Valuations

Executive Summary The Fed offered more explicit near-term forward rate guidance at its meeting last week. This guidance will reduce yield volatility at the front-end of the curve during the next few months. We expect the Fed to deliver two more 50 basis point rate hikes (in June and July) before settling into a pattern of hiking by 25 bps at each meeting. Our anticipated Fed hike path is shallower than what is priced in the market, but it also lasts longer. Investors should position for this outcome by buying the December 2022 SOFR futures contract versus the December 2024 contract. Economic and financial market indicators suggest that the 10-year Treasury yield will fall back during the next six months, alongside falling inflation. Rate Expectations Bottom Line: Investors should keep portfolio duration close to benchmark for now, though we expect to get an opportunity to reduce portfolio duration later this year once inflation and bond yields are lower. Feature Last week was a chaotic one for the US bond market. Treasury yields rose and the Fed delivered its first 50 basis point rate increase since 2000. Yet, there is a broad consensus that the Fed’s message was dovish relative to expectations. In this week’s report we try to make sense of these confusing market signals. We do this by focusing on two important occurrences: (1) The Fed’s “dovish” 50 basis point rate hike and (2) The 10-year Treasury yield breaking above 3% for the first time since 2018. The Fed Takes Back Control Chart 1An Uncertain Rates Market Fed Chair Jay Powell had a clear agenda for last week’s FOMC press conference. Simply, he wanted to provide more concrete forward rate guidance to a market that had become increasingly volatile (Chart 1). The problem is that while the Fed had been explicit about its intention to lift rates, it hadn’t provided any firm guidance about its anticipated pace of tightening. This led to wild speculation in rates markets. Will the Fed lift rates at every meeting or every other meeting? Will it move in traditional 25 basis point increments or perhaps 50 basis point increments? Maybe even 75 basis point increments? This sort of speculation is unacceptable to Chair Powell who said in his opening remarks that the Fed “will strive to avoid adding uncertainty to what is already an extraordinarily challenging and uncertain time.”1 New Explicit Forward Guidance From Chair Powell’s post-meeting press conference, we can discern the following about the Fed’s near-term rate hike intentions. The Fed will not lift rates by 75 basis points at any single meeting. Two more 50 basis point rate hikes are likely at the June and July FOMC meetings. After July, the Fed will likely continue to lift rates at each FOMC meeting. Inflation’s trend will dictate whether these rate increases are delivered in 50 bps or 25 bps increments. The Fed will continue to lift rates at every meeting until it is confident that it has “done enough to get us on a path to restore price stability.” It’s also worth noting that, in addition to delivering a 50 basis point rate hike and providing firmer forward rate guidance, the Fed announced that it will begin shrinking its balance sheet on June 1. The Fed will follow the plan that was presented in the minutes from the March FOMC meeting and that we discussed in a recent report.2 Turning to markets, we see that the overnight index swap curve (OIS) is priced for an additional 201 bps of rate increases between now and the end of 2022 (Chart 2). This is consistent with three more 50 basis point rate hikes and two more 25 basis point rate hikes at this year’s five remaining FOMC meetings. If delivered, those hikes would bring the fed funds rate up to a range of 2.75% to 3.00%. Chart 2Rate Expectations Looking out until the end of 2023, we see the OIS curve priced for 262 bps of rate increases. That is, the market is priced for roughly 200 bps of tightening between now and the end of 2022, but only another 62 bps of rate increases in 2023. In fact, Chart 2 shows that the OIS curve has the funds rate peaking at 3.49% near the middle of 2023 and then edging slowly back down. Related Report  US Investment StrategyWage-Price Spiral? Not So Fast Based on our view that inflation will decline between now and the end of the year, we see the Fed delivering only 175 bps of additional tightening this year (50 bps rate hikes in June and July, followed by three more 25 bps hikes). This is slightly lower than what is priced in the curve. However, given the strong state of private sector balance sheets, we can also easily envision 25 basis point rate increases continuing at every meeting in 2023. That scenario would push the fed funds rate above 4% by the end of 2023, significantly higher than what is priced in the market. We recommend that investors position for this “slower, but longer” tightening cycle by buying the December 2022 SOFR futures contract versus the December 2024 contract (see “Yield Curve Trades” table on page 12). Charts 3A-3D focus more specifically on what’s priced in for the next few FOMC meetings. The charts show where the fed funds rate is expected to land after each meeting, as implied by the fed funds futures curve. Additionally, we use an ‘x’ to denote where we expect the fed funds rate to be at the end of each meeting. You can see that we expect the fed funds rate to be about 25 bps lower than the market by the end of September. Our expectation of a slower near-term hike pace stems from our view that inflation has already peaked.3 With that in mind, it’s notable that monthly core PCE inflation printed below levels consistent with the Fed’s 2022 forecasts in both February and March (Chart 4). In addition, last week’s employment report showed a significant deceleration in average hourly earnings (Chart 5). Average hourly earnings are an imperfect wage measure because they don’t adjust for the changing industry composition of the workforce. However, an adjusted measure that gives each industry group equal weighting is also starting to slow (Chart 5, bottom panel). Chart 3AMay 2022 FOMC Meeting Chart 3BJune 2022 FOMC Meeting Chart 3CJuly 2022 FOMC Meeting Chart 3DSeptember 2022 FOMC Meeting Chart 4Tracking Below The Fed's Forecast Chart 5Peak Wage Growth Bottom Line: The Fed’s more explicit rate guidance will reduce yield volatility at the front-end of the curve. Two more 50 basis point rate hikes are likely in June and July, but we expect falling inflation will prompt the Fed to switch to 25 basis point hikes after that. We also expect the tightening cycle to last longer than what is currently priced in the curve. Investors should keep portfolio duration close to benchmark and should position for our expected “slower, but longer” tightening cycle by owning the December 2022 SOFR futures contract versus the December 2024 contract. A Quick Note On The Neutral Rate And Financial Conditions Chart 6Financial Conditions Chart 2 shows that the market expects the Fed to lift the funds rate until it is slightly above the range of the Fed’s long-run neutral rate estimates (2% - 3%). At that point, restrictive monetary policy will presumably weigh on economic growth enough for the Fed to back away from tightening. While forecasters need some estimate of the neutral rate to predict where bond yields will land at the end of the cycle, it’s important to understand that Fed policymakers are not guided by these same concerns. In fact, Chair Powell said the following last week when asked whether the Fed intended to lift rates above estimates of neutral: … there’s not a bright line drawn on the road that tells us when we get [to neutral]. So we’re going to be looking at financial conditions, right. Our policy affects financial conditions and financial conditions affect the economy. So we’re going to be looking at the effect of our policy moves on financial conditions. Are they tightening appropriately? And then we’re going to be looking at the effects on the economy. And we’re going to be making a judgment about whether we’ve done enough to get us on a path to restore price stability. In other words, actual Fed policy will not be guided by neutral rate estimates. Instead, the Fed will continue lifting rates at a regular pace until it sees enough evidence of tightening financial conditions and slowing inflation. For this reason, it will be critical to monitor broad indexes of financial conditions as the Fed tightens policy. At present, the Goldman Sachs Financial Conditions Index remains deep in “accommodative” territory, but it is rising quickly (Chart 6). Based on history, we might expect the pace of tightening to slow once the index breaks into “restrictive” territory. Conversely, if financial conditions don’t tighten very much, then it will encourage the Fed to hike more aggressively.  The Return Of 3% Treasury Yields Chart 7Back Above 3% The 10-year Treasury yield broke above 3% after the FOMC meeting on Wednesday and it has so far held firm above that key psychological level. The last time the 10-year yield reached these heights was near the end of the last tightening cycle in 2018 (Chart 7). One big difference between today and 2018 being that today’s 3% 10-year yield consists of a much higher inflation component and a much lower real yield (Chart 7, bottom panel). At 2.88%, the cost of inflation compensation embedded in the 10-year yield is too high, and it will fall as inflation rolls over and the Fed tightens. There is a question, however, about whether this drop in 10-year inflation expectations will translate into a lower nominal bond yield or simply be offset by a rising 10-year real yield. The answer will depend on how quickly inflation comes down off its highs. Chart 85y5y Is Above Neutral If inflation falls quickly during the next few months, then the market will start to price-in a less aggressive Fed. This will hold down the 10-year real yield. However, if inflation remains sticky near its current level, then the market will judge that the Fed still has a lot of work to do. This will pressure 10-year real yields higher even if long-dated inflation expectations recede. It’s often simpler to ignore the breakdown between real yields and inflation expectations and focus purely on the nominal bond yield itself. This exercise strongly suggests that long-maturity nominal bond yields will fall back somewhat during the next six months. First, we observe that the 5-year/5-year forward Treasury yield has risen to 3.19%, above the upper-end of survey estimates of the long-run neutral fed funds rate (Chart 8). Long-maturity forward yields have rarely moved much above the range of neutral rate estimates during the past decade. Second, high-frequency indicators that historically correlate with bond yields have not justified the recent move higher in the 10-year yield. The ratio between the CRB Raw Industrials commodity price index and gold and the relative performance of cyclical versus defensive equity sectors have both stalled out, even as yields have shot up (Chart 9). Finally, the change in bond yields correlates strongly with the level of economic data surprises. Positive data surprises tend to coincide with a rising Treasury yield, and vice-versa. Economic data surprises have been positive during the past few months, justifying the move higher in yields (Chart 10). However, that trend is poised to reverse in the coming months. Economic momentum is bound to slow now that the Fed is tightening and the labor market is close to full employment. Further, the Economic Surprise Index exhibits a strong mean-reverting pattern. Extremely high values tend to be followed by lower values, and vice-versa. A simple auto-regressive model of the Surprise Index suggests that it is on track to turn negative within the next month. Chart 9Bonds Go Their Own Way Chart 10Economic Data Surprises Bottom Line: Our indicators suggest that the 10-year Treasury yield will fall back somewhat during the next six months. That said, on a longer-run horizon we continue to expect that interest rates will rise further than the market anticipates. Investors should maintain neutral portfolio duration for now, but stand ready to re-initiate below-benchmark positions later this year once inflation and bond yields are lower. A Quick Note On The Yield Curve And Credit Spreads Yield Curve Positioning Not only have bond yields increased since the Fed meeting last Wednesday, but the Treasury curve has also steepened significantly. The turnaround in the yield curve has been startling. The 2-year/10-year Treasury slope was inverted one month ago, but it is now back up to 40 bps (Chart 11). But despite the big moves in the 2/10 slope, the yield curve remains quite flat beyond the 5-year maturity point. In fact, the 2/5/10 butterfly spread – the 5-year yield minus the yield on a duration-matched 2/10 barbell – remains far too high compared to the 2/10 slope (Chart 11, bottom 2 panels). Therefore, our recommended yield curve positioning remains unchanged. Investors should buy the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Credit Spreads A steeper yield curve has positive implications for corporate bond spreads. All else equal, a steeper yield curve suggests that we are further away from the end of the economic recovery, meaning that corporate bonds have a longer window for outperformance. That said, at 40 bps, the 2-year/10-year Treasury slope is still relatively flat, and while corporate bond spreads have widened during the past few months, the high-yield index option-adjusted spread is still close to its 2019 level and the 12-month breakeven spread for the investment grade index is still below its median since 1995 (Chart 12). Chart 11Favor The 5-Year Chart 12Corporate Bond Valuation We remain cautious on corporate credit for the time being. Specifically, we recommend an underweight allocation (2 out of 5) to investment grade corporates and a neutral allocation (3 out of 5) to high-yield. However, if the 2-year/10-year Treasury slope were to steepen to above 50 bps and/or if corporate bond spreads were to widen further, then we may see an opportunity this year to tactically increase exposure. Stay tuned. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1    https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220504.p… 2    Please see US Bond Strategy Weekly Report, “Peak Inflation,” dated April 19, 2022. 3    Please see US Bond Strategy Weekly Report, “Peak Inflation,” dated April 19, 2022.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Special Report

Highlights All four of our US Equity indicators are currently pointing in a bearish direction. Our Monetary Indicator has fallen to a three decade low, our Technical Indicator has broken into negative territory, our Valuation Indicator still signals extreme equity pricing, and our Speculation Indicator does not yet support a contrarian buy signal. Still, we do not expect a US recession over the coming year, which implies that S&P 500 revenue growth will stay positive. Nonrecessionary earnings contractions are rare, and are almost always associated with a significant contraction in profit margins. Our new profit margin warning indicator currently suggests the odds of falling margins are low, although the risks may rise later this year. Stocks are extremely expensive, but rich valuations are being driven by extremely low real bond yields, rather than investor exuberance. Valuation is unlikely to impact US stock market performance significantly over the coming year unless long-maturity bond yields rise substantially further. Technical analysis of stock prices has a long and successful history at boosting investment performance, which ostensibly suggests that investors should be paying more attention to technical conditions in the current environment. However, technical trading rules have been less helpful in expansionary environments when inflation is above average and when stock prices and bond yields are less likely to be positively correlated (as is currently the case). As such, the recent technical breakdown of the US equity market may simply reflect a reduced signal-to-noise ratio associated with these economic and financial market regimes. For now, we see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio over the coming 6 to 12 months. Rising odds of a recession, declining profit margins, and a large increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market, the risks of which should be monitored closely by investors. Feature In Section 1 of our report, we reviewed why a recession in the US is unlikely over the coming 6 to 12 months. However, we also highlighted that the risks to the economic outlook are meaningful and that an aggressively overweight stance toward risky assets is currently unwarranted. During times of significant uncertainty, investors should pay relatively more attention to long-term economic and financial market indicators with a reliable track record. In this report we begin by briefly reviewing the message from our US Equity Indicators, and then turn to a deeper examination of the top-down outlook for earnings, the determinants of rich valuation in the US stock market, and whether investors should rely on technical indicators in the current environment. We conclude that, while an indicator-based approach is providing mixed signals about the US equity market, we generally see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. Aside from tracking the risk of a recession, investors should be closely attuned to signs of a contraction in profit margins or shifting neutral rate expectations as a basis to reduce equity exposure to below-benchmark levels. A Brief Review Of Our US Equity Indicators Chart II-1Our Equity Indicators Are Pointing In A Bearish Direction Chart II-1 presents our US Equity Indicators, which we update each month in Section 3 of our report. We highlight our observations below: Chart II-1 shows that our Monetary Indicator has fallen to its lowest level since 1995, when the Fed surprised investors and shifted rapidly in a hawkish direction. The indicator is most acutely impacted by the speed of the rise in 10-year Treasury yields and a massive surge in the BCA Short Rate Indicator to levels that have not prevailed since the late 1970s (Chart II-2). Our Technical Indicator has recently broken into negative territory, which we have traditionally interpreted as a sign to sell stocks. The indicator has been dragged lower by a deterioration in stock market breadth across several tracked measures and by weak sentiment (Chart II-3). The momentum component of the indicator is fractionally positive but is exhibiting clear weakness. Our Valuation Indicator continues to highlight that US equities are extremely overvalued relative to their history, despite the recent sell-off in stock prices. Our Speculation Indicator arguably provides the least negative signal of our four indicators, at least from a contrarian perspective. In Q1 2021, the indicator nearly reached the all-time high set in March 2000, but it has since retreated significantly and has exited extremely speculative territory. While this may eventually provide a positive signal for stocks, equity returns have historically been below average during months when the indicator declines. Thus, the downtrend in the Speculation Indicator still points to weakness in stock prices, at least over the nearer term. Chart II-2Our Monetary Indicator Is Falling In Part Because Of Surging Interest Rate Expectations Chart II-3All Three Components Of Our Technical Indicator Are Falling In summary, all four of our US Equity indicators are currently pointing in a bearish direction, which clearly argues against an aggressively overweight stance favoring equities within a multi-asset portfolio. At the same time, we reviewed the odds of a US recession over the coming year in Section 1 of our report and argued that a recession is not likely over the coming 12 months. Thus, one key question for investors is whether a nonrecessionary contraction in earnings is likely over the coming year. We address this question in the next section of our report, before turning to a deeper examination of the relative importance of equity valuation and technical indicators. Gauging The Risk Of A Nonrecessionary Earnings Contraction Chart II-4Nonrecessionary Earnings Declines Usually Occur Due To Falling Margins Based on S&P data, there have been five cases since 1960 when 12-month trailing earnings per share fell year-over-year, while the economy continued to expand (Chart II-4). Sales per share growth remained positive in four of these cases (panel 2), underscoring that falling profit margins have been mostly responsible for these nonrecessionary earnings declines. We have noted our concern about how elevated US profit margins have become and have argued that a significant further expansion is not likely to occur over the coming 12-24 months.1 To gauge the risk of a sizeable decline in margins over the coming year, we construct a new indicator based on the seven instances when S&P 500 margins fell outside the context of a recession. This includes two cases when margins fell but earnings did not (because of buoyant revenue growth). We based the indicator on these five factors: Changes in unit labor cost growth to measure the impact of wage costs on firm profitability; Lagging changes in commodity prices as a proxy for material costs; The level of real short-term interest rates as a proxy for borrowing costs; Changes in a sales growth proxy to measure the impact of operating leverage on margins; And changes in the ISM manufacturing index to capture any residual impact on margins from the business cycle. Chart II-5The Odds Of A Nonrecessionary Profit Margin Contraction Are Currently Low Chart II-5 presents the indicator, which is shaded both for recessionary periods and the seven nonrecessionary margin contraction episodes we identified. While the indicator does not perfectly predict margin contractions outside of recessions, it did signal 50% or greater odds of a margin contraction in four of the seven episodes we examined, and signals high odds of a contraction in margins during recessions. Among the three cases in which the indicator failed to indicate falling margins during an expansion, two of those failures were episodes when earnings growth did not ultimately contract. The inability to explain the 1997-1998 margin contraction is the most relevant failure of the indicator, in addition to two false signals in 1963 and 1988. Still, the approach provides a useful framework to gauge the risk of falling profit margins, and the results provide an interesting and somewhat surprising message about the relative importance of the factors we included. We would have expected that accelerating wages would have been the most significant factor explaining nonrecessionary profit margin declines. Wages were highly significant, but they were the second most important factor behind our sales growth proxy. Lagged commodity prices were the third most significant factor, followed by real short-term interest rates. Changes in the ISM manufacturing index were least significant, underscoring that our sales growth proxy already captures most of the effect of the business cycle on profit margins. This suggests that operating leverage is an important determinant of margins during economic expansions, and that investors should be most concerned about declining profit margins when both revenue growth is slowing significantly and wage growth is accelerating. The indicator currently points to low odds of a nonrecessionary margin contraction, but this is likely to change over the coming year. We expect that all five of the factors will evolve in a fashion that is negative for margins over the coming twelve months: While the pace of its increase is slowing, median wage growth continues to accelerate, even when adjusting for the fact that 1st quartile wage growth is growing at an above-average rate (Chart II-6). Combining the latter with higher odds of at or below-trend growth this year implies that unit labor costs may rise further over the coming twelve months. Analysts expect S&P 500 revenue growth to slow nontrivially over the coming year (Chart II-7). Current expectations point to growth slowing to a level that would still be quite strong relative to what has prevailed over the past decade; however, accelerating wage costs in lockstep with decelerating revenue growth is exactly the type of combination that has historically been associated with falling margins during economic expansions. Chart II-6Wage Growth Is Accelerating... Chart II-7...And Revenue Growth Is Set To Slow​​​​​​ Although these are less impactful factors, the lagged effect of the recent surge in commodity prices will also weigh on margins over the coming year, as will rising real interest rates and a likely slowdown in manufacturing activity in response to slower goods spending. In addition to our new indicator, we have two other tools at our disposal to track the odds of a decline in profit margins over the coming year. First, Chart II-8 illustrates that an industry operating margin diffusion index does a decent job at leading turning points in S&P 500 profit margins, despite its volatility. And second, Chart II-9 highlights that changes in the sales and profit margin diffusion indexes sourced from the Atlanta Fed’s Business Inflation Expectations Survey have predicted turning points in operating sales per share and margins over the past decade. Chart II-9 does suggest that profit margins may not rise further, but flat margins are not likely to be a threat to earnings growth over the coming year if a recession is avoided (as we expect). Chart II-8Sector Diffusion Indexes Are Not Signaling A Major Warning Sign For Margins... Chart II-9...Neither Are The Atlanta Fed Business Sales And Margin Diffusion Indexes     The conclusion for investors is that the odds of a decline in profit margins over the coming year are elevated and should be monitored, but are seemingly not yet imminent. In combination with expectations for slowing revenue growth, this implies, for now, that earnings growth over the coming year will be low but positive. Valuation, Interest Rates, And The Equity Risk Premium As noted above, our Valuation Indicator continues to highlight that US Equities are extremely overvalued relative to their history. Our Valuation Indicator is a composite of different valuation measures, and we sometimes receive questions from investors asking about the seemingly different messages provided by these different metrics. For example, Chart II-10 highlights that equity valuation has almost, but not fully, returned to late-1990 conditions based on the Price/Earnings (P/E) ratio, but is seemingly more expensive based on the Price/Book (P/B) and especially Price/Sales (P/S) ratios. In our view, this apparent discrepancy is easily resolved. Relative to the P/E ratio, both the P/B and especially P/S ratios are impacted by changes in aggregate profit margins, which have risen structurally over the past two decades because of the rising share of broadly-defined technology companies in the US equity index (Chart II-11). Barring a major shift in the profitability of US tech companies over the coming year, we do not see discrepancies between the P/E, P/B, or P/S ratios as being particularly informative for investors. As an additional point, we also do not see the Shiller P/E or other cyclically-adjusted P/E measures as providing any extra information about the richness or cheapness of US equities today, as these measures tend to move in line with the 12-month forward P/E ratio (Chart II-12). Chart II-10US Equities Are Extremely Overvalued, Based On Several Valuation Metrics Chart II-11Tech Margins Have Caused Stocks To Look Especially Expensive On A Price/Sales Basis In our view, rather than focusing on different measures of valuation, it is important for investors to understand the root cause of extreme US equity prices, as well as what factors are likely to drive equity multiples over the coming year. As we have noted in previous reports, the reason that US stocks are extremely overvalued today is very different from the reason for similar overvaluation in the late 1990s. Charts II-13 and II-14 present two different versions of the equity risk premium (ERP), one based on trailing as reported earnings (dating back to 1872), and one based on twelve-month forward earnings (dating back to 1979). Chart II-12The Shiller P/E Ratio Does Not Convey Any 'New' Information About Valuation Chart II-13The Equity Risk Premium Is In Line With Its Historical Average… The ERP accounts for the portion of equity market valuation that is unexplained by real interest rates, and the charts highlight that the US ERP is essentially in line with its historical average based on both measures, in sharp contrast to the stock market bubble of the late 1990s. This underscores that historically low interest rates well below the prevailing rate of economic growth are the root cause of extreme equity overvaluation in the US (Chart II-15), meaning that very rich pricing can be thought of as “rational exuberance.” Chart II-14…In Sharp Contrast To The Late 1990s Chart II-15US Equities Are Extremely Expensive Because Bond Yields Are Extremely Low     Chart II-16The Equity Risk Premium Is Fairly Well Explained By The Misery Index Over the longer term, the risks to US equity valuation are clearly to the downside, as we detailed in our October 2021 report.2 But over the coming 6 to 12 months, US equity multiples are likely to be flat or modestly up in the US. As we noted in Section 1 of our report, a significant further rise in long-maturity bond yields will likely necessitate a major shift in neutral rate expectations on the part of investors and the Fed, which we think is more likely a story for next year than this year. And Chart II-16 highlights that the ERP has historically been well explained by the sum of unemployment and inflation (the Misery Index), which should come down over the coming several months as inflation moderates and the unemployment rate remains low. To conclude, it is absolutely the case that US equities are extremely expensive, but this fact is unlikely to impact US stock market performance significantly unless long-maturity bond yields rise substantially further. Technical Analysis Amid A Shifting Economic Regime Technical analysis of financial markets, and especially stocks, has a long history. It has also provided disciplined investors with significant excess returns over time. A simple stock / bond switching rule based on whether stock prices were above their nine-month moving average at the end of the previous month has significantly outperformed since the 1960s, earning an average excess annual return of 1.3% relative to a 60/40 stock/bond benchmark portfolio (Chart II-17). This outsized performance has come at the cost of only a minor increase in portfolio volatility. Ostensibly, then, investors should be paying more attention to equity technical conditions in the current environment, which we noted above are not positive. Our Technical Indicator has recently broken into negative territory, and the S&P 500 has clearly fallen back below its 200-day moving average. However, Chart II-17 presented generalized results over long periods of time. Over the past two decades, investors have been able to rely on a durably negative correlation between stock prices and bond yields to help boost portfolio returns from technically-driven switching rule strategies. Chart II-18 highlights that this correlation has been much lower over the past two years than has been the case since the early 2000s, raising the question of whether similar switching strategies are viable today. In addition, there is the added question of whether technical analysis is helpful to investors during certain types of economic and financial market regimes, such as high inflation environments. Chart II-17Technically-Driven Trading Rules Have Historically Provided Investors With A Lot Of Alpha Chart II-18Switching-Rule Strategies May Not Work As Well When Stock Prices And Bond Yields Are Not Positively Correlated To test whether the message from technical indicators may be relied upon today, we examine the historical returns from a technically-driven portfolio switching strategy during nonrecessionary months under four conditions that reflect the economic and political realities currently facing investors: months when both stock and bond returns are negative; months of above-average inflation; months of above-average geopolitical risk; and the 1970s, when the Misery Index was very elevated. In all the cases we consider, the switching rule is simple: whether the S&P 500 index was above its nine-month moving average at the end of the previous month. If so, the rule overweights equities for the subsequent months; if not, the rule overweights a comparatively risk-free asset. We consider portfolios with either 10-year Treasurys or 3-month Treasury bills as the risk-free asset, as well as a counterfactual scenario in which cash always earns a 1% annual rate of return (to mimic the cash returns currently available to investors). Table II-1 presents the success and whipsaw rate of the trading rule. Table II-2 presents the annualized cumulative returns from the strategy. The tables provide three key observations: As reflected in Chart II-17, both Tables II-1 and II-2 highlight that simple technical trading rules have historically performed well, and that outperformance has occurred in both recessionary and nonrecessionary periods. Relative to nonrecessionary periods overall, technical trading rules have underperformed during the particular nonrecessionary regimes that we examined. It is the case not only that these strategies have performed in inferior ways during these regimes, but also that they were less consistent signals in that they generated significantly more “whipsaws” for investors. Among the four nonrecessionary regimes that we tested, technical indicators underperformed the least during periods of above-average geopolitical risk, and performed abysmally during nonrecessionary (but generally stagflationary) months in the 1970s. Table II-1During Expansions, Technically-Driven Switching Rules Underperform… Table II-2…When Inflation Is High And When Stocks And Bonds Lose Money The key takeaway for investors is that technical analysis is likely to be helpful for investors to improve portfolio performance as we approach a recession but may be less helpful in an expansionary environment in which inflation is above average and when stock prices and bond yields are less likely to be positively correlated. Investment Conclusions Echoing the murky economic outlook that we detailed in Section 1 of our report, our analysis highlights that an indicator-based approach is providing mixed signals about the US equity market. On the one hand, all four of our main equity indicators are currently providing a bearish signal, and the risk of a nonrecessionary contraction in S&P 500 profit margins over the coming year is elevated – albeit seemingly not imminent. On the other hand, our expectation that the US will not slip into recession over the coming year implies that revenue growth will stay positive, which has historically been associated with expanding earnings. In addition, US equity multiples are likely to be flat or modestly up, and the recent technical breakdown in the S&P 500 may simply reflect a reduced signal-to-noise ratio that appears to exist in expansionary environments in which inflation is high and the stock price / bond yield correlation is near-zero or negative. Netting these signals out, we see our equity indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. The emergence of a recession, declining profit margins, and a significant increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market. We will continue to monitor these risks and adjust our investment recommendations as needed over the coming several months. Stay tuned! Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate   Footnotes 1     Please see The Bank Credit Analyst “OUTLOOK 2022: Peak Inflation – Or Just Getting Started?” dated December 1, 2021, available at bca.bcaresearch.com 2 Please see The Bank Credit Analyst “The “Invincible” US Equity Market: The Longer-Term Outlook For US Stocks In Relative And Absolute Terms,” dated September 30, 2021, available at bca.bcaresearch.com

Executive Summary A housing slowdown has begun and it will proceed in three stages. First, rising mortgage rates will lead to slowing demand. Second, weak demand will push inventories higher and cause home prices to decelerate. Finally, construction activity will trend down signaling a peak in the fed funds rate. We are at least one year away from housing signaling a peak in interest rates. Agency MBS returns will improve going forward, but the sector is still not sufficiently attractive to increase exposure. Housing Starts Are A Useful Fed Indicator Bottom Line: Maintain an underweight allocation to agency MBS within US bond portfolios and favor low coupons (1.5%-2.5%) over high coupons (3%-4.5%). Feature Chart 1The Highest Mortgage Rate Since 2011 The biggest question for investors continues to be how the economy and financial markets will react to the Federal Reserve’s hawkish pivot, a pivot that has led to sharply higher bond yields and a much flatter yield curve. However, it’s not just this re-shaping of the Treasury curve that has changed the economic landscape. The Fed’s hawkish pivot has also sent the mortgage rate back above 5% for the first time since 2011 (Chart 1). This week’s report considers what an elevated mortgage rate means for the future path of Fed rate hikes. It also updates our view on Agency MBS.   Housing Is Critical For Fed Policy Housing is probably the most important channel through which monetary policy impacts the economy. This is simply the result of the fact that monetary policy directly influences mortgage rates and mortgage rates are a major determinant of housing demand. Not only that, but empirical research has shown residential investment to be an excellent leading indicator of recession.1 Related Report  Global Fixed Income StrategyGlobal Bond Yields Take A Breather From these facts we can draw two conclusions. First, monetary policy works in large part through its influence on housing activity. Second, trends in housing activity can send important signals about the stance of monetary policy. For example, we observe that periods of Fed tightening tend to occur when the 12-month moving average of housing starts is above the 24-month moving average. Meanwhile, periods of Fed rate cuts tend to occur when the 12-month moving average of housing starts is below the 24-month moving average (Chart 2). This is a fairly reliable relationship going back to the early 1970s, the sole exception being the late-1980s when the Fed delivered a series of rate hikes as housing activity trended down. Chart 2Housing Starts Are A Useful Fed Indicator Chart 2 shows us that housing starts are currently trending higher, consistent with a period of Fed tightening. However, it also tells us that we should start to anticipate the end of the tightening cycle when the 12-month moving average of housing starts falls below the 24-month moving average. While the elevated mortgage rate will certainly slow housing activity going forward, we expect that we are still at least one year away from receiving that signal from the housing starts data. A Housing Slowdown In Three Steps We see the coming housing slowdown proceeding in three steps. First, higher mortgage rates will crimp demand. This is already starting to occur. New and existing home sales have both dipped in recent months, and mortgage purchase applications are down off their highs (Chart 3). Chart 3Phase 1: Weaker Demand Demand weakness will continue until the housing slowdown reaches its second phase. The second phase will be characterized by rising home inventories and decelerating home prices. This has still not occurred. The total inventory of new and existing homes is near its all-time low and home prices were up 18% during the 12-month period ending in January (Chart 4). The second phase of the housing slowdown is critical because builders will be incentivized to add supply as long as inventories remain low and prices remain elevated. That is, the housing slowdown will not reach its third phase – declining housing starts – until weak demand pushes inventories up and prices down, making new construction less attractive. Presently, while homebuilder equities have sold off as mortgage rates have risen, homebuilder confidence is still extremely high (Chart 5). This tells us that we are still quite far away from seeing a trend reversal in housing starts. Chart 4Phase 2: Falling Prices Chart 5Phase 3: Less Construction Bottom Line: A trend reversal in housing starts, as indicated by the 12-month moving average dipping below the 24-month moving average, will send a strong signal that the Fed is near the peak of its tightening cycle. Given that the housing slowdown is still in its early stages, we view this development as at least one year away. Agency MBS: The Rout Is Over, But It’s Still Too Soon To Buy Chart 6Poor MBS Performance Agency Mortgage-Backed Securities (MBS) have performed terribly during the past year (Chart 6). Not only have the securities drastically underperformed duration-matched Treasuries, but they have also performed worse than investment grade corporate bonds and Agency-backed Commercial Mortgage-Backed Securities. The chief reason for the poor performance has been the surge in bond yields and the resulting increase in Agency MBS duration. It became less attractive for homeowners to prepay their mortgages as mortgage rates rose. This caused MBS duration to extend, meaning that every further increase in yields led to a more severe drop in price. Chart 7 shows that the average duration of the conventional 30-year Agency MBS index was around 3.0 at the beginning of 2021. It is now above 6.0! The good news is that this is probably about as high as the index duration will get. The refi option on most mortgages is already out-of-the-money. That is, close to 0% of the amount outstanding of the conventional 30-year MBS index can profitably refinance with the mortgage rate at its current level (Chart 7, panel 2). We also observe that the average price of the index has fallen to well below par (Chart 7, panel 3) and the average convexity of the index is close to zero (Chart 7, bottom panel). The key point is that there is now very little convexity risk in the MBS index, so further movements in bond yields will lead to much smaller changes in index duration. Low convexity risk means that the worst of the MBS duration extension has already passed. MBS returns should be somewhat better going forward, though we still don’t recommend increasing exposure to the sector. At this juncture, the main reason to stay defensive on Agency MBS is that spreads simply don’t offer sufficient value. The average index spread versus Treasuries is close to its lowest level since 2000 (Chart 8). Interestingly, dramatic MBS underperformance didn’t lead to spread widening during the past year because MBS yields kept getting compared to longer and longer duration Treasuries as the MBS index duration extended. Chart 7The Extension Trade Is Over Chart 8MBS Spreads Are Too Tight MBS value is also relatively poor compared to investment grade rated corporate bonds. The option-adjusted spread differential between Agency MBS and investment grade corporates is close to its median since 2000 (Chart 8, panel 2). MBS value looks slightly more expensive if we adjust for index duration by using the 12-month breakeven spread (Chart 8, bottom panel). With value relative to investment grade corporates either at its historical median or slightly more expensive, we don’t see a compelling case for favoring Agency MBS over investment grade corporates. Bottom Line: MBS index duration extension has likely run its course. We therefore expect MBS returns to improve somewhat during the next 6-12 months. That said, we continue to recommend an underweight allocation to the sector as current spreads don’t justify favoring MBS over Treasuries or investment grade corporates. Take A Look At Low Coupons We think investors should consider favoring low coupons (1.5%-2.5%) within an overall underweight allocation to agency MBS. We view this recommendation as a way to position for a drop in Treasury yields between now and the end of the year. In prior reports we noted that long-dated forward Treasury yields are elevated relative to survey estimates of the long-run neutral fed funds rate, and also that we expect inflation to trend down in the coming months.2 While we continue to recommend keeping portfolio duration close to benchmark on a 6-12 month horizon, a low-coupon bias within Agency MBS is a good way to position for the possibility that falling inflation will push bond yields down. To see why, we need to simply consider that low coupon mortgages are the least likely to refinance and thus low-coupon MBS have the highest durations (Chart 9). With convexity currently close to zero for the entire coupon stack (Chart 10), MBS relative coupon positioning can really be boiled down to a play on rates and duration risk. Chart 9Agency MBS 30-Year Conventional Coupon Stack: OAS vs. Duration Chart 10Agency MBS 30-Year Conventional Coupon Stack: OAS vs. Convexity A further rise in bond yields will cause higher coupon MBS (3%-4.5%) to outperform lower coupon MBS (1.5%-2.5%), while a drop in bond yields will lead to low-coupon outperformance. Given our current macro outlook, we think it makes sense to bet on the latter. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.nber.org/papers/w13428 2 Please see US Bond Strategy Weekly Report, “Peak Inflation”, dated April 19, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Special Report

Executive Summary Spreads Near 2017-19 Average The main indicators that determine corporate bond performance are valuation, the cyclical/monetary environment and corporate balance sheet health. US corporate bond valuation is quite expensive. Spreads are off their post-COVID lows, but consistent with the 2017-19 average. The flat 2-year/10-year Treasury curve indicates that the cyclical/monetary backdrop is relatively poor. What’s more, the yield curve could easily invert within the next few months as the Fed tightens. This would send an even more negative signal for corporate bond returns.  Corporate balance sheets are currently in excellent shape, but their health will deteriorate within the next 12 months as profit growth slows and interest rates rise. Relative valuation favors high-yield over investment grade corporates, and high-yield has a track record of outperformance during periods of restrictive monetary conditions and strong corporate balance sheets. Bottom Line: Investors should cyclically reduce exposure to US corporate bonds while retaining a preference for high-yield over investment grade. We recommend downgrading investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) and high-yield corporates from overweight (4 out of 5) to neutral (3 out of 5). Feature Chart 1A Rapid Recovery US corporate bonds have had a very good run since the March 2020 peak in spreads. Investment grade corporates outperformed a duration-matched position in US Treasuries by 23% during the first 12 months of the recovery, the best 12-month excess return since 2010 (Chart 1). That same period also saw an extremely rapid re-normalization of credit spreads. It took just 11 months for the investment grade corporate index option-adjusted spread (OAS) to reach 90 bps following its March 2020 peak, and the index delivered an annualized excess return of 26% during that period. In contrast, it took 109 months for the index OAS to reach 90 bps following the 2008 recession and corporates only beat duration-matched Treasuries by an annualized 4% during that time (Table 1). Table 1US Investment Grade Corporate Bond Returns From Spread Peak Until 90 BPs The outlook for US corporate bond returns looks much different today. Spreads are tighter and the Fed is rapidly removing policy accommodation. Against this backdrop, we decided last week to cyclically reduce our corporate bond exposure.1  Specifically, we recommended downgrading investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) and high-yield corporates from overweight (4 out of 5) to neutral (3 out of 5) within US bond portfolios. This Special Report discusses the rationale for our recent decision. First, we examine trends in the main indicators that determine corporate bond performance. These indicators fall into three categories: (i) valuation, (ii) cyclical/monetary indicators and (iii) balance sheet health. We then discuss the outlook for the relative performance of high-yield versus investment grade corporates. Valuation Starting with a simple examination of the average investment grade index OAS, we see that the spread has widened somewhat off its pre- and post-pandemic lows, but remains close to the average level seen between 2017 and 2019 (Chart 2). The index OAS is a reasonable gauge of value relative to recent history, but for a longer historical perspective we should adjust the index to account for its changing average credit rating and duration. To do this, we first re-weight the index to maintain a constant distribution between the different credit rating buckets. Next, we control for the index’s changing duration by calculating a 12-month breakeven spread. The 12-month breakeven spread is the spread widening that must occur during the next 12 months for the corporate index to perform in line with a duration-matched position in Treasuries. It can be approximated by dividing the index OAS by average index duration. Finally, Chart 3 presents the 12-month breakeven spread as a percentile rank since 1995. It shows that, after controlling for credit rating and duration, the investment grade corporate index has only been more expensive than current levels 24% of the time since 1995. Notice that the spread bounced off the 0% line in late-2021, indicating that it had reached all-time expensive levels. Chart 2Spreads Near 2017-19 Average Chart 3Investment Grade Valuation All in all, we can conclude that investment grade corporate bonds are quite expensive. Spreads aren’t so low that they would justify an underweight allocation in a supportive cyclical/monetary environment. But they are tight enough that it makes sense to proceed cautiously in a neutral or negative cyclical/monetary environment, like the one we are in today.   Cyclical/Monetary Indicators The slope of the yield curve is the key variable we use to assess the current state of the cyclical/monetary environment. A very flat or inverted yield curve signals a relatively restrictive monetary policy backdrop, and we have shown that such a backdrop tends to coincide with poor excess corporate bond returns. Conversely, we have found that corporate bonds perform best early in the economic recovery when the yield curve is very steep. This steep yield curve signals that monetary conditions are highly accommodative, and thus supportive of credit spread tightening. Today, the yield curve is sending a somewhat confusing message. The 2-year/10-year Treasury slope briefly inverted last week, and it remains flat at 22 bps. Meanwhile, the 3-month/10-year Treasury slope is very steep, up above 200 bps (Chart 4)! Chart 4Conflicting Signals From The Yield Curve We discussed how to interpret the signals from different yield curve segments in a recent Special Report.2 We found that the 2-year/10-year Treasury slope sends the most useful signal for corporate bond excess returns, and we therefore view current cyclical/monetary conditions as negative for corporate bonds. In Table 2 we split each of the past six economic cycles into phases based on the 2-year/10-year Treasury slope. We define Phase 1 of the cycle as the period from the end of the prior recession until the 2-year/10-year slope breaks below 50 bps. Phase 2 of the cycle encompasses the time when the slope is between 0 bps and 50 bps. Phase 3 of the cycle spans from when the yield curve inverts until the start of the next recession. Table 2US Corporate Bond Performance In Different Phases Of The Cycle The table shows annualized excess returns for both investment grade and high-yield corporate bonds in each of the three phases, and those returns exhibit a clear pattern. Returns are best in Phase 1 when the yield curve is steep. They take a step down in Phase 2 when the slope is between 0 bps and 50 bps, though they usually stay positive. Negative returns are most likely in Phase 3, after the yield curve inverts. Chart 5Limited Room For Curve Steepening With the 2-year/10-year Treasury slope at 22 bps, we are firmly in Phase 2 of the cycle. However, we could easily see the 2-year/10-year slope invert within the next few months while a breakout above 50 bps seems less likely. In fact, there are only two ways in which the 2-year/10-year Treasury slope can steepen further from current levels. First, the market could bid up its expectation of the long-run neutral fed funds rate, pushing long-dated bond yields higher. Second, expectations for the pace of near-term Fed tightening could diminish, pulling short-dated yields down. At the long-end, the 5-year/5-year forward Treasury yield is already above survey estimates of the long-run neutral rate (Chart 5). At the front-end, the market is discounting a rapid pace of 272 bps of tightening during the next 12 months (Chart 5, bottom panel), but that pace has limited room to fall given current extremely high inflation readings. Turning back to a comparison of the signals from the 2-year/10-year slope and 3-month/10-year slope, it is worth pointing out that the 3-month/10-year slope is influenced by yield movements at the very front-end of the curve. Meanwhile, the 2-year/10-year slope is purely a function of rate expectations beyond the next two years. As a result, we can view the 3-month/10-year slope as sending a timelier signal about Fed rate hikes and cuts, while the 2-year/10-year slope gives a better reading of how the market views the ultimate economic impact of Fed actions. For example, the 3-month/10-year Treasury slope inverted in 2019 just before the Fed started cutting rates (Chart 6A). The 2-year/10-year slope, however, only briefly dipped below zero. The message from the market was that the Fed would cut rates, but those cuts would be sufficient to sustain the economic recovery. As a result, corporate bonds performed well during this period, consistent with the message from the 2-year/10-year slope. Another interesting example occurred in early 2000 (Chart 6B). This time, the 2-year/10-year Treasury slope inverted while the 3-month/10-year slope remained steep. In this case, the 3-month/10-year slope was telling us that Fed rate hikes would continue, while the 2-year/10-year slope was telling us that those hikes would eventually kill the economic recovery. Once again, corporate bonds took their cues from the 2-year/10-year Treasury slope and performed poorly during this period. Chart 6AStrong Performance In 2019 Chart 6BPoor Performance In 2000 Obviously, the current situation looks more like 2000 than 2019, but with the 2-year/10-year slope still positive there remains scope for positive excess corporate bond returns in the near-term. That said, with high odds of 2-year/10-year curve inversion within the next few months and spreads at relatively tight levels, it makes sense to scale back exposure today in advance of the worst phase of the cycle. Balance Sheet Health The final factor we consider is the health of nonfinancial corporate sector balance sheets, and in fact, this is currently the lone bright spot for corporate bond investors. Our Corporate Health Monitor (CHM), a composite indicator of six key balance sheet ratios, is deep in “improving health” territory (Chart 7). This positive signal is driven by exceptionally high Interest Coverage (Chart 7, panel 2) and Free Cash Flow-To-Debt that is just off its highs (Chart 7, panel 3). Return On Capital is up sharply since 2020 but has not recovered its previous peak (Chart 7, bottom panel). Chart 7Balance Sheets Are In Great Shape While corporate balance sheets are in excellent shape right now, their health will certainly deteriorate going forward as profit growth comes down off its highs and interest rates rise. The only question is whether this deterioration will happen slowly or quickly. Turning to history, two relevant periods stand out (Chart 8). First is the mid-1990s when investment grade corporate bond excess returns peaked in July 1997, 16 months before our CHM moved into “deteriorating health” territory. Conversely, the CHM sent a negative signal before the excess return peak in 2007. But even then, investment grade corporates only outperformed Treasuries by an annualized 0.8% between when the 2-year/10-year slope fell below 50 bps in 2005 and when the CHM moved above zero in 2006. In other words, investors didn’t sacrifice much return by heeding the yield curve’s signal even when the CHM was deep in “improving health” territory. Chart 8Cyclical Corporate Bond Performance Investment Conclusions In summary, we view corporate bond valuations as expensive, and the flat 2-year/10-year Treasury slope suggests that the economic recovery is in its mid-to-late stages. Corporate balance sheets are currently in excellent shape, but they will deteriorate going forward as profit growth slows and interest rates rise. The above three factors suggest that corporate bonds could continue to outperform duration-matched Treasuries in the near-term. However, with spreads already at tight levels, we likely aren’t sacrificing much in the way of excess returns by turning cyclically defensive today. This move also ensures that we will not be invested when the credit cycle eventually turns and corporate bond spreads move significantly wider. Retain A Preference For High-Yield Versus Investment Grade While we recommend downgrading allocations for both investment grade (from neutral to underweight) and high-yield (from overweight to neutral), we think investors should still retain a preference for high-yield corporates over investment grade. To see why, let’s return to the 2005-06 period we looked at in the previous section. The yield curve dipped below 50 bps in 2005 when the CHM was still deep in “improving health” territory, and while investment grade corporate bond returns were low during the time between the signal from the yield curve and the signal from the CHM, junk excess returns were very strong (Chart 9). This makes some sense intuitively. Higher-rated investment grade corporates responded negatively to the Federal Reserve’s removal of monetary policy accommodation, but lower-rated junk spreads stayed well bid because actual default risk was benign. It wasn’t until after the CHM rose above zero that junk bonds started to underperform. In terms of present-day valuations, much like for investment grade, junk spreads are up off their 2021 lows. However, they remain close to their pre-pandemic trough (Chart 10). We also note that the differential between high-yield and investment grade spreads was much tighter in 2006-07. Given the similarities between that period and today, we wouldn’t be surprised to see junk spreads compress further relative to investment grade. Chart 9The Bullish Case For Junk Chart 10High-Yield Valuation Another way to approach high-yield bond valuation is through the lens of our Default-Adjusted Spread. The Default-Adjusted Spread is the difference between the junk index OAS and 12-month default losses, and we have shown that it has a strong correlation with excess returns (Table 3). Specifically, a Default-Adjusted Spread above 100 bps usually coincides with positive excess junk returns versus Treasuries, and higher spreads tend to coincide with higher returns. Table 3The Default-Adjusted Spread & High-Yield Excess Returns To estimate the Default-Adjusted Spread for the next 12 months we need assumptions for the default and recovery rates (Chart 11). To do this, we model the 12-month speculative grade default rate as a function of gross nonfinancial corporate leverage – total debt over pre-tax profits – and lagged C&I lending standards. We then model the 12-month recovery rate based on the default rate itself. Chart 11Default And Recovery Rate Models Corporate pre-tax profit growth was exceptionally strong during the past 12 months, and we expect it to slow significantly going forward. Profit growth can be modeled as a function of nominal GDP growth and unit labor costs (Chart 12). If we assume that nominal GDP growth comes in at 7.3% this year (the Fed’s median 2.8% real GDP estimate plus 4.5% inflation) and that unit labor cost growth rises to 6%, then profit growth will fall to 0.5% during the next 12 months. If we assume that corporate debt growth remains close to its current level (Chart 12, bottom panel), then we calculate that gross leverage will rise to 6.5 during the next 12 months. Chart 12Profit Growth Will Slow Significantly Table 4 shows the output from our default and recovery rate models under the base case assumption described above. It also shows results for an optimistic case where leverage is 6.0 and a pessimistic case where it is 7.0. The Default-Adjusted Spread is fairly low in the base and pessimistic cases, but it is comfortably above the key 100 bps threshold in all three scenarios. This suggests that junk bonds should deliver positive excess returns versus duration-matched Treasuries during the next 12 months. Table 4Default-Adjusted Spread Scenarios   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Portfolio Allocation Summary, “The Beginning Of The End”, dated April 5, 2022. 2 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. Treasury Index Returns Spread Product Returns Recommended Portfolio Specification Other Recommendations

Special Report

Highlights There is no evidence of a decline in US corporate credit or bank lending spreads over the past few decades, meaning that any excess savings effect structurally depressing interest rates is occurring in the Treasury market. We note the possible mechanisms of action for excess savings to lower government bond yields, by lowering the current policy rate, expectations for the policy rate in the future, or the term premium on long-maturity bonds. To investigate the impact that excess savings may be having on bond yields, we define historical periods of abnormal yields based on the gap between long-maturity Treasury yields and the potential rate of economic growth. This reflects our view that potential growth is the equilibrium interest rate under normal economic conditions. Since 1960, there have been three major episodes when the difference between bond yields and economic growth was large and persistent, but the first two seem to be easily explained by the stance of US monetary policy rather than by a savings/investment imbalance. The excess savings story better fits the facts after 2000. We do find evidence that a global savings glut lowered bond yields during the early-2000s, and it may have even modestly contributed to the excessive household credit demand that ultimately caused the global financial crisis. But as a deviation from equilibrium, the effect of the global savings glut was relatively insignificant compared to what has prevailed over the past decade. Excess savings did certainly play a role in lowering long-term investor expectations for the Federal funds rate during the last economic cycle, but it did so for cyclical reasons that spanned several years rather than as a result of demographic effects or other structural factors unrelated to the business cycle. That is an important distinction, as long-term investor expectations for the Fed funds rate remained low in the second half of the last economic expansion despite a reduction in savings and significantly stronger growth. The historical impact of FOMC meetings on the structural decline in long-maturity US Treasury yields strongly implies that fixed-income investors have been guided by the Fed to expect a lower average Fed funds rate. It is our view that the Fed has a backward-looking neutral rate outlook, informed by an incomplete understanding of the economic circumstances of the latter half of the last expansion. A low neutral rate narrative has become entrenched in the minds of investors and the Fed itself, and we regard this as the primary factor anchoring yields at the long-end of the maturity spectrum. This phenomenon is only likely to dissipate once short-term interest rates rise and a recession does not materialize. While the nearer-term outlook more likely favors a neutral or at best modestly short duration stance within a fixed-income portfolio, investors should remain structurally short duration in response to a potentially rapid shift in long-term interest rate expectations from the Fed and fixed-income investors over the coming few years. Feature Chart II-110-Year US Treasury Yields Are The Lowest Relative To Headline Inflation In Over 60 Years For many investors, one of the most striking features of the pandemic, especially over the past year, is how low US long-maturity government bond yields have remained in the face of the highest headline consumer price inflation in four decades (Chart II-1). To many investors, this has provided even further evidence of a structural “excess savings” effect that has kept interest rates well below the prevailing rate of economic activity. The theory of secular stagnation, revived by Larry Summers in late 2013, is a related concept, but many investors believe that interest rates will remain low even in a world in which the US economy is growing at or even above its trend. The fundamental basis for this view is the idea that over the longer term, the real rate of interest is determined by the balance (or imbalance) between desired savings and investment, and that advanced economies have and will continue to experience excess savings – defined as a chronically high level of desired savings relative to the investment opportunities available. According to this view, in order for the actual level of savings to equal investment, interest rates must fall. Chart II-2Do Excess Savings Explain This Gap? (Spoiler: No) This report challenges the view that excess savings are mostly responsible for the current level of long-term bond yields in the US. We agree that excess savings have played a role in explaining changes in long-term bond yields at different points over the past 20 years; we also agree that it is normal for interest rates in advanced economies to trend down over time in response to a demographically-driven decline in potential growth. But our goal is not to explain the downtrend in interest rates over time. Instead, we aim to explain the gap between the level of long-term bond yields today and the prevailing rate of economic activity, or consensus forecasts of the trend rate of growth (Chart II-2). We do not believe that this gap is economically justified, nor do we believe that it is driven by excess savings. We conclude that the Fed’s backward-looking neutral rate outlook is the primary factor anchoring US Treasury yields at the long-end of the maturity spectrum. This is only likely to change once short-term interest rates rise and a recession does not materialize; it suggests that investors should remain structurally short duration in response to a potentially rapid shift in long-term interest rate expectations from the Fed and fixed-income investors over the coming few years. Excess Savings And Interest Rates: Defining A “Mechanism Of Action” Households, businesses, and governments can directly purchase debt securities in capital markets, but they do not typically provide loans directly to borrowers. Direct lending usually occurs through the banking system, which means that excess savings would only lower interest rates in the economy through one of the following ways: By lowering the Fed funds rate By lowering long-maturity government bond yields relative to the Fed funds rate, by reducing either the term premium or investors’ expectations for the average Fed funds rate in the future By lowering corporate bond yields relative to duration-matched government bond yields By lowering lending rates on bank loans relative to banks’ cost of borrowing Charts II-3-II-5 highlight that there is no evidence of a structural decline in corporate credit spreads or bank lending rates relative to the Fed funds rate, so we can rule out this effect as a mechanism of action for excess savings to have structurally lowered interest rates. Chart II-6 highlights that interest paid on bank deposits lags the Fed funds rate, so we can also rule out the idea that excess deposits force the Fed to keep the effective Fed funds rate low. Chart II-3No Evidence Of A Structural Decline In Corporate Credit Spreads… Chart II-4…Or Auto Loan Rate Spreads… Chart II-5…Or Personal Loan Rate Spreads… Chart II-6...Or Bank Deposit Rate Spreads This means that if excess savings are depressing interest rates in the US, that the effect is truly occurring in the Treasury market. As noted, this could occur by lowering the current policy rate, expectations for the policy rate in the future, or the term premium on long-maturity bonds. Related Report  The Bank Credit AnalystR-star, And The Structural Risk To Stocks All of these effects are certainly possible. Keynes’ paradox of thrift highlights that excess savings can manifest itself as a chronic shortfall in aggregate demand, which would persistently lower the Fed funds rate as the Fed responds to a long period of high unemployment. This could also lower the term premium on long-maturity bond yields in a scenario in which the Fed repeatedly engages in asset purchases to help stabilize aggregate demand. As well, domestic excess savings could lower the term premium on long-maturity bond yields, as aging savers directly purchase government securities as part of their retirement portfolios. Finally, foreign capital inflows could also cause this effect, especially if they originate from countries with chronic current account surpluses that use an increase in US dollar reserves to purchase long-maturity US government securities. Table II-1 summarizes these possible mechanisms of action for excess savings to lower US government bond yields. With these mechanisms in mind, we review the past 60 years to identify periods of “abnormal” bond yields, with the goal of understanding whether excess savings appear to explain major gaps. Table II-1Possible Mechanisms Of Action For Excess Savings To Lower Long-Term Government Bond Yields Identifying Periods Of “Abnormal” Long-Maturity Bond Yields Chart II-7There Have Been Three Distinct Periods Of Abnormal Long-Maturity Bond Yields Chart II-7 shows the difference between nominal 10-year US Treasury yields and nominal potential GDP growth. Panel 2 shows an alternative version of this series using the ten-year median annualized quarterly growth rate of nominal GDP in lieu of estimates of potential growth, which highlights a generally similar relationship. This approach to defining “abnormal” long-maturity bond yields reflects our view that the potential rate of economic growth is the equilibrium interest rate under normal economic conditions. To see why, given that GDP also effectively represents gross domestic income, an interest rate that is persistently below the potential growth rate of the economy would create a strong incentive to borrow on the part of households and especially firms. Chart II-7 makes it clear that the relationship has been mean-reverting over time, but that there have been three major episodes when the difference between bond yields and economic growth was large and persistent. The first episode occurred from 1960 to the late 1970s, and saw government bond yields average well below the prevailing rate of economic growth. We do not see this period as having been caused by an excess of desired savings relative to investment. As we discussed in our November Special Report,1 this gap represented a period of persistently easy monetary policy which contributed to excessive aggregate demand and a structural rise in inflation. The second major episode is also easily explained, as it occurred in response to the first. Following a decade of high inflation, Fed chair Paul Volcker raised interest rates aggressively beginning in 1979 to combat inflationary expectations, which led to a two-decade period of generally tight monetary policy. Like the first period, this was not caused by an imbalance between desired savings and investment. The third episode has prevailed since the late-1990s, and has seen a negative yield/growth gap on average – albeit one that has been smaller than what occurred in the 1960s and 1970s. From 2000 to 2007, the gap was generally negative, although it turned positive by the end of the economic cycle. It was modestly negative on average from 2008 to 2010, and only became persistently negative starting in 2011. The gap fell to a new low during the COVID-19 pandemic, and remains wider today than at any point during the last economic recovery. It is these post-2000 periods of a persistently negative yield/growth gap that should be closely investigated for evidence of an excess savings effect. The Global Savings Glut As noted, prior to 2000, the yield/growth gap in the US seems clearly explained by the Fed’s monetary policy stance, not by an excess savings effect. So the question is whether there is any evidence of excess savings having caused this negative gap since 2000. In our view, the answer is yes, but the effect was relatively small compared to what prevails today. We do find evidence of a global savings glut during the early-2000s. Chart II-8 highlights that the private and external sector savings/investment balances in China and emerging markets more generally were persistently positive during the 2000s. Chart II-9 highlights that multiple estimates of the term premium declined around that time – especially during Greenspan’s “conundrum” period of between 2004 and 2005. Chart II-8There Was A Global Savings Glut Prior To The Global Financial Crisis Chart II-9The Global Savings Glut Does Seem To Have Lowered The Term Premium On US 10-Year TreasurysChart II-10 breaks down the components of the 10-year yield into the 5-year yield and the 5-year/5-year forward yield, and highlights that the negative correlation between the two components lasted for only one year. Overall, the 10-year Treasury yield was lower than potential growth for roughly two years as a result of the global savings glut effect.       Chart II-10Still, The Global Savings Glut Effect Did Not Last Long And Was Not Especially Large In Magnitude This was a significant event, and it may even have modestly contributed to the excessive household credit demand that ultimately caused the global financial crisis. But as a deviation from equilibrium, it was relatively insignificant compared to what has prevailed over the past decade. Excess Savings And US Household Deleveraging Chart II-11Most Of The Post-2007 Decline In 10-Year Yields Is Attributable To Lower Long-Term Fed Funds Rate Expectations Chart II-11 highlights that, relative to June 2007 levels, the vast majority of the cumulative decline in the 10-year Treasury yield has occurred because of a decline in implied long-term expectations for the Fed funds rate, rather than a major decline in the term premium. The chart also shows that almost all the decline in implied long-term interest rate expectations since 2007 occurred during the 2008/2009 recession. This normally occurs during a recession as investors price in a low average Fed funds rate at the short end of the curve; the anomaly is that these expectations remained permanently low even as the economy recovered and as the Fed raised interest rates from 2015 to 2018. To us, Chart II-11 also underscores that the Fed’s asset purchases are not the main culprit behind low long-maturity bond yields today, given that the decline in long-term expectations for the Fed funds rate persisted even as the Fed stopped purchasing assets in 2014. It is not difficult to see why investors lowered their long-term Fed funds rate expectations in the immediate aftermath of the global financial crisis, even as economic recovery took hold. Chart II-12 highlights that the “balance sheet” nature of the 2008/2009 recession unleashed the longest period of US household deleveraging in the post-WWII period, and Chart II-13 highlights that this occurred despite extremely low interest rates – and in contrast to other countries like Canada that did not experience the same loss in household net worth. Chart II-12Household Deleveraging Did Lower The Neutral Rate For Several Years Following The Global Financial Crisis Chart II-13The US Balance Sheet Recession Structurally Impaired Credit Demand For Several Years After 2008     Given that interest rates represent the price of borrowing, it is entirely unsurprising that a US balance sheet recession led to a persistent period in which credit growth was essentially unresponsive to interest rates, as households struggled to rebuild wealth lost during the recession and were unable to, or uninterested in, releveraging. This is another way of saying that the neutral rate of interest fell during that period, which we agree did occur. It is also accurate to characterize the US as having experienced a sharp increase in desired savings over that period, as highlighted by the explosion in the US private sector financial balance in the initial years of the last economic recovery (Chart II-14). Chart II-14Excess Savings Surged After 2008, But Eventually Normalized. Long-Term Rate Expectations Ignored The Normalization. So excess savings did certainly play a role in lowering long-term investor expectations for the Federal funds rate during the last economic cycle, but it did so because of cyclical reasons that spanned several years rather than because of demographic effects or other structural factors unrelated to the business cycle. That is an important distinction, because while Chart II-14 shows that this excess savings effect eventually waned in importance, long-term investor expectations for the Fed funds rate remained low in the second half of the last economic expansion. Chart II-15Growth Was Historically Weak Last Cycle, But Only Because Of The First Few Years Of The Expansion Chart II-15 highlights that the cumulative annualized growth in real per capita GDP during the last economic cycle was significantly below that of the average of previous expansions, but this was only the case because of the very slow growth period between 2008 and 2014. Per capita growth during the latter half of the expansion was comparable to that of previous expansions, and this occurred while the Fed was raising interest rates. And yet, investors only modestly raised their long-term interest rate expectations during that period. In our view, it is this fact that holds the key to understanding why investors’ long-term rate expectations are still low today. An Alternative Explanation For Today’s Extremely Low Long-Maturity Bond Yields Chart II-16Fixed-Income Investors Have Been Guided By The Fed To Expect A Low Average Fed Funds Rate Chart II-16 highlights that, since 1990, all of the structural decline in US 10-year Treasury yields has occurred within a three-day window on either side of FOMC meetings. This strongly suggests that fixed-income investors have been guided by the Fed to expect a low average Fed funds rate, which is consistent with how similar 5-year/5-year forward US Treasury yields are in relation to published FOMC and market participant estimates of the average longer-run Fed funds rate (as shown in Chart II-2). This raises the important question of why the Fed did not revise up its expectation for the neutral rate during or following the second half of the last economic expansion, when growth was much stronger than during the first half. In our view, one of the clearest articulations of the Federal Reserve’s understanding of the neutral rate of interest was presented in a 2015 speech by Lael Brainard at the Stanford Institute for Economic Policy Research. Brainard noted the following: “The neutral rate of interest is not directly observable, but we can back out an estimate of the neutral rate by relying on the observation that output should grow faster relative to potential growth the lower the federal funds rate is relative to the nominal neutral rate. In today’s circumstances, the fact that the US economy is growing at a pace only modestly above potential while core inflation remains restrained suggests that the nominal neutral rate may not be far above the nominal federal funds rate, even now. In fact, various econometric estimates of the level of the neutral rate, or similar concepts, are consistent with the low levels suggested by this simple heuristic approach.”2 Chart II-17The Fed, Wrongly, Sees The 2019 Experience As Having Confirmed A Low Neutral Rate... Given how the Fed determines the neutral rate is, two factors explain why the Fed’s estimates of the neutral rate have not increased (and, in fact, fell modestly in March). First, core inflation remained below 2% from 2015-2019, despite the fact that the economy was clearly growing at an above-trend pace during this period in the face of Fed rate hikes. We have noted in previous reports the role that the 2014 collapse in oil prices had on household inflation expectations. The latter were already vulnerable to a disinflationary shock, given how negative the output gap had been in the first half of the expansion.3 We do not think that the decline in inflation expectations that occurred following the 2014 collapse in oil prices reflects a low neutral rate, but rather we believe that the Fed saw this as a conundrum that supported the expectation of a low average Fed funds rate. The second event explaining the Fed’s persistently low long-term rate expectations is the fact that the Fed was forced to cut interest rates in 2019, which we believe it saw as confirmation that the stance of monetary policy had become either meaningfully less easy or openly tight. From the Fed’s point of view, this perspective was also supported by recessionary indicators, such as the inversion of the 2-10 yield curve (Chart II-17), and popular (but now discontinued) econometric estimates of the real neutral rate of interest, such as those calculated by the Laubach-Williams model (panel 3). Chart II-18...Without Appreciating The Damaging Impact The China-US Trade War Had On Global Activity However, this view entirely ignores the fact that the US and global economies were negatively impacted in 2018 and 2019 by a politically-motivated nonmonetary shock to aggregate demand: the China-US trade war, which also impacted or targeted several major advanced economies. Chart II-18 highlights that global trade uncertainty exploded during this period, which severely damaged business confidence around the world and caused a slowdown in global industrial production. Tighter Chinese policy also likely contributed to the slowdown in global activity, but the bottom line is that factors other than US monetary policy contributed to economic weakness during this period, and that it is incorrect to infer from the 2018/2019 experience that interest rates rose to or exceeded the neutral rate of interest. In short, it is our view that the Fed has simply become backward-looking in how it perceives the neutral rate of interest; it has not yet observed a period when the Fed funds rate has risen to its estimate of neutral but is unambiguously still easy. Fixed-income investors, having demonstrably anchored their own assessments to those of the Fed over the past 30 years, have had no basis to come to a meaningfully different conclusion. We believe that the Fed’s backward-looking low neutral rate outlook has now become entrenched in the minds of investors and the Fed itself, and is the primary factor anchoring yields at the long-end of the maturity spectrum. This will probably only change once short-term interest rates rise and a recession does not materialize. As a final point, we clearly acknowledge that private savings increased massively during the pandemic. Investors who are inclined to see excess savings as the primary driver of low bond yields will point to this fact. But this was a forced increase in savings, rather than a desired one. The rise in household sector savings occurred mostly because of a substantial reduction in services spending, as pandemic restrictions and forced changes in behavior prevented the consumption of many services. The household savings rate has already returned to its pre-pandemic level in the US, and 5-year/5-year forward Treasury yields have risen to a higher point than they were prior to the onset of the COVID-19 pandemic. US households are likely to deploy a portion of their enormous stock of excess savings, as the pandemic continues to recede in importance, which is one of the main reasons to expect that the US economy will not succumb to a recession over the coming 12-18 months – and why investors and the Fed may soon be presented with evidence that warrants an increase in their long-term interest rate expectations. Investment Conclusions There are two important investment implications of the view that the Fed’s backward-looking neutral rate projection is the primary factor anchoring yields at the long end of the maturity spectrum. As we noted in Section 1 of our report, the first implication is that investors will likely be faced with a recession scare as the 2-10 yield curve durably inverts and as rate sensitive sectors of the economy, such as housing, inevitably slow in response to the extremely sharp rise in mortgage rates that has occurred over the past three months. We believe that it is ultimately the level of interest rates that matters for economic activity, rather than the change in interest rates. Large changes over short periods of time, however, create a degree of uncertainty about the trajectory of rates that temporarily impacts economic activity. This underscores that investors should not maintain an aggressively overweight stance toward global equities in a multi-asset portfolio, as it is likely that concerns about corporate profits will increase significantly at some point this year. The second investment implication is that US long-maturity bond yields could increase to much higher levels over the coming 12-24 months than many investors expect, in a scenario in which pandemic-driven price pressure dissipates, real wages recover, and no major politically-driven nonmonetary policy shocks emerge. We acknowledge that long-term interest rate expectations are unlikely to change until hard evidence of the economy’s capacity to tolerate interest rates above the Fed’s implied current estimate of the neutral rate emerges. This is a case, however, when we believe that investors should heed the now-famous words of Rüdiger Dornbusch: “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” As such, while the nearer-term outlook more likely favors a neutral or at best modestly short duration stance within a fixed-income portfolio, investors should remain structurally short duration in response to a potentially rapid shift in long-term interest rate expectations from the Fed and fixed-income investors over the coming few years. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1 Please see The Bank Credit Analyst "Gauging The Risk Of Stagflation," dated October 29, 2021, available at bca.bcaresearch.com 2 Lael Brainard, Normalizing Monetary Policy When The Neutral Rate Is Low, December 2015 3 Please see The Bank Credit Analyst "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated December 18, 2020, available at bca.bcaresearch.com

Executive Summary Table 1Equity Capitulation Scorecard We have put together a framework to capture the extent to which recent economic and political developments have been priced in by the equity market.  It has seven criteria: Rate stabilization has not materialized yet, monetary conditions will continue to tighten Economic growth expectations do not yet reflect the deteriorating economic backdrop.  US GDP forecasts will be downgraded which will be a drag on equity performance Earnings growth expectations need to come down to reflect supply disruptions, raging input prices, and the stronger dollar Oil prices have stabilized which provides support for US equities Valuations have retraced, signaling that the market is reasonably priced Technicals signal that the market is oversold “Black swans”: The effects of the war in Ukraine will be a drag on US equities and are not yet fully priced in.  However, China’s pledge to be more investor-friendly is a positive. On balance, risks for US equities slightly outweigh the upside opportunity. Bottom Line: Although many ingredients for a sustainable rally are already in place, our analysis concludes that US equities have not hit rock bottom yet, and time is needed to resolve remaining headwinds. Feature The S&P 500 and NASDAQ are in correction territory, having pulled back 13% and 22%, respectively from their peak. Over the past few months, investors had to process a witches’ brew of staggering inflation, impending monetary tightening, and a war in the heart of Europe. Too much! Related Report  US Equity StrategyAre We There Yet? However, over the past couple of days, US equities have staged an aggressive rally: The S&P rebounded 5.5% and the NASDAQ 8%. While we are long-term investors and don’t focus on short-term market moves, we find a recent market turn a good excuse to take a close look at US equities and gauge whether this recent rally is a “dead-cat bounce” or the market has truly bottomed and is in the early stages of a recovery rally. To do so, we have put together a framework to capture the extent to which recent economic and political developments have been priced in by the equity market. “Equity Capitulation” Framework Historically, equities bottomed when bad news had been reflected in expectations, valuations had come down to reflect the new economic reality, and investors had capitulated. Here are our criteria for an equity rebound this economic cycle: Monetary tightening has been priced in and rates have stabilized Economic growth expectations have been downgraded Energy prices have normalized Earnings growth expectations have come down and earnings are unlikely to surprise on the downside Investors have capitulated and sentiment is rock-bottom Valuations have lost their “good times” froth and are attractive There are resolutions of the geopolitical factors that have contributed to market turmoil In this report, we will go through each of the criteria and do our best to gauge whether “we are there yet.” Pricing In Tighter Monetary Policy – Rate Stabilization Is Still Elusive The recent correction of US equities reflects a repricing due to tighter monetary policy. The million-dollar question is how much monetary tightening is priced in and when will rates stabilize? To our minds, this is one of the key conditions for a sustainable bull market. Last week, the Fed raised rates for the first time since 2018. This first rate hike is 0.25 - 0.50, which did not come as a surprise and was broadcast well in advance. The latest dot plot also signals that the Fed expects the target rate to reach 1.75% by the end of 2022, i.e., six more hikes are expected this year. However, a day after the announcement, the market is pricing eight to nine rate hikes (Chart 1), with the Fed rate ending the year at 2.25-2.5%. Thus, the market expects aggressive Fed action and is likely to be positively surprised when the Fed takes a more measured approach than anticipated. This is certainly positive for equities.   Chart 1The Market Is Pricing More Hikes In 2022 Then The Fed Chart 2Monetary Conditions Will Continue To Tighten However, despite the market coming to terms with an aggressive hiking schedule, monetary conditions are still easy (Chart 2), and real rates are negative. With the Fed’s emphasis on combating inflation, it is reasonable to expect that monetary conditions will continue to tighten, and real rates will rise. Also, nominal rates don’t yet show any signs of stabilization either (Chart 3). What does this mean for equities? Empirical analysis demonstrates that it takes around three months after the first hike for equities to adjust to a new monetary regime and deliver positive returns (Chart 4). Chart 3Rates Have Not Stabilized Yet Chart 4Adjusting to A Tighter Monetary Regime Takes Time Monetary conditions are likely to tighten further. Rate stabilization, which we are looking for, has not materialized just yet. On a positive note, we don’t expect any negative surprises from the Fed. Forecasts Need To Reflect Slowing Economic Growth According to the Bloomberg consensus, economic growth expectations for 2022 are still robust and have not been substantially downgraded (Chart 5). The market still expects the US economy to grow at 3.55%, compared to 3.8% in January, despite monetary tightening, falling ISM PMI readings (Chart 6), and soaring energy costs. The Fed is more realistic about the effects of its policy on economic growth, changing expectations from 4% to 2.8%. The logical conclusion is that more GDP growth downgrades are on the way. The latest reading of the Atlanta Fed stands at only 1.3%. Chart 5Economic Forecasts Do Not Yet Reflect Deteriorating Macro Backdrop Chart 6Surveys Signal Growth A Slow Down It is also important to note that both the direct and indirect effects of the war in Ukraine are yet to be reflected in US growth forecasts: Since the beginning of the war, the GSCI Commodities index has increased by 11%. One might argue that soaring commodity prices are a temporary phenomenon and forward curves signal eventual reversion to long-term averages. However, this may take months and even years, and by then, most of the stockpiles and hedges are likely to run out. Growth expectations are likely to fall, or worse yet, economic growth may surprise on the downside. Earnings Expectations Need To Come Down Similar to economic growth forecasts, bottom-up earnings growth expectations have barely budged (Chart 7): The market is still expecting about 9% earnings growth over the next 12 months. However, global supply disruptions and raging input prices are bound to cut into corporate profitability and slow earnings growth. Chart 7Earnings Expectations Have Not Budged To make things worse, the US dollar has appreciated by nearly 10% since the beginning of 2021 (Chart 8). Since companies in the S&P 500 derive 40% from abroad, the strong greenback is bound to translate into softer overseas profits, cutting into the profitability of US multinationals. The effect of a stronger currency will be further exacerbated by the withdrawal of US companies from Russia to protest the war in Ukraine. While most US companies have limited exposure to Russia, there are some that will take a hit: For example, Philip Morris derives 8% of sales from that market. McDonald’s announced that closing its restaurants in Russia will cost $50 million a month or 9% of annual sales. While it is hard to accurately gauge the effect of the war and self-sanctions on US corporate profits, on the margin it is definitely a negative. Chart 8Dollar Has Strengthened Significantly Earnings growth expectations have barely budged, and do not reflect a surge in commodity prices, a war, and slowing economic growth. We posit that downgrades are highly likely, and will be a drag on US equity performance. Oil Prices Have Stabilized The key channel for the war in Ukraine to affect the rest of the world is through the supply of energy. High energy prices present an economic danger because they touch every facet of the economy. Goldman Sachs estimates that spiraling electricity prices have already taken down 900,000 tonnes of aluminum capacity and 700,000 tonnes of zinc capacity in Europe. Certainly, in the past, a jump in the oil price has often been associated with recessions and negative equity returns (Chart 9). Therefore, we consider it a major shot in the arm that the WTI has come down from $130 to $105 on the back of lockdowns in China. This hiatus gives policymakers and oil producers time to negotiate deals and restart production – the onus is on US shale producers and Gulf nations. However, the long-term resolution is yet to be seen. Chart 9Oil Price Increases Have Been Associated With Negative Equity Returns Oil price stabilization provides solid support for US equity performance. Valuations – No Longer An Excuse Not To Buy The correction in US equity markets has taken the froth off valuations: The S&P 500 forward multiple has come down from roughly 23x to 19x earnings (Chart 10), with all of the change attributable to multiple contraction. The BCA S&P 500 Valuation Indicator shows that the index is no longer “overvalued” (Chart 11). Outright cheap? No. But valuations can no longer be an excuse not to buy. Also, there are multiple corners of the market that are outright cheap – lots of bottom fishing is already taking place. Chart 10Valuations Have Moderated Chart 11The S&P 500 Is No Longer Overvalued...   Valuations have moderated and the market is reasonably priced. Technicals – The Market Is Oversold While valuation multiples may contract further, most technical and sentiment indicators are flashing capitulation. The AAII Investor Bull/Bear Sentiment Indicator is below its March 2020 reading while the BCA Technical Indicator has shifted towards the oversold zone (Chart 12). It is important to note that this indicator is driven primarily by momentum components – its reading is oblivious to the top-heavy index composition and reflects prospects for large caps. A useful way to look under the index’s hood is to consider the number of stocks that retraced from their highs, currently over 95% of NASDAQ stocks have retraced  (Chart 13). This high a reading flashes that the market is oversold, and there are lots of bargains to be had. Chart 12...Or Overbought Chart 13Majority Of Stocks Are Oversold   Technicals indicate an oversold market. Black Swans Have Landed The war in Ukraine: Optimism about a potential peace deal between Russia and Ukraine seems premature – the conflict is just getting started and neither side will be backing off until it has to surrender unconditionally. However, while the war is contained in Ukraine, and Russian gas is flowing to Europe, any crisis in the equity market would be averted. The war in Ukraine will remain a headwind to global equities for a while. And while the US equity market is insulated from the direct consequences of the crisis, indirect effects will continue to reverberate through its economy for now. The direct and indirect effects of the war in Ukraine will be a drag on US equities and are not yet fully priced in. China pledged to keep capital markets stable and vowed to support overseas stock listings, indicating that regulation of Big Tech will end soon. In addition, it promised to offer support for property developers to minimize their risks. And China’s pledge to be more investor-friendly is believable as in its current stage of economy and with the onset of COVID, the government is in dire need of propping up both the economy and the stock market. Of course, China still presents great uncertainty associated with lockdowns. This is a positive for the US market as there are a number of Chinese companies listed on the US stock exchanges. Putting It All Together Our Equity Capitulation scorecard has seven different criteria, as discussed above. According to our assessment of the economic and market environments, there are two factors that signal near-term equity rebound: Investor capitulation or Technicals, and Energy prices. However, there are still headwinds: Monetary conditions will continue to tighten, economic and earnings growth expectations will be downgraded, and the war in Ukraine is unlikely to end soon. On balance, risks for US equities slightly outweigh the opportunity. The final score is -1, which indicates a mildly negative stance on US equities (Table 1). However, most of the outstanding negatives are likely to be resolved soon (i.e., downward revisions of expectations). Table 1Equity Capitulation Scorecard Investment Implications Our equity capitulation indicator signals that cautious investors should continue to be underweight equities on the back of monetary tightening, slowing growth, and upcoming downward revision cycles. While Technicals and valuations make equities tempting, volatility in equities is likely to continue, and rallies will probably be short-lived. As always, long-term investors have more latitude in investment decision-making, and we believe that the long-term outlook for equities is positive. Bottom Line Our analysis concludes that US equities have not hit rock bottom yet, although many ingredients are already in place: Valuations are attractive, and equities are outright oversold. While buying equities at these levels is tempting, we recommend patience: Economic growth expectations are still elevated, and bottom-up earnings growth forecasts need to come down to reflect slowing growth and the direct and indirect effects of the war in Ukraine.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Executive Summary Ebbing Stagflation Fear Will Prompt Rerating European inflation will rise further before peaking this summer. Core CPI will reach between 2.8% and 3.2% by year-end before receding. The combination of stabilizing growth and the eventual peak in inflation will cause stagflation fears to recede. European assets have greater upside. Cyclicals, small-caps, and financials will be major beneficiaries of declining stagflation fears. The underperformance of UK small-cap stocks is nearing its end. UK large-cap equities are a tactical sell against Eurozone and Swedish shares. TACTICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Buy European & Swedish Equities / Sell UK Large Caps Stocks 03/21/2022     Bottom Line: Stagflation fears are near an apex as commodity inflation recedes. A peak in these fears will allow European asset prices to perform strongly over the coming quarters.     Despite a glimmer of hope that Ukraine and Russia may find a diplomatic end to the war, the reality on the ground is that the conflict has intensified. Although the hostilities are worsening and the European Central Bank (ECB) surprised the markets with its hawkish tone, European assets have begun to catch a bid. The crucial question for investors is whether this rebound constitutes a new trend or a counter-trend move? Our view about Europe is optimistic right now. The path is not a direct line upward. The recent optimism about the outcome of the Russia-Ukraine talks is premature; however, we are getting to the point when markets are becoming desensitized to the war and energy prices are losing steam. Moreover, the increasing number of statements by Chinese economic authorities pointing toward greater stimulus and support to alleviate the pain created by China’s stringent zero-COVID policy are another positive omen. Higher Inflation For Some Time European headline inflation is set to exceed 7% this summer and core CPI will increase between 2.8% and 3.2% by the end of 2022. Related Report  European Investment StrategySpring Stagflation The main force that will push inflation higher in Europe remains commodity prices. Energy inflation is extremely strong at already 32% per annum (Chart 1). It will increase further because of both the recent jump in Brent prices to EUR122/bbl on March 8 and the upsurge in natural gas prices, which were as high as EUR212/MWh on the same day before settling to EUR106/MWh last Friday. The impact of energy prices will not be limited to headline inflation and will filter through to core CPI (Chart 1, bottom panel). The average monthly percentage change in the Eurozone core CPI inflation stands at 0.25% for the past six months (compared to an average of 0.09% over the past ten years), or the period when energy-prices inflation has been the strongest. Assuming monthly inflation remains at such an elevated level, annual core CPI will hit 3.3% in the Eurozone by the end of 2022 (Chart 2). Chart 2Core CPI to Rise Further Chart 1Energy Inflation: Alive And Well The picture is not entirely bleak. Many forces suggest that these inflationary forces will recede before year-end in Europe. Energy prices are peaking, which is consistent with a diminishing inflationary impulse from that space. We showed two weeks ago that the massive backwardation of oil curves, the heavy bullish sentiment, and the high level of risk-reversals were consistent with a severe but transitory adjustment in the energy market. Oil markets will experience further volatility, as uncertainty around peace/ceasefire negotiations continues to evolve in Ukraine. Nonetheless, the peak in energy prices has most likely been reached. BCA’s energy strategists expect Brent to average $93/bbl in 2022 and in 2023. The potential for a decline in headline CPI after the summer is not limited to energy prices. Dramatic moves in the commodity market, from metals to agricultural resources, have made headlines. Yet, the rate of change of commodity prices is decelerating, hence, the commodity impulse to inflation is slowing sharply. As Chart 3 shows, this is a harbinger of a slowdown in European headline CPI. Related Report  European Investment StrategyFallout From Ukraine Looking beyond commodity markets, the recent deceleration in European economic activity also suggests weaker inflation in the latter half of 2022. Germany will likely suffer a recession because it already registered a negative GDP growth in Q4 2021. Q1 2022 growth will be even worse because of the country’s high exposure to both China and fossil fuel prices. More broadly, the recent deceleration in the rate of change of both the manufacturing and services PMIs is consistent with an imminent peak in the second derivative of goods and services CPI (Chart 4). Chart 3Commodity Impulse Is Peaking Chart 4Inflation's Maximum Momentum Is Now Underlying drivers of inflation also remain tame in Europe. European negotiated wages are only expanding at a 1.5% annual rate, which translates into unit labor costs growth of 1% (Chart 5). This contrast with the US, where wages are expanding at a 4.3% annual rate. A peak in inflation, however, does not mean that CPI readings will fall below the ECB’s 2% threshold anytime soon. The European economy continues to face supply shortages that the Ukrainian conflict exacerbates (Chart 6). Moreover, the recent wave of COVID-19 in China increases the risk of disruptions in supply chains, as highlighted by the closure of Foxconn factories in Shenzhen. Finally, inflation has yet to peak; mathematically, it will take a long time before it falls back below levels targeted by Frankfurt. Chart 5The European Labor Market Is Not Inflationary Chart 6Not Blemish-Free Bottom Line: European headline inflation will peak this summer, probably above 7%. Additionally, core CPI is likely to reach between 2.8% and 3.2% in the second half of 2022. As a result of a decline in the commodity impulse, inflation will decelerate afterward, but it will remain above the ECB’s 2% target for most of 2023. Hopes For Growth Two weeks ago, we wrote that Europe was facing a stagflation episode in the coming one to two quarters, but that, ultimately, economic activity will recover well. Recent evidence confirms that assessment. Chart 7A Coming Chinese Tailwind? The tone of Chinese policymakers is becoming more aggressive, in favor of supporting the economy. On March 16, Vice-Premier Liu He highlighted that Beijing was readying to support property and tech shares and that it will do more to stimulate the economy. True, this response was made in part to address the need to close cities affected by the sudden spike of Omicron cases around China. Nonetheless, the global experience with Omicron demonstrates that, as spectacular and violent the surge in cases may be, it is short-lived. Meanwhile, the impact of stimulus filters through the economy over many months. As a result, Europe will experience the impact of China’s Omicron-induced slowdown, while it also suffers from the growth-sapping effects of the Ukrainian conflict; however, it will also enjoy the positive effect on growth of a rising credit impulse over several subsequent quarters (Chart 7). Beyond China, the other themes we have discussed in recent weeks remain valid. First, European fiscal policy will become looser, as governments prepare to fight the slowdown caused by the war, while also increasing infrastructure spending to wean Europe off Russian energy. Moreover, European military spending is well below NATO’s 2% objective. This will not remain the case, as military expenditure may leap from less than EUR100bn per year to nearly EUR400bn per year over the coming decade. Second, European spending on consumer durable goods still lags well behind the trajectory of the US. With the energy drag at its apex today, consumer spending on durable goods will be able to catch up in the latter half of the year, especially with the household savings rate standing at 15% or 2.5 percentage points above its pre-COVID level. Bottom Line: European growth will be very low in the coming quarters. Germany is likely to face a technical recession as Q1 2022 data filters in. Nonetheless, Chinese stimulus, European fiscal support, pent-up demand, and a declining energy drag will allow growth to recover in the latter half of the year. As a result, we agree with the European Commission estimates that European growth will slow markedly this year. Market Implications In the context of a transitory shock to European economic activity and a coming peak in inflation, European stock prices have likely bottomed. Chart 8Depressed Sentiment To Help Beta Sentiment has reached levels normally linked with a durable market floor. The NAAIM Exposure Index has fallen to a point from which global markets often recover. Europe’s high beta nature increases the odds that European equities will greatly benefit in that context (Chart 8). Valuations confirm that sentiment toward European assets has reached a capitulation stage. The annual rate of change of the earnings yields in the earnings yields has hit 73%, which is consistent with a market bottom (Chart 9). More importantly, the change in European forward P/E tracks closely our European Stagflation Sentiment Proxy (ESSP), based on the difference between the Growth and Inflation Expectations’ components of the ZEW survey (Chart 10). For now, our ESSP indicates that stagflation fears in Europe have never been so widespread, but these fears will likely dissipate as energy inflation declines. This process will lift European earnings multiples. Chart 9Bad News Discounted? Chart 10Ebbing Stagflation Fear Will Prompt Rerating Earnings revisions will likely bottom soon as well. The ESSP is currently consistent with a dramatic decline in European net earnings revisions (Chart 10, bottom panel). It will take a few more weeks for lower earnings revisions to be fully reflected. However, they follow market moves and, as such, the 17% decline in the MSCI Europe Index that took place earlier this year already anticipates their fall. Consequently, as stagflation fears recede, earnings revisions will rise in tandem with equity prices. Chart 11Maximum Pressure On Corporate Spreads A decline in stagflation fears is also consistent with a decrease in European credit spreads in the coming months (Chart 11). This observation corroborates the analysis from the Special Report we published jointly with BCA’s Global Fixed-Income Strategy team last week.  In terms of sectoral implications, a decline in stagflation fears is often associated with a rebound in the performance of small-cap equities relative to large-cap ones (Chart 12, top panel). This reflects the greater sensitivity of small-cap equities to domestic economic conditions compared to large-cap stocks. Moreover, small-cap equities had been oversold relative to their large-cap counterparts but now, momentum is improving (Chart 12). As a result, it is time to buy these equities. Similarly, financials have suffered greatly from the recent events associated with the Ukrainian conflict. European financial institutions have not only been penalized for their modest exposure to Russia, they have also historically declined when stagflation fears are prevalent (Chart 13). This relationship reflects poor lending activity when the economy weakens, and the risk of a policy-induced recession caused by high inflation. Financials will continue their sharp rebound as stagflation fears dissipate. Chart 13Financials Have Suffered Enough Chart 12Small-Caps Time To Shine The dynamics in inflation alone are very important. As Table 1 highlights, in periods of elevated inflation over the past 20 years, financials underperform the broad market by 11.3% on average. It is also a period of pain for small-cap equities and cyclicals. Logically, exiting the current environment will offer opportunities in European cyclical equities and for financials in particular. Table 1Who Suffers From High Inflation? Chart 14Long Industrials & Materials / Short Energy Finally, a pair trade buying industrials and materials at the expense of energy makes sense today. Materials and industrials suffer relative to energy equities when stagflation rises, especially in periods when these fears reflect rising energy pressures (Chart 14). A reversal in relative earnings revisions in favor of materials and industrials will propel this position higher. Bottom Line: Sentiment toward European assets reached a selling climax in recent weeks. Stagflation fears in Europe have reached an apex, and their reversal will lift both multiples and earnings revisions in the subsequent quarters. Diminishing stagflation fears will also boost the appeal of European corporate credit, contributing to an easing in financial conditions. Small-cap stocks, cyclicals, and financials will reap the greatest benefits from this adjustment. Going long materials and industrials at the expense of energy stocks is an attractive pair trade. Key Risk: A Policy Mistake The view above is not without risks. The number one threat to European growth and assets is a policy mistake from the ECB. On March 10, 2022, the ECB’s policy statement and President Christine Lagarde’s press conference showed that the Governing Council (GC) will decrease asset purchases faster than anticipated. Chart 15Will The ECB Repeat It Past Mistakes? It is important to keep in mind the dynamics of 2011. Back then, the ECB opted to increase interest rates as European headline CPI was drifting toward 2.6% on the back of rising energy prices. According to our ESSP, the April 2011 interest rates hike took place at the greatest level of stagflation fears recorded until the current moment (Chart 15). Lured by rising inflation, the ECB ignored underlying weaknesses in European economic activity, which wreaked havoc on European financial markets and growth. If the ECB were to increase rates as growth remains soft, a similar outcome would take place. For now, the ECB’s communications continue to de-emphasize the need for rate hikes in the near term, which suggests that the GC is cognizant of the risk created by weak growth over the coming months. Waiting until next year, when activity will be stronger and the output gap will be closed, will offer the ECB a better avenue to lift rates durably. This risk warrants close monitoring of the ECB’s communication over the coming months. If headline inflation does not peak by the summer, the ECB is likely to repeat its past error, which will substantially hurt European assets. Our optimism is tempered by this threat. UK Outperformance Long In The Tooth? Last week, the Bank of England (BoE) increased the Bank Rate by 25bps to 0.75%, in a move that was widely expected. Yet, the pound fell 0.7% against the euro and gilt yields fell 6 bps. This market reaction reflected the BoE’s choice to temper its forward guidance. The central bank is now expected to increase interest rates to 2.2% next year, before they decline in 2024. The dovish projection of the BoE shows the MPC’s concerns over the impact of higher energy costs and rising National Insurance contributions on household spending. In the BoE’s opinion, the economy is very inflationary right now, but it will slow, which will mitigate the inflationary impact down the road. We share the BoE’s worries about the UK’s near-term economic outlook. The combination of higher taxes, higher interest rates, and rising energy costs will have an impact on growth. However, the rapid decline in small-cap stocks, which have massively underperformed their large cap-counterparts, already discounts considerable bad news (Chart 16). Additionally, small-cap equities relative to EPS have begun to stabilize, while relative P/E and price-to-book ratios have also corrected their overvaluations. In this context, UK small-cap equities are becoming attractive. Chart 17UK vs Eurozone: A Stagflation Bet Chart 16UK Small-Cap Stocks Have Purged Their Excesses In contrast to small-cap stocks, UK large-cap equities have greatly benefited from the global stagflation scare. The UK large-cap benchmark had the right sector mix for the current environment, overweighting defensive names as well as energy and resources. It is likely that when stagflation fears recede, UK equities will undo their outperformance (Chart 17). Technically, UK equities are massively overbought against Euro Area and Swedish stocks, both of which have been greatly impacted by stagflation fears and their pro-cyclical biases (Chart 18 & 19). An attractive tactical bet will be to sell UK large-cap stocks while buying Eurozone and Swedish equities, as energy inflation declines and as China’s stimulus boosts global industrial activity in the latter half of 2022 Bottom Line: Move to overweight UK small-cap stocks within UK equity portfolios. Go long Euro Area and Swedish equities relative to UK large-cap stocks as a tactical bet. Chart 18UK Overbought Relative To Euro Area... Chart 19… And Sweden   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Special Report

Executive Summary Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries​​​​ Tectonic geopolitical trends are taking shape in Emerging Markets (EMs) today that will leave an indelible imprint on the next decade. First, EMs have gone on a relatively unnoticed public debt binge at a time when the economic prospects of the median EM citizen have deteriorated. This raises the spectre of sudden fiscal populism, aggressive foreign policy or social unrest in EMs. China, Brazil and Saudi Arabia appear most vulnerable to these risks. Second, the defense bill of major EMs could be comparable to that of the top developed countries of the world in a decade from now. Investors must brace for EMs to play a central role in the defense market and in wars, in the coming years. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. To extract most from the theme of EM militarization, we suggest a Long on European Aerospace & Defense relative to European Tech stocks.   Trade Recommendation Inception Date Return LONG EUROPEAN AEROSPACE & DEFENSE / EUROPEAN TECH EQUITIES (STRATEGIC) 2022-03-18   Bottom Line: Even as EMs are set to emerge as protagonists on the world stage, investors must prepare for these countries to exhibit sudden fiscal expansions, bouts of social unrest or a newfound propensity to initiate wars. The only way to dodge these volatility-inducing events is to leverage geopolitics to foresee these shocks. Feature Only a few weeks before Russia’s war with Ukraine broke out, a client told us that he was having trouble seeing the importance of geopolitics in investing. “It seems like geopolitics was a lot more relevant a few years back, with the European debt crisis, Brexit, and Trump. Now it does not seem to drive markets at all”, said the client. To this we gave our frequent explanation which is, “Our strategic themes of Great Power Struggle, Hypo-Globalization, and Nationalism/Populism are now embedded in the international system and responsible for an observable rise in geopolitical risk that is reshaping markets”. In particular we highlighted our pessimistic view on both Russia and Iran, which have incidentally crystallized most clearly since we had this client conversation. Related Report  Geopolitical StrategyBrazil: The Road To Elections Won't Be Paved With Good Intentions Globally key geopolitical changes are afoot with Russia at war. In the coming weeks and months, we will write extensively about the dramatic changes we see taking shape in the realm of geopolitics and investing. We underscored the dramatic geopolitical realignment taking place as Russia severs ties with the West and throws itself into China’s arms in a report titled “From Nixon-Mao To Putin-Xi”. In this Special Report we highlight two key geopolitical themes that will affect emerging markets (EMs) over the coming decade. The aim is to help investors spot these trends early, so that they can profit from these tectonic changes that are sure to spawn a new generation of winners and losers in financial markets. (For BCA Research’s in-depth views on EMs, do refer to the Emerging Markets Strategy (EMS) webpage). Trend #1: Beware The Wrath Of EMs On A Debt Binge Chart 1The Pace Of Debt Accumulation Has Accelerated In Major EMs Investors are generally aware of the debt build-up that has taken place in the developed world since Covid-19. The gross public debt held by the six most developed countries of the world (spanning US, Japan, Germany, UK, France and Italy) now stands at an eye-watering $60 trillion or about 140% of GDP. This debt pile is enormous in both absolute and relative terms. But at the same time, the debt simultaneously being taken on by EMs has largely gone unnoticed. The cumulative public debt held by eight major EMs today (spanning China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey) stands at $20tn i.e., about 70% of GDP. Whilst the absolute value of EM debt appears manageable, what is worrying is the pace of debt accumulation. The average public debt to GDP ratio of these EMs fell over the early 2000s but their public debt ratios have now doubled over the last decade (Chart 1). EMs have been accumulating public debt at such a rapid clip that the pace of debt expansion in EMs is substantially higher than that of the top six developed countries (Chart 1). These six DMs have a larger combined GDP than the eight EMs with which they are compared. Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em (For in-depth views on China’s debt, do refer to China Investment Strategy (CIS) report here). Now developed countries taking on more debt makes logical sense for two reasons. Firstly, most developed countries are ageing, and their populations have stopped growing. So one way to prop up falling demand is to get governments to spend more using debt. Secondly, this practice seems manageable because developed country central banks have deep pockets (in the form of reserves) and their central banks are issuers of some of the safest currencies of the world. But EMs using the same formula and getting addicted to debt at an earlier stage of development is risky and could prove to be lethal in some cases. Also distinct from reasons of macroeconomics, the debt binge in EMs this time is problematic for geopolitical reasons. This Time Is Different EMs getting reliant on debt is problematic this time because their median citizen’s economic prospects have deteriorated. Growth is slowing, inflation is high, and job creation is stalling; thereby creating a problematic socio-political backdrop to the EM debt build-up. Growth Is Slowing: In the 2000s EMs could hope to grow out of their social or economic problems. The cumulative nominal GDP of eight major EMs more than quadrupled over the early 2000s but a decade later, these EMs haven not been able to grow their nominal GDP even at half the rate (Chart 2). Inflation Remains High: Despite poorer growth prospects, inflation is accelerating. Inflation was high in most major EMs in 2021 (Chart 3) i.e., even before the surge seen in 2022. Chart 2Major EM’s Growth Engine Is No Longer Humming Like A Well-Tuned Machine​​​​​ Chart 3Despite Slower Growth, Inflation In Major EMs Remains High​​​​​ Rising Unemployment: Employment levels have improved globally from the precipice they had fallen into in 2020. But unemployment today is a far bigger problem for major EMs as compared to developed markets (Chart 4). If the economic miseries of the median EM citizen are not addressed, then they can produce disruptive sociopolitical effects that will fan market volatility. This problem of rising economic misery alongside a rapid debt build-up, can also be seen for the next tier of EMs i.e. Mexico, Indonesia, Iran, Poland, Thailand, Nigeria, Argentina, Egypt, South Africa and Vietnam. While the average public debt to GDP ratios of these EMs fell over the early 2000s, the pace of debt accumulation has almost doubled over the last decade (Chart 5). Furthermore, the growth engine in these smaller EMs is no longer humming like a well-tuned machine and inflation remains at large (Chart 5). Chart 4Unemployment - A Bigger Problem In Major EMs Today​​​​​ Chart 5Smaller EMs Must Also Deal With Rising Debt, Alongside Slowing Growth​​​​​ Chart 6The Debt Surge In EMs This Time, Poses Unique Challenges History suggests that periods of economic tumult are frequently followed by social unrest. The eruption of the so-called Arab Spring after the Great Recession illustrated the power of this dynamic. Then following the outbreak of Covid-19 in 2020 we had highlighted that Turkey, Brazil, and South Africa are at the greatest risk of significant social unrest. We also showed that even EMs that looked stable on paper faced unrest in the post-Covid world, including China and Russia. In this report we take a decadal perspective which reveals that growth is slowing, and debt is growing in EMs. Given that EMs suffer from rising economic miseries alongside growing debt and lower political freedoms (Chart 6), it appears that some of these markets could be socio-political tinderboxes in the making. Policy Implications Of The EM Debt Surge “As it turns out, we don't 'all' have to pay our debts. Only some of us do.” – David Graeber, Debt: The First 5,000 Years (Melville House Publishing, 2011) The trifecta of fast-growing debt, slowing growth and/or low political freedoms in EMs can add to the volatility engendered by EMs as an asset class. Given the growing economic misery in EMs today, politicians will be wary of outbreaks of social unrest. To quell this unrest, they may resort broadly to fiscal expansion and/or aggressive foreign policy. Both of these policy choices can dampen market returns in EMs. Chart 7India's Performance Had Flatlined Post Mild Populist Tilt Policy Choice #1: More Fiscal Spending Despite High Debt Policymakers in some EMs may respond by de-prioritizing contentious structural reforms and prioritizing fiscal expansion. The Indian government’s decision to repeal progressive changes to farm laws in late 2021, launch a $7 billion home-building program in early 2022 and withholding hikes in retail prices of fuel, illustrates how policymakers are resorting to populism despite high public debt levels. As a result, it is no surprise that MSCI India had been underperforming MSCI EM even before the war in Ukraine broke out (Chart 7). Brazil is another EM which falls into this category, while China’s attempts to run tighter budgets have failed in the face of slowing growth. Policy Choice #2: Foreign Policy Aggression EMs may also adopt an aggressive foreign policy stance. Russia’s decision to invade Ukraine, Turkey’s interventions in several countries, and China’s increasing assertiveness in its neighboring seas and the Taiwan Strait provide examples. Wars by EMs are known to dampen returns as the experience of the Russian stock market shows. Russian stocks fell by 14% during its invasion of Georgia in 2008 and are down 40% from 24 February 2022 until March 9, 2022, i.e. when MSCI halted trading. If politicians fail to pursue either of these policies, then they run the risk of social unrest erupting due to tight fiscal policy or domestic political disputes. In fact, early signs of social discontent are already evident from large protests seen in major EMs over the last year (see Table 1). Table 1Social Unrest In Major EMs Is Already Ascendant Bottom Line: The last decade has seen major EMs go on a relatively unnoticed public debt binge. This is problematic because this debt surge has come at a time when economic prospects of the median EM citizen have deteriorated. Politicians will be keen to quell the resultant discontent. This raises the specter of excessive fiscal expansion, aggressive foreign policy, and/or social unrest. All three outcomes are negative from an EM volatility perspective. Trend #2: The Rise And Rise Of EM Defense Spends Great Power Rivalry is an outgrowth of the multipolar structure of international relations. This theme will drive higher defense spending globally. In this report we highlight that even after accounting for a historic rearmament in developed countries following Russia’s invasion of Ukraine, a decade from now EMs will play a key role in driving global military spends. The defense bill of the six richest developed countries of the world (the US, Japan, Germany, UK, France and Italy) will increasingly be rivaled by that of the top eight EMs (China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey). While key developed markets like Japan and Germany in specific (and Europe more broadly) are now embarking on increasing defense spends, the unstable global backdrop will force EMs to increase their military budgets as well. The combination of these forces could mean that the top eight EM’s defense spends could be comparable to that of the top six developed markets in a decade from now i.e., by 2032 (Chart 8). This is true even though the six DMs have a larger GDP. The assumptions made while arriving at the 2032 defense spend projections include: Substantially Higher Pace Of Defense Spends For Developed Countries: To reflect the fact that Russia’s invasion of Ukraine will trigger a historical wave of armament in developed markets we assume that: (a) NATO members France, Germany and Italy (who spent about 1.5% of GDP on an average on defense spends in 2019) will ramp up defense spending to 2% of GDP by 2032, (b) US and UK i.e. NATO members who already spend substantially more than 2% of GDP on defense spends will still ‘increase’ defense spends by another 0.4% of GDP each by 2032 and finally (c) Japan which spends less than 1% of GDP on defense spends today, in a structural break from the past will increase its spending which will rise to 1.5% of GDP by 2032. China And Hence Taiwan As Well As India Will Boost Spends: To capture China’s increasingly aggressive foreign policy stance and the fact that India as well as Taiwan will be forced to respond to the Chinese threat; we assume that China increases its stated defense spends from 1.7% of GDP in 2019 to 3% by 2032. Taiwan follows in lockstep and increases its defense spends from 1.8% of GDP in 2019 to 3% by 2032. India which is experiencing a pincer movement from China to its east and Pakistan to its west will have no choice but to respond to the high and rising geopolitical risks in South Asia. The coming decade is in fact likely to see India’s focus on its naval firepower increase meaningfully as it feels the need to fend off threats in the Indo-Pacific. India currently maintains high defense spends at 2.5% of GDP and will boost this by at least 100bps to 3.5% of GDP by 2032. Defense Spending Trends For Five EMs: For the rest of the EMs (namely Russia, Saudi Arabia, South Korea and Brazil), the pace of growth in defense spending seen over 2009-19 is extrapolated to 2032. For Turkey, we assume that defense spends as a share of GDP increases to 3% of GDP by 2032. Extrapolation Of Past GDP Growth For All Countries: For all 14 countries, we extrapolate the nominal GDP growth calculated by the IMF for 2022-26 as per its last full data update, to 2032. This tectonic change in defense spending patterns has important historical roots. Back in 1900, UK and Japan i.e., the two seafaring powers were top defense spenders (Chart 9). Developed countries of the world continued to lead defense spending league tables through the twentieth century as they fought expensive world wars. Chart 8Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries​​​​​​ Chart 9Back In 1900, Developed Countries Like UK And Japan Were Top Military Spenders​​​​​​ Chart 10By 2000, EMs Had Begun Spending Generously On Armament But things began changing after WWII. Jaded by the world wars, developed countries began lowering their defense spending. By the early 2000s EMs had now begun spending generously on armament (Chart 10). The turn of the century saw growth in developed markets fade while EMs like China and India’s geopolitical power began rising (Chart 11). Then a commodities boom ensued, resulting in petro-states like Saudi Arabia establishing their position as a high military spender. The confluence of these factors meant that by 2020 EMs had becomes major defense spenders in both relative and absolute terms too (Chart 12). Going forward, we expect the coming renaissance in DM defense spending in the face of Russian aggression, alongside rising geopolitical aspirations of China, to exacerbate this trend of rising EM militarization. Chart 11The 21st Century Saw Developed Countries’ Geopolitical Power Ebb Chart 12EMs Today Are Top Military Spenders, Even In Absolute Terms Why Does EM Weaponizing Matter? History suggests that wars are often preceded by an increase in defense spends: Well before WWI, a perceptible increase in defense spending could be seen in Austria-Hungary, Germany, and Italy (Chart 13). These three countries would go on to be known as the Triple Alliance in WWI. Correspondingly France, Britain and Russia (i.e., countries that would constitute the Triple Entente) also ramped up military spending before WWI (Chart 14). Chart 13Well Before WWI; Austria-Hungary, Germany, And Italy Had Begun Ramping Up Defense Spends​​​​​​ Chart 14The ‘Triple Entente’ Too Had Increased Defense Spends In The Run Up To WWI​​​​​​ History tragically repeated itself a few decades later. Besides Japan (which invaded China in 1937); Germany and Italy too ramped up defense spending well before WWII broke out (Chart 15). These three countries would come to be known as the Axis Powers and initiated WWII. Notably, Britain and Russia (who would go on to counter the Axis Powers) had also been weaponizing since the mid-1930s (Chart 16). Chart 15Axis Powers Had Been Increasing Defense Spends Well Before WWII​​​​​ Chart 16Allied Powers Too Had Been Increasing Defense Spends In The Run Up To WWII​​​​​ Chart 17Militarily Active States Have Been Ramping Up Defense Spends Russia, Ukraine, Turkey and Gulf Arab states like Iraq have been involved in wars in the recent past and noticeably increased their defense budgets in the lead-up to military activity (Chart 17). Given that a rise in military spending is often a leading indicator of war and given that EMs are set to spend more on defense, it appears that significant wars are becoming more rather than less likely, which Russia’s invasion of Ukraine obviously implies. A large number of “Black Swan Risks” are clustered in the spheres of influence of Russia, China, and Iran, which are the key powers attempting to revise the US-led global order today (Map 1). Map 1Black Swan Risks Are Clustered Around China, Russia & Iran Distinct from major EMs, eight small countries pose meaningful risks of being involved in wars over the next. These countries are small (in terms of their nominal GDPs) but spend large sums on defense both in absolute terms (>$4 billion) and in relative terms (>4% of GDP). Incidentally all these countries are located around the Eurasian rimland and include Israel, Pakistan, Algeria, Iran, Kuwait, Oman, Ukraine and Morocco (Map 2). In fact, the combined sum of spending undertaken by these countries is so meaningful that it exceeds the defense budgets of countries like Russia and UK (Chart 18). Map 2Eight Small Countries That Spend Generously On Defense Chart 188 Countries Located Near The Eurasian Rimland, Spend Large Sums On Defense​​​​ Bottom Line: As EM geopolitical power and aspirations rise, the defense bill of top developed countries will be challenged by the defense spending undertaken by major EMs. On one hand this change will mean that certain EMs may be at the epicenter of wars and concomitant market volatility. On the other hand, this change could spawn a new generation of winners amongst defense suppliers. Investment Conclusions In this section we highlight strategic trades that can be launched to play the two trends highlighted above. Trend #1: Beware The Wrath Of EMs On A Debt Binge Investors must prepare for EMs to witness sudden fiscal expansions, unusually aggressive foreign policy stances, and/or bouts of social unrest over the next few years. The only way to dodge these volatility-inducing events in EMs is to leverage geopolitics to foresee socio-political shocks. Using a simple method called the “Tinderbox Framework” (Table 2), we highlight that: Table 2Tinderbox Framework: Identifying Countries Most Exposed To Socio-Political Risks Within the eight major EMs; China, Brazil, Russia and Saudi Arabia face elevated socio-political risks. Amongst the smaller ten EMs, these risks appear most elevated for Egypt, South Africa and Argentina. It is worth noting that Brazil, South Africa and Turkey appeared most vulnerable as per our Covid-19 Social Unrest Index that we launched in 2020. We used the tinderbox framework in the current context to fade out effects of Covid-19 and to add weight to the debt problem that is brewing in EMs. Client portfolios that are overweight on most countries that fare poorly on our “Tinderbox Framework” should consider actively hedging for volatility at the stock-specific level. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. China’s public debt ratio is high and social pressures may be building with limited valves in place to release these pressures (Table 2). The renminbi has performed well amid the Russian war, which has weighed down the euro, but China faces a confluence of domestic and international risks that will ultimately drag on the currency, while the euro will benefit from the European Union’s awakening as a geopolitical entity in the face of the Russian military threat. Trend #2: EM’s Will Drive Wars In The 21st Century Wars are detrimental to market returns.1 Furthermore, as the history of world wars proves, even the aftermath of a war often yields poor investment outcomes as wars can be followed by recessions. It is in this context that investors must prepare for the rise of EMs as protagonists in the defense market, by leveraging geopolitics to identify EMs that are most likely to be engaged in wars. While we are not arguing that WWIII will erupt, investors must brace for proxy wars as an added source of volatility that could affect EMs as an asset class. To profit from these structural changes underway we highlight two strategic trades namely: 1.  Long Global Aerospace & Defense / Broad Market Thanks to the higher spending on defense being undertaken by major EMs, global defense spends will grow at a faster rate over the next decade as compared to the last. We hence reiterate our Buy on Global Aerospace & Defense relative to the broader market. 2.  Long European Aerospace & Defense / European Tech Up until Russia invaded Ukraine and was hit with economic sanctions, Russia was the second largest exporter of arms globally accounting for 20% global arms exports. With Russia’s ability to sell goods in the global market now impaired, the two other major suppliers of defense goods that appear best placed to tap into EM’s demand for defense goods are the US (37% share in the global defense exports market) and Europe (+25% share in the global defense exports market). Chart 19American Defense Stocks Have Outperformed, European Defense Stocks Have Underperformed​​​​​​ Chart 20Defense Market: Russia’s Loss Could Be Europe’s Gain​​​​​ But given that (a) American aerospace & defense stocks have rallied (Chart 19) and given that (b) France, Germany, and Italy are major suppliers of defense equipment to countries that Russia used to supply defense goods to (Chart 20), we suggest a Buy on European Aerospace & Defense relative to European Tech stocks to extract more from this theme. In fact, this trade also stands to benefit from the pursuance of rearmament by major European democracies which so far have maintained lower defense spends as compared to America and UK. This view from a geopolitical perspective is echoed by our European Investment Strategy (EIS) team too who also recommend a Long on European defense stocks and a short on European tech stocks. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      Please see: Andrew Leigh et al, “What do financial markets think of war in Iraq?”, NBER Working Paper No. 9587, March 2003, nber.org.  David Le Bris, “Wars, Inflation and Stock Market Returns in France, 1870-1945”, Financial History Review 19.3 pp. 337-361, December 2012, ssrn.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally. But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. Fractal trading watchlist: Brent crude oil, and oil equities versus banks equities. The DAX Has Sold Off ##br##Because It Expects Profits To Plunge… …But The S&P 500 Has Sold Off ##br##Because The Long Bond Has Sold Off   Bottom Line: In the Ukraine crisis, the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market, before the cavalry of lower bond yields ultimately charges to the rescue. Feature Given the onset of the largest military conflict in Europe since the Second World War, with the potential to escalate to nuclear conflict, you would have thought that the global stock market would have crashed. Yet since Russia’s full-scale invasion of Ukraine on February 24 to the time of writing, the world stock market is down a modest 4 percent, while the US stock market is barely down at all. Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Admittedly, since the invasion, European bourses have fallen – for example, Germany’s DAX by 10 percent. And stock markets were already falling before the invasion, meaning that this year the DAX is down 20 percent while the S&P 500 is down 12 percent. But there is a crucial difference. While the DAX year-to-date plunge is due to an expected full-blooded profits recession that the Ukraine crisis will unleash, the S&P 500 year-to-date decline is due to the sell-off in the long-duration bond (Chart I-1 and Chart I-2). This difference in drivers will also explain the fate of these markets as the crisis evolves, just as in the pandemic.   Chart I-1The DAX Has Sold Off Because It Expects Profits To Plunge...   Chart I-2...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off During The Pandemic, Central Banks And Governments Saved The Day… We can think of a stock market as a real-time calculator of the profits ‘run-rate.’ In this regard, the real-time stock market is several weeks ahead of analysts, whose profits estimates take time to collect, collate, and record. For example, during the pandemic, the stock market had already discounted a collapse in profits six weeks before analysts’ official estimates (Chart I-3 and Chart I-4). Chart I-3The German Stock Market Is Several Weeks Ahead Of Analysts Chart I-4The US Stock Market Is Several Weeks Ahead ##br##Of Analysts We can also think of a stock market as a bond with a variable rather than a fixed income. Just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like when bond yields change. It turns out that the long-duration US stock market has the same duration as a 30-year bond, while the shorter-duration German stock market has the same duration as a 7-year bond. Pulling this together, and assuming no change to the very long-term structural growth story, we can say that: The US stock market = US profits multiplied by the 30-year bond price (Chart I-5 and Chart I-6). The German stock market = German profits multiplied by the 7-year bond price (Chart I-7 and Chart I-8). Chart I-5US Profits Multiplied By The 30-Year Bond Price... Chart I-6...Equals The US Stock Market Chart I-7German Profits Multiplied By The 7-Year Bond Price... Chart I-8...Equals The German Stock Market When bond yields rise – as happened through December and January – the greater scope for a price decline in the long-duration 30-year bond will hurt the US stock market both absolutely and relatively. But when bond yields decline – as happened at the start of the pandemic – this same high leverage to the 30-year bond price can protect the US stock market. When bond yields decline, the high leverage to the 30-year bond price can protect the US stock market. During the pandemic, the 30-year T-bond price surged by 35 percent, which more than neutralised the decline in US profits. Supported by this surge in the 30-year bond price combined with massive fiscal stimulus that underpinned demand, the pandemic bear market lasted barely a month. What’s more, the US stock market was back at an all-time high just four months later, much quicker than the German stock market. …But This Time The Cavalry May Take Longer To Arrive Unfortunately, this time the rescue act may take longer. One important difference is that during the pandemic, governments quickly unleashed tax cuts and stimulus payments to shore up demand. Whereas now, they are unleashing sanctions on Russia. This will choke Russia, but will also choke demand in the sanctioning economy. Another crucial difference is that as the pandemic took hold in March 2020, the Federal Reserve slashed the Fed funds rate by 1.5 percent. But at its March 2022 meeting, the Fed will almost certainly raise the interest rate (Chart I-9). Chart I-9As The Pandemic Took Hold, The Fed Could Slash Rates. Not Now. As the pandemic was unequivocally a deflationary shock at its outset, it was countered with a massive stimulatory response from both central banks and governments. In contrast, the Ukraine crisis has unleashed a new inflationary shock from soaring energy and food prices. And this on top of the pandemic’s second-round inflationary effects which have already dislocated inflation into uncomfortable territory. Our high conviction view is that this inflationary impulse combined with sanctions will be massively demand-destructive, and thereby ultimately morph into a deflationary shock. Yet the danger is that myopic policymakers and markets are not chess players who think several moves ahead. Instead, by fixating on the immediate inflationary impulse from soaring energy and food prices, they will make the wrong move. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market. Compared with the pandemic, both the sell-off and the recovery will take longer to play out. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. One further thought. The Ukraine crisis has ‘cancelled’ Covid from the news and our fears, as if it were just a bad dream. Yet the virus has not disappeared and will continue to replicate and mutate freely. Probably even more so, now that we have dismissed it, and Europe’s largest refugee crisis in decades has given it a happy hunting ground. Hence, do not dismiss another wave of infections later this year. The Investment Conclusions Continuing our chess metaphor, a tactical investment should consider only the next one or two moves, a cyclical investment should be based on the next five moves, while a long-term structural investment (which we will not cover in this report) should visualise the board after twenty moves. All of which leads to several investment conclusions: On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally (Chart I-10). Chart I-10When Stock Markets Sell Off, The Dollar Rallies But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. How Can Fractal Analysis Help In A Crisis? When prices are being driven by fundamentals, events and catalysts, as they are now, how can fractal analysis help investors? The answer is that it can identify when a small event or catalyst can have a massive effect in reversing a trend. In this regard, the extreme rally in crude oil has reached fragility on both its 65-day and 130-day fractal structures. Meaning that any event or catalyst that reduces fears of a supply constraint will cause an outsized reversal (Chart I-11). Chart I-11The Extreme Rally In Crude Oil Is Fractally Fragile Equally interesting, the huge outperformance of oil equities versus bank equities is reaching the point of fragility on its 260-day fractal structure that has reliably signalled major switching points between the sectors (Chart I-12). Given the fast-moving developments in the crisis, we are not initiating any new trades this week, but stay tuned. Chart I-12The Huge Outperformance Of Oil Equities Versus Banks Equities Is Approaching A Reversal Fractal Trading Watchlist Biotech To Rebound US Healthcare Vs. Software Approaching A Reversal Norway's Outperformance Could End Greece’s Brief Outperformance To End Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary We look at the Ukraine crisis in the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. Our high-conviction view is that the Ukraine crisis will be net deflationary, because the economic and financial sanctions imposed on Russia will lead to a generalized demand destruction. Bond yields will be lower in the second half of the year. Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Stay structurally overweight the 30-year T-bond. The ultimate low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Fractal trading watchlist: We focus on banks, add alternative electricity, and review bitcoin. Every Shock Is Always Supplanted By A New Shock Bottom Line: The recent rise in bond yields and the associated outperformance of cyclical sectors such as banks, ‘value’, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move within a much bigger structural downtrend. This structural downtrend is now set to resume. Feature Suddenly, nobody is worried about Covid and everybody is worried about nuclear war. Or as Vladimir Putin warns, “such consequences that you have never experienced in your history.” The life lesson being that every shock is always supplanted by a new shock. Hence, in this report we look at the Ukraine crisis through a wider lens. We look at the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. The Predictability Of Shocks Shocks are very predictable. This sounds like a contradiction, but we don’t mean the timing or nature of individual shocks. As specific events, Russia’s full-scale invasion of Ukraine and the global pandemic were ‘tail-events’ that did come as shocks. Yet the statistical distribution of such tail-events is very predictable. This predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term strategy for investment, or life in general. The predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term investment strategy. We define a shock as any event that causes the long-duration bond price in a major economy to rally or slump by at least 20 percent, albeit this is just one definition.1On this definition, the Ukraine crisis is not yet a far-reaching economic or financial shock, but it is certainly well-placed to become one. Applying this definition of a shock through the last 60 years, the statistical distribution of shocks over any long period is well-defined and very predictable. For example, over a ten-year period the number of shocks exhibits a Poisson distribution with parameter 3.33 (Chart I-1), while the time between shocks exhibits an Exponential distribution with parameter 3.33. Chart 1The Statistical Distribution Of Shocks Is Very Predictable Many economists and investment strategists present their long-term forecasts for the economy and financial markets, yet completely ignore this very predictable distribution of shocks – making their long-term forecasts worthless! The question to such economists and strategists is why are there no shocks over your forecasting horizon? Their typical answer is that it is not an economist’s job to predict ‘acts of god’ or ‘black swans.’ But if insurance companies can incorporate the very predictable distribution of acts of god and black swans, then why can’t economists and strategists? Over any ten-year period, the likelihood of suffering a shock is a near-certainty, at 95 percent; in any five-year period, it is an extremely high 80 percent; in a two-year period, it is a coin toss at 50 percent; and even in one year it is a significant 30 percent (Chart I-2). Chart I-2On A Multi-Year Horizon, Another Shock Is A Near-Certainty Witness that since just 2016 we have experienced Brexit, and the election of Donald Trump as US president. These were binary-outcome events where we could ‘visualise’ the tail-event in advance, but many dismissed it as implausible. Then we had a global pandemic, and now Russia’s full-scale invasion of Ukraine. Therefore, the crucial question is not whether we will experience shocks. We always will. The crucial question is, will the shock be net deflationary or net inflationary? Our high-conviction view is that the Ukraine crisis will be net deflationary. Meaning that even if it starts as inflationary, it will quickly morph into deflationary. The Danger From Higher Energy Prices: The Obvious And The Not So Obvious Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns – most recently, the 1999-2000 trebling of crude and the subsequent 2000-01 downturn, and the 2007-2008 trebling of crude and the subsequent 2008-09 global recession. Begging the question, should we be concerned that the Ukraine crisis has lifted the crude oil price to a near-trebling since October 2020, not to mention the massive spike in natural gas prices? Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns. Of course, we know that the root cause of both the 2000-01 downturn and the 2008-09 recession was not the oil price surge that preceded them. As their names make crystal clear, the 2001-01 downturn was the dot com bust and the 2008-09 recession was the global financial crisis. And yet, and yet… while the oil price surge was not the culprit, it was certainly the accessory to both murders. The obvious way that high energy prices hurt is that they are demand destructive to both energy and non-energy consumption. In this regard, the good news is that the economy is becoming much less energy-intensive – every unit of real output requires about 40 percent less energy than at the start of the millennium (Chart I-3). Nevertheless, even if the scope to hurt is lessening, higher energy prices are still demand destructive. Chart I-3The Economy Is Becoming Less Energy-Intensive The not so obvious way that high energy prices hurt is that they risk driving up the long-duration bond yield and thereby tipping more systemically important economic and financial fragilities over the brink. This was the where the greater pain came from in both 2000 and 2008 (Chart I-4 and Chart I-5). Chart I-4Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 1999 Chart I-5Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 2008 Fortunately, the recent decline in the 30-year T-bond yield suggests that the bond market is looking through the short-term inflationary impulse of higher energy prices (Chart I-6). Instead, it is focussing on the deflationary impulse that will come from the demand destruction that the higher prices will trigger. Chart I-6Today, The Bond Market Is Looking Through The Inflationary Impulse From Higher Energy Prices The economic and financial sanctions imposed on Russia will only lead to additional demand destruction. Sanctions restrict trade and economic and financial activity – therefore they hurt both the side that is sanctioned and the side that is sanctioning. This mutuality of pain caused the West to balk at both the timing and severity of its sanctions. But absent an unlikely backdown from Russia, the sanctions noose will tighten, choking growth everywhere.   If bond yields were to re-focus on inflation and move higher, it would add a further headwind to the economy and markets, forcing the 30-year T-bond yield back down again from a ‘line in the sand’ at around 2.4-2.5 percent. So, the long-duration bond yield will go down directly or via a short detour higher. Either way, bond yields will be lower in the second half of the year. Given the very tight connection between bond yields and stock market sector, style, and country allocation, it will become clear that the recent outperformance of cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move in a much bigger structural downtrend (Chart I-7). This structural downtrend is set to resume. Chart I-7When Bond Yields Decline, Banks Underperform Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Yet, the over-arching message from the anatomy of shocks is that the ultimate structural low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Stay structurally overweight the 30-year T-bond.   Fractal Trading Watchlist This week’s analysis focusses on banks, adds alternative electricity, and reviews bitcoin. Supporting the fundamental arguments in the main body of this report, the recent outperformance of banks has reached the point of fractal fragility that has signalled several important turning-points through the past decade (Chart 1-8). Accordingly, this week’s recommended trade is to go short world banks versus world consumer services, setting the profit target and symmetrical stop-loss at 12 percent.  Chart I-8The Recent Outperformance Of Banks May Soon End Alternative Electricity Is Rebounding From An Oversold Position Bitcoin's Support Is Holding Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 20 percent. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5 Indicators To Watch - Interest Rate Expectations Chart II-6 Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations