-globalization is the result since EU-Russia and US-China economic integration cannot easily be mended in the context of great power struggle. Domestic instability in Russia, China, and the US is leading to nationalism and aggressive foreign policy, as leaders find themselves unwilling or unable to stabilize domestic politics through productive economic pursuits. Investment Takeaways BCA has shifted its House View to a neutral asset allocation stance on equities relative to bonds (Chart 18). Chart 18BCA House View: Neutral Stocks Versus Bonds BCA House View: Neutral Stocks Versus Bonds BCA House View: Neutral Stocks Versus Bonds Geopolitical Strategy remains defensively positioned, favoring defensive markets and sectors, albeit with some exceptions that reflect our long-term views. Tactically stay long US 10-year Treasuries, large caps versus small caps, and defensives versus cyclicals. Stay long Mexico and short the UAE (Chart 19). Strategically stay long gold, US equities relative to global, and aerospace/defense sectors (Chart 20). Among currencies favor the USD, EUR, JPY, and GBP. Chart 19Stay Defensive In Q3 2022 Stay Defensive In Q3 2022 Stay Defensive In Q3 2022 ​​​​​​ Chart 20Stick To Long-Term Geopolitical Trades Stick To Long-Term Geopolitical Trades Stick To Long-Term Geopolitical Trades ​​​​​​ Chart 21Favor Semiconductors But Not Taiwan Favor Semiconductors But Not Taiwan Favor Semiconductors But Not Taiwan ​​​​​ Chart 22Indian Tech Will Rebound Amid China's Geopolitical Risks Indian Tech Will Rebound Amid China's Geopolitical Risks Indian Tech Will Rebound Amid China's Geopolitical Risks ​​​​​ Chart 23Overweight ASEAN Overweight ASEAN Overweight ASEAN Go long US semiconductors and semi equipment versus Taiwan broad market (Chart 21). While we correctly called the peak in Taiwanese stocks relative to global and EM equities, our long Korea / short Taiwan trade was the wrong way to articulate this view and remains deeply in the red. Similarly our attempt to double down on Indian tech versus Chinese tech was ill-timed. China eased tech regulations sooner than we expected. However, the long-term profile of the trade is still attractive and Chinese tech will still suffer from excessive government and foreign interference (Chart 22). Go long Singapore over Hong Kong, as Asian financial leadership continues to rotate (see Chart 5 above). Stay long ASEAN among emerging markets. We will also put Malaysia on upgrade watch, given recent Malaysian equity outperformance on the back of Chinese stimulus and growing western interest in alternatives to China (Chart 23).     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

In this week’s report “Adaptive Expectations: Revisiting Our Views”, we concluded that the S&P 500 is unlikely to find a bottom until inflation turns and monetary conditions stabilize, and US equities will follow a “fat and down” trajectory. We recommended that investors should overweight defensives vs. cyclicals. Accordingly, today we downgrade our overweight in Travel complex (Hotels, Cruises, and Airlines) to underweight. As a reminder, we recently moved retailing and durables categories to below benchmark. The key reason for this call is the effect of persistently high inflation on discretionary spending. In the past, we have written about the bifurcation of the US consumer, and that, while lower-income Americans are struggling with soaring prices of food, gas, and shelter, wealthier Americans are more comfortable and just shift their spending away from goods to services, such as eating out and travel. We expect strong profits for the travel sector this summer on the back of strong consumer demand and return of the business and international travel. We have discussed the drivers of the industry in these reports (here and here). Yet, markets are forward-looking, and the outlook for the industry beyond the summer months is dimming. With inflation entrenched, now even middle- and upper-class Americans as well as retirees are also starting to feel the pain. The US equity and bond market selloffs of the past 12 months have wiped out about $12 trillion and $3.5 trillion off their respective market value. This adds up to a combined $15.5 trillion or about 60% of US GDP (Chart 1). These are nest eggs and pensions shrinking by the day, diminishing future spending, and causing anxiety about the future. And while the S&P 500 is still at a level above the pandemic lows, adjusted for inflation, most of the gains are gone. On top of the reduced value of investments, negative real wage growth dampens consumer confidence (Chart 2). To make things worse, fears of recession and impending layoffs are pervasive in media stories, stoking fear of the future, and perhaps, making an economic downturn a self-fulfilling prophecy. Therefore, even wealthier Americans may have to tighten their belts and reduce their discretionary spending, with travel and leisure categories being on top of their list. Chart 1 CHART 1 CHART 1 Chart 2 CHART 2 CHART 2 Therefore, after the summer vacation surge is over, hotels and airlines are likely to experience slower demand which will weigh on their sales and pricing power. At the same time, these are industries most affected by the rising cost of fuel (airlines and cruise lines) and rising wages (hotels). As a result, we expect profitability to diminish and earnings growth recovery to stall. We have a negative outlook on the travel industry on a tactical time horizon. Bottom Line: Entrenched inflation is weighing on discretionary spending, and travel is likely to be the next victim of curtailed spending. We downgrade the S&P Hotels and the S&P Airlines indexes from overweight to underweight.  

Executive Summary Surge In Yields Tanked Equities Surge In Yields Tanked Equities Surge In Yields Tanked Equities In this week’s report, we conduct a post-mortem analysis of the past week’s market panic and probe the effect of the new developments on US equities. Inflation is embedded. US equities won’t find a bottom until inflation turns decisively.  The Fed will continue to tighten monetary policy, and rates will rise until inflation rolls over. The Fed “put” is also no longer at play as the Fed has signaled that it cares far more about combating inflation than about the performance of the stock market. Economic growth is decelerating and is already surprising on the downside. Watch rates. With rates stable, the S&P 500 performance will be a function of earnings growth. With rates rising, the multiple will contract and will exacerbate the damage done by the earnings recession. Bottom Line: The S&P 500 is unlikely to find a bottom until inflation turns and monetary conditions stabilize. In addition, economic growth is slowing and an earnings recession is likely. We believe US equities will follow a “fat and down” trajectory in light of the recent developments. We recommend that investors “not be heroes” and keep sector allocation close to the benchmark. Overweight defensives vs. cyclicals. Feature The May CPI reading showed that despite the Fed’s “heroic actions,” inflation has not yet peaked—a data point that has shocked both the market and Fed officials. In an unprecedented move, the Fed, which prides itself on its transparent communication style and its ability to move the market by guiding its expectations, leaked its intention to raise rates by 75 bps to the WSJ despite the communications blackout period. Since last Friday, equity markets around the globe have been in turmoil, with the S&P 500 falling 8%. The NASDAQ is down 7%. Is this just a leg down of the “Fat and Flat” market we have called for with a rebound waiting in the wings, or is there a structural change in the inflationary backdrop and a relentless bear market set to continue? To answer these questions, we will revisit our macroeconomic calls to better understand what expectations need to be adapted to the new reality and what we should expect for US equities over the next three to six months. Sneak Preview: US equities are likely to fall further as monetary conditions continue to tighten and earnings growth is set to contract. We believe that equities will trade in a wide “channel” with multiple rallies and pullbacks, but the general direction is down until inflation turns decisively, and fears of recession dissipate. Why Did Equities Tank? The last few days in the markets were simply brutal. What were investors (and the Fed) panicking about? Here is our hunch: Inflation is not abating, while growth is slowing. Are we in the early innings of stagflation? We believe that stagflation is certainly a high risk. The Fed’s aggressive tightening of monetary conditions is bound to further slow economic growth and taper demand. However, the Fed has no means of controlling the supply side of the equation such as prices of food or energy, which surge because of constrained supply. Will monetary tightening be even more aggressive than expected? Will 75-bps rate rises become the Fed’s new normal? During the press conference, Chairman Powell reassured the market that a 75-bps rate hike is an extraordinary measure. However, both 50-bps and 75-bps rate hikes will be on the table in July. Are the markets on the cusp of a new monetary regime, and is the easy money of the past 12 years a thing of the past? The Fed’s balance sheet has increased from $2 trillion in 2009 to an unprecedented $9 trillion in 2022. This ultra-easy monetary policy has lifted asset values both in private and public markets. The new monetary regime of liquidity being drained from the financial markets to combat inflation is bound to be a major headwind for most asset classes. We believe that it will take a while to bring inflation back to the 2% target, and easy money in the near future is no longer in the cards. It is also unlikely that such a major Fed balance sheet expansion will ever be repeated. The Fed’s tightening via both rising rates and QT will result in a dearth of liquidity in the fixed income space— a credit/counterparty “black swan” may materialize, with MBS most exposed to this risk yet again. Withdrawal of liquidity is a hit to many asset classes, from private markets to unprofitable small-cap growth companies to fixed income markets. This is a serious concern that should be monitored. Incorporating New Data Into Macro And Market Calls We have been writing about these calls for a few months—let’s revisit them here to consider what may have changed recently. Peak Inflation Is Elusive We have never quite bought the argument of transitory inflation. To us, inflation is a product of excessive demand fueled by ultra-easy fiscal and monetary policy and supply chains hobbled by the pandemic. Recently, the situation has been exacerbated by shortages of food and energy. Inflation has spread from pandemic-related goods to “stickier” service items and is broad-based (Chart 1). The wage/price spiral is relentless (Chart 2), as consumer inflation expectations are on the rise, and the job market is on fire. Chart 1Inflation Is Entrenched And Broad-based Inflation Is Entrenched And Broad-based Inflation Is Entrenched And Broad-based   While we always believed that it would take inflation a long time to reach the coveted 2% level, we assumed that peak inflation was behind us. Our view that inflation was going to roll over was more down to a base effect rather than the Fed’s actions. In addition, we observed that demand for goods pulled forward by the pandemic had started fading, suppressed by rising prices and negative real wage growth. The Citigroup Inflation Surprise Index had also turned (Chart 3). Chart 2Wage-Price Spiral Is Relentless Wage-Price Spiral Is Relentless Wage-Price Spiral Is Relentless Chart 3Inflation Was Surprising On The Downside Inflation Was Surprising On The Downside Inflation Was Surprising On The Downside   It is little consolation that we were in good company when rattled by the May headline inflation reading, which came in at 8.5% year on year, and 1% higher than in April. Headline inflation was certainly affected by the price of food and energy, while core inflation was down to a higher price of shelter and goods (Chart 4). While energy is excluded from core inflation, it permeates all aspects of the economy, increasing costs of raw materials, manufacturing, and transportation, which eventually get passed through to the prices of goods and services. The same is the case with the rising wage bill. Chart 4Inflation Picked Up Because Of Prices Of Shelter And Core Goods Adaptive Expectations: Revisiting Our Views Adaptive Expectations: Revisiting Our Views Importantly, what is next? It would help if US shale producers ramped up production, and the Saudis opened their oil spigots, bringing the price of energy down. Short of that, the price of oil should become a function of a slowing economy and fading demand for goods as interest rates rise (Chart 5). While the Fed has little control over food and energy prices, wage-price dynamics fall squarely in its court. The key channel through which the Fed controls inflation is by cooling the economy and reducing the demand for labor. Rising unemployment is the only way to extinguish inflation in a decisive way. Chart 5Rates Surged Rates Surged Rates Surged Eventually, inflation will turn but it may be in fits and starts, and each data point will have a heavy effect on the pace of monetary tightening and the direction of equity markets, with lower inflation readings igniting rallies and higher readings triggering sell-offs. Inflation is embedded. Of course, sooner or later, it will abate but until then we expect a much more aggressive monetary policy. Monetary Conditions Have Tightened Dramatically As we summarized in our “Market Capitulation Scorecard,” one of the key conditions of an equity market bottom, and potentially, even a sustainable rebound, is stabilization in monetary conditions. We hypothesized that this could happen as the Fed tightens monetary conditions and growth slows and inflation turns, pulling down long rates. We also believed that the market focus is going to start shifting away from concerns about inflation to concerns about economic growth. Friday’s inflation reading has changed that – now investors worry about inflation and growth. Rates have initially skyrocketed, with the 10-year Treasury yield moving by 30bps points over the course of three days from 3.18 to 3.48. Real rates increased from 0.38% to 0.63%. US financial conditions have tightened sharply (Chart 6), moving to the neutral level.   What’s next is the most difficult question of this report. It is likely this fast and furious move in rates has accomplished in five days what usually takes weeks. Tighter monetary policy, as it stands now, until more data comes in, is priced in. These moves capture changes in dot-plot expectations revised by the Fed, with the peak rate moving from around 3% to 4%. And, of course, that move got priced into the equity space with the S&P 500 pulling back sharply (Chart 7). Chart 6Financial Conditions Are Moving Into Restrictive Territory Financial Conditions Are Moving Into Restrictive Territory Financial Conditions Are Moving Into Restrictive Territory Chart 7Surge In Yields Tanked Equities Surge In Yields Tanked Equities Surge In Yields Tanked Equities The Fed will continue to tighten monetary policy and rates will rise until inflation rolls over. However, once inflation abates, long rates are likely to stabilize, signaling slower growth ahead. The Fed Won’t Come To The Rescue The Fed “put” is no longer at play as the Fed has signaled that it cares far more about combating inflation than the performance of the stock market. In fact, falling equities will play into Powell’s hand as a negative wealth effect is likely to put a lid on inflationary pressures, with wealthier Americans paying the toll. Kansas City Fed President Esther George, the only member of the FOMC that voted against a 75bps rate hike in the June meeting (she was in favor of 50 bps) said in May: “The Federal Reserve is not targeting equity markets in its battle against inflation, but that is "one of the avenues" where the impact of tighter monetary policy will be felt".1 Further, the Fed is very concerned about a recent pick-up in the long-term consumer inflation expectations (Chart 8) and will likely err on the side of caution to manage these expectations and avoid a self-fulfilling prophecy. Chart 8The Fed Is Worried About Inflation Expectations The Fed Is Worried About Inflation Expectations The Fed Is Worried About Inflation Expectations Economic Growth Is Slowing Fast, Both At Home And Abroad A tighter monetary policy is designed to slow economic growth. The World Bank has downgraded global GDP growth expectations from 4.1% to 2.9%, and import volumes are declining. The Atlanta GDPNow forecast is hovering around zero (Chart 9). The Philly Fed survey has just crossed into negative territory (Chart 10). Retail sales are contracting both in nominal and real terms. According to the Citi Economic Surprise Index, economic growth is surprising on the downside (Chart 11). While the probability of a recession has picked up over the past few weeks, it is earnings growth disappointment that will have an adverse effect on equities in the near term. Chart 9Consensus Expectation Are Still Too High Consensus Expectation Are Still Too High Consensus Expectation Are Still Too High Chart 10Many Signs That Economy Is Slowing Sharply Many Signs That Economy Is Slowing Sharply Many Signs That Economy Is Slowing Sharply Chart 11Economic Growth Disappoints Economic Growth Disappoints Economic Growth Disappoints   We maintain our view that economic growth is decelerating and is already surprising on the downside. Earnings Growth Will Contract And Take The Market With It       We stated in last week’s “Is An Earnings Recession In The Cards?” report that this year’s sell-off has been triggered by fears of an aggressive Fed, tighter monetary policy, and rising rates. However, the decom- position of the total return demonstrates that the pullback was all about multiple contraction, while strong earnings growth helped absorb the blow. We hypothesized that the multiple contraction phase is complete and that the next leg of the bear market will be all about growth, and earnings growth in particular (Chart 12). Hence if rates stabilize, then multiples will stay at the current level, and returns will be a function of earnings growth. However, the 10-year Treasury rate increasing from 3.18 has resulted in the S&P 500 multiple contracting from 16.7 to 15.6 over the course of just three days, while earnings growth expectations have remained mostly intact. Currently, according to our very simple model (Chart 13), a 3.5% 10-year Treasury yield corresponds to the S&P 500 forward multiple of 16.8x, which is close to where the S&P 500 stands today. If rates rise further, the forward multiple will fall. Chart 12Multiple Contraction Will Be Followed By Earnings Growth Deceleration Multiple Contraction Will Be Followed By Earnings Growth Deceleration Multiple Contraction Will Be Followed By Earnings Growth Deceleration Chart 13Higher Rates Translate Into Lower Equity Multiples Adaptive Expectations: Revisiting Our Views Adaptive Expectations: Revisiting Our Views Our earnings growth model predicts that earnings growth will trend towards zero over the next three months (Chart 14). Chart 14Earnings Growth Will Trend To Zero And Then Contract Adaptive Expectations: Revisiting Our Views Adaptive Expectations: Revisiting Our Views Our scenario analysis matrix shows that if multiples stay stable around 17x forward earnings, while earnings contract by zero to five percent next quarter, the index will be flat to slightly down (Table 1). Broadly speaking, with a stable multiple, the market will move in line with earnings growth. If rates continue to rise and the multiple falls to 16x, going another 11% down is likely. Table 1The S&P 500 Target Scenario Analysis Adaptive Expectations: Revisiting Our Views Adaptive Expectations: Revisiting Our Views Watch rates. With rates stable, the S&P 500 performance will be a function of earnings growth, and the market is likely to be range-bound. With rates rising, a multiple will contract further, and equities will fall. Investment Implications: “Fat And Down” The SPX has discounted plenty of negative news now that it is officially in bear market territory. However, we believe that the S&P 500 is not yet close to the bottom. The market is again pricing in tighter monetary policy and rising rates, which is accompanied by multiple contraction. It is hard to see equities bottoming without inflation peaking. In addition, we are predicting that the next leg of the bear market will be driven by earnings growth, which is likely to contract due to an economic slowdown both at home and abroad. As such, “fat and down” may be a more likely outcome than just “fat and flat.” Bottom Line Equities will move in a wide range over the next three to six months. However, if rates are to rise further and earnings growth is to contract, they may be trading in a downward sloping “channel,” or “fat and down.” We recommend that investors “not be heroes” and keep sector allocation close to the benchmark. Overweight defensives vs. cyclicals.     Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     https://www.reuters.com/business/feds-george-policy-not-aimed-equity-markets-though-it-will-be-felt-there-cnbc-2022-05-19/#:~:text=WASHINGTON%2C%20May%2019%20(Reuters),Esther%20George%20said%20on%20Thursday.   Recommended Allocation Recommended Allocation: Addendum Is Earnings Recession In The Cards? Is Earnings Recession In The Cards?

Executive Summary Structural Tailwinds For The Franc Structural Tailwinds For The Franc Structural Tailwinds For The Franc  Volatility in FX markets is likely to remain elevated, as witnessed by the reaction of a full circle of central bank meetings this week.Policy convergence remains a good bet for interest rate curves and currency pairs. The SNB surprised markets by raising interest rates by 50 bps, to -0.25%, the first hike since 2007.Higher volatility will continue to buoy the Swiss franc in the short run.Structural appreciation in the franc is also likely over the coming decades (Feature Chart). Swiss stocks often perform well during economic downturns, but they are not particularly cheap, and are vulnerable to higher interest rates. Investors should only overweight Swiss stocks if they expect more significant downside to global stocks.Valuation favors the franc versus the dollar. However, EUR/CHF and GBP/CHF are closer to fair value. CHF/JPY is expensive; hence, the yen is a better hedge for downside economic surprises. Go short CHF/JPY as a trade.BCA’s Foreign Exchange Strategy was short CHF/SEK at 10.2 with stop loss at 10.5. That stop was hit overnight, triggering a loss of -3.3%. Stand aside for now.Bottom Line: Favor the franc over the short term against other pro-cyclical currencies, with a view to downgrade CHF when it becomes evident that economic growth is bottoming. Any further bout of Swiss equity outperformance, prompted by global risk aversion, offers an attractive selling opportunity versus Eurozone stocks.Feature Chart 1The SNB Has Capitulated To Rising Inflation The SNB Has Capitulated To Rising Inflation The SNB Has Capitulated To Rising Inflation  Volatility in FX markets is likely to remain elevated. This week, the Fed delivered its first 75 bps interest rate hike since 1994. It also increased its expected year-end level for the Fed Funds rate to 3.4% from 1.9%, and to 3.8% from 3.4% at the end of 2023. The FX market had been warming up to a hawkish surprise, but the dollar surged on the news, hitting a fresh two-decade high of 105.5, before later reversing gains.Meanwhile, the European Central Bank (ECB) held an emergency meeting on Wednesday, to try to mitigate the rise in Italian yields, which hit as high as 4.2% on Tuesday, or 243 bps over German 10-year yields. The subsequent statement released by the Governing Council offered no concrete details. Yes, the reinvestments of the proceeds from maturing debt in the Pandemic Emergency Purchase Program (PEPP) will flow mostly to peripheral markets, but investors want clarity on the nature of the long-awaited policy plan to tackle fragmentation risk in the Euro Area. As a result, peripheral bond markets will remain fragile until a bold program comes to fruition.To cement currency volatility this week, SNB Governor Thomas Jordan surprised markets by raising interest rates by 50 bps in Switzerland, to -0.25%, the first hike since the Global Financial Crisis (Chart 1). The negative interest rate threshold for sight deposits was also lowered, a move encouraging banks to pack reserves at the SNB. The Bank of England also raised interest rates in line with market expectations. The move initially disappointed GBP bulls, but sterling is holding above our 1.20 floor.An environment of monetary policy uncertainty, rising recession risks in response to high inflation, and the potential for central bank policy mistakes bodes well for safe-haven assets. In Europe, the market with the strongest defensive profile is Switzerland. In this report, we address whether investors should bet on continued appreciation of the franc and an outperformance of Swiss stocks, especially now that the SNB has turned hawkish.Switzerland Versus The WorldGlobal economic growth is slowing and a small/open economy like Switzerland’s has not been spared. The KOF economic barometer, a key leading indicator for Swiss GDP growth, has collapsed over the past twelve months from 144 to 97 as global industrial activity decelerated (Chart 2). Despite softening growth, global inflation refuses to decline, forcing central banks worldwide to lean into the slowdown. This threatens to cut the post-pandemic business cycle expansion short. Chart 2The SNB Is Tightening Into A Slowing Economy The SNB Is Tightening Into A Slowing Economy The SNB Is Tightening Into A Slowing Economy  Surprisingly, the Swiss economy is generally performing better than the rest of Europe. Historically, Swiss economic performance is procyclical due to the large share of exports within its GDP. Hence, a slowdown in global manufacturing often creates a large threat to Swiss growth. Going forward, can the Swiss economy diverge from that of the rest of the world (Chart 3)? Such a divergence is not probable, but a few factors will protect the Swiss economy:Switzerland still has one of the lowest policy rates in the G10, even after today’s 50bps interest rate increase. This has tremendously helped ease monetary conditions. Our monetary gauge is at its most accommodative level in over two decades (Chart 4). Chart 3The Swiss Economy Is Procyclical The Swiss Economy Is Procyclical The Swiss Economy Is Procyclical   Chart 4Swiss Monetary Conditions Are Still Accommodative Swiss Monetary Conditions Are Still Accommodative Swiss Monetary Conditions Are Still Accommodative  Swiss inflation remains the lowest in the G10 outside Japan. In Switzerland, the main driver of price increases has been goods, while services inflation remains subdued. Consequently, the SNB has been tolerating an appreciating franc to temper imported inflation (Chart 5), while keeping domestic borrowing costs at very accommodative levels. In its updated forecasts, the SNB now expects a -0.25% interest rate to allow Swiss inflation to moderate to 1.9% in 2023 and 1.6% in 2024. Chart 5Swiss Inflation Is Surprising To The Upside Swiss Inflation Is Surprising To The Upside Swiss Inflation Is Surprising To The Upside  Part of the reason Switzerland has low inflation has been the tremendous productivity gains, especially relative to its trading partners (Chart 6). Swiss income-per-capita is elevated, but wage growth has lagged output gains, which limits the risk of a wage-inflation spiral. It is notable that part-time employment continues to dominate job gains, implying that the need for precautionary savings will remain high in Switzerland. Chart 6A Productivity Profile For Switzerland A Productivity Profile For Switzerland A Productivity Profile For Switzerland  Higher productivity growth and the elevated national savings leave their footprint on the trade data. The Swiss trade balance is hitting fresh highs, unlike Europe or Japan (Chart 7). This could potentially create a problem for the Swiss economy as it puts upward pressure on the CHF at a time when global manufacturing output is slowing. However, Switzerland specializes in high value-added exports with an elevated degree of complexity, that stand early in global supply chains. These type of goods are likely to remain in high demand in a global environment marked by supply-chain bottlenecks and high-capacity utilization.  Chart 7Structural Tailwinds For The Franc Structural Tailwinds For The Franc Structural Tailwinds For The Franc  Finally, Switzerland does not import energy to fulfill its electricity production. Hydropower accounts for roughly 61.4% of electricity generation, followed by nuclear power at 28.5%. This has partially insulated Switzerland from the energy shock hurting economic activity and trade balances in the EU. For example, German electricity generation is 28.8% coal and 14.7% natural gas.Bottom Line: The Swiss economy is reopening and is relatively insulated from the Russia-Ukraine conflict. This limits to some degree how closely Switzerland will track the global and European economic slowdown. It creates a departure from the traditional pro-cyclicality of the Swiss economy.The SNB, The SARON Curve, And The Swiss FrancIf the Swiss economy surprises to the upside, the case for the SNB to tolerate a rising franc becomes even stronger. The pace of foreign exchange reserve accumulation is already decelerating (Chart 8). Governor Thomas Jordan has been very clear: as global prices rise, the fair value of the franc is also rising, which implies a willingness to tolerate currency strength. In a purchasing power parity framework, higher external inflation makes Swiss goods relatively cheaper. This allows foreigners to bid up the currency.Even with today’s updated pricing, the SNB is still expected to remain among the most dovish central banks in the G10 (Chart 9). If inflationary pressures prove sticky, the SNB will step up its hawkish rhetoric. If inflationary fears subside, then global rates will fall as well, which has usually been a boon for the franc. More specifically, this would be negative for the EUR/CHF cross (Chart 10). Chart 8Less Intervention By The SNB Less Intervention By The SNB Less Intervention By The SNB   Chart 9The SARON Curve Has Adjusted Higher The SARON Curve Has Adjusted Higher The SARON Curve Has Adjusted Higher   Chart 10EUR/CHF And Bund Yields Can Continue To Diverge EUR/CHF And Bund Yields Can Continue To Diverge EUR/CHF And Bund Yields Can Continue To Diverge  The Swiss economy can tolerate an appreciating CHF, but can it withstand higher interest rates? We believe so. Switzerland is a net creditor nation, but its domestic non-financial debt is also extremely elevated. Thus, the Swiss economy is vulnerable to higher rates, especially the housing market (Chart 11). Nonetheless, internal adjustments will soften the blow and increase affordability. Of note, property speculation in Switzerland has decreased in response to macroprudential measures. Growth in rental housing prices, which usually constitute the bulk of investment homes, has collapsed, but the price of owner-occupied homes has proven more robust (Chart 12). A cap on the percentage of secondary homes in any Canton as well as tighter lending standards have also helped. In a renewed update to its Financial Stability Report, Fritz Zurbrügg, Vice Chairman of the Governing Board, suggests that Swiss banks are well capitalized, especially given the recent reactivation of the countercyclical capital buffer. Chart 11Higher Rates Are A Risk For Swiss Real Estate Higher Rates Are A Risk For Swiss Real Estate Higher Rates Are A Risk For Swiss Real Estate   Chart 12Some Adjustment Already In Investment Home Prices Some Adjustment Already In Investment Home Prices Some Adjustment Already In Investment Home Prices  In the very near term, demographics might also be a tailwind. The pandemic limited immigration to Switzerland, but the working-age population is rebounding anew (Chart 13), which will create a cushion under housing and support domestic demand. Chart 13A Small Demographic Tailwind For Home Prices A Small Demographic Tailwind For Home Prices A Small Demographic Tailwind For Home Prices  Stronger aggregate demand in an inflationary world will justify the need for less monetary accommodation. In a nutshell, the SNB is likely to continue walking the path of “least regrets” like most central banks, by tightening monetary policy to meet its 2% inflation mandate, but pausing if economic conditions warrant.The currency has historically been used as a key tool for calibrating financial conditions. From a fundamental perspective, our PPP models suggest the franc is quite cheap versus the dollar but at fair value versus the euro and sterling. This is echoed by Governor Jordan, who no longer views the franc as expensive. Our models adjusts the consumption basket in Switzerland for an apples-to-apples comparison across both the UK and the eurozone (Chart 14). Chart 14AA CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP   Chart 14BA CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP  Finally, hedging costs for shorting the franc against the dollar have risen substantially (Chart 15). As such, any short bets on the franc are likely being placed naked. If the Fed ends up tempering its pace of rate hikes next year in response to weaker US activity, short-covering activity is likely to accentuate any pre-existing strength in the CHF. Chart 15Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive  Bottom Line: The franc is undervalued against the dollar, and a good hedge against a rise in volatility versus other procyclical currencies. This places the franc in a good “heads I win, tails I don’t loose too much” bet. Swiss interest rates are also likely to climb higher. However, because the franc will do the bulk of the monetary tightening, the SNB is likely to lag the expectations now embedded in the SARON curve.What About Swiss Equities?Despite the cyclical nature of the Swiss economy, Swiss equities are extremely defensive. Swiss stocks have little to do with the domestic economy and are mostly a collection of large multinationals, dominated by the healthcare and consumer staples sectors, which together account for roughly 60% of the Swiss MSCI benchmark.This defensive attribute has created its own problem for Swiss equities. Relative to the Eurozone, the Swiss market has moved massively ahead of profitability, and it is now more expensive than at the apex of the European debt crisis in 2012 (Chart 16). Moreover, the jump in German yields is becoming increasingly problematic for Swiss stocks that historically perform poorly when global interest rates are rising (Chart 17). Chart 16Swiss Stocks Are Expensive Swiss Stocks Are Expensive Swiss Stocks Are Expensive   Chart 17A Lost Tailwind A Lost Tailwind A Lost Tailwind  In the near term, Swiss equities will only be able to defy the gravitational pull created by demanding valuations and higher yields if global risk aversion remains elevated. However, once global stocks find a floor and Italian spreads begin to narrow, Swiss stocks are likely to underperform massively (Chart 18). It could take a few more weeks before the BTP/Bund spreads narrow as the recent ECB announcement was rather tepid. However, the ECB holding an emergency meeting and issuing a formal statement addressing the problem facing peripheral bond markets suggests that a formal program designed to manage fragmentation risk will emerge before the end of the summer.Beyond their defensive attributes, Swiss stocks also correlate to the Quality Factor. The robust performance of this factor since the turn of the millennium, in Europe and globally, has allowed the Swiss market to greatly outperform Eurozone equities (Chart 19). However, the Quality Factor has begun to underperform, which indicates that the Swiss market is losing another of its underpinnings. Chart 18Near-term, Follow Risk Aversion Near-term, Follow Risk Aversion Near-term, Follow Risk Aversion   Chart 19Swiss Stocks Are About Quality Swiss Stocks Are About Quality Swiss Stocks Are About Quality  These observations imply that over the next 12 to 18 months, Swiss equities will underperform their Euro Area counterparts. Materials and consumer staples stand out as the two sectors with the most extended valuations relative to their Euro Area competitors, especially since their relative performances have become dissociated from relative profits (Chart 20). They should carry maximum underweights relative to their European counterparts. The healthcare sector is Switzerland’s largest market weight. It is not as expensive relative to the Eurozone as the materials and consumer staples sectors, but it carries enough of a premium that investors should still underweight this sector relative to its eurozone competitor (Chart 21). Chart 20Dangerous Setup For Swiss Materials and Staples Dangerous Setup For Swiss Materials and Staples Dangerous Setup For Swiss Materials and Staples   Chart 21The Swiss Heavyweight Is Becoming Pricey The Swiss Heavyweight Is Becoming Pricey The Swiss Heavyweight Is Becoming Pricey  Bottom Line: The defensive nature of the Swiss market has allowed for a large outperformance over European equities. However, the Swiss market is now very expensive on a relative basis, and it is vulnerable to higher interest rates. While global risk aversion can still buoy the Swiss market in the near term, conditions are falling into place for Swiss stocks to underperform their Eurozone counterpart over a 12-to-18 month window. Materials and consumer staples are the sectors mostly likely to experience a large underperformance relative to their Euro Area competitors, followed by the healthcare sector. Investment ConclusionsVolatility in FX markets is likely to remain elevated, as witnessed by the reaction of a full circle of central bank meetings this week.Policy convergence remains a good bet for interest rate curves and currency pairs. The SNB surprised markets by raising interest rates by 50 bps, to -0.25%, the first hike since 2007 (Chart 1).Higher volatility will continue to buoy the Swiss franc in the short run.Structural appreciation in the franc is also likely over the coming decades.Swiss stocks often perform well during economic downturns, but they are not particularly cheap, and vulnerable to higher interest rates. Investors should only overweight Swiss stocks if they expect more significant downside to global stocks.Valuation favors the franc versus the dollar. However, EUR/CHF and GBP/CHF are closer to fair value. CHF/JPY is expensive; hence the yen is a better hedge for downside economic surprises. Go short CHF/JPY as a trade.BCA’s Foreign Exchange Strategy was short CHF/SEK at 10.2 with stop loss at 10.5. That stop was hit overnight, triggering a loss of -3.3%. Stand aside for now. Chester NtoniforForeign Exchange Strategistchestern@bcaresearch.comMathieu Savary Chief European StrategistMathieu@bcaresearch.com

Executive Summary Structural Tailwinds For The Franc Structural Tailwinds For The Franc Structural Tailwinds For The Franc Volatility in FX markets is likely to remain elevated, as witnessed by the reaction of a full circle of central bank meetings this week. Policy convergence remains a good bet for interest rate curves and currency pairs. The SNB surprised markets by raising interest rates by 50 bps, to -0.25%, the first hike since 2007. Higher volatility will continue to buoy the Swiss franc in the short run. Structural appreciation in the franc is also likely over the coming decades (Feature Chart).  Swiss stocks often perform well during economic downturns, but they are not particularly cheap, and are vulnerable to higher interest rates. Investors should only overweight Swiss stocks if they expect more significant downside to global stocks. Valuation favors the franc versus the dollar. However, EUR/CHF and GBP/CHF are closer to fair value. CHF/JPY is expensive; hence, the yen is a better hedge for downside economic surprises. Go short CHF/JPY as a trade. BCA’s Foreign Exchange Strategy was short CHF/SEK at 10.2 with stop loss at 10.5. That stop was hit overnight, triggering a loss of -3.3%. Stand aside for now. Bottom Line: Favor the franc over the short term against other pro-cyclical currencies, with a view to downgrade CHF when it becomes evident that economic growth is bottoming. Any further bout of Swiss equity outperformance, prompted by global risk aversion, offers an attractive selling opportunity versus Eurozone stocks. Feature Chart 1The SNB Has Capitulated To Rising Inflation The SNB Has Capitulated To Rising Inflation The SNB Has Capitulated To Rising Inflation Volatility in FX markets is likely to remain elevated. This week, the Fed delivered its first 75 bps interest rate hike since 1994. It also increased its expected year-end level for the Fed Funds rate to 3.4% from 1.9%, and to 3.8% from 3.4% at the end of 2023. The FX market had been warming up to a hawkish surprise, but the dollar surged on the news, hitting a fresh two-decade high of 105.5, before later reversing gains. Meanwhile, the European Central Bank (ECB) held an emergency meeting on Wednesday, to try to mitigate the rise in Italian yields, which hit as high as 4.2% on Tuesday, or 243 bps over German 10-year yields. The subsequent statement released by the Governing Council offered no concrete details. Yes, the reinvestments of the proceeds from maturing debt in the Pandemic Emergency Purchase Program (PEPP) will flow mostly to peripheral markets, but investors want clarity on the nature of the long-awaited policy plan to tackle fragmentation risk in the Euro Area. As a result, peripheral bond markets will remain fragile until a bold program comes to fruition. To cement currency volatility this week, SNB Governor Thomas Jordan surprised markets by raising interest rates by 50 bps in Switzerland, to -0.25%, the first hike since the Global Financial Crisis (Chart 1). The negative interest rate threshold for sight deposits was also lowered, a move encouraging banks to pack reserves at the SNB. The Bank of England also raised interest rates in line with market expectations. The move initially disappointed GBP bulls, but sterling is holding above our 1.20 floor. An environment of monetary policy uncertainty, rising recession risks in response to high inflation, and the potential for central bank policy mistakes bodes well for safe-haven assets. In Europe, the market with the strongest defensive profile is Switzerland. In this report, we address whether investors should bet on continued appreciation of the franc and an outperformance of Swiss stocks, especially now that the SNB has turned hawkish. Switzerland Versus The World Global economic growth is slowing and a small/open economy like Switzerland’s has not been spared. The KOF economic barometer, a key leading indicator for Swiss GDP growth, has collapsed over the past twelve months from 144 to 97 as global industrial activity decelerated (Chart 2). Despite softening growth, global inflation refuses to decline, forcing central banks worldwide to lean into the slowdown. This threatens to cut the post-pandemic business cycle expansion short. Chart 2The SNB Is Tightening Into A Slowing Economy The SNB Is Tightening Into A Slowing Economy The SNB Is Tightening Into A Slowing Economy Surprisingly, the Swiss economy is generally performing better than the rest of Europe. Historically, Swiss economic performance is procyclical due to the large share of exports within its GDP. Hence, a slowdown in global manufacturing often creates a large threat to Swiss growth. Going forward, can the Swiss economy diverge from that of the rest of the world (Chart 3)? Such a divergence is not probable, but a few factors will protect the Swiss economy: Switzerland still has one of the lowest policy rates in the G10, even after today’s 50bps interest rate increase. This has tremendously helped ease monetary conditions. Our monetary gauge is at its most accommodative level in over two decades (Chart 4). Chart 3The Swiss Economy Is Procyclical The Swiss Economy Is Procyclical The Swiss Economy Is Procyclical Chart 4Swiss Monetary Conditions Are Still Accommodative Swiss Monetary Conditions Are Still Accommodative Swiss Monetary Conditions Are Still Accommodative Swiss inflation remains the lowest in the G10 outside Japan. In Switzerland, the main driver of price increases has been goods, while services inflation remains subdued. Consequently, the SNB has been tolerating an appreciating franc to temper imported inflation (Chart 5), while keeping domestic borrowing costs at very accommodative levels. In its updated forecasts, the SNB now expects a -0.25% interest rate to allow Swiss inflation to moderate to 1.9% in 2023 and 1.6% in 2024. Chart 5Swiss Inflation Is Surprising To The Upside Swiss Inflation Is Surprising To The Upside Swiss Inflation Is Surprising To The Upside Part of the reason Switzerland has low inflation has been the tremendous productivity gains, especially relative to its trading partners (Chart 6). Swiss income-per-capita is elevated, but wage growth has lagged output gains, which limits the risk of a wage-inflation spiral. It is notable that part-time employment continues to dominate job gains, implying that the need for precautionary savings will remain high in Switzerland. Chart 6A Productivity Profile For Switzerland A Productivity Profile For Switzerland A Productivity Profile For Switzerland Higher productivity growth and the elevated national savings leave their footprint on the trade data. The Swiss trade balance is hitting fresh highs, unlike Europe or Japan (Chart 7). This could potentially create a problem for the Swiss economy as it puts upward pressure on the CHF at a time when global manufacturing output is slowing. However, Switzerland specializes in high value-added exports with an elevated degree of complexity, that stand early in global supply chains. These type of goods are likely to remain in high demand in a global environment marked by supply-chain bottlenecks and high-capacity utilization.  Chart 7Structural Tailwinds For The Franc Structural Tailwinds For The Franc Structural Tailwinds For The Franc Finally, Switzerland does not import energy to fulfill its electricity production. Hydropower accounts for roughly 61.4% of electricity generation, followed by nuclear power at 28.5%. This has partially insulated Switzerland from the energy shock hurting economic activity and trade balances in the EU. For example, German electricity generation is 28.8% coal and 14.7% natural gas. Bottom Line: The Swiss economy is reopening and is relatively insulated from the Russia-Ukraine conflict. This limits to some degree how closely Switzerland will track the global and European economic slowdown. It creates a departure from the traditional pro-cyclicality of the Swiss economy. The SNB, The SARON Curve, And The Swiss Franc If the Swiss economy surprises to the upside, the case for the SNB to tolerate a rising franc becomes even stronger. The pace of foreign exchange reserve accumulation is already decelerating (Chart 8). Governor Thomas Jordan has been very clear: as global prices rise, the fair value of the franc is also rising, which implies a willingness to tolerate currency strength. In a purchasing power parity framework, higher external inflation makes Swiss goods relatively cheaper. This allows foreigners to bid up the currency. Even with today’s updated pricing, the SNB is still expected to remain among the most dovish central banks in the G10 (Chart 9). If inflationary pressures prove sticky, the SNB will step up its hawkish rhetoric. If inflationary fears subside, then global rates will fall as well, which has usually been a boon for the franc. More specifically, this would be negative for the EUR/CHF cross (Chart 10). Chart 8Less Intervention By The SNB Less Intervention By The SNB Less Intervention By The SNB Chart 9The SARON Curve Has Adjusted Higher The SARON Curve Has Adjusted Higher The SARON Curve Has Adjusted Higher Chart 10EUR/CHF And Bund Yields Can Continue To Diverge EUR/CHF And Bund Yields Can Continue To Diverge EUR/CHF And Bund Yields Can Continue To Diverge The Swiss economy can tolerate an appreciating CHF, but can it withstand higher interest rates? We believe so. Switzerland is a net creditor nation, but its domestic non-financial debt is also extremely elevated. Thus, the Swiss economy is vulnerable to higher rates, especially the housing market (Chart 11). Nonetheless, internal adjustments will soften the blow and increase affordability. Of note, property speculation in Switzerland has decreased in response to macroprudential measures. Growth in rental housing prices, which usually constitute the bulk of investment homes, has collapsed, but the price of owner-occupied homes has proven more robust (Chart 12). A cap on the percentage of secondary homes in any Canton as well as tighter lending standards have also helped. In a renewed update to its Financial Stability Report, Fritz Zurbrügg, Vice Chairman of the Governing Board, suggests that Swiss banks are well capitalized, especially given the recent reactivation of the countercyclical capital buffer. Chart 11Higher Rates Are A Risk For Swiss Real Estate Higher Rates Are A Risk For Swiss Real Estate Higher Rates Are A Risk For Swiss Real Estate Chart 12Some Adjustment Already In Investment Home Prices Some Adjustment Already In Investment Home Prices Some Adjustment Already In Investment Home Prices In the very near term, demographics might also be a tailwind. The pandemic limited immigration to Switzerland, but the working-age population is rebounding anew (Chart 13), which will create a cushion under housing and support domestic demand. Chart 13A Small Demographic Tailwind For Home Prices A Small Demographic Tailwind For Home Prices A Small Demographic Tailwind For Home Prices Stronger aggregate demand in an inflationary world will justify the need for less monetary accommodation. In a nutshell, the SNB is likely to continue walking the path of “least regrets” like most central banks, by tightening monetary policy to meet its 2% inflation mandate, but pausing if economic conditions warrant. The currency has historically been used as a key tool for calibrating financial conditions. From a fundamental perspective, our PPP models suggest the franc is quite cheap versus the dollar but at fair value versus the euro and sterling. This is echoed by Governor Jordan, who no longer views the franc as expensive. Our models adjusts the consumption basket in Switzerland for an apples-to-apples comparison across both the UK and the eurozone (Chart 14). Chart 14AA CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP Chart 14BA CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP Finally, hedging costs for shorting the franc against the dollar have risen substantially (Chart 15). As such, any short bets on the franc are likely being placed naked. If the Fed ends up tempering its pace of rate hikes next year in response to weaker US activity, short-covering activity is likely to accentuate any pre-existing strength in the CHF. Chart 15Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive Bottom Line: The franc is undervalued against the dollar, and a good hedge against a rise in volatility versus other procyclical currencies. This places the franc in a good “heads I win, tails I don’t loose too much” bet. Swiss interest rates are also likely to climb higher. However, because the franc will do the bulk of the monetary tightening, the SNB is likely to lag the expectations now embedded in the SARON curve. What About Swiss Equities? Despite the cyclical nature of the Swiss economy, Swiss equities are extremely defensive. Swiss stocks have little to do with the domestic economy and are mostly a collection of large multinationals, dominated by the healthcare and consumer staples sectors, which together account for roughly 60% of the Swiss MSCI benchmark. This defensive attribute has created its own problem for Swiss equities. Relative to the Eurozone, the Swiss market has moved massively ahead of profitability, and it is now more expensive than at the apex of the European debt crisis in 2012 (Chart 16). Moreover, the jump in German yields is becoming increasingly problematic for Swiss stocks that historically perform poorly when global interest rates are rising (Chart 17). Chart 16Swiss Stocks Are Expensive Swiss Stocks Are Expensive Swiss Stocks Are Expensive Chart 17A Lost Tailwind A Lost Tailwind A Lost Tailwind In the near term, Swiss equities will only be able to defy the gravitational pull created by demanding valuations and higher yields if global risk aversion remains elevated. However, once global stocks find a floor and Italian spreads begin to narrow, Swiss stocks are likely to underperform massively (Chart 18). It could take a few more weeks before the BTP/Bund spreads narrow as the recent ECB announcement was rather tepid. However, the ECB holding an emergency meeting and issuing a formal statement addressing the problem facing peripheral bond markets suggests that a formal program designed to manage fragmentation risk will emerge before the end of the summer. Beyond their defensive attributes, Swiss stocks also correlate to the Quality Factor. The robust performance of this factor since the turn of the millennium, in Europe and globally, has allowed the Swiss market to greatly outperform Eurozone equities (Chart 19). However, the Quality Factor has begun to underperform, which indicates that the Swiss market is losing another of its underpinnings. Chart 18Near-term, Follow Risk Aversion Near-term, Follow Risk Aversion Near-term, Follow Risk Aversion Chart 19Swiss Stocks Are About Quality Swiss Stocks Are About Quality Swiss Stocks Are About Quality These observations imply that over the next 12 to 18 months, Swiss equities will underperform their Euro Area counterparts. Materials and consumer staples stand out as the two sectors with the most extended valuations relative to their Euro Area competitors, especially since their relative performances have become dissociated from relative profits (Chart 20). They should carry maximum underweights relative to their European counterparts. The healthcare sector is Switzerland’s largest market weight. It is not as expensive relative to the Eurozone as the materials and consumer staples sectors, but it carries enough of a premium that investors should still underweight this sector relative to its eurozone competitor (Chart 21). Chart 20Dangerous Setup For Swiss Materials and Staples Dangerous Setup For Swiss Materials and Staples Dangerous Setup For Swiss Materials and Staples Chart 21The Swiss Heavyweight Is Becoming Pricey The Swiss Heavyweight Is Becoming Pricey The Swiss Heavyweight Is Becoming Pricey Bottom Line: The defensive nature of the Swiss market has allowed for a large outperformance over European equities. However, the Swiss market is now very expensive on a relative basis, and it is vulnerable to higher interest rates. While global risk aversion can still buoy the Swiss market in the near term, conditions are falling into place for Swiss stocks to underperform their Eurozone counterpart over a 12-to-18 month window. Materials and consumer staples are the sectors mostly likely to experience a large underperformance relative to their Euro Area competitors, followed by the healthcare sector.  Investment Conclusions Volatility in FX markets is likely to remain elevated, as witnessed by the reaction of a full circle of central bank meetings this week. Policy convergence remains a good bet for interest rate curves and currency pairs. The SNB surprised markets by raising interest rates by 50 bps, to -0.25%, the first hike since 2007 (Chart 1). Higher volatility will continue to buoy the Swiss franc in the short run. Structural appreciation in the franc is also likely over the coming decades. Swiss stocks often perform well during economic downturns, but they are not particularly cheap, and vulnerable to higher interest rates. Investors should only overweight Swiss stocks if they expect more significant downside to global stocks. Valuation favors the franc versus the dollar. However, EUR/CHF and GBP/CHF are closer to fair value. CHF/JPY is expensive; hence the yen is a better hedge for downside economic surprises. Go short CHF/JPY as a trade. BCA’s Foreign Exchange Strategy was short CHF/SEK at 10.2 with stop loss at 10.5. That stop was hit overnight, triggering a loss of -3.3%. Stand aside for now.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Mathieu Savary Chief European Strategist Mathieu@bcaresearch.com   Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Forecast Summary