United States

Executive Summary US Treasury yields have surged in response to high US inflation and Fed tightening expectations. However, the move looks overdone in the near-term. Too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short. These factors will act to stabilize Treasury yields over the next few months, even with the cyclical backdrop remaining bond bearish. Markets Think The Fed Will Hike More Sooner And Less Later – The Opposite Is More Likely Recommendation Inception Level Inception Date Long Dec 2022/Short Dec 2024 3-Month SOFR Future 0.25 Feb 22/22 New Trade: Go long the December 2022 US SOFR interest rate futures contract versus shorting the December 2024 SOFR contract. The former discounts too many Fed hikes for this year and the latter discounts too few hikes over the next three years. Bottom Line: US Treasury yields now discount the maximum likely hawkish scenario for Fed rate hikes in 2022, with risks all pointing in the direction of the Fed delivering less than expected. Upgrade US duration exposure to neutral from below-benchmark on a tactical basis. Feature Chart 1A Near-Term Overshoot For UST Yields During the BCA Research US Bond Strategy quarterly webcast last week, we announced a shift in our recommended US duration stance, moving from below-benchmark to neutral. This move was more tactical (i.e. shorter-term) in nature, as we still strongly believe that bond markets are underestimating the eventual peak for US bond yields over the next couple of years. In the near term, however, we see several good reasons to expect the recent big run-up in US bond yields to pause, warranting a more neutral tactical duration exposure (Chart 1). We discuss those reasons – and the implications for both US duration strategy - in this report published jointly by BCA Research’s US Bond Strategy and Global Fixed Income Strategy services. Reason #1: Too Many Fed Rate Hikes Are Now Discounted For 2022 The US overnight index swap (OIS) curve currently discounts 146bps of Fed rate hikes by the end of 2022. This is a big change from the start of the year when only 77bps of hikes were priced (Chart 2). The OIS curve repricing now puts the path of the funds rate for this year well above the last set of FOMC interest rate projections published at the December 2021 Fed meeting. In other words, the market has already moved to discount a big upward shift in the FOMC “dots” for 2022, and even for 2023, at next month’s FOMC meeting. Chart 2Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely We think a more likely outcome for 2022 is that the Fed lifts rates four or five times, not six or even seven times as some Wall Street investment banks are forecasting. We set out the reasons why we think the Fed will go less than expected in the rest of this report. At a minimum, there is virtually no chance that the Fed will provide guidance to markets that is more hawkish than current market pricing, which would push bond yields even higher in the near term. Reason #2: US Inflation Will Soon Peak The relentless string of upside surprises on US inflation has been the main reason the bond market has moved so rapidly on pricing in more Fed rate hikes. The story is about to change, however, as US inflation should peak sometime in the next few months and begin to rapidly decelerate toward levels much closer to, but still well above, the Fed’s 2% inflation target. Already, the intense global inflation pressures from commodities and traded goods prices over the past year has started to lose potency. The annual growth rate of the CRB Raw Industrials index has eased from a peak of 45% in June to 18%, in line with slowing growth momentum of global manufacturing activity (Chart 3, top panel). The softening of input price pressures is evident in business survey measures like the ISM Manufacturing Prices Paid index, which typically leads US headline CPI inflation by six months and has fallen by 16 points since the peak in June (middle panel). Chart 3Global Inflation Pressures Easing The global supply chain disruptions that have caused inventory shortages in products ranging from new cars to semiconductors also appear to be easing. Supplier delivery times are shortening according to the ISM Manufacturing and Non-Manufacturing surveys (bottom panel). Combined with other indications of the loosening of supply chain logjams, like lower shipping costs, the influence of supply disruptions on inflation should diminish, on the margin. Energy prices should also soon contribute to disinflationary momentum (Chart 4). BCA Research’s Commodity & Energy Strategy service is forecasting the Brent oil price to reach $76/bbl at the end of 2022 and $80/bbl at the end of the 2023. That represents a significant decline from the current $95/bbl price that reflects a large risk premium for the potential oil market supply disruptions in response to a Russian invasion of Ukraine. A war-driven spike in oil prices does risk extending the current period of high US (and global) inflation. However, it should be noted that the annual growth in oil prices has been decelerating even as oil prices have been rising recently, showing the power of base effect comparisons that should lead to a lower contribution to overall inflation from energy prices over the next 6-12 months. ​​​​​​Chart 4Oil Prices Will Soon Turn Disinflationary Chart 5A Changing Mix Of US Consumer Spending Will Lower Overall Inflation   Looking beyond the commodity space, a shifting mix of US consumer spending should also help push overall US inflation lower. US core CPI inflation hit a 34-year high of 6.0% in January, fueled by 11.7% growth in core goods inflation (Chart 5). We anticipate that overall core inflation will slow to levels more consistent with the trends seen in more domestically focused sectors like core services and shelter, where inflation is running around 4%. US consumers have started to shift their spending patterns away from goods, which was running well above its pre-pandemic trend, back toward services, which was running below its pre-pandemic trend (Chart 6). This will help narrow the gap between goods and services inflation, particularly as easing supply chain disruptions help dampen goods inflation. Chart 6Goods Inflation Should Soon Peak​​​​​ Chart 7There Are Still Pockets Of Available US Labor Market Supply​​​​​​ Chart 8US Wage Growth Should Soon Begin To Moderate There is also the potential for some of the pressures stemming from the tight US labor market to become a bit less inflationary in the coming months. While the overall US unemployment rate of 4% is well within the range of full employment NAIRU estimates produced by the FOMC, there are notable differences across employment categories suggesting that there are still sizeable pockets of labor supply. For example, the unemployment rate for managerial and professional workers is a tiny 2.3%, while the unemployment rate for services workers was a more elevated 6.7% (Chart 7, top panel). There are also noteworthy differences in US labor market trends when sorted by wage growth. Employment in industries with lower wages – predominantly in services – has not returned to the pre-pandemic peak, unlike employment in higher wage cohorts (middle panel).1 As the US economy puts the Omicron variant in the rearview mirror, service industries most impacted by pandemic restrictions should see an increase in labor supply as workers return to the labor force. This will help close the one percentage point gap between the labor force participation rate for prime-aged workers (aged 25-54) and its pre-pandemic peak (bottom panel). This will also help to mitigate the current upturn in service sector wage growth, which reached 5.2% at the end of 2021 according to the US Employment Cost Index (Chart 8). When US inflation finally peaks in the next few months – most notably for goods prices and service sector wages – the Fed will be under less pressure to hike rates as aggressively as discounted in current bond market pricing. Reason #3: US Inflation Expectations Have Stabilized Chart 9TIPS Breakevens Are Not Telling The Fed To Be More Aggressive The Fed always pays a lot of attention to inflation expectations, particularly market-based measures like TIPS breakevens, to assess if its monetary policy stance is appropriate. The current message from breakevens is that the Fed does not have to turn even more hawkish than expected to bring inflation back down to levels consistent with the Fed’s 2% target. The 10-year TIPS breakeven is currently 2.4%, down from a peak of 2.8% and within the 2.3-2.5% range that we deem consistent with the Fed’s inflation target. Inflation expectations are even more subdued on a forward basis, with the 5-year TIPS breakeven, 5-years forward now down to 1.95% (Chart 9). Shorter term TIPS breakevens remain elevated, with the 2-year breakeven at 3.7%. We continue to favor positioning for a narrower 2-year TIPS breakeven spread – realized inflation will soon peak and the New York Fed’s Consumer Expectations survey shows that household inflation expectations for the next three years have already fallen significantly (bottom panel). Lower inflation expectations, both market-based and survey-based, suggest that the Fed can be cautious on the pace of rate hikes after liftoff next month. Reason #4: US Financial Conditions Are Tightening Alongside Cooling US Growth Momentum We have long described the link between financial markets and the Fed’s policy stance as “The Fed Policy Loop.” In this framework, the markets act as a regulator on Fed hawkishness (Chart 10). If the Fed comes across as overly hawkish, risk assets will sell off (lower equity prices, wider corporate credit spreads), the US dollar will appreciate, the US Treasury curve will flatten and market volatility measures like the VIX index will increase. All of those trends act to tighten US financial conditions, threatening a growth slowdown that will force the Fed to back off from its previous hawkish bias. Chart 10The Fed Policy Loop Financial conditions have indeed tightened as markets have priced in more Fed rate hikes in 2022 (Chart 11). Since the start of the year, the S&P 500 is down 9% year-to-date, US investment grade corporate spreads have widened 26bps, the 2-year/10-year US Treasury curve has flattened by 34bps and the VIX index has increased 11 pts. In absolute terms, US financial conditions remain highly stimulative and the risk asset selloff so far poses little threat to US economic growth. However, if the Fed were to deliver all of the rate hikes in 2022 that are currently discounted in the US OIS curve, the market selloff would deepen as investors began to worry about a Fed-engineered economic slowdown. This would lead to a more significant tightening of financial conditions, representing an even bigger risk to US growth. The Fed cannot risk appearing too hawkish too soon, with US growth momentum already showing signs of slowing (Chart 12). The Conference Board US leading economic indicator has stopped accelerating and may be peaking, US business confidence is softening and consumer confidence is very depressed according to the University of Michigan survey. Importantly, high inflation is cited as the main reason for weak consumer confidence, as wage increases have not matched price increases. If realized inflation falls, as we expect, this could actually provide a boost to consumer confidence as households would feel an improvement in real incomes and spending power – a development that could eventually lead to more Fed rate hikes in 2023 if consumer spending improves, especially if inflation stays above the Fed’s 2% target. Chart 11Fed Hawkishness Has Already Tightened Financial Conditions​​​​​​ Chart 12Not The Best Time For The Fed To Be More Aggressive​​​​​ For now, however, the risk of a preemptive tightening of financial conditions will ensure that the Fed delivers fewer rate hikes than the market expects this year. Reason #5: Treasury Market Positioning Is Now Very Short Chart 13Reliable Bond Indicators Calling For A Pause In The UST Selloff The final reason to increase US duration exposure now is that Treasury market positioning has become quite short and has become a headwind to higher bond yields and lower bond prices. The JP Morgan fixed income client duration survey shows that bond investors are running duration exposures well below benchmark (Chart 13). Speculators are also running significant short positions in longer-maturity US Treasury futures. This suggests limited selling power in the event of more bond bearish news and increased scope for short-covering in the event of risk-off event – like a shooting war in Ukraine – or surprisingly negative US economic data. On that front, the Citigroup US data surprise index, which is typically highly correlated to the momentum of US Treasury yields, has dipped a bit recently but remains at neutral levels (top panel). A similar measure of neutrality is sent by some of our preferred cyclical bond indicators like the ratio of the CRB raw industrials index to the price of gold – the 10-year yield is now in line with that ratio, which appears to be peaking (middle panel). Investment Conclusions Given the five reasons outlined in this report – too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short – we decided last week to upgrade our recommended US portfolio duration to neutral from below-benchmark. However, this move is only for a tactical investment horizon. We still see the cyclical backdrop as bond bearish, as Treasury yields do not yet reflect how high US interest rates will rise in the upcoming tightening cycle. The 5-year Treasury yield, 5-years forward is currently at 2.0%. This lies at the low end of the range of estimates of the longer-run neutral fed funds rate (Chart 14) from the New York Fed’s survey of bond market participants (2%) and the median FOMC longer-run interest rate projection from the Fed dots (2.5%). We see the Fed having to lift rates faster than markets expect in 2023 and 2024. US inflation this year is expected to settle at a level above the Fed’s 2% target before picking up again next year alongside renewed tightening of labor market conditions once the remaining supply of excess labor is fully absorbed. Chart 14The Cyclical UST Bear Market Is Not Over Yet Chart 15Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract As a way to position for the Fed doing fewer rate hikes than expected in 2022, but more hikes than expected in 2023/24, we are entering a new trade this week – going long the December 2022 3-month SOFR US interest rate futures contract versus a short position in the December 2024 3-month SOFR contract.  The implied interest rate spread on those two contracts has tightened to 25bps (Chart 15). We expect that trend to reverse, however, with the spread increasing as markets eventually move to price out rate hikes in 2022 and price in much more Fed tightening in 2023 and 2024. We will discuss the implications of the shift in our US duration stance for our views on non-US bond markets in next week’s Global Fixed Income Strategy report. Our initial conclusion is that our country allocation recommendations for government bonds will remain unchanged – underweighting the US, UK, and Canada; overweighting core Europe, peripheral Europe, Japan and Australia – but we will also increase duration exposure within most (if not all) countries. As in the US, we also see markets pricing in too many rate hikes in the UK and Canada for 2022 but too few rate hikes over the next two years. On the other hand, markets are pricing in too many rate cumulative hikes over the next 2-3 years in Europe, Australia and Japan (Table 1). Table 1Markets Have Pulled Forward Rate Hikes Everywhere   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The definitions for the wage cohorts can be found in the footnote of Chart 7. Cyclical Recommendations (6-18 Months) Tactical Overlay Trades

Special Report

Executive Summary Earnings Growth Outpacing Multiple Expansion The US Energy sector is in a good place right now: Rising demand and faltering supply from OPEC 2.0 translate into a price of oil anchored at around $80 to $85/bbl. This price is twice the breakeven production cost for the majority of US producers. High prices have also created an opening for US Energy producers to restart Capex to increase production. Further, the Energy sector tends to outperform in an environment of high inflation and rising rates. As a real asset, oil is also a good inflation hedge, a quality that extends to Energy-related equities.  The favorable macro backdrop is also complimented by bombed-out valuation. Meanwhile, technicals are overbought signaling that a near-term pause is needed for prices to reset. Bottom Line: We reiterate our cyclical overweight in the Energy sector, despite the rising probability or a near-term pullback. Within Energy, we recommend a cyclical overweight of the upstream and equipment & services segments, underweight midstream, and equal weight downstream and integrated stocks.  Feature Dear client, In lieu of the February 28th publication, we will be sending you a Special Report on Wednesday, February 23rd written by our US Political Strategy service colleagues. Our regular weekly publication will resume Monday, March 7th. Kind Regards, Irene Tunkel Chief Strategist, US Equity Strategy Part I Recap Last week, in Part I of this Special Report, we described the structure of the Energy sector, its value chain, key industry drivers, and supply/demand/oil price dynamics. The Energy value chain consists of four distinct segments, with each segment corresponding to a section of the oil production value chain. The GICS classifies them as Oil & Gas Exploration and Production (Upstream or E&P), Oil & Gas Equipment and Services (E&S), Storage and Transportation (Midstream or S&T), and Refining and Marketing (Downstream or R&M). Integrated Oil & Gas straddles the entire supply chain (Integrated). Demand exceeds supply: We concluded that crude oil demand is expected to return to trend, driven by strong economic growth and the receding pandemic. In the meantime, production remains suppressed because of curtailments by OPEC 2.0 members, investment restraint from US producers, and multiple supply disruptions. Sizzling tensions with Iran, Russia, and a possible new market share war with the Saudis exacerbate supply problems and lead to heightened volatility in crude oil prices. The US Energy producers are ramping up supply: To meet the increasing oil demand, US shale oil producers are now perfectly positioned to pick up the slack in supply. To ramp up production, the US oil companies will have to invest in new and existing wells, starting a new Capex cycle, after “seven lean years” of Capex (Chart 1). There are early signs that the US Energy sector is in the early innings of new Capex and production. This week, we rely on our investment process, i.e., analysis of the macroeconomic backdrop, fundamentals, valuations, and technicals to shape our view on each segment of the Energy value chain. We are currently overweight the Energy sector and are ahead of the benchmark by 35%. Chart 1The Energy Industry Is In The Early Innings Of New Capex Cycle Macroeconomic Backdrop Can Withstand Rising Rates And High Inflation The Energy sector tends to outperform in the environment of high inflation and rising rates (Chart 2). As a real asset, oil is also a good inflation hedge, a quality that extends to Energy-related equities. Appreciating Dollar Is A Temporary Phenomenon There is a tight inverse relationship between the USD and energy prices due to the simple fact that commodity prices are quoted in dollars. Over the past seven years, the nominal WTI oil price has been over 70% inversely correlated with the strength of the USD trade-weighted index (TWI), with a beta of oil to USD of -1.6. That is, a 1% change in the TWI would be expected to translate into a $1.60/barrel change in the price of WTI (Chart 3). Chart 2The Energy Sector Is Resilient To Rising Rates Chart 3Price Of Oil And USD Are Inversely Correlated According to the BCA Research FX Strategy team, the recent dollar strengthening is a temporary phenomenon, catalyzed by the rising interest-rate differential with the rest of the world. However, historically, equity portfolio flows have been more important than other factors in explaining dollar moves. Rising rates undermine the performance of US equities and are likely to lead to a reversal in cross-border equity flows, damaging the key pillar of support for the dollar. Hence, risks to the dollar are on the downside. Fundamentals And Valuations The Energy Sector Is Enjoying Strong Sales EIA reports that “global oil consumption outpaced oil production for the six consecutive quarters, ending with the fourth quarter of 2021 (4Q21), which has led to persistent withdrawals from global oil inventories and significant increases in crude oil prices”.1 As a result of higher production, and WTI prices increasing from $52 to $85 over 2021, energy company sales have soared (Chart 4). Looking ahead, we expect sales growth to remain robust, albeit lower than in 2021: Not only are comparables more challenging, but economic growth is also decelerating. What can bring the strong sales growth to a halt? The answer is that it may be either higher prices or higher volumes: Surging prices destroy demand while surging volumes suppress oil prices, which, eventually, weigh on Capex and production. At the moment, both production levels and price are in a sweet spot: All segments of the value chain are benefiting from high but not excessive prices and volumes. Chart 4Energy Sales Surged In 2021 Chart 5Sector Profitability Is Tied To The Price Of Oil Profit Recovery Continues The overall profitability of the Energy sector is also tightly linked to the price of oil (Chart 5). The BCA Research house view is WTI centered around $80-85, with substantial volatility triggered by geopolitical tensions. With oil prices likely peaking, barring any negative geopolitical developments, earnings growth normalization off the high levels is expected (Chart 6). However, even if they are slowing, Energy sector earnings are expected to grow by 26% over the next 12 months, exceeding S&P 500 earnings by 17%. Further, over the next five years, energy earnings growth is expected to re-accelerate towards the 26% range. Chart 6Energy Sector's Earnings Growth To Exceed The Market's Chart 7Margins To Continue To Expand Importantly, sector operating margins are expected to expand towards 10% (Chart 7), which is quite a feat considering the broad-based margin contraction of the other S&P 500 sectors and industries. Our verdict? Earnings growth expectations look darn good! Despite Recent Outperformance, Valuations Are Still Attractive The BCA valuation indicator, which is a composite of P/B, P/S, and DY relative to the S&P 500, standardized relative to its own history, shows that the sector is still undervalued (Chart 8), despite a recent run of performance – earnings growth still outpaces multiple expansion (Chart 9). The energy sector is currently trading with a nearly 40% discount to the S&P 500 (Table 1) on a forward earnings basis (12.4x vs 20.3x). Chart 8Still Undervalued… Chart 9Earnings Growth Outpacing Multiple Expansion Table 1Valuation Summary Cheap But Overbought! Curiously, despite modest valuations, from a technical standpoint the sector appears overbought (Chart 10). Worse yet, our Energy Sentiment Composite is outright in the bullish zone (Chart 11) with a reading last achieved in 2009. This is certainly concerning, as euphoria is inevitably followed by panic and disappointment. However, we need to keep in mind that the technical indicators are short term in scope by design, and their main use is to help refine the position entry and exit timing. Chart 10...But Overbought! Chart 11Sentiment Is Extended Why such a pronounced dichotomy with valuations? Technical indicators are based on returns, which have been rather outstanding for the sector, while valuations take into account earnings growth, which explains and justifies the surging returns. Too Much Cash Our analysis would be amiss if we did not bring energy companies’ free cash flow (FCF) into the discussion. With a curtailed supply of energy and rising prices, these companies have been awash in cash (Chart 12) – their FCF has increased by nearly 80% year over year, and profits have surged. What will companies do with this windfall? Well, first and foremost, during the seven lean years of extreme Capex discipline, these companies have gotten their commitment to returning cash to shareholders embedded in the corporate psyche, which is something that is unlikely to change fast. Energy continues to be the highest-yielding sector in the S&P 500 (Chart 13). However, having learned the lesson the hard way, many companies are adopting variable dividends to avoid potential disappointment if the oil price collapses. In addition to disbursing cash, the energy companies are paying off debt and are investing in expanding production. Chart 12Windfall Of Cash Chart 13Energy Is The Highest Yielding Sector Investment Outlook By Segments Of The Energy Value Chain The macroeconomic backdrop for Energy appears benign, with rates rising, inflation elevated, and the dollar likely contained. The sector also appears attractive from both a profitability and a valuation standpoint. However, a near-term pullback is likely as the sentiment around the sector is overly bullish – but that is likely to be short-lived. While we like the sector overall, we aim to provide granular industry group recommendations. To do so, we will zoom in on each segment of the value chain. Oil And Gas Exploration & Production (Upstream) Strong demand recovery and OPEC 2.0 oil production shortages bode well for the US E&P companies, which are cautiously starting to restart capital investment and ramp up production. We expect the E&P, especially shale oil production, companies to be one of the best performing energy subsectors, with WTI anchored around a consensus of $80-85/bbl. The upstream segment is highly dependent on the price of oil, which is currently in a sweet spot: High but not high enough to cause demand destruction (Chart 14). With oil prices peaking, E&P sales growth is decelerating (Chart 15). However, upstream also benefits from the sustainable cost reductions achieved through improved experience in well siting, drilling, and completion techniques. Chart 14Upstream Earnings Depend On The Price Oil Chart 15Sales Growth Is Normalizing As a result of growing, albeit decelerating, sales and effective cost management, E&P is one of the most profitable segments of the energy complex: Operating margins are currently at 22% and are expected to expand to 27% (Chart 16). From a valuation standpoint, the industry is trading at 10 times forward earnings, which represents an 50% discount to the S&P 500. The BCA valuation indicator for the industry group is also in the undervalued territory (Chart 17). Chart 16Margins To Continue To Expand Chart 17E&P Is Still Cheap Overweight Oil and Gas Exploration & Production industry Equipment And Services Is A High Octane Play On The New Capex Cycle Upstream Capex is revenue for E&S companies. After “seven lean years” of the Capex cycle, the fortunes of E&S companies are finally turning, with a rising price of oil finally enticing upstream companies to expand production by reopening existing and drilling new wells (Chart 18). According to CFRA, upstream Capex is expected to increase by 25% in 2022, and 7% in 2023. With the new energy Capex cycle in sight, Oil Services is the only energy segment for which sales growth is expected to accelerate over the coming year (Chart 19). In fact, sales will continue to grow at a healthy clip until the cycle matures – a time period measured in years. Chart 18Capex Has Restarted Chart 19Sales Growth Is Rebounding Sharply   The profitability of the sector is also normalizing after a pandemic slump, and margins are expected to stay flat (Chart 20) despite industry labor costs rising sharply to 8% year over year (Chart 21). Earnings are expected to rise by a third in 2022, albeit off very low levels. Chart 20Profit Margins Will Stabilize Chart 21Rising Wages Are Cutting Into Profitability In terms of valuations, the E&S industry is one of the cheapest in the sector, with the BCA Valuations Indicator standing at -1.5 standard deviations below a long-term average. We are positive on the Energy Equipment and Services space, which we consider a high octane play on the upcoming production increases and the new energy cycle. Overweight Energy Equipment and Services Storage And Transportation Will Benefit From Rising Production Volumes The midstream segment is one of the most profitable in the energy supply chain. This industry has high fixed costs, and its profitability is a function of production volume, not oil price. (Chart 22). From that standpoint, the industry is in a good place: US production volume, especially of shale oil, is poised to increase, filling the pipelines and driving sales growth. However, there are also challenges: Pipelines installed in older shales start to see original contractual commitments expiring, resulting in lower cash flows as the pipelines try to re-commit suppliers within a market that has an abundance of pipeline capacity. On the cost side, the S&T segment is seeing an increase in labor costs, with average hourly earnings (AHE) rising close to 10%. Chart 22Production Volume Is A Driver Of Midstream Segment's Profitability With challenges on the sales side and rising costs, it is not surprising that the market expects earnings in the S&T industry to stay flat over the next year or so (Chart 23). Operating profit margins will contract over the next year from the 19% the industry is enjoying now to roughly 14% (Chart 24). Chart 23Midstream Earnings Are To Stay Flat Chart 24Industry Is Highly Profitable But Margins Are Contracting In addition, it is important to note that pipelines run through public land. The recent tightening of EPA regulations and an administration hostile to fossil fuel may halt or slow down pipeline build-out. This may be a short-term negative as some companies may have to forego some of their investments. Over the long run, this may limit pipeline availability and lead to higher energy transportation and storage costs. Underweight Energy Storage and Transportation Industry Energy Refining And Marketing– Favorable Backdrop But No Oomph Similar to the midstream segment, refiners are a high fixed cost operation, and their business is only loosely dependent on the price of oil. Profitability of downstream companies is a function of capacity utilization of the refining facilities, and the crack spread or price differential between the price of crude and refined oil. Thanks to rising demand for oil, and rising volumes, capacity utilization stands at nearly 90% and is approaching pre-pandemic levels (Chart 25, bottom panel). Crack spreads are also high in absolute terms thanks to low inventories (Chart 25, top panel). Chart 25High Capacity Utilization and Wide Crack Spreads Are A Boon For Downstream… Chart 26...But Razor-Thin Margins Make The Industry Vulnerable With the upstream segment ramping up production, refining volumes should increase, further improving capacity utilization. And while margins are razor-thin, they are projected to increase over the next year (Chart 26). The key concern about the industry is that, with margins this narrow, there is little or no buffer to absorb changes in crack spreads or capacity utilization should oil prices rise or volumes decline. And yet, downstream, while cheap, is more expensive than Oil Services, midstream, or Integrated Oil. Equal-weight Energy Refining and Marketing industry Integrated Oil & Gas Is A Safe Bet Integrated Oil is an industry that is diversified across all the segments of the value chain. The characteristics that allowed Integrated Companies to maintain their stock prices better during the downturn – less financial leverage, less reinvestment volatility, stronger dividend support, and counter-cyclical improvement of downstream operations – will work against these stocks during an oil price recovery. As such, while Integrated stocks should benefit from higher prices and production volumes, this is a lower beta proposition: It is better to own Integrated Oil on the way down, but riskier and higher beta E&P or Oil Services stocks during the up leg of the energy cycle. Equal-Weight Integrated Oil & Gas Investment Implications The US Energy sector is in a good place right now: Rising demand and faltering supply from OPEC 2.0, translates into a price of oil anchored around $80 to $85/bbl. This price is twice the breakeven production cost for the majority of the US producers. Rising oil prices had resulted in windfall profits and surging free cash flow, which the Energy companies are dutifully returning to shareholders. High prices have also created an opening for US Energy producers to restart their Capex to increase production. This positive stance of upstream companies is benefiting the entire supply chain. Energy Equipment and Services providers are enjoying accelerated sales growth as E&P increases Capex. Transportation and storage companies are benefiting from higher volumes. And last, the downstream segment benefits from high-capacity utilization of its refineries and wide crack spreads thanks to low refined oil inventories. We are cyclically positive on the Energy sector, the fundamentals of which are solid, and for which valuations are modest. However, overextended technicals indicate that a near-term correction after a strong run is highly likely. We won’t sell to avoid the pullback but will use it as an opportunity to add to the existing positions. Within the Energy Sector, we are constructive on the upstream and E&S segments, both of which benefit from the high price of oil. We are less keen on the midstream segment, which, despite the benefits of increased production volume, is handicapped by rising labor costs, and expiring transportation contracts. And lastly, we are equal-weight the downstream segment, which, despite rising volumes and wide crack spreads, has razor-thin margins. Integrated Oil is the most diversified segment, which is more resilient during the down leg of the energy cycle, but too tame during the upcycle. Bottom Line We recommend a cyclical overweight to the Energy sector as it is in the early innings of the new energy cycle, thanks to surging demand and constrained production capacity out of the US. It is also the highest yielding sector in the S&P 500. However, a near-term pullback after a strong run is likely – we will leverage it to add to our existing overweight. We also recommend a cyclical overweight of the upstream and Oil Equipment & Services segment, underweight midstream, and equal weight downstream.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com       Footnotes 1     https://www.eia.gov/outlooks/steo/   Recommended Allocation

Executive Summary While inflation has unquestionably surprised to the upside, the US will not enter a self-reinforcing spiral unless an inflation mindset takes hold throughout the economy. The two leading surveys have wildly different takes on consumer confidence. The available evidence sides with the Conference Board’s robust reading rather than the University of Michigan’s dismal one. We are not concerned about housing’s near-term outlook. There is an undersupply of homes in America and mortgage rates have not backed up enough to put a meaningful dent in demand. Financial markets are jumpy and will likely remain hypersensitive to speculation about the Fed’s policy choices. We nonetheless continue to favor risk assets over the next twelve months and will look out for tactical buying opportunities whenever volatility is on the cusp of easing. Consumers Aren't Chasing High Prices And That's A Good Sign Bottom Line: The ride is likely to be bumpy for financial markets this year, but we expect it will ultimately be rewarding. Growth will hold up despite recurring fears. Feature Our recent discussions with colleagues and investors indicate that US financial market participants are preoccupied with one of three issues: a potential inflation breakout, a slowdown induced by a consumption shortfall or, worse yet, both. We add to our thoughts on inflation and consumption after digging into some less-watched series, and check in on the housing market following the surge in mortgage rates. Our conclusion remains unchanged: we still expect potent growth in 2022, and we think investors should maintain at least equal weight exposures to risk assets. Amidst elevated volatility brought on by Fed uncertainty, however, investors should be willing to act more opportunistically. Consumers Are Not Adding Fuel To The Fire … We have spoken repeatedly about the inflation mindset, a concept lifted from Japan’s ongoing experience with chronic stagnation. The malaise ailing Japan is in large part attributable to the deflation mindset that has swept consumers, businesses and investors. Economic participants conditioned to expect continuously falling prices change their behavior to adapt to them, so consumers have put off discretionary purchases, anticipating that goods will be cheaper (and better) next year; businesses confronting steadily falling revenue have shunned investment in favor of shrinking their cost bases to preserve profit; and investors have been willing to funnel capital to the lowest-yielding sovereign bonds in the world, content with meager purchasing power accretions. The central theorem of macroeconomics – my spending is your income and your spending is my income – has sentenced the economy to quietly wither in a self-reinforcing loop. Conversely, we believe an inflation mindset in which economic actors expect continually rising prices is a necessary precondition for an upward inflation spiral. The spiral is stoked by a chain reaction of worker and investor demands for increased compensation, wholesale and retail price hikes, and consumers’ rush to maximize their declining purchasing power by buying ahead of the next inevitable increase. Despite all the inflation agita, Treasury investors are untroubled about its long-run prospects, as their 5-year inflation expectations five years from now remain below the bottom end of the Fed’s target range (Chart 1). The hedgers, speculators and market makers who compose the CPI swaps market are also serene (Chart 2). Though all parties see intense price pressures lasting for another year, they expect them to dissipate over time (Table 1). Chart 1Long-Run Inflation Expectations Are Subdued, ... Chart 2... Despite Big Near-Term Swings Per the University of Michigan’s sentiment survey, consumers also anticipate that near-term inflation pressures will fade in the intermediate term (Chart 3). They are consequently wary about making large purchases at a price they’ll later come to regret. Viewing today’s high prices as temporary, they think it is a historically inopportune time to buy cars, houses and large household durables. Their responses suggest that the inflation mindset has yet to make any headway with consumers; for now, there is no danger that shoppers harbor inflation fears that could become self-fulfilling. Table 1The Inflations Expectations Curve Is Sharply Inverted Chart 3Survey Says: Temporary! The share of respondents citing sticky/rising prices as a reason for buying cars now is at very low levels (Chart 4, top panel) while those citing high prices as a reason not to buy continues to make record highs (Chart 4, middle panel). The spread between the two has never been wider (Chart 4, bottom panel) – a sizable majority of consumers with discretion over when they buy is committed to waiting out the conditions that have sent prices zooming higher. Chart 4Resisting A Spiral Michigan respondents have been on the right side of chronically deflating new car prices, as those who think prices won’t come down have been nearly continuously outnumbered for the last 40 years (Chart 5, bottom panel). Since vehicle buying conditions became a regular survey component, there have been only three stretches when consumers reported a net urgency to buy, all of which coincided with real increases in new car prices (Chart 5, top panel). The chart is silent on the direction of causality, though we would suspect that consumer urgency follows from observed price increases, which it then amplifies and/or extends. Chart 5Just Say No The Michigan surveyors also ask consumers about the timeliness of buying houses and major household durables. Charts for houses (not shown) and durables (Chart 6) look much like cars, though the Good-Won’t Come Down/Bad-Prices Are High spread for houses is as persistently negative as it is for cars (ex-the 2012 to 2015 recovery from the aftermath of the housing bust). Consumer demand for the biggest-ticket items is apparently more elastic than it is for major appliances. Chart 6Consumers Aren't Chasing Household Durables Prices Higher,Either Bottom Line: Consumers are disinclined to go along with surging prices on big-ticket items. An inflationary spiral will not take hold while they are committed to putting off major purchases with the expectation that they will get a better deal in the future. … But Could They Be Losing Their Nerve? Consumers’ discipline has positive inflation implications, but the bombed-out vehicle buying conditions chart in the Executive Summary could be sending a worrisome growth signal. Foregone spending is lost income, and if enough buyers defer purchases, a recession could be just around the bend. True enough, but investors should keep in mind that the buying conditions indexes measure demand urgency, not overall demand. Those with discretion over the timing of their purchases may be holding off, but American consumers are not turning Japanese. Surging home and new and used car prices eloquently testify to fierce competition among buyers. We do not therefore see cause for concern in the diverging consumer confidence surveys. Over time, the indexes produced by the Conference Board and the University of Michigan have tended to send similar messages (Chart 7). The relationship has frayed over the last five years, however, and the two series completely diverged last spring. That would be of no more than passing interest if the composite average of both surveys’ expectations component had not formerly been such a reliable coincident indicator of real consumption growth (Chart 8). Chart 7Parting Company Chart 8The Confidence-Consumption Link Has Been Severed Investors may wonder whether consumption will take its lead from the Conference Board’s cheer or Michigan’s gloom. The Conference Board survey consists of just five questions asking respondents to assess current business and employment conditions and offer their six-month expectations about business conditions, employment conditions and their family’s income. The more extensive Michigan survey runs to twelve full pages, touching on business conditions; personal finances; economic policy; unemployment, interest-rate, inflation and home-price expectations; and buying conditions for homes, household durables and motor vehicles. A layperson reading through the Michigan survey might think it was designed to provoke anxiety in unsuspecting respondents – what are the chances your income will keep pace with inflation, that you or your spouse will involuntarily lose a job over the next five years, that you will have enough money for retirement, etc. – but its readings are not uniformly bleak. Since the financial crisis, it has tended to be cheerier than the Conference Board survey when inflation is low or negative while its relative nosedive has coincided with inflation’s breakout (Chart 9). The relationship would logically follow from the Michigan survey’s explicit focus on inflation and one’s personal relation to it. The Conference Board survey is linked much more closely to perceptions of the job market (Chart 10) and it may therefore be expected to lag during disinflationary/deflationary periods but outperform when inflation accelerates. Chart 9The Michigan Survey Is Sensitive To Inflation, ... Chart 10... While The Conference Board's Tracks Strength In The Labor Market Bottom Line: Given the robust growth outlook, we are inclined to side with the Conference Board’s upbeat consumer confidence reading. We do not expect that flush households with pent-up demand will turn into misers. The 2,400-Square-Foot Gorilla Chart 11Level Trumps Direction The sharp backup in mortgage rates so far this year has many observers concerned about the potential consequences of a housing slowdown. A major slump would idle construction workers, pressure housing industry suppliers, and dampen demand for the furnishings and major appliances that fill homes. We think the concerns are overdone and believe that the housing market will be well supported through the rest of the year. Affordability concerns come back to the level-versus-direction debate that has flared ever since real economic growth began to decelerate from its torrid 6.5% pace in the first half of last year. 3% or 4% is nothing to sneeze at for an economy with a long-run trend growth rate of 1.75 – 2%, however. Deceleration from an extremely high level to a very high level still leaves room for ample corporate earnings gains and risk assets duly delivered chunky excess returns across last year’s second half. 30-year fixed mortgage rates have risen 100 basis points from their pandemic low but remain extremely low relative to history (Chart 11, middle panel). As a result, homes remain quite affordable (Chart 11, top panel), despite the relative increase in median home prices (Chart 11, bottom panel). The horizontal line across the affordability series puts its level into a fuller context. Except for a few years in the early seventies, when the median home price was just two-and-a-half times median household income, affordability never exceeded 140 before the global financial crisis ushered in zero interest rate policy. A supply shortfall will bolster the market. Household formations have outstripped housing starts by a wide margin over the last two years (Chart 12, top panel) and available inventory (Chart 12, middle panel) and vacant units (Chart 12, bottom panel) are at all-time lows. Homebuilder sentiment is firing on all cylinders (Chart 13, top panel), as current sales are strong (Chart 13, second panel), buyer traffic remains elevated (Chart 13, third panel) and future sales expectations are rosy (Chart 13, bottom panel). Chart 12There Isn't Enough Supply ...​​​​​​ Chart 13... And Builders Know It​​​​​​ Bottom Line: Despite the backup in mortgage rates and twelve months of turbo-charged home price appreciation, housing will do just fine this year. A slump weighing on employment and activity is not in store. Investment Implications 2022 has so far been characterized by the serial emergence of issues that have roiled financial markets. Rising rates/falling tech stocks, impending Fed rate hikes, persistent upside inflation surprises and Ukraine have combined to push the VIX into the 20s and 30s, knock the S&P 500 down 9% and drive losses in Treasuries and spread product. We expect that concerns about Fed policy, growth and inflation will linger throughout the year and across the entirety of the Fed’s rate hiking cycle, waxing and waning with the news and data flow. Our base case is that 2022 growth will be quite strong, boosted by avid consumption and investment underpinned by savings and wealth gains, easy monetary conditions, and a tight job market. We expect that stout macro fundamentals will support earnings gains and that a dearth of alternatives to equities that can be expected to generate positive inflation-adjusted returns will keep earnings multiples elevated. If the mildness of Omicron variant infections points to a future in which COVID-19 becomes no more than a nuisance, global growth will get an additional fillip and some supply-chain pressures should ease, allowing inflation to come off the boil. While we reiterate our constructive view on financial markets and the economy, however, we do not expect a smooth ride to our year-end destination. Most investors lack first-hand experience managing against an inflation backdrop that has not been in place since the early ‘80s and volatility will likely be elevated as they find their footing. We are therefore adopting a more tactical perspective, seeking out opportunities to exploit temporary volatility, and we advise that clients consider shortening timeframes and increasing turnover to the extent their individual mandates will allow it. We do not think that the major inflection point marked by a shift from accommodative to restrictive monetary policy settings will arrive until the second half of 2023 at the earliest, but the run-up to it will likely be bumpy.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

Executive Summary A Swedish Warning Stocks are oversold but downside risks persist. The Fed is on the verge of beginning a tightening cycle, which creates a process often linked to deeper and longer equity corrections around the world. Global economic activity is decelerating, as growth transitions away from splurging on consumer goods to a return to trend in the service sector. Equities are more levered to industrial than services activity, which creates a risk window. Ukraine remains another near-term hurdle. Equity risk premia are not elevated enough to compensate for these threats. Despite near-term risks, the equity bull market will recover and Europe stocks will ultimately outperform. Bottom Line: Investors need to continue to hold portfolio hedges as the near-term outlook remains treacherous for equities. Nonetheless, a wholesale portfolio liquidation is unwarranted as we face a mid-cycle slowdown, not a recession. Feature Last week’s pattern of relaxation and renewed tensions in Ukraine is an acute reminder that markets remain fragile in the near-term. Investors must still contend with an imminent monetary tightening cycle in the US. Additionally, a few cracks are emerging on the global growth picture as a transition from spending on goods to services takes place. Under this light, we worry that risk premia remain too low, and that equities are still vulnerable to further near-term pullbacks. The situation is particularly complex for Europe, which is most exposed to the Ukrainian problems and to the global manufacturing cycle. We thus continue to recommend investors exposed to Europe hold protections. Oversold Enough? Many commentators argue that following the January equity sell-off, the mood of investors soured enough to warrant buying equities anew and closing our eyes. Most famously, the AAII Bull/Bear ratio is once again flirting with its 2018 and 2020 lows, two periods that, in hindsight, proved to be selling climaxes (Chart 1). The picture is complex. BCA’s Equity Capitulation Index is indeed becoming oversold (Chart 2). However, its reading is murky. It can either decline further, which would imply greater weaknesses in stocks, or rebound. Our first instinct is to look at the indicator’s behavior at the onset of Fed tightening cycles, which constitute close historical analogues: Chart 2... But Maybe Not Enough Chart 1Stocks Are Oversold...   In late 2015, when the last Fed tightening cycle began, the Capitulation Index plunged to much lower levels as stocks collapsed. In the background, the global economy was weakened by EM countries hammered by China’s slowdown and balance of payments crises. Around the hiking cycle that begun in June 2004, the Capitulation Index never plunged considerably, but the S&P 500 fell more than 8% between March and August 2004, in a volatile pattern. Back then, both US and global growth was very robust. In 1999, once the Fed resumed hiking rates after the 75bps of cuts following the LTCM debacle, the Capitulation Index and equities were very resilient. This strength persisted until the Nasdaq peaked in March 2000. The S&P 500 formed a complex top between March and August before starting a relentless collapse that September. Following the onset of the 1994-1995 tightening cycle, the Capitulation Index collapsed to much more oversold readings than current ones and equities entered a range-bound volatile episode that lasted until Q1 1995, as the Fed stopped hiking rates. The economy was replete with inflation fears and a mid-cycle slowdown was descending upon the US. The hiking cycle that started in 1988 did not witness significant downside in the Capitulation Index and stocks, but it took place soon after the 1987 crash when equities had become exceptionally oversold. Black Monday itself happened as inflation fear rose as a result of a weak dollar and as the Fed hiked rates through 1987. In 1984, the rate hike cycle was accompanied by a collapse in the Capitulation Index. The tightening in financial conditions caused by the Fed was exacerbated by the surge in the dollar that hurt US profitability and increased EM borrowing costs tremendously. After the 1981 hiking cycle, the Capitulation Index plunged as the US economy entered the second leg of the early 1980s double-dip recession. The latter was an economic crisis prompted by Federal Chairman Paul Volcker’s willingness to put an end to the inflation mentality of the 1970s. These historical experiences highlight one thing: Economic conditions were key to periods when the beginning of a tightening cycle caused a deeper correction in stocks than the one witnessed until now. Economic Clouds Today, the big question shaping the investment world is inflation. BCA expects inflation to peak over the coming months, whether in the US or in Europe. However, this process will take more time. CPI will not crest until after the Fed has begun to hike rates. In the meantime, there are plenty of factors that could easily fan inflation worries and, consequently, a continued upward repricing of the Fed’s interest rate path in the next few weeks. As Arthur Budaghyan highlighted in the most recent Emerging Market Strategy Report, US labor costs are rapidly rising, with the Atlanta Fed Median Wage growth measure up 5.1% annually and the Employment Cost Index (ECI) expanding at a 4.5% annual rate. Of particular worry, this surge in wages does not reflect underlying productivity and unit labor costs, which are up 3.2% annually (Chart 3), their highest rate since 2001, when the Fed funds rate was 4% and 10-year Treasurys yielded 5.4%.  Chart 3US Wage-Price Spiral? Elevated unit labor costs are a powerful inducement for inflation and, thus, are likely to continue to fan inflation fears among market participants. Of particular concern today, the rise in unit labor costs is not counterbalanced by a decline in US import prices and foreign deflationary pressures. Inflation fears remain a major risk for the market. As our BCA Monetary Indicator highlights, the liquidity backdrop is not supportive of equities anymore (Chart 4). Moreover, the technical picture is deteriorating, while speculation remains elevated. With investors fretting about the threat of inflation, the danger is that they start to anticipate a greater deterioration in monetary conditions. The problem is not unique to the US. At the global level, 75% of central banks are tightening policy and those that have not yet done so are gearing up to remove monetary accommodation. Adding to inflation fears are signs of a slowdown in the global goods sector. This slowdown reflects a natural transition from the spending binge on goods that took place during the pandemic, which is ebbing, to service spending, which is accelerating (Chart 5). This pattern is particularly evident for US consumers, the largest spenders in the world. Chart 5Transitioning From Goods To Services Chart 4Deteriorating Liquidity Conditions   One of the world’s most sensitive economies to the global industrial cycle is already feeling the pinch from this adjustment: Sweden. Swedish economic numbers have been weakening and Swedish assets are particularly soft (Chart 6), which heralds poorly for the global manufacturing sector. This deceleration in goods spending and industrial activity is a problem for equities because stock market profits are more geared toward the evolution of the industrial cycle than the service sector (Chart 7). Chart 6A Swedish Warning Chart 7Manufacturing, Not Services, Drives Profits Investment Conclusions In this context, it is prudent to maintain hedges to protect stock holdings. It is commonly argued that stocks are expensive, but if one considers the low level of bond yields, these valuations can be justified. Chart 8 challenges this notion. Yes, the earnings yield is still very elevated relative to 30-year Treasury bond yields; however, it is at its lowest in 42 years against core inflation. Why would core inflation be relevant? In a context in which investors are worried about the impact of inflation on both profit margins (higher labor costs) and the direction of policy, they are unlikely to remain unmoved by inflation fears, especially as the perception of higher policy rates may lift rates higher. Moreover, with many investors anxious that the Fed is falling far behind the curve, the marginal market players could easily become the individuals concerned that a catch up by the Fed will lead the economy into a recession. Considering the risks linked to Ukraine, the potentially negative impact on profitability of slowing goods spending, the growing policy uncertainty globally and in the US, and the inversion of many segments of the yield curve, prudence remains appropriate (Chart 9). Chart 8Value Is In The Eye Of The Beholder Chart 9Rising Policy Uncertainty Chart 10The Importance Of Manufacturing To Europe The problem for European equities is their elevated beta and pro-cyclicality. A pullback in US stocks will automatically drag down European stocks. Moreover, the region’s heavy reliance on manufacturing activity is reflected in the sectoral tilt of European benchmarks. As a result, the performance of European stocks is particularly sensitive to the evolution of the global industrial cycle (Chart 10). Add the fact that European economies are much more exposed to potential energy market disruptions emanating from Ukraine and the recent rebound in Europe’s relative equity performance becomes tenuous at best. Why would these dynamics be temporary and only warrant hedges, not a cyclical underweight in stocks and Europe? First, the inflation fear will recede in the second half of 2022. Our Global Supply Disruption Index has peaked and suggests that inflation surprises will soon ebb. Moreover, a measure of suppliers’ constraints based on the ISM Supplier Delivery Times, Backlog of Orders, Prices Paid, and Inventories is also rolling over (Chart 11). Second, a deepening of the stock market correction will tighten financial conditions and push credit spreads higher. This is a deflationary process that will cause inflation fears to recede and, thus, the pricing of expected Fed rate hikes to lessen. Third, the slowdown in the goods sector is concentrated among consumer goods. Capex will firm up. Capex intentions are elevated in Europe and the US, and global capital goods orders remain robust, despite having decelerated from their extraordinary rebound following the Q1 2020 shutdowns (Chart 12). Moreover, the political and corporate demand to build greater redundancy in global supply chains following the disruptions caused by the Sino-US trade war and COVID-19 will also boost corporate investments for a few more years. This means that many industrial sectors will recover globally and propel industrial equities higher. Chart 11Apex Bottlenecks? Chart 12Capex Will Stay Strong Fourth, Matt Gertken, BCA’s geopolitical strategist, continues to see a limited Ukrainian conflict as the most likely outcome of the current tensions.  As a result, any dislocation to global stocks and European assets caused by a conflict will be transitory. Finally, the business cycle has further to run. In 1994/95 and in 2015/16, the Fed tightening cycle materialized around the time of a mid-cycle slowdown. The economy recovered and profit firmed up anew, which allowed stocks to rebound. The Fed Funds rate is rising but remains below the neutral rate. Interest rates in Europe also have ample scope to rise before monetary policy becomes tight. Simultaneously, the recovering service sector will continue to support employment and, thus, final demand. Equity bear markets rarely materialize outside of recessions (Chart 13).   Chart 13Bear Markets Demand A Recession Bottom Line: Global equities are oversold, but the combination of rising inflation, Fed tightening, Ukrainian risks, and a transition from a goods-driven recovery to a service sector-led economy means that stocks risk becoming even more oversold in the near term. European equities are not immune to these threats. While rising rates are a lesser problem for Europe than the US, the developments in Ukraine and a manufacturing transition represent greater hurdles. Ultimately, the difficulties faced by stocks reflect a mid-cycle slowdown taking place alongside a period of policy tightening. It will be, therefore, temporary. Consequently, investors should not abandon stocks, but rather continue to hold protections.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Executive Summary The Market Thinks The Fed Will Be Unable To Raise Rates Much Above 2% The Fed tightening cycle is likely to proceed in two stages. In the first stage, which is now well anticipated, the Fed will seek to restore its credibility by raising rates to 2% – the lower bound of what it regards as “neutral” – by early next year. The decline in goods inflation over the next 12 months, facilitated by the easing of supply-chain bottlenecks, will allow the Fed to take a break from tightening for most of 2023. Unfortunately, the respite from rate hikes will not last. The neutral rate of interest is around 3%-to-4%, significantly higher than what either the Fed or investors believe. A wage-price spiral will intensify starting in late 2023, setting the stage for the second, and more painful, round of tightening. Trade Inception Level Initiation Date Stop Loss Long June 2023 3-month SOFR futures contract (SFRM3) / December 2024 (SFRZ4) -8 bps Feb 17/2022 -30 bps New Trade: Go short the December 2024 3-month SOFR futures contract versus the June 2023 contract. Investors expect the fed funds rate to be somewhat higher in mid-2023 than at end-2024. They are wrong about that. Bottom Line: The market has priced in the first stage of the Fed’s tightening cycle, which suggests that bond yields will stabilize over the next few quarters. However, the market has not priced in the second stage. Once it starts to do so, the bull market in equities will end. Investors should remain bullish on stocks for now but look to reduce equity exposure by the middle of 2023.   Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing Russia’s geopolitical outlook over the long run. I hope you will find it insightful. Best regards, Peter Berezin Chief Global Strategist Who’s the Boss? Who sets interest rates: The economy or the Fed? The answer is both. In the short run, the Fed has complete control over interest rates. In the long run, however, the economy calls the shots. If the Fed sets rates too high, unemployment will rise, forcing the Fed to cut rates. If the Fed sets rates too low, the opposite will happen. Chart 1The Fed's Estimate Of The Neutral Rate Is Still Quite Low By Historical Standards Thus, over the long haul, it all boils down to where the neutral rate of interest – the interest rate consistent with full employment and stable inflation – happens to be. In the latest Summary of Economic Projections, released on December 15th, 9 out of 17 FOMC participants penciled in 2.5% as their estimate of the appropriate “longer run” level of the federal funds rate. Six participants thought the neutral rate was lower than 2.5%, while two participants thought it was higher (both put down 3%). Back in 2012, when the Fed began publishing its dot plot, the median FOMC participant thought the neutral rate was 4.25%. Investors have revised up their estimate of the neutral rate over the past two months. But at 2.09%, the 5-year/5-year forward bond yield – a widely-used proxy for the neutral rate – is still exceptionally low by historic standards (Chart 1). Desired Savings and Investment Determine the Neutral Rate Chart 2The Savings-Investment Balance Determines The Neutral Rate Of Interest One can think of the neutral rate as the interest rate that equates aggregate demand with aggregate supply at full employment. If interest rates are above neutral, the economy will suffer from inadequate demand; if interest rates are below neutral, the economy will overheat. As Box 1 explains, the difference between aggregate demand and aggregate supply can be expressed as the difference between how much investment an economy needs to undertake and the savings it has at its disposal. Savings can be generated domestically by deferring consumption or imported from abroad via a current account deficit. Anything that reduces savings or raises investment will lead to a higher neutral rate of interest (Chart 2). With this little bit of theory under our belts, let us consider the forces shaping savings and investment in the United States. Desired Savings Are Falling in the US There are at least six reasons to expect desired savings to trend lower in the US over the coming years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and generous government transfer payments (Chart 3). While some of that money will remain sequestered in bank deposits, much of it will eventually be spent. Household wealth has soared. Personal net worth has risen by 128% of GDP since the start of the pandemic, the largest two-year increase on record (Chart 4). Conservatively assuming that households will spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 3.8% of GDP. Chart 3Plenty Of Pent-Up Demand Chart 4Net Worth Has Soared The household deleveraging cycle is over (Chart 5). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. Banks are easing lending standards on consumer loans across the board. Corporate profit margins are peaking. As a share of GDP, corporate profits are near record-high levels (Chart 6). Despite a tight labor market, wage growth has failed to keep up with inflation over the past two years. Real wages should recover over time. To the extent that households spend more of their income than businesses, a rising labor share should translate into lower overall savings. Chart 5US Household Deleveraging Pressures Have Abated Chart 6Corporate Profits Are Near Record Highs... But Wage Growth Has Failed To Keep Up Baby boomers are retiring. Baby boomers are leaving the labor force en masse. They hold over half of US household wealth, considerably more than younger generations (Chart 7). As baby boomers transition from net savers to net dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 8). Chart 7Baby Boomers Have Amassed A Lot Of Wealth Chart 8Fiscal Policy: Tighter But Not Tight Investment Will Not Decline to Offset the Reduction in Savings A favorite talking point among those who espouse the secular stagnation thesis is that slower trend growth will curb investment demand, leading to an ever-larger savings glut. There are a number of problems with this argument. For one thing, most of the decline in US potential GDP growth has already occurred, implying less need for incremental cuts to investment spending in the future. According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today, mainly due to slower labor force growth. The CBO expects potential growth to edge down to 1.7% over the next few decades (Chart 9). Moreover, US investment spending has been weaker over the past two decades than one would have expected based on the evolution of trend GDP growth. As a consequence, the average age of both the residential and nonresidential capital stock has risen to the highest level in over 50 years (Chart 10). Chart 9Most Of The Deceleration In US Potential Real GDP Growth Has Already Taken Place Chart 10The Aging Capital Stock As the labor market continues to tighten, firms will devote greater efforts to automating production. Already, core capital goods orders have broken out to the upside (Chart 11). On the housing front, the NAHB reported this week that despite rising mortgage rates, foot traffic and prospective sales remain at exceptionally strong levels (Chart 12). Building permits also surprised on the upside. Chart 11The Outlook For US Capex Is Bright Chart 12Homebuilder Confidence Remains Strong Overseas Appetite for US Assets May Wane A larger current account deficit would allow the US to spend more than it earns without the need for higher interest rates to incentivize additional domestic savings. The problem is that the US current account deficit is already quite large, having averaged 3.1% of GDP over the past four quarters. Furthermore, as a result of the accumulation of past current account deficits, external US liabilities now exceed assets by 69% of GDP (Chart 13). It is far from clear that foreigners will want to maintain the current pace of US asset purchases, let alone increase them from current levels. Chart 13The US Has Become Increasingly Indebted To The Rest Of The World The Two-Stage Path to Neutral Chart 14The Market Thinks The Fed Will Be Unable To Raise Rates Much Above 2% Investors expect the Fed to raise rates seven times by early next year and then stop hiking (and perhaps even start cutting!) in late 2023 and beyond (Chart 14). However, if we are correct that the neutral rate of interest is higher than widely believed, the Fed will eventually need to lift rates to a higher level than what is currently being discounted. It is impossible to be certain what this level is, but a reasonable estimate is somewhere in the range of 3%-to-4%. This is about 100-to-200 basis points above current market pricing. The path to the “new neutral” will not follow a straight line. As we have argued in the past, inflation is likely to evolve in a “two steps up, one step down” fashion. We are presently at the top of those two steps. Inflation will decline over the next 12 months as goods inflation falls sharply and services inflation rises only modestly, before starting to move up again in the second half of 2023. Falling Goods Inflation in 2022 Chart 15Goods Inflation Should Fade Chart 15 shows that the current inflationary episode has been driven by rising goods prices, particularly durable goods. This is highly unusual since goods prices, adjusting for quality improvements, usually trend sideways-to-down over time. As economies continue to reopen, the composition of consumer spending will shift from goods to services. At the same time, supply bottlenecks should abate. The combination of slowing demand and increasing supply will cause goods inflation to tumble. Investors are underestimating the extent to which goods inflation could recede over the remainder of the year as pandemic-related distortions subside. For example, used vehicle prices have jumped by over 50% during the past 18 months (Chart 16). Assuming automobile chip availability improves, we estimate that vehicle-related prices will go from adding 1.6 percentage points to headline inflation at present to subtracting 0.9 points by the end of the year – a swing of 2.5 percentage points (Chart 17). Chart 16AVehicle, Food, And Energy Prices Could All Retreat From Extended Levels (I) Chart 16BVehicle, Food, And Energy Prices Could All Retreat From Extended Levels (II) Chart 17Even If Underlying Core Inflation Does Not Change, Inflation Will Fall This Year As Goods Prices Come Back Down To Earth Along the same lines, we estimate that energy inflation will go from raising inflation by 1.7 points at present to lowering inflation by 0.3 points by the end of the year. This is based on the WTI forward curve, which sees oil prices retreating to $80/bbl by the end of 2022 from $91/bbl today. A normalization in food prices should also help keep a lid on goods inflation. Service Inflation Will Rise Only Modestly in 2022 Could rising service inflation offset the decline in goods inflation this year? It is possible, but we would bet against it. While certain components of the CPI services basket, such as rents, will continue to trend higher, a major increase in service inflation is unlikely unless wages rise more briskly. As Chart 18 underscores, the bulk of recent wage growth has occurred at the bottom end of the income distribution. That is not especially surprising. Whereas employment among medium-and-high wage workers has returned to pre-pandemic levels, employment among low-wage workers is still 6% below where it was in early 2020 (Chart 19). Chart 18The Bulk Of Recent Wage Growth Has Occurred At The Bottom End Of The Income Distribution Chart 19Employment Among Low-Wage Workers Still Lagging Chart 20Workers Are Starting To Return To Their Jobs Following The Omicron Wave Looking out, labor participation among lower-paid workers will recover now that enhanced unemployment benefits have expired. A decline in the number of life-threatening Covid cases should also help bring back many lower-paid service workers. According to the Census Bureau’s Household Pulse Survey, a record 8.7 million employees were absent from work in the middle of January either because they were sick or looking after someone with Covid symptoms. Consistent with declining case counts, February data show that fewer employees have been absent from work (Chart 20). Predicting Wage-Price Spirals: The Role of Expectations A classic wage-price spiral is one where self-fulfilling expectations of rising prices prompt workers to demand higher wages. Rising wages, in turn, force firms to lift prices in order to protect profit margins, thus validating workers’ expectations of higher prices. For the time being, such a relentless feedback loop has yet to emerge. Market-based measures of long-term inflation expectations have actually fallen since October and remain below the Fed’s comfort zone (Chart 21). Survey-based measures have moved up, but not by much (Chart 22). To the extent that US households are reluctant to buy a new vehicle, it is because they expect prices to decline (Chart 23). Chart 21Market-Based Expectations Remain Below The Fed's Comfort Zone Chart 22Survey-Based Measures Of Long-Term Inflation Expectations Have Ticked Up, But Not By Much Still, if it turns out that the neutral rate of interest is higher than widely believed, then monetary policy must also be more stimulative than widely believed. This raises the odds that, at some point, the economy will overheat and a wage-price spiral will develop. It is impossible to definitively say when that point will arrive. Inflationary processes tend to be highly non-linear: The labor market can tighten for a long time without this having much impact on inflation, only for inflation to surge once the unemployment rate has fallen below a critical threshold. The Sixties as a Template for Today? The sudden jump in inflation in the 1960s offers an interesting example. The unemployment rate in the US fell to NAIRU in 1962. However, it was not until 1966, when the unemployment rate had already fallen nearly two percentage points below NAIRU, that inflation finally took off. Within the span of ten months, both wage growth and inflation more than doubled. US inflation would end up finishing the decade at 6%, setting the stage for the stagflationary 1970s (Chart 24). Chart 23The Expectation of Lower Prices Is Keeping Many People From Buying A Car Chart 24Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Our guess is that we are closer to 1964 than 1966, implying that the US economy may still need to overheat for another one or two years before a true wage-price spiral emerges. When the second wave of inflation does begin, however, investors will find themselves in a world of pain. Stay overweight stocks for now but look to reduce equity exposure by the middle of next year. This Week’s Trade Idea Given our expectation that inflation will come down sharply in 2022 before beginning to rise again in late 2023 and into 2024, we recommend shorting the December 2024 3-month SOFR futures contract versus the June 2023 contract. Current market pricing provides an attractive entry point for the trade, with the implied interest rate for the June 2023 contract 8 bps higher than that of the December 2024 contract. We expect the interest rate spread to eventually widen substantially in favor of higher rates (lower futures contract prices) in 2024. Box 1The Neutral Rate Through The Lens Of The Savings-Investment BalancePeter Berezin Chief Global Strategist peterb@bcaresearch.com   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores