Economy

Highlights Short-term inflation risk will escalate further if politics causes new supply disruptions. Long-term inflation risk is significant as well. There is a distinct risk of a geopolitical crisis in the Middle East that would push up energy prices: the US’s unfinished business with Iran. The primary disinflationary risk is China’s property sector distress. However, Beijing will strive to maintain stability prior to the twentieth national party congress in fall 2022. South Asian geopolitical risks are rising. The Indo-Pakistani ceasefire is likely to break down, while Afghani terrorism will rebound. Book gains on our emerging market currency short targeting “strongman” regimes. Feature Investors are underrating the risk of a global oil shock. This was our geopolitical takeaway from the BCA Conference this year. Investors are focused on the risk of inflation and stagflation, always with reference to the 1970s. The sharp increase in energy prices due to the Arab Oil Embargo of 1973 and the Iranian Revolution of 1979 are universally cited as aggravating factors of stagflation at that time. But these events are also given as critical differences between the situation in the 1970s and today. Unfortunately, there could be similarities. From a strictly geopolitical perspective, the risk of a conflict in the Middle East is significant both in the near term and over the coming year or so. The risk stems from the US’s unfinished business with Iran. More broadly, any supply disruption would have an outsized impact as global energy inventories decline. OPEC’s spare capacity at present can cover a 5 million barrel shock (Chart 1). In this week’s report we also provide tactical updates on China, Russia, and India. Geopolitics And The 1970s Inflation Chart 2Wage-Price Spiral, Stagflation In 1970s Fundamentally the stagflation of the 1970s occurred because global policymakers engendered a spiral of higher wages and higher prices. The wage-price spiral was exacerbated by a falling dollar, after President Nixon abandoned the gold standard, and a commodity price surge (Chart 2). Monetary policy clearly played a role. It was too easy for too long, with broad money supply consistently rising relative to nominal GDP (Chart 3). Central banks including the Federal Reserve were focused exclusively on employment. Policymakers saw the primary risk to the institution’s credibility as recession and unemployment, not inflation. Fear of the Great Depression lurked under the surface. Fiscal policy also played a role. The size of the US budget deficit at this time is often exaggerated but there is no question that they were growing and contributed to the bout of inflation and spike in bond yields (Chart 4). The reason was not only President Johnson’s large social spending program, known as the “Great Society.” It was also Johnson’s war – the Vietnam war. Chart 3Central Banks Focused On Employment, Not Prices, In 1970s On top of this heady mix of inflationary variables came geopolitics. The Yom Kippur war in 1973 prompted Arab states to impose an embargo on Israel’s supporters in the West. The Arab embargo cut off 8% of global oil demand at the time. Oil prices skyrocketed, precipitating a deep recession (Chart 5). Chart 4Johnson's 'Great Society' And Vietnam War Spending The embargo came to a halt in spring of 1974 after Israeli forces withdrew to the east of the Suez Canal. The oil shock exacerbated the underlying inflationary wave that continued throughout the decade. The Iranian revolution triggered another oil shock in 1979, bringing the rise in general prices to their peak in the early 1980s, at which point policymakers intervened decisively. Chart 5Arab Oil Embargo And Iranian Revolution There is an analogy with today’s global policy mix. Fear of the Great Recession and deflation rules within policymaking circles, albeit less so among the general public. The Fed and the European Central Bank have adjusted their strategies to pursue an average inflation target and “maximum employment.” Chart 6Wage-Price Spiral Today?​​​​​​ The Biden administration is reviving big government with a framework agreement of around $1.2 trillion in new deficit spending on infrastructure, green energy, and social programs likely to pass Congress before year’s end. In short, the macro and policy backdrop are changing in a way that is reminiscent of the 1970s despite various structural differences between the two periods. It is too early to declare that a wage-price spiral has developed but core inflation is rising and investors are right to be concerned about the direction and potential for inflation surprises down the road (Chart 6). These trends would not be nearly as concerning if they were not occurring in the context of a shift in public opinion in favor of government versus markets, labor versus capital, onshoring versus offshoring, and protectionism versus free trade. Investors should note that the last policy sea change (in the opposite direction) lasted roughly 30-40 years. The global savings glut – shown here as the combined current account balances of the world’s major economies – has begun to decline, implying that a major deflationary force might be subsiding. Asian exporters apparently have substantial pricing power, as witnessed by rising export prices, although they have yet to break above the secular downtrend of the post-2008 period (Chart 7). Chart 7Hypo-Globalization Is Inflationary A commodity price surge is also underway, of course, though it is so far manageable. The US and EU economies are less energy-intensive than in the 1970s and there is considerable buffer between today’s high prices and an economic recession (Chart 8). Chart 8Wage-Price Spiral Today? The problem is that there is a diminishing margin of safety. Furthermore, a crisis in the Middle East is not far-fetched, as there is a concrete and distinct reason for worrying about one: the US’s unresolved collision course with Iran. A crisis in the Persian Gulf would greatly exacerbate today’s energy shortages. Iran: The Risk Of An Oil Shock Iran now says it will rejoin diplomatic talks over its nuclear program in late November. This development was expected, and is important, but it masks the urgent and dangerous trajectory of events that could blow up any day now. It is emphatically not an “all clear” sign for geopolitical risk in the Persian Gulf. The US is hinting, merely hinting, that it is willing to use military force to prevent Iran from going nuclear. The Iranians doubt US appetite for war and have every reason to think that nuclear status will guarantee them regime survival. Thus the Iranians are incentivized to use diplomacy as a screen while pursuing nuclear weaponization – unless the US and Israel make a convincing display of military strength to force Iran back to genuine diplomacy. A convincing display is hard to do. A secret war is taking place, of sabotage and cyber-attacks. On October 26 a cyber-attack disrupted Iranian gas stations. But even attacks on nuclear scientists and facilities have not dissuaded the Iranians from making progress on their nuclear program yet. Iran does not want to be attacked but it knows that a ground invasion is virtually impossible and air strikes alone have a poor record of winning wars. The Iranians have achieved 60% highly enriched uranium and are expected to achieve nuclear breakout capacity – the ability to make a nuclear device – sometime between now and December (Table 1). The IAEA no longer has any visibility in Iran. The regime’s verified production of uranium metal can only be used for the construction of a warhead. Recent technical progress may be irreversible, according to the Institute for Science and International Security.1 If that is true then the upcoming round of diplomatic negotiations is already doomed. Table 1Iran’s Compliance With Nuclear Deal And Time Until Breakout (Oct 2021) American policymakers seem overconfident in the face of this clear nuclear proliferation risk. This is strange given that North Korea successfully manipulated them over the past three decades and now has an arsenal of 40-50 nuclear weapons. The consensus goes as follows: Regime instability: Americans emphasize that the Iranian regime is unstable, lacks genuine support, and faces a large and restive youth population. This is all true. Indeed Iran is one of the most likely candidates for major regime instability in the wake of the COVID-19 shock. Chart 9AIran's Economy Sees Inflation Spike ...​​​​​​ Chart 9B... Yet Some Green Shoots Are Rising However, popular protest has not had any effect on the regime over the past 12 years. Today the economy is improving and illicit oil revenues are rising (Chart 9). A new nationalist government is in charge that has far greater support than the discredited reformist faction that failed on both the economic and foreign policy fronts (Chart 10). The sophisticated idea that achieving nuclear breakout will somehow weaken the regime is wishful thinking.  If it provokes US and/or Israeli air strikes, it will most likely see the people rally around the flag and convince the next generation to adopt the revolutionary cause.2 If it does not provoke a war, then the regime’s strategic wisdom will be confirmed. American military and economic superiority: Americans tend to think that Iran will back down in the face of the US’s and Israel’s overwhelming military and economic superiority. It is true that a massive show of force – combined with the sale of specialized weaponry to Israel to enable a successful strike against extremely hardened nuclear facilities – could force Iran to pause its nuclear quest and go back to negotiations. Yet the US’s awesome display of military power in both Iraq and Afghanistan ended in ignominy and have not deterred Iran, just next door, after 20 years. Nor have American economic sanctions, including “maximum pressure” sanctions since 2019. The US is starkly divided, very few people view Iran as a major threat, and there is an aversion to wars in the Middle East (Chart 11). The Iranians could be forgiven for doubting that the US has the appetite to enforce its demands. ​​​​​​ ​​​​​​ In short the US is attempting to turn its strategic focus to China and Asia Pacific, which creates a power vacuum in the Middle East that Iran may attempt to fill. Meanwhile global supply and demand balances for energy are tight, with shortages popping up around the world, giving Iran greater leverage. From an investment point of view, a crisis is likely in the near term regardless of what happens afterwards. A crisis is necessary to force the US and Iran to return to a durable nuclear deal like in 2015. Otherwise Iran will reach nuclear breakout and an even bigger crisis will erupt, potentially forcing the US and Israel (or Israel alone) to take military action. Diplomatic efforts will need to have some quick and substantial victories in the coming months to convince us that the countries have moved off their collision course. A conflict with Iran will not necessarily go to the extreme of Iran shutting down the Strait of Hormuz and cutting off 21% of the world’s oil and 26% of liquefied natural gas (Chart 12). If that happens a global recession is unavoidable. It would more likely involve lesser conflicts, at least initially, such as “Tanker War 2.0” in the Persian Gulf.3 Or it could involve a flare-up of the ongoing proxy war by missile and drone strikes, such as with the Abqaiq attack in 2019 that knocked 5.7 million barrels per day offline overnight. The impact on oil markets will depend on the nature and magnitude of the event. What are the odds of a military conflict? In past reports we have demonstrated that there is a 40% chance of conflict with Iran. The country’s nuclear program is at a critical juncture. The longer the world goes without a diplomatic track to defuse tensions, the more investors should brace for negative surprises. Bottom Line: There is a clear and present danger of a geopolitical oil shock. The implication is that oil and LNG prices could spike in the coming zero-to-12 months. The implication would be a dramatic “up then down” movement in global energy prices. Inflation expectations should benefit from simmering tensions but a full-blown war would cause an extreme price spike and global recession. China: The Return Of The Authoritative Person Another reason that today’s inflation risk could last longer than expected is that China’s government is likely to backpedal from overtightening monetary, fiscal, and regulatory policy. If this is true then China will secure its economic recovery, the global recovery will continue, commodity prices will stay elevated, and the inflation expectations and bond yields will recover. If it is not true then investors will start talking about disinflation and deflation again soon. We are not bullish on Chinese assets – far from it. We see China entering a property-induced debt-deflation crisis over the long run. But over the 2021-22 period we have argued that China would pull back from the brink of overtightening. Our GeoRisk Indicator for China highlights how policy risk remains elevated (see Appendix). So far our assessment appears largely accurate. The government has quietly intervened to prevent the troubled developer Evergrande from suffering a Lehman-style collapse. The long-delayed imposition of a nationwide property tax is once again being diluted into a few regional trial balloons. Alibaba founder Jack Ma, whom the government disappeared last year, has reappeared in public view, which implies that Beijing recognizes that its crackdown on Big Tech could cause long-term damage to innovation. At this critical juncture, a mysterious “authoritative” commentator has returned to the scene after five years of silence. Widely believed to be Vice Premier Liu He, a Politburo member and Xi Jinping confidante on economic affairs, the authoritative person argues in a recent editorial that China will stick with its current economic policies.4 However, the message was not entirely hawkish. Table 2 highlights the key arguments – China is not oblivious to the risk of a policy mistake. Table 2Messages From China’s ‘Authoritative Person’ On Economic Policy (2021) Readers will recall that a similar “authoritative Person” first appeared in the People’s Daily in May 2016. At that time, the Chinese government had just relented in the face of economic instability and stimulated the economy. It saw a 3.5% of GDP increase in fiscal spending and a 10.0% of GDP increase in the credit impulse from the trough in 2015 to the peak in 2016. The authoritative person was explaining that the intention to reform would persist despite the relapse into debt-fueled growth. So one must wonder today whether the authoritative person is emerging because Beijing is sticking to its guns (consensus view) or rather because it is gradually being forced to relax policy by the manifest risk of financial instability. To be fair, a recent announcement on government special purpose bonds does not indicate major fiscal easing. If local governments accelerate their issuance of new special purpose bonds to meet their quota for the year then they are still not dramatically increasing the fiscal support for the economy. But this announcement could protect against downside growth risks. The first quarter of 2022 will be the true test of whether China will remain hawkish. Going forward there are two significant dangers as we see it. The first is that policymakers prove ideological rather than pragmatic. An autocratic government could get so wrapped up in its populist campaign to restrain high housing costs that it refuses to slacken policies enough and causes a crash. The second danger is that inflation stays higher for longer, preventing authorities from easing policy even when they know they need to do so to stabilize growth. The second danger is the bigger of the two risks. As for the first risk, ideology will take a backseat to necessity. Xi Jinping needs to secure key promotions for his faction in the top positions of the Communist Party at the twentieth national party congress in 2022. He cannot be sure to succeed if the economy is in free fall. A self-induced crash would be a very peculiar way of trying to solidify one’s stature as leader for life at the critical hour. Similarly China cannot maintain a long-term great power competition with the United States if it deliberately triggers property deflation and financial turmoil. It can and will continue modernizing and upgrading its military, e.g. developing hypersonic missiles, even if it faces financial turmoil. But it will have a much greater chance of neutralizing US regional allies and creating a regional buffer space if its economic growth is stable. Ultimately China cannot prevent financial instability, economic distress, and political risk from rising in the coming years. There will be a reckoning for its vast imbalances, as with all countries. It could be that this reckoning will upset the Xi administration’s best-laid plans for 2022. But before that happens we expect policy to ease. A policy mistake today would mean that very negative economic outcomes will arrive precisely in time to affect sociopolitical stability ahead of the party congress next fall. We will keep betting against that. Bottom Line: China’s “authoritative” media commentator shows that policymakers are not as hawkish as the consensus holds. The main takeaway is that policymakers will adjust the intensity of their reform efforts to maintain stability. This is standard Chinese policymaking and it is more important than usual ahead of the political rotation in 2022. Otherwise global inflation risk will quickly give way to deflation risk as defaults among China’s property developers spread and morph into broader financial and economic instability. Indo-Pakistani Ceasefire: A Breakdown Is Nigh India and Pakistan agreed to a ceasefire along the line of control in February 2021. While the agreement has held up so far, a breakdown is probably around the corner. It was never likely to last for long. Over the short run, the ceasefire made sense for both countries: COVID-19 Risks: The first wave of the pandemic had abated but COVID-19-related risks loomed large. India had administered less than 15 million vaccine doses back then and Pakistan only 100,000. Dangerous Transitions Were Underway: With America’s withdrawal from Afghanistan in the works, Pakistan was fully focused on its western border. India was pre-occupied with its eastern front, where skirmishes with Chinese troops forced it to redirect some of its military focus. As we now head towards the end of 2021, these constraints are no longer binding. COVID-19 Risks Under Control: The vaccination campaign in India and Pakistan has gathered pace. More than 50% of India’s population and 30% of Pakistan’s have been given at least one dose. Pakistan’s Ducks Are Lined-up In Afghanistan: America’s withdrawal from Afghanistan has been completed. Afghanistan is under Taliban’s control and Pakistan has a better hold over the affairs of its western neighbor. One constraint remains: India and China remain embroiled in border disputes. Conciliatory talks between their military commanders broke down a fortnight ago. Winter makes it nearly impossible to undertake significant operations in the Himalayas but a failure of coordination today could set up a conflict either immediately or in the spring. While India may see greater value in maintaining the ceasefire than Pakistan, India has elections due in key northern states in 2022. India’s northern states harbor even less favorable views of Pakistan than the rest of India. Hence any small event could trigger a disproportionate response from India. Bottom Line: While it is impossible to predict the timing, a breakdown in the Indo-Pakistani ceasefire may materialize in 2022 or sooner. Depending on the exact nature of any conflict, a geopolitically induced selloff in Indian equities could create a much-needed consolidation of this year’s rally and ultimately a buying opportunity. Russia, Global Terrorism, And Great Power Relations Part of Putin’s strategy of rebuilding the Russian empire involves ensuring that Russia has a seat at the table for every major negotiation in Eurasia. Now that the US has withdrawn forces from Afghanistan, Russia is pursuing a greater role there. Most recently Russia hosted delegations from China, Pakistan, India, and the Taliban. India too is planning to host a national security advisor-level conference next month to discuss the Afghanistan situation. Do these conferences matter for global investors? Not directly. But regional developments can give insight into the strategies of the great powers in a world that is witnessing a secular rise in geopolitical risk. China, Russia, and India have skin in the game when it comes to Afghanistan’s future. This is because all three powers have much to lose if Afghanistan becomes a large-scale incubator for terrorists who can infiltrate Russia through Central Asia, China through Xinjiang, or India through Pakistan. Hence all three regional powers will be constrained to stay involved in the affairs of Afghanistan. Terrorism-related risks in South Asia have been capped over the last decade due to the American war (Chart 13). The US withdrawal will lead to the activation of latent terrorist activity. This poses risks specifically for India, which has a history of being targeted by Afghani terrorist groups. And yet, while China and Russia saw the Afghan vacuum coming and have been engaging with Taliban from the get-go, India only recently began engaging with Taliban. The evolution of Afghanistan under the Taliban will also influence the risk of terrorism for the rest of the world. In the wake of the global pandemic and recession, social misery and regime failures in areas with large youth populations will continue to combine with modern communications technology to create a revival of terrorist threats (Chart 14). American officials recently warned of the potential for transnational attacks based in Afghanistan to strike the homeland within six months. That risk may be exaggerated today but it is real over the long run, especially as US intelligence turns its strategic focus toward states and away from non-state actors. India, Europe, and other targets are probably even more vulnerable than the United States. If Russia and China succeed in shaping the new Afghanistan’s leadership then the focus of militant proxies will be directed elsewhere. Beyond terrorism, if Russia and China coordinate closely over Afghanistan then India may be left in the cold. This would reinforce recent trends in which a tightening Russo-Chinese partnership hastens India’s shift away from neutrality and toward favoring the US and the West in strategic matters. If these trends continue to the point of alliance formation, then they increase the risk that any conflicts between two powers will implicate others. Bottom Line: Afghanistan is now a regional barometer of multilateral cooperation on counterterrorism, the exclusivity of Russo-Chinese cooperation, and India’s strategic isolation or alignment with the West. Investment Takeaways It is too soon to play down inflation risks. We share the BCA House View that they will subside next year as pandemic effects wane. But we also see clear near-term risks to this view. In the short run (zero to 12 months), a distinct risk of a Middle Eastern geopolitical crisis looms. A gradual escalation of tensions is inflationary whereas a sharp spike in conflict would push energy prices into punitive territory and kill global demand. Over the next 12 months, China’s economic and financial instability will also elicit policy easing or fiscal stimulus as necessary to preserve stability, as highlighted by the regime’s mouthpiece. Obviously stimulus will not be utilized if the economic recovery is stable, given elevated producer prices. In a future report we will show that Russia is willing and able to manipulate natural gas prices to increase its bargaining leverage over Europe. This dynamic, combined with the risk of cold winter weather exacerbating shortages, suggests that the worst is not yet over. Geopolitical conflict with Russia will resume over the long run. Stay long gold as a hedge against both inflation and geopolitical crises involving Iran, Taiwan/China, and Russia. Maintain “value” plays as a cheap hedge against inflation. Book a profit of 2.5% on our short trade for currencies of emerging market “strongmen,” Turkey, Brazil, and the Philippines. Our view is still negative on these economies. Stay long cyber-security stocks. Over the long run, inflation risk must be monitored. We expect significant inflation risk to persist as a result of a generational change in global policy in favor of government and labor over business and capital. But the US is maintaining easy immigration policy and boosting productivity-enhancing investments. Meanwhile China’s secular slowdown is disinflationary. The dollar may remain resilient in the face of persistently high geopolitical risk. The jury is still out.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      David Albright and Sarah Burkhard, "Iran’s Recent, Irreversible Nuclear Advances," Institute for Science and International Security, September 22, 2021, isis-online.org. 2     Ray Takeyh, "The Bomb Will Backfire On Iran," Foreign Affairs, October 18, 2021, foreignaffairs.com. 3     See Aaron Stein and Afshon Ostovar, "Tanker War 2.0: Iranian Strategy In The Gulf," Foreign Policy Research Institute, August 10, 2021, fpri.org. 4     "Ten Questions About China’s Economy," Xinhua, October 24, 2021, news.cn.     Section II: Appendix: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia South Africa Section III: Geopolitical Calendar

Highlights Increasing consumption should be a lot easier than increasing savings. After all, most people like to spend! It is getting them to work that should be challenging. Yet, the conventional wisdom is that deflation is a much tougher problem to overcome than inflation. It is true that the zero-bound constraint on interest rates makes it more difficult for central banks to react to deflationary forces. However, monetary policy is not the only game in town; fiscal policy becomes more effective as interest rates fall because governments can stimulate the economy without incurring onerous financing costs. When the borrowing rate is below the growth rate of the economy, the more profligate a government has been in the past, the more profligate it can be in the future, while still maintaining a stable debt-to-GDP ratio. The pandemic banished the bond vigilantes. Governments ran massive budget deficits, but bond yields still dropped. While budget deficits will decline from their highs, fiscal policy will remain structurally more accommodative in the post-pandemic period. The combination of easier fiscal policy, increased household net worth, and other factors has raised the neutral rate of interest in the US and most other economies. This means that monetary policy is currently much more stimulative than widely believed. This is good news for equities and other risk assets in the near term, even if it does produce a major hangover down the road. New trade: Short US consumer discretionary stocks relative to other cyclicals. Consumer durable goods spending will slow as services spending and capex continue to recover. A Paradoxical Problem Economic pundits like to say that deflation is a tougher problem to overcome than inflation. We hear this statement so often that we do not think twice about it. In many respects, it is a rather strange perspective. Inflation results from too much spending relative to output, whereas deflation results from too little spending. Yet, people like to spend! One would think it would be much easier to get people to consume than to get them to work. The claim that deflation is a bigger problem than inflation is really just a statement about the limits of monetary policy. If the economy is overheating, central banks can theoretically raise rates as high as they want. In contrast, if the economy is in a deflationary funk, the zero-bound constraint limits how far interest rates can fall. Fortunately, there are other ways of stimulating the economy when interest rates cannot be cut any further. Most notably, governments can utilize fiscal policy by cutting taxes, spending more on goods and services, or increasing transfer payments. Getting Paid To Eat Lunch When interest rates are very low, not only is fiscal stimulus a free lunch, but you actually get paid for eating more. If the borrowing rate is below the growth rate of the economy, the more profligate a government has been in the past, the more profligate it can be in the future, while still maintaining a stable debt-to-GDP ratio. This sounds so counterintuitive that it is worth thinking through a simple example. Suppose you currently earn $100,000 per year and expect your income to rise by 8% per year. You have $100,000 in debt, which incurs an interest rate of 3%, and want to keep your debt-to-income ratio constant at 100% over time. Next year, your income will be $108,000, so you should target a debt level of $108,000. Thus, this year, you can spend $105,000 on goods and services, make $3,000 in interest payments, and take on $8,000 in additional debt. Now, suppose you have been spendthrift in the past and have accumulated $200,000 in debt. You still want to keep your debt-to-income ratio constant, but this time at 200%. How much can you spend this year? The answer is $110,000. If you spend $110,000 and pay an additional $6,000 in interest, your cash outflows will exceed your income by $16,000, taking your debt to $216,000 — exactly twice next year’s income. Notice that by maintaining a higher debt balance, you can actually spend $5,000 more while still keeping your debt-to-income ratio constant. Appendix A proves this point mathematically. One might protest that the interest rate you face would be higher if you had more debt. Fair enough, although in our example, the interest rate would need to rise above 5.5% for spending to decline. The more important point is that unlike people, governments which issue debt in their own currencies get to choose whatever interest rate they want. Granted, if central banks set interest rates too low, the economy will overheat, leading to higher inflation. But this just reinforces the point we made at the outset, which is that inflation and not deflation is the real constraint to macroeconomic policy. A Blissful Outcome For Stocks We would not have waded through this theoretical discussion if it did not serve a practical purpose. In April of last year, we wrote a controversial report asking if, paradoxically, the pandemic could turn out to be good for stocks. We noted that by combining monetary easing with fiscal stimulus, policymakers could steer equity markets towards a “blissful outcome” where the economy was operating at full capacity, yet interest rates were lower than they were before (Chart 1). If such a blissful state were reached, earnings would return to their pre-pandemic level, but the discount rate would remain below its pre-pandemic level, thus allowing stock prices to rise above their pre-pandemic peak. In the months following our report, the stock market played out this narrative.   From Blissful To Blissless? Chart 2Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate More recently, bond yields have risen, stoking fears that we are moving towards less auspicious conditions for equities. There is no doubt that many central banks are looking to normalize monetary policy. That said, what central banks regard as normal today is very different from what they thought was normal in the past. Back in 2012, when the Fed began publishing its “dot plot,” the FOMC thought the neutral rate of interest was around 4.25%. Today, it thinks the neutral rate is only 2.5%. And based on the New York Fed’s survey of market participants and primary dealers, investors believe the neutral rate is even lower than the Fed’s estimate (Chart 2). Even if the Fed did not face political pressure to keep interest rates low, it probably would not want to raise them all that much anyway. The same applies to most other central banks. Why The Neutral Rate Is Higher Than The Fed Believes There are at least four reasons to think that the neutral rate of interest is higher than what the Fed believes:   Reason #1: The drag on growth from the household deleveraging cycle is ending As a share of disposable income, US household debt has declined by nearly 40 percentage points since 2008. Debt-servicing costs are now at record low levels (Chart 3). The Fed’s Senior Loan Officer Survey points to an increasing willingness to lend (Chart 4). The Conference Board’s Leading Credit Index also remains in easing territory (Chart 5). Chart 3The Deleveraging Cycle Has Run Its Course Real personal consumption increased by only 1.6% in Q3. However, this was largely driven by a 54% drop in auto spending on the back of the semiconductor shortage. While vehicle purchases normally account for only 4% of consumer spending, the sector still managed to shave 2.4 percentage points off GDP growth in Q3. Chart 4Banks Are Easing Credit Standards Chart 5A Positive Signal For Credit Growth Spending on services rose by 7.9%, an impressive feat considering the quarter saw the peak in the Delta variant wave.   Reason #2: Fiscal policy is likely to remain accommodative in the post-pandemic period The combination of lower real rates and higher debt levels has increased the budget deficit consistent with a stable debt-to-GDP ratio in the US and most developed markets (Chart 6). This point has not been lost on governments. While the flow of red ink will abate, the IMF estimates that the US cyclically-adjusted primary budget deficit will be 3% of GDP larger in 2022-26 than it was in 2014-19. The IMF also expects most other advanced economies to run larger budget deficits (Chart 7). Chart 8A Record Rise In Household Net Worth Reason #3: Higher asset prices will bolster spending According to the Federal Reserve, US household net worth rose by over 113% of GDP between 2019Q4 and 2021Q2, the largest six-quarter increase on record (Chart 8). Empirical estimates of the wealth effect suggest that households spend about 5-to-8 cents on goods and services for every additional dollar of housing wealth, and 2-to-4 cents for every additional dollar of equity wealth. Based on the latest available data, we estimate that US homeowner equity has increased by $5 trillion since the start of 2020, while household equity holdings have increased by $15.8 trillion. Together, this would translate into 2.5%-to-4% of GDP in additional annual consumption. And this does not even include any spending arising from the $2.4 trillion in incremental bank deposits that households have amassed since the start of the pandemic.    Chart 9Most Of The Deceleration In US Potential Real GDP Growth Has Already Occurred Reason #4: Population aging will drain savings Aging populations can affect the neutral rate either by dragging down investment demand or reducing savings. The former would lead to a lower neutral rate, while the latter would lead to a higher rate. As Chart 9 shows, most of the decline in US potential GDP growth has already occurred. According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.8% today, mainly due to slower labor force growth. The CBO expects potential growth to edge down to 1.5% over the next few decades. The average age of the US capital stock is now the highest on record (Chart 10). Whereas real business fixed investment is 6% below its pre-pandemic trend, core capital goods orders – a leading indicator for capex – are 17% above trend. Capex intentions remain near multi-year highs (Chart 11). All this suggests that investment spending is unlikely to fall much in the future. Chart 10The Average Age Of The US Capital Stock Is Now The Highest On Record Chart 11Capex Intentions Remain At Lofty Levels In contrast, the depletion of national savings from an aging population is just beginning. Baby boomers are leaving the labor force en masse. They hold over half of US household wealth, considerably more than younger generations (Chart 12). As baby boomers transition from net savers to net dissavers, national savings will fall. UnTaylored  Monetary Policy The Taylor Rule prescribes the Fed to hike rates by between 50-to-100 bps for each percentage point that output rises relative to its potential. Over the past decade, the Fed has favored the higher output gap coefficient, meaning that a permanent one percentage-point increase in aggregate demand should translate, all things equal, into a one percentage-point increase in the neutral rate of interest. Taken at face value, the combination of increased household wealth and looser fiscal policy may have raised the neutral rate in the US by more than five percentage points since the pandemic. This estimate, however, does not consider feedback loops: A higher term structure for interest rates would depress asset prices, thus obviating some of the wealth effect. Higher rates would also reduce the incentive for governments to run large budget deficits. Taking these feedback loops into account, a reasonable estimate is that the neutral rate in the US is about 2% in real terms, or slightly over 4% in nominal terms based on current long-term inflation expectations. This is close to the historic average for real rates, although well above current market pricing. The implication for investors is that US monetary policy is currently more stimulative than widely believed. This is the good news. The bad news is that in the absence of fiscal tightening, the Fed will eventually be forced to raise rates by more than investors are discounting. Higher Inflation Won’t Force The Fed’s Hand… Just Yet When will the Fed be forced to move away from its baby-step approach to monetary policy normalization and adopt a more aggressive stance? Our guess is not for another two years. Last week, we argued that inflation in the US and many other countries is likely to follow a “two steps up, one step down” trajectory of higher highs and higher lows over the remainder of the decade. We are currently near the top of those two steps: Most of the recent increase in inflation has been driven by surging durable goods prices (Chart 13). Considering that durable goods prices usually fall over time, this is not a sustainable source of inflation. Chart 13ADurable Goods Spending Has Further To Fall (I) Chart 13BDurable Goods Spending Has Further To Fall (II) In modern service-based economies, structurally high inflation requires rapid wage growth. While US wage growth has picked up recently, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 14). The Fed welcomes this development, given its expanded mandate to pursue “inclusive growth.” At some point in the future, long-term inflation expectations could become unmoored. However, that has not happened yet, whether one looks at market-based or survey-based expectations (Chart 15). Thus, for now, investors should remain constructive on stocks. Chart 14Wages At The Bottom End Of The Income Distribution Are Rising Briskly   New Trade: Short Consumer Discretionary Stocks Relative To Other Cyclicals We continue to favor cyclical stocks over defensives. Within the cyclical category, however, we are cautious on consumer discretionary names. Spending on consumer durable goods still has further to fall in order to return to trend. Durable goods prices will also come down, potentially squeezing profit margins. Go short the Consumer Discretionary Select Sector SPDR Fund (XLY) versus an S&P 500 sector-weighted basket of the Industrial Select Sector SPDR Fund (XLI), the Energy Select Sector SPDR Fund (XLE), and the Materials Select Sector SPDR Fund (XLB). Appendix A Peter Berezin Chief Global Strategist pberezin@bcaresearch.com View Matrix Special Trade Recommendations This table provides trade recommendations that may not be adequately represented in the matrix on the preceding page. Current MacroQuant Model Scores

Special Report

Highlights Faced with large excesses in the housing market, we contend that Beijing’s goal is to achieve flat property prices in the coming years. Stable property prices would allow for improved housing affordability over the coming years while precluding debt deflation. However, when authorities fix/control prices, they lose control of volumes/activity. The housing market will not clear. Property sales and construction activity will hit an air pocket. Shrinking construction activity will weigh on China’s economy and China-plays around the world. Feature The recent struggles of several Chinese property developers to service their debt have put the mainland’s real estate market on the radar of global investors. What is the outlook for the Chinese property market and what will be its impact on the mainland and global economies? What does it mean for global financial markets? In contrast to the US housing debacle in 2008, the central pressure point in China’s property market adjustment will not be home prices and mortgage defaults but retrenchment by property developers and a downsizing in construction activity. That is why we are maintaining our negative view on Chinese demand for raw materials and machinery. This will have implications for emerging Asia, developing countries that produce raw materials and machinery stocks worldwide. How Important Is The Property Market? Chart 1Land Sales Revenue And Property Developers Funding Are Sizable In a 2020 paper,1 Kenneth Rogoff and Yuanchen Yang estimate that real estate investment accounted for 12-15% of GDP in China between 2011 and 2018. This compares with a 7% share of GDP in the US at the peak of the housing boom in 2005. Hence, the sheer size of real estate construction in China – which does not include infrastructure investment – implies that real estate investment is very important for the mainland economy. The above numbers do not capture secondary effects from fluctuations in real estate investment. Thereby, the impact of property construction is greater than what is implied by its share of GDP. Further, local governments derive more than 40% of their aggregate revenues – budgetary and off budgetary (managed funds) – from land sales (Chart 1, top panel). As land sales dry up, local government revenues will plummet, undermining their ability to finance infrastructure spending – which is also a major part of the economy. Property developers’ annual funding makes up a very large 20% of GDP, which attests to their importance to the economy and the financial system (Chart 1, bottom panel).  Critically, construction activity drives demand for raw materials and machinery. Granted, Chinese imports of raw materials and machinery used in real estate construction and infrastructure building are non-trivial, the shockwaves from the downturn will spill over to the rest of the world in general and to developing economies in particular. Excesses  The Chinese property market’s vulnerability stems from its excesses. These excesses are apparent on multiple fronts. Table 1Chinese Housing Is Expensive / Unaffordable 1. Extreme Overvaluation: Compared to most countries around the world, housing in China is very expensive. The house price-to-household income ratio is 19 in tier-1 cities, 10 in tier-2 and 7 in tier-3 cities (Table 1). For comparison, even after the recent surge in property prices, the house price-to-income ratio is 4 in the US nationwide. Importantly, the mortgage rate in China – currently at 5.4% – is considerably higher than mortgage rates in the US or in other developed economies. The high house price-to-income ratio and relatively high mortgage rate entail that mortgage interest payments account for a larger share of household income in China than in any advanced economy. For new buyers, assuming a 30% down-payment, mortgage interest payments alone make up 28% of household income on average nationwide (Table 1). Chart 2Chinese Households Are As Leveraged As Their US Peers Finally, Chinese household indebtedness is much higher than is often presumed by the global investment community – the household disposable income-to-debt ratio is close to 100%, as high as it is in the US (Chart 2). All this does not mean that China will experience a US-style 2008 credit crisis with households defaulting on their mortgages. As we discuss below, the adjustment process will be different in China than it was in the US. 2. Capital misallocation: Property developers have been building the wrong type of housing at the wrong prices and for the wrong type of buyers. They have been building high-end houses and selling them at very high prices to high-income households who have been buying multiple properties as investments. This represents capital misallocation. Widespread home vacancies confirm this thesis. As of 2017, 21.5% of the housing stock was vacant according to the Survey and Research Center for China Household Finance.  As per the same source, only 11.5% of homebuyers in 2018 were first timers. That compares with 70% of first-time buyers in 2008-2010. In 2018, 22.5% of homebuyers already owned two or more dwellings while 66% owned one. Clearly, housing in China has become an object of speculation which has made it unattainable for first-time homebuyers. Chart 3Property Developers Have Accumulated Massive Assets 3. Speculation and the carry trade: There is nothing wrong with individuals investing in real estate. This practice is widespread all around the world. However, contrary to many other countries, multiple home owners in China do not rent out their properties, but instead keep their houses vacant. For those few owners who rent their houses, the current rental yield on properties rarely exceeds 2%. Given that the mortgage rate is currently 5.4%, the carry costs for individual investors is negative. Therefore, property investors in China can only expect to profit from ever rising prices. This strategy has paid off enormously over the last 20 years. Yet, past performance does not guarantee future gains. A stampede into real estate since 2009 has made housing extremely expensive and has instigated socio-political problems that have made Beijing wary. Critically, property speculation has been prevalent not only among households but also among property developers. The latter have been participating in the largest carry trade of the past 12 years. Facing borrowing costs that were lower than the pace of house price appreciation, property developers in China have done what any business would do: they borrowed as much as they could and accumulated real estate assets in the form of land, incomplete construction as well as completed but unsold properties. Chart 4Property Developers Are Very Leveraged As long as the rate of annual asset price appreciation exceeds the borrowing costs (the carry), carrying these assets on a balance sheet produces lofty profits. The top panel of Chart 3 demonstrates that housing starts have chronically exceeded completions, i.e., developers have been starting but not completing/delivering properties. The gap between starts and completions – unfinished construction – has ballooned (Chart 3, bottom panel). In short, property developers have been holding on to a lot of land and unfinished construction and have been financing it via debt. The asset-to-equity ratio for property developers trading on the A-share market has surged to 9 (Chart 4).  Overall, the primary reason for real estate asset accumulation in China by individuals and companies has been expectations of continuous price appreciation. When an investor purchases an asset that generates little or no recurrent cash flow and the only rationale for holding onto it is expectations for continuous price appreciation, it qualifies as speculation – not investment. This speculation can continue only as long as there is demand from new buyers. Bottom Line: The property market is suffering from numerous excesses such as extreme overvaluation, capital misallocation and widespread speculative activities. Clouds Are Forming Over Real Estate Odds are that the speculative fever that has held the Chinese housing market in its grip is waning. Chart 5Less Funding = Less Completions = Less Commodity Demand First, the three red lines introduced by authorities a year ago limit property developers’ ability to take on more debt. In fact, many property developers are being forced to reduce their indebtedness to meet these regulatory requirements. These rules mean that property developers will have to reduce new construction at best or sell their assets at worst. When many developers try to offload their assets simultaneously, asset prices will deflate, producing a vicious debt deflation cycle. Second, the reluctance of authorities to bail out large property developers – which are struggling to service their debt – is sending a clear message to both onshore and offshore creditors not to lend to property developers. This is especially true for small and medium banks, trust companies, wealth management products and onshore and offshore bondholders. These lenders along with pre-sales account for the lion’s share of financing options for property developers. Chart 5 illustrates that diminishing funding for property developers weighs down on completion, i.e., less construction work and less demand for raw materials and machinery (Chart 5, bottom panel). Third, the property carry trade does not make sense when the rate of real estate asset price appreciation drops below property developers’ borrowing costs. A negative carry means incurring losses, necessitating the sale of assets, including land and completed properties. A rush to offload assets amid a buyer strike could prompt classic debt deflation. Chart 6Households’ House Buying Intentions Have Plummeted Finally, the upcoming pilot program for a real estate tax and a broader public campaign by Beijing against buying houses as an investment has discouraged individuals from purchasing properties. The proportion of households planning to buy a house has dropped to only 7.7% in Q3 2021 from 11.6% in Q4 2020 (Chart 6). House sales contracted by 16% in September from a year ago and initial reports point to further deterioration in October.     Bottom Line: Central authorities in China are attempting to tackle the property market because they reckon that an expensive and speculative property market could either create socio-political problems down the road or get out of control and crumble of its own accord. Beijing’s objective is to achieve a soft landing by acting preemptively and managing it.  The Role Of Policy Why is Beijing obsessed with taming the property market? We suspect the current hawkish stance is due to the following: Chart 7Housing Prices Correlate With Starts Housing is becoming unaffordable for low- and some middle-income residents in China. This may give rise to a sense of injustice/inequality and goes against president Xi’s common prosperity goals. This is also negatively affecting family formation and demographics and, ultimately, the nation’s potential growth rate. Beijing believes that the 2019 protests in Hong Kong were to a certain extent due to housing unaffordability. The latter fanned young people’s rage toward authorities and the political system. The Communist party leadership wants to avoid a similar uprising in the mainland. Anytime policymakers have stimulated in the past 12 years, property prices have surged widening the gap between the poor and the rich and making housing even more unaffordable. Presently, they are reluctant to do the same. Also, authorities are clamping down on property developers because historically there was a strong positive correlation between property starts and house prices (Chart 7). The basis for this positive correlation is that whenever property developers start new projects, they raise expectations of higher future prices via aggressive marketing. As a result, people become more inclined to buy houses. In fact, over the years more supply has not precluded property prices from surging and vice versa, as shown in Chart 7. Finally, the central government has learned from its own experience in 2015 and from the US case in 2008 that when a bubble bursts, it is difficult to stop it. Chinese economic policymakers prefer to be proactive than reactive. All of the above does not mean that authorities are planning to instigate a property market crash and will stand by and not stimulate. If and when broad economic conditions deteriorate to the point that income growth and employment are jeopardized, authorities will rachet up their stimulus. Presently, the unemployment rate for the 25-59 age group is very low and the urban labor market is tight (Chart 8). In addition, the nation’s exports are booming, so it is a good time to undertake some deleveraging. In brief, there is now no urgency to stimulate aggressively. Bottom Line: Considering the size of the real estate market and how dire its fundamentals are, we expect economic conditions to get much worse in China. That will ultimately force policymakers to stimulate more aggressively. The End Of The Property Carry Trade Conditions have fallen into place for the property carry trade by developers to unravel: Faced with limited access to funding, a diminished willingness on the part of creditors to rollover their debt as well as plummeting home sales, property developers have already dramatically cut back on land purchases (Chart 9, top panel). Chart 8China's Labor Market Is Strong Chart 9China's Construction Cycle In Perspective   However, they have so far been completing and delivering pre-sold homes to buyers who had paid in advance. In the last couple of years 90% of homes have been pre-sold. Hence, these completions do not generate new cash inflows for real estate developers. Yet, this completion work has supported construction activity and demand for materials over the past 12 months (Chart 9, bottom panel). Looking forward, reduced funding entails shrinking completions with negative ramifications for the economy (Chart 5 above). Real estate deflation, lack of new sales and restricted financing could turn property developers’ liquidity troubles into a solvency issue. This is how typical financial/credit crises develop – they start with liquidity strains and then turn into solvency problems as the value of collaterals drop, becoming insufficient to cover debt obligation. Defaults ensue. Property development is an extremely fragmented industry in China. There are officially around 100 000 property developers in China. Even the largest ones like Evergrande have a very small share of the market. Therefore, authorities cannot ensure that the sector will function properly by ring fencing or bailing out several large developers. In sum, authorities have very little control over real estate construction because it is quite spread out across the country and involves many private small- and medium-sized developers. We think that Beijing’s goal is to achieve flat property prices in the coming years. Authorities realize that property deflation could be devastating but are also less tolerant of growing excesses and imbalances in this area. Flat home prices and rising incomes will lead to a lower house price-to-income ratio, i.e., will make home ownership more affordable. In short, policymakers are attempting to fix property prices to achive a soft landing. Yet, there is a caveat: when authorities fix/control prices, they lose control of volumes/activity. This will likely be the case in China. Without meaningful drop in house prices, low-and middle-income first-time homebuyers will not become buyers right away and healthy property developers will be unwilling to snap up the assets of their troubled competitors. Hence, the market will not clear and the property sales and construction activity will hit an air pocket. Bottom Line: After more than a decade of speculative excesses, policymakers have embarked on the very difficult task of controlling house prices. They can control house prices via administrative measures. Yet, as expectations of rapidly rising property prices vanish, land sales, home purchases and property construction will likely shrink substantially for a period of time. Investment Recommendations A few market-relevant observations: Chinese non-TMT stocks and China-related plays globally are at risk from shrinking construction activity on the mainland. Critically, EM non-TMT stocks have not priced in the slowdown. Chart 10 illustrates that China’s credit and fiscal spending impulse is back to its previous low, but EM non-TMT stocks have not corrected much. In the past, Chinese onshore property stocks correlated with global material stocks (Chart 11). The basis is that China’s construction accounts for a considerable share of global raw materials consumption. Hence, the bear market in Chinese property stocks is raising a red flag for global material stocks. Chart 10EM Ex-TMT Stocks Are Not Pricing China's Slowdown Chart 11A Red Flag For Global Materials   EMs are most vulnerable, and the US is the least exposed to China’s construction and infrastructure investment segments. The basis is that the US is a closed economy and trades very little with China. That is why we believe that the US dollar has more upside and US equities will continue outperforming the global stock index as China’s slowdown persists. Putting it all together, we recommend the following strategies: Avoid EM stocks and underweight EM versus DM in a global equity portfolio. Continue shorting select EM currencies versus the US dollar. Avoid local currency bonds and favor US credit over EM credit markets. Avoid bottom fishing in Chinese offshore corporate bonds, including high-yield ones. As for Chinese equities, investors should stay with the long onshore A shares / short investable index strategy. We also reiterate a strategy we have been recommending for both onshore and offshore stocks since May 9, 2019: short property stocks relative to the benchmark. This has been a very profitable trade. Today, we recommend closing the long position in Chinese insurance stocks given that credit woes will worsen before they improve. One way for global investors to bet on China’s slowdown while hedging the risk of stronger growth in DM is via the following trade: short global materials / long global industrials. Our report from July 30 elaborated the bullish case for global industrials beyond China’s slowdown. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Footnotes 1 See Kenneth S. Rogoff and Yuanchen Yang, "Peak China Housing," National Bureau of Economic Research, August 2020. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

In lieu of next week’s report, I will be presenting the quarterly Counterpoint webcast titled ‘Where Is The Groupthink Wrong? (Part 2)’. I do hope you can join. Highlights If a continued surge in the oil price – or other commodity or goods prices – started driving up the 30-year T-bond yield, the markets and the economy would feel the pain. We reiterate that the pain point at which the Fed would be forced to volte-face is only around 30 bps away on the 30-year T-bond, equal to a yield of around 2.4-2.5 percent. That would be a great buying opportunity for bonds. Given the proximity of this pain point, it is too late to short bonds, or for equity investors to rotate into value and cyclical equity sectors. That tactical opportunity has almost played out. On a 6-month and longer horizon, equity investors should prefer long-duration defensive sectors such as healthcare. Chinese long-duration bond yields are on a structural downtrend. Fractal analysis: The Korean won is oversold. Feature 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 about the trebling of the crude oil price since March 2020? 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, by driving up the bond yield and tipping an already fragile market and economy over the brink. Today, could oil become the accessory to another murder? (Chart I-1) Chart I-1AOil Was The Accessory To The Murder In 2008... Chart I-1B...Could It Become The Accessory To Another Murder?   Oil Is The Accessory To Many Murders Turn the clock back to the 1970s, and it might seem more straightforward that the recession of 1974 was the direct result of the oil shock that preceded it. Yet even in this case, we can argue that oil was the accessory, rather than the true culprit of that murder. It is correct that the specific timing, magnitude, and nature of OPEC supply cutbacks were closely related to geopolitical events – especially the US support for Israel in the Arab-Israeli war of October 1973. Yet as neat and popular as this explanation is, it ignores a bigger economic story: the collapse in August 1971 of the Bretton Woods ‘pseudo gold standard’, which severed the fixed link between the US dollar and quantities of commodities. To maintain the real value of oil, the OPEC countries were raising the price of crude oil well before October 1973. Meaning that while geopolitical events may have influenced the precise timing and magnitude of price hikes, OPEC countries were just ‘staying even’ with the collapsing real value of the US dollar, in which oil was priced. Seen in this light, the true culprit of the recession was the collapse of the Bretton Woods system, and the oil price surge through 1973-74 was just the accessory to the murder (Chart I-2). Chart I-2In 1973-74, OPEC Was Just 'Staying Even' With A Collapsing Real Value Of The Dollar A quarter of a century later in 1999, the oil price again trebled within a short time span – and by the turn of the millennium, the ensuing inflationary fears had pushed up the 10-year T-bond yield from 4.5 percent to almost 7 percent (Chart I-3). With stocks already looking expensive versus bonds, it was this increase in the bond yield – rather than a decline in the equity earnings yield – that inflated the equity bubble to its bursting point in early 2000 (Chart I-4). Chart I-3In 1999, As Oil Surged, So Did The Bond Yield... Chart I-4...Making Expensive Equities Even More Expensive To repeat, for the broader equity market, the last stage of the bubble was not so much that stocks became more expensive in absolute terms (the earnings yield was just moving sideways). Rather, stock valuations worsened markedly relative to sharply higher bond yields. Seen in this light, the oil price surge through 1999 was once again the accessory to the murder. Eight years later in 2007-08, the oil price once again trebled with Brent crude reaching an all-time high of $146 per barrel in July 2008. Again, the inflationary fears forced the 10-year T-bond yield to increase, from 3.25 percent to 4.25 percent during the early summer of 2008 (Chart I-5) – even though the Federal Reserve was slashing the Fed funds rate in the face of an escalating financial crisis (Chart I-6). Chart I-5In 2008, As Oil Surged, So Did The Bond Yield... Chart I-6...Even Though The Fed Was Slashing Rates In The Face Of A Financial Crisis Suffice to say, driving up bond yields in the summer of 2008 – in the face of the Fed’s aggressive rate cuts and a global financial system teetering on the brink – was not the smartest thing that the bond market could do. On the other hand, neither could it override its Pavlovian fears of the oil price trebling. Seen in this light, the oil price surge through 2007-08 was once again the accessory to the murder. Inflationary Fears May Once Again Lead To Murder Fast forward to today, and the danger of the recent trebling of the oil price comes not from the oil price per se. Instead, just as in 2000 and 2008, the danger comes from its potential to drive up bond yields, which can tip more systemically important economic and financial fragilities over the brink. One such fragility is the extreme sensitivity of highly-valued growth stocks to the 30-year T-bond yield, as explained in The Fed’s ‘Pain Point’ Is Only 30 Basis Points Away. On this note, one encouragement is that while shorter duration yields have risen sharply through October, the much more important 30-year T-bond yield has just gone sideways. A much bigger systemic fragility lies in the $300 trillion global real estate market, as explained in The Real Risk Is Real Estate (Part 2). Specifically, the global real estate market has undergone an unprecedented ten-year boom in which prices have doubled in every corner of the world. Over the same period, rents have risen by just 30 percent, which has depressed the global rental yield to an all-time low of 2.5 percent. Structurally depressed rental yields are justified by structurally depressed 30-year bond yields. Therefore, any sustained rise in 30-year bond yields risks undermining the foundations of the $300 trillion global real estate market (Chart I-7). Chart I-7Structurally Depressed Rental Yields Are Justified By Structurally Depressed 30-Year Bond Yields Nowhere is this truer than in China, where prime real estate yields in the major cities are at a paltry 1 percent. In this context, the recent woes of real estate developer Evergrande are just the ‘canary in the coalmine’ warning of an extremely fragile Chinese real estate sector. This will put downward pressure on China’s long-duration bond yields. As my colleague, BCA China strategist, Jing Sima, points out, “Chinese long-duration bond yields are on a structural downtrend…yields are likely to move structurally to a lower bound.” But it is not just in China. Real estate is at record high valuations everywhere and contingent on no major rise in long-duration bond yields. In the US, there is a tight relationship between the (inverted) 30-year bond yield and mortgage applications for home purchase (Chart I-8), and a tight relationship between mortgage applications for home purchase and building permits (Chart I-9). Thereby, higher bond yields threaten not only real estate prices. They also threaten the act of building itself, an important swing factor in economic activity. Chart I-8The Bond Yield Drives Mortgage Applications... Chart I-9...And Mortgage Applications Drive Building Permits To repeat, focus on the 30-year T-bond yield – as this is the most significant driver for both growth stock valuations, and for real estate valuations and activity. To repeat also, the 30-year T-bond yield has been generally well-behaved over the past few months. But if a continued surge in the oil price – or other commodity or goods prices – started driving up the 30-year T-bond yield, the markets and the economy would feel pain. And at some point, this pain would force the Fed to volte-face. We reiterate that this pain point is only around 30 bps away, equal to a yield on 30-year T-bond of around 2.4-2.5 percent – a level that would be a great buying opportunity for bonds. Given the proximity of this pain point, it is too late to short bonds or for equity investors to rotate into value and cyclical equity sectors. That tactical opportunity has almost played out. On a 6-month and longer horizon, equity investors should prefer long-duration defensive sectors such as healthcare. The Korean Won Is Oversold Finally, in this week’s fractal analysis, we note that the Korean won is oversold – specifically versus the Chinese yuan on the 130-day fractal structure of that cross (Chart I-10). Chart I-10The Korean Won Is Oversold Given that previous instances of such fragility have reliably indicated trend changes, this week’s recommended trade is long KRW/CNY, setting the profit target and symmetrical stop-loss at 2 percent.   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  

Highlights Democrats are backing off from corporate tax hikes, a positive surprise for the earnings outlook. However, the reconciliation bill will be even more stimulating than expected at a time when the output gap is closed. Short-run inflation risks are high and Democratic bills will feed into that. Long-run inflation risks will need to be monitored. Compromises on legislation will help Democrats on the margin in the 2022 midterm elections but gridlock would freeze fiscal policy. Maintaining low corporate taxes while boosting government spending on infrastructure, R&D, renewables, and social safety should be good for productivity, potential growth, and the US dollar over the long run.   We still give 65% odds for the reconciliation bill to pass. Reconciliation is the critical means of avoiding a national debt default after the December 3 deadline. This assumes that bipartisan infrastructure passes (80% odds). With the market already pricing the impending Democratic agreement, we are closing our long renewable energy trade for a gain of 30% and our long infrastructure basket for a gain of 8%. Feature A major plot twist in Congress occurred over the past two weeks: corporate and individual tax cuts are on the chopping block as the December 3 deadline approaches for the Biden administration’s signature piece of legislation. This development is uncertain but not unlikely. It would fit with our annual theme of bipartisan structural reform in the sense that it would mark a further Democratic cooptation of the previous Republican administration’s policies for the sake of popular opinion. Investors should not bet on zero tax hikes but they should prepare for positive surprises relative to the 5.5%-7% corporate tax hike that was previously envisioned. Rotation from low-tax to high-tax sectors was already underway prior to this news, which favors that trend (Chart 1). Chart 1Democrats Scrap Corporate Tax Hike? In this report we update investors with the status of negotiations: what is in the bill, what is not, what remains undecided, what will be the net effect, and how will Wall Street respond? Details are subject to change up to the very moment before Congress votes. Here is what we know right now.   What’s Essential To The Bill? Before the reconciliation bill, the $550 billion bipartisan infrastructure bill still has a subjective 80% chance of passage. The Senate already approved it on August 10, with 19 Republicans in favor. It stalled in the House of Representatives because the left wing refused to vote for it until party leaders reached a framework agreement on the larger social spending bill. The latter can only pass via the partisan reconciliation process. That framework could be agreed any day now but even if it suffers a surprise delay the House can push through the infrastructure bill fairly quickly. Infrastructure stocks still have some room to rise in the lead-up to President Biden’s signature but their ability to outperform the market going forward will depend on a range of factors outside politics and policy (Chart 2). Chart 2Infrastructure Bill Already Priced As for the main reconciliation bill, House Speaker Nancy Pelosi claims that “more than 90 percent of everything is agreed to” in the framework agreement – but critical provisions are still in flux. The headline price tag has fallen from $3.5 trillion to $1.5-$2 trillion, leaving $1.75 trillion as the happy medium. The root of the disagreement is that the Democrats are a “big tent” party with two major factions of relatively equal strength. Moderates and conservatives have the upper hand on economics, whereas liberals have the upper hand on social issues (Chart 3). On the spending side, progressives have insisted on five policy priorities: the “care” economy (child care, elderly care), affordable housing, climate change, immigration, and health care. They say they can negotiate on the size and duration of the relevant programs but not on whether they are included.1 The Senate parliamentarian has already ruled out immigration so the other four priorities will be included, albeit watered down.  West Virginia Senator Joe Manchin’s initial demands to Senate Majority Leader Chuck Schumer are highlighted in Table 1. Manchin’s demands for a lower price tag are being met by the progressives’ willingness to pass smaller or short-lived programs with “sunset clauses.” The idea is that Republicans will suffer for allowing them to expire. History shows that it is very difficult to remove an entitlement once it is established. Table 1West Virginia Senator Joe Manchin’s Initial Demands For Biden’s Reconciliation Bill The following items look to be included but pared back in size: The Child Tax Credit (from $450 billion to ~$100 billion). This benefit was enhanced by COVID-19 stimulus and is likely to be kept in place, albeit for one year instead of five years. This sets up a “cliff” in December 2022.   Paid family and medical leave (from $225 billion to ~$100 billion). This benefit looks likely to be lowered from 12 weeks to four weeks and targeted toward low-income groups for a duration of three-to-four years. Medicare benefits expansion to include dental, vision, and hearing aid (from $358 billion to ~$200 billion or less). This provision is under pressure due to costs but Senator Bernie Sanders of Vermont insists that it will be included to some extent. Dental is likely to be slashed. This part of the bill was supposed to be paid for by allowing Medicare to negotiate drug prices, which is still being discussed. The Hill reports that the government may be given the power to negotiate prices for Medicare Part B but not Part D.2  On the revenue side, Pelosi says the deal will include a harmonization of overseas taxes. This would include a minimum 15% corporate tax rate on book earnings in keeping with the international agreement the Biden administration has negotiated. An estimated ~$400 billion in new revenue would be raised. Senators Manchin and Kyrsten Sinema of Arizona agree. Pelosi also claims agreement on tougher tax enforcement and a bulked-up Internal Revenue Service – a measure that is said to bring in $135 billion in revenue but which can be exaggerated to help cover the cost of new spending, at least on paper. What’s Already Been Chopped? Pelosi claims that the climate change disagreements are resolved. Manchin hails from a coal state where every single county favored President Trump for reelection. He  has nixed the Clean Energy Performance Program (CEPP) as well as any tax on carbon emissions.3 However, the $150 billion from CEPP will not be saved but redirected toward various other green energy projects. This solution confirms our view this year that Democrats would provide green subsidies but not punitive green measures. The US and global policy setting is favorable for renewable stocks, though the energy crunch in China and Europe is a sign that this trade is not a one-way trade since popular backlash against green policies is possible in future (Chart 4). Manchin is opposing the expansion of Medicaid to 12 states that have refused to expand it. The other 38 states had to pay 10% of the cost; a federal expansion would give it to the 12 laggards for free. Eliminating the provision entirely would put the onus back on the 12 states (useful for local Democrats) while cutting $141 billion from the overall cost of the reconciliation bill.4 Democrats have also agreed to cut the $88 billion proposal to make two years of community college tuition-free.   Chart 4Renewable Stocks Brush Off Energy Realism (For Now) Universal preschool (pre-kindergarten), which would cost $450 billion, is popular but now under fire. It is not in the list of progressive priorities and could be slashed. Housing aid at $300 billion is expected to be cut by half or more. Elderly care could fall from $400 billion to half or one-third of that. Immigration provisions are unlikely to appear in the final reconciliation bill, as noted above. The Senate Parliamentarian Elizabeth MacDonough has ruled that immigration is not germane to direct fiscal matters, which are the focus of the reconciliation process.5 The Democrats have a vested interest in immigration and are not acting with any urgency on the border in the meantime, setting up an immigration crisis in 2022 and beyond (Chart 5). Table 2 shows the original Democratic spending plan with annotations for the latest developments, which are all subject to change in the very near term. Chart 5Looming Crisis On Southern Border Table 2Senate Democratic Spending Plan Up For Negotiation What’s Next On The Chopping Block? On the revenue side, the following provisions are being debated: Corporate and Individual Tax Hikes: Senator Kyrsten Sinema of Arizona – who won her seat by a 2.4% margin in a state that President Biden carried by only 0.3% of the vote – has ostensibly succeeded in scrapping the corporate tax hike and individual income tax hike from the reconciliation package. Our guess is that these tax hikes will still somehow make it into the bill in a weaker form but if Sinema prevails then $710 billion in new revenue will be forgone.  Billionaire Tax: Democrats are also looking at a “billionaire tax,” although it would more accurately be called a hundred-millionaire tax based on what is known. It would be a yearly tax levied on the unrealized capital gains of those who own $1 billion in assets or who make $100 million in income over three consecutive years. Non-publicly traded assets would be taxed upon sale. This mark-to-market proposal is said to raise $250 billion in revenue, although nobody knows since tax evasion would be rife.6 It would be a popular tax but it is complex to administer, its constitutionality is uncertain, and it is being introduced in the eleventh hour. House negotiators would prefer straightforward corporate and high-income tax hikes.  Tax On Stock Buybacks: There is also a proposal to levy a 2% tax on stock buybacks, which would be popular and not so hard to implement as a wealth tax. But it is also being introduced late in the game. SALT Deduction Cap: Democrats from high tax states have relentlessly pushed to remove the cap on their deductions passed by Republicans. A temporary repeal for 2022-23 is being discussed but would be a handout to the upper and upper-middle class. Total repeal could deprive the overall package of $85 billion per year in revenue. Tobacco and E-Cigarettes: This tax is estimated to raise $97 billion but is regressive. Table 3 highlights the tax provisions according to the original Democratic plan along with annotations for recent developments. Table 3Democratic Tax Plan Up For Negotiation The Hyde amendment is lurking under the radar and could torpedo the entire bill – but we bet it will not. This provision has been included in legislation for half a century to prevent taxpayer money from directly funding abortion. President Biden, a Catholic, supported it until his 2020 presidential campaign when he caved to pressure from the progressives to remove it. However, Manchin insists on it.7 Since abortion is a moral dilemma, Manchin cannot compromise on it. Yet his “nay” would sink the entire reconciliation bill. So this is a mini-crisis waiting to happen and Hyde will most likely be included to save the bill. What’s The Time Frame? There are three soft deadlines and one hard deadline for these bills to pass. The soft deadlines are the following: October 31 – Transportation Funding Expires: House members want to pass the bipartisan infrastructure bill by October 31, along with a renewal of transport funds. This is a good plan because it separates bipartisan infrastructure from partisan reconciliation. But a short-term extension is also an option for transportation funding. It may be necessary if reconciliation is further delayed and House progressives refuse to support an infrastructure vote. November 1-2 – World Leaders Summit and UN Climate Change Conference: Democrats want a climate deal before Biden arrives in Glasgow, Scotland for the COP26 climate talks. It looks as if this will be achieved as we go to press. If not, Biden can offer vague promises instead. There will be no shortage of promises at Glasgow. November 9 – US Special Elections: If Democrats passed something before the various off-year elections are held then they would give their candidates a badly needed boost. Biden’s collapsing approval rating has been an albatross for Democratic candidates, including in the Virginia gubernatorial race (Chart 6). A signing ceremony at the White House would help take it off their necks. But lawmakers cannot speed up complex and controversial legislation just to save Terry McAuliffe’s bacon. The hard deadline is December 3, the new deadline for funding the federal government and raising the national debt limit. Republicans are unlikely to vote to raise the debt ceiling a second time this year so Democrats will most likely be forced to include it in the reconciliation bill. Importantly, the debt ceiling will help to ensure the reconciliation bill’s passage. Any Democratic senator or lawmaker who votes against the bill will bear unique responsibility for a default on the national debt and financial turmoil, not to mention the doom of his or her party in the midterm elections.  If anything this extreme cost suggests that our 65% subjectively probability for the bill’s passage is too low. What Are The Investment Implications? Democrats are likely to produce a $1.75-$2 trillion spending bill that raises around $1 trillion in new tax revenue. Our previous estimates of a net deficit impact of $1.2-$1.6 trillion for both the infrastructure and reconciliation bills will be updated when the framework reconciliation bill is put into writing but so far does not look far off the mark. Estimates for fiscal multipliers range widely (Table 4). The bipartisan infrastructure bill, with traditional or “hard” public investments, could have a multiplier of 0.4 to 2.2, based on the CBO’s retrospective 2015 estimates for the American Recovery and Reinvestment Act (the stimulus passed during the Great Recession). The partisan reconciliation bill, with “human infrastructure” and social welfare spending, could have a fiscal multiplier ranging from 0.6x (the average of the COVID-19 relief in 2020) to 1.2 or 1.4 (Moody’s estimates of the impact of expanding the Child Tax Credit in 2010).  Table 4Range Of Fiscal Multipliers For Government Spending However, the US output gap is virtually closed and stands at a positive 1.5% of GDP, according to Bloomberg consensus estimates (Chart 7). Thus additional deficit spending is inflationary on the margin. Core inflation is elevated and there is no immediate prospect for commodity prices to fall drastically in the next few months given tight global supplies, the approach of winter weather, and the looming conflict over Iran’s nuclear program in the Persian Gulf. A future political liability is thus taking shape. American consumers and small businesses are becoming increasingly concerned about inflation, much more so than taxes and regulation (Chart 8). By the time of the midterm election in fall 2022, inflation may have subsided. But if it has not then the Democrats will take the blame. Chart 7The Vanishing Output Gap Chart 8The Inflation Threat The equity sectors that stood to suffer the most from any repeal of President Trump’s Tax Cuts And Jobs Act of 2017 were real estate, technology, health care, and utilities. The sectors that stood to suffer least were energy, industrials, consumer staples, and materials. If Democrats maintain Trump’s corporate rate then the former sectors will see a relief rally. However, Big Tech will suffer marginally from the imposition of a minimum global corporate tax. The global macro context favors cyclical sectors and value stocks over defensive sectors and growth stocks as long as bond yields and inflation expectations continue to rise. Chart 9 shows that companies that were formerly high tax companies rallied tremendously in the wake of Trump’s tax cuts, while those with high foreign tax risk underperformed. That process will likely be reaffirmed if Trump’s headline corporate rate is preserved while the minimum rate is imposed on companies with high foreign tax risk. Over the long run, inflation may or may not prove to be as big of a problem. The Biden bills should boost productivity, on top of the productivity improvement that has already occurred as a result of COVID-19 digitization efforts. US corporates would maintain a high degree of competitiveness if the corporate rate were to stay put. The original Biden plan would have put the US back at the highest level of integrated corporate income taxes out of all the OECD countries. Keeping corporate rates low, combined with public investments in infrastructure, the digital economy, renewable energy, and the social safety net should boost productivity, potential growth, and the US dollar. Chart 9High-Tax Basket Stands To Benefit - Along With Value Stocks If Congress returns to gridlock after the 2022 midterm elections as expected, then the fiscal splurge may be on pause at least until 2025. In that case the inflation risk in coming years will depend more on global rather than domestic developments. We have long argued that inflation risks are rising due to populism and fiscal extravagance in the United States. The Biden administration’s legislation marks a return of Big Government and a net increase in the budget deficit over the coming decade. However, the latest developments suggest it will not be the extravagant democratic-socialist blowout originally envisioned. If that proves true, then its long-run impact will be beneficial for the US economy and politics.  On a deeper level, the most important takeaway from the above analysis is that the Democrats remain limited by checks and balances. Beneath all the partisan acrimony, a new consensus is emerging in the US in favor of proactive fiscal policy (infrastructure, social safety net) and more hawkish trade policy (supply chain resilience, onshoring). The drivers of this new consensus are powerful: the elites do not want rebellion, the masses want a more favorable domestic economy, and both want greater strategic security relative to foreign competitors. The likely passage of the Strategic Competition Act by the end of the year, or at least the semiconductor portion of it, and the passage of a bulked up annual defense bill despite Democrats’ allegedly dovish bias, will further emphasize this point.  By compromising the plan to come closer to moderate senators’ demands, the Democrats are courting the median US voter and likely to minimize their losses in the midterm elections. Even assuming they still lose the House of Representatives at least, the new policy consensus will continue to develop because it shares core elements with the Republican agenda.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix   Footnotes 1     See Congressional Progressive Caucus, “CPC Calls For 5 Key Priorities To Be Included In The American Jobs Plan,” April 9, 2021, progressives.house.gov. See also Tyler Stone, “Rep. Ilhan Omar: If Our Progressive Priorities Aren’t Met, No Legislation Will Pass,” July 30, 2021, realclearpolitics.com. 2     See Jennifer Scholtes, Marianne Levine, and Alice Miranda, “What’s Still In The Dem Megabill? Cheat Sheet On 12 Big Topics,” Politico, October 25, 2021, politico.com; Jordain Carney, “Sanders draws red lines on Medicare expansion, drug pricing plan in spending bill,” The Hill, October 26, 2021, thehill.com.  3    Benjamin J. Hulac, “Manchin Tries To Slow Clean Energy Shift As West Virginia Clings To Coal,” Roll Call, October 26, 2021, rollcall.com. 4    Jordain Carney, “Manchin Says Framework ‘Should’ Be Possible This Week,” The Hill, October 25, 2021, thehill.com. 5    Lisa Desjardins, “Read the Senate rules decision that blocks Democrats from putting immigration reform in the budget,” PBS, September 20, 2021, pbs.org.  6    See Naomi Jagoda, “Billonaire Tax Gains Momentum,” The Hill, October 26, 2021, thehill.com; Steven M. Rosenthal, “Wyden’s Billionaire Income Tax Is Ambitious But Problematic,” Tax Policy Center, October 25, 2021, taxpolicycenter.org; Scott A. Hodge, “The Rich Are Not Monolithic and Taxing Their Wealth Invites Tax Collection Volatility,” Tax Foundation, October 26, 2021, taxfoundation.org. 7     Sam Dorman, “Biden says he’d sign reconciliation package including Hyde Amendment,” Fox News, October 6, 2021, foxnews.com.