Equities

Highlights Inflation is set to decelerate, job creation has a speed limit, and super-spreaders of new-variant Covid-19 infections will create speed bumps in the economy.  This means that in the second half of the year: Bonds will rally. The US dollar will rally. Growth stocks will outperform value stocks. US stocks will outperform non-US stocks. Fractal trade shortlist: Brazilian real, Saudi Tadawul All Share, and Marine Transportation.  Feature Chart of the WeekThe 60 Percent Correction In Lumber Shows What Happens When Supply Bottlenecks Ease. Are Used Cars Next? As Supply Bottlenecks Ease, Inflation Will Cool Since mid-March, US inflation has surged to 5 percent. Yet bond yields have drifted lower, by almost 50 bps in the case of the 30-year T-bond yield, equating to a handsome return of 12 percent. The seeming contradiction between rising inflation and declining bond yields has puzzled some people, but it shouldn’t. In 2009, the same pattern occurred in reverse. Inflation collapsed, culminating in a modern era low of -2 percent in July 2009. Yet while inflation was collapsing, bond yields rose sharply (Chart I-2 and Chart I-3). Chart I-2In 2009, Bond Yields Rose When Year-On-Year Inflation Fell Chart I-3In 2021, Bond Yields Fell When Year-On-Year Inflation Rose We can explain this seeming contradiction with an analogy from driving. The inflation rate is like your average speed over the past mile. But the bond market cares much more about your average speed over the next mile, or even over the next 5-10 miles. If you are driving at a constant speed, then your speed over the past mile is a good guide to your future speed. But if you have been driving unusually fast or unusually slowly, there is a more important predictor of your future speed. That important predictor is your acceleration – meaning, what is happening to your speed over successive hundred yards stretches. In the same way, during episodes of unusually low or unusually high inflation, the bond market focusses on the monthly rate of inflation, and specifically the moment that it stops decreasing, as in early-2009, or stops increasing, as in mid-2021. In 2008, after a long sequence of declining monthly rates of inflation that went deep into negative territory, the December 2008 print marked the first substantial increase. Hence, the bond yield also bottomed in December 2008 (Chart I-4), even though annual inflation did not bottom until July 2009. Chart I-4In 2009, Bond Yields Bottomed When Month-On-Month Inflation Bottomed Similarly, in 2020-21, after a six month sequence of increasing monthly rates of inflation, the May 2021 print marked the end of the rising trend. To the extent that this was anticipated, most of the decline in the bond yield has happened since mid-May (Chart I-5). Chart I-5In 2021, Bond Yields Topped When Month-On-Month Inflation Topped Since mid-May, the 60 percent crash in the lumber price shows what happens when supply bottlenecks ease. Other prices that are being supported by temporary supply constraints – such as used car prices – are likely to suffer the same fate (Chart of the Week). Hence, so long as the coming monthly prints confirm an ongoing deceleration in inflation, the current rally in bonds will stay intact. Jobs: The Hard Work Starts Now Staying on the theme of speed, there is a well-defined speed limit to every post-recession jobs recovery. In A Fed Rate Hike By Early 2023 Is Pie In the Sky, we pointed out the remarkable consistency in the pace of post-recession US jobs recoveries. The last five recessions had different causes, severities, durations and peak unemployment rates. Yet in the recoveries that followed each recession, the unemployment rate declined at a remarkably consistent pace of 0.4-0.5 percent per year (Table I-1). Table I-1After Every Recession, The Pace Of Recovery In The Jobs Market Is Near-Identical Reassuringly at the last FOMC press conference, Jay Powell supported this thesis: Most of the act of sort of going back to one's old job – that's kind of already happened. So, this is a question of people finding a new job. And that's just a process that takes longer. There may be something of a speed limit on it. You've got to find a job where your skills match, you know, what the employer wants. It's got to be in the right area. There's just a lot that goes into the function of finding a job. Powell’s comments lead to two further points: The act of going back to one’s old job for those on ‘temporary layoff’ is relatively straightforward. For job creation, this is the low hanging fruit, most of which has already been picked. Now comes the much harder part – finding jobs for those ‘not on temporary layoff’ whose numbers have barely declined from the peak (Chart I-6). Chart I-6For Job Creation, The Low Hanging Fruit Has Already Been Picked One way of encapsulating this is to observe that the unemployment rate – including those on temporary layoff – has already made 80 percent of the journey from its recession peak to the February 2020 trough, which makes it seem that the jobs recovery is largely done. However, the unemployment rate for those not on temporary layoff has made only 25 percent of the journey (Chart I-7). Moreover, this process is not a straight line, it is a curve. The first quarter of the journey is the easiest, then it gets harder. Chart I-7The Hard Part Is Finding Jobs For Those Unemployed 'Not On Temporary Layoff' As we, and Jay Powell, have pointed out, the process to reduce this unemployment rate has a remarkably consistent speed limit of 0.4-0.5 percent per year. Starting at the current rate of 2.5 percent and a target of 1.5 percent, this means full employment will not be reached before the second half of 2023. And even this assumes clear blue skies for the world economy through the next two years, which is a tall order. We conclude that the market pricing of a Fed funds rate lift-off in December 2022 is much too optimistic, making the December 2022 Eurodollar contract a good buy. The End Of Pandemic Restrictions Will Unleash Super-Spreaders On July 19, the UK will remove all its domestic pandemic restrictions – meaning no more facemasks, social distancing, and limits on the size of gatherings. This doesn’t mean that the pandemic is over in the UK. Far from it. The delta variant of the virus is rampant. Rather, with a large portion of the population vaccinated, the government is replacing state-imposed laws and regulations with a libertarian onus on personal responsibility. Given that Covid-19 is not going away, the UK strategy raises a fundamental question. Other than implementing a vaccination program, what role should a government take in containing the virus? In Who’s Right On The Pandemic – Sweden Or Denmark? we revealed two important findings: First, it is a misunderstanding that state-imposed restrictions cause the collapse in social consumption. This is a classic confusion between correlation and causation. The true cause of the recession is that a virulent disease focuses millions of people on self-preservation, shunning crowds and public places. But to the extent that the pandemic also leads to state-imposed restrictions, many people blame the slowdown on these correlated restrictions rather than on the underlying cause – the voluntary change in behaviour. Second, without state-imposed restrictions, the majority will voluntarily change their behaviour to avoid catching and spreading the virus, but a minority will not. When a virus is spreading, this is critical because a tiny minority of so-called ‘super-spreaders’ is responsible for most infections. Put simply, economic growth depends on the behaviour of the majority and in a pandemic the majority will voluntarily reduce their social consumption. This explains why libertarian Sweden and lockdown Denmark suffered similar contractions in their economies (Chart I-8). Chart I-8Libertarian Sweden Has Not Significantly Outperformed Lockdown Denmark... In contrast, containing the virus depends on restricting the minority of super-spreaders. Which explains why libertarian Sweden suffered a much worse outbreak of the disease than lockdown Denmark (Chart I-9). Chart I-9...But Libertarian Sweden Has Suffered Many More Covid-19 Casualties The worry now is that the end of state-imposed restrictions will unleash super-spreaders and super-spreading events. This will allow the virus to replicate, mutate, and create new variants which are potentially more transmissible and resistant to existing vaccines. Pulling together our three themes for the second half of the year, inflation is set to decelerate, job creation has a natural speed-limit, and super-spreaders of new-variant Covid-19 infections will create speed bumps in the economy. This means that:  Bonds will rally. The US dollar will rally. Growth stocks will outperform value stocks. US stocks will outperform non-US stocks Candidates For Countertrend Reversal This week, we present three candidates for countertrend reversal. First, the Brazilian real’s recent surge has hit expected resistance at 65-day fractal fragility. A good way to play a continued reversal is to short BRL/COP (Chart I-10). Chart I-10The Brazilian Real Is Correcting Second, within emerging markets, the strong rally in the Saudi equity market is vulnerable to a setback, especially versus other markets. A good way to play this is to short the Saudi Tadawul All Share index versus the FTSE Bursa Malaysia KLCI, given that the 260-day fractal structure is at the point of fragility that marked the major top in 2014 (Chart I-11). Chart I-11The Saudi Stock Market Is Vulnerable To A Setback Finally, coming full circle to short-term supply bottlenecks, one major beneficiary has been the Marine Transportation sector which, since February, has outperformed the world market by 70 percent. As the supply bottlenecks ease, this is vulnerable to correction, especially as the 260-day fractal structure is at the point of fragility that marked the major top in 2007 (Chart I-12). Chart I-12Underweight Marine Transportation Hence, this week’s recommended trade is to underweight Marine Transportation versus the market, setting the profit target and symmetrical stop-loss at 16.5 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area   Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - 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  

The bond market continues to dictate the pace for the SPX and relative sector performance. The 30-year US Treasury yield retraced nearly half a percent from the mid-March peak triggering a US equity market rotation from cyclical and value sectors like materials, into growth sectors such as technology. AMZN alone moved more than 3% yesterday breaking out to fresh all-time highs signaling continued outperformance of growth stocks, while more value sectors lag behind (see chart). With growth rolling over and the Fed staying pat despite a slightly more hawkish stance, we expect the rates market to remain range bound for a while longer, further supporting a strong run of growth stocks in general, and tech in particular. Bottom Line: The rotation trade into growth at the expense of value has more room to run.  

Foreword Today we are publishing a charts-only report focused on the S&P 500, Cyclicals/Defensives, Growth/Value, and Small/Large. Many of the charts are self-explanatory; to some we have added a short commentary. The charts cover macro, valuations, fundamentals, technicals, and the uses of cash. Our goal is to equip you with all the data you need to make investment decisions along these style dimensions. We also include performance, valuations and earnings growth expectations tables for all styles, sectors, industry groups, and industries (GICS 1, 2 and 3). We hope you will find this publication, which we plan to update on a monthly basis, useful. Overarching Investment Themes Macro Economic growth remains robust, albeit slowing from a high peak. The business cycle has moved to an unusual slowdown stage, characterized by high growth. Investors’ inflation fears are dissipating, and the reflation trade is on the way out. However, concerns remain: According to the Consumer Confidence Survey, higher inflation is getting embedded into consumer expectations, potentially propagating a vicious cycle of stronger demand and higher prices (Chart 1). Fed rhetoric is becoming more hawkish. Yet, investors are shrugging it off, concluding a more active Fed is worth it to tame inflation. Companies are struggling to fill job openings and are hit with rising materials prices. However, corporate America's pricing power remains at an all-time high, helping offset the margin squeeze (Chart 2). Chart 1Consumer Confidence Survey: Inflation Expectations Chart 2Corporate Pricing Power Post-pandemic economic recovery was plagued by shortages and supply-chain disruptions. While it will take a long time for the supply issues to be resolved, bottlenecks are showing early signs of easing as delivery times are starting to fall (Chart 3). Last, but not least, consumers have money to spend, but prefer to splurge on services and experiences rather than goods. Chart 3Philadelphia Fed Business Survey: Delivery Times Valuations And Profitability The US stock market remains expensive, trading more than two standard deviations above the long-term average (Chart 4). Cyclicals look even worse, trading three standard deviations above Defensives. The six-month forward earnings outlook for the S&P 500 remains healthy with the BCA earnings model pointing towards higher growth. Hopefully, the index will grow into its elevated valuation. Small, Value, and Cyclicals also have impressive earnings growth expectations relative to their safer counterparts, but growth has peaked across the board, which does not bode well for performance. Chart 4Valuations Indicator (S&P 500) Uses Of Cash Share buybacks and other shareholder-friendly activities are on the rise again and are expected to gain steam this year and next. A falling denominator in the EPS ratio is another factor that will propel the S&P 500 higher (Chart 5). Capex is still lagging. A pickup in Capex will signal that the post-pandemic recovery is firmly on track, and life is fully back to normal as companies are comfortable investing in future growth. This will give the US equity rally, especially Cyclicals, a new lease of life (Chart 6). Chart 5Buybacks Chart 6Capex/Sales Investment Implications Normalization has been sending ripples through the US equity markets, as investors rotate back into Growth, and away from the reflation trade, and give a cold shoulder to small caps. We recommend a rotation from Value into Growth. While we are agnostic between Small and Large, we prefer both small- and large-cap Growth to large caps in general. While we think that the value trade has (mostly) run its course, we still like the Cyclicals most exposed to Consumer and Business Services, Infrastructure, and Oil.     Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   S&P 500 Chart 7Macroeconomic Backdrop Chart 8Profitability Chart 9Valuations And Technicals Chart 10Uses Of Cash Cyclicals Vs Defensives Chart 11Macroeconomic Backdrop Chart 12Profitability Chart 13Valuation And Technicals Chart 14Uses Of Cash Growth Vs Value Chart 15Macroeconomic Backdrop Chart 16Valuations, Profitability And Technicals Small Vs Large Chart 17Macroeconomic Backdrop Chart 18Profitability Chart 19Valuations And Technicals Chart 20Uses Of Cash  Table 1Performance Table 2Valuations And Forward Earnings Growth Recommended Allocation Footnotes  .

Special Report

Highlights Barring major surprises, President Macron will be re-elected in 2022. Any dramatic reversal in the pandemic that leads to a new recession would benefit the opposition candidate. Otherwise, Macron will remain the frontrunner. A second term for President Macron would see a continuation of the structural reforms started in 2017, but with a longer process for coalition-building in the National Assembly. This is bullish for France. Reducing the size of the state will go a long way to improve France’s economic competitiveness over the long run. Tactically, favor the more defensive Spanish market over the highly cyclical French market. Underweight French consumer discretionary equities relative to their European and global peers. Longer term, overweight French industrials equities relative to German ones, and overweight French tech equities relative to European ones. Ahead of the election, buy the dip on any euro weakness and French OAT/German bund spread widening. Feature The French presidential election is nine months away, and it is already starting to catch investors’ attention as one of the main political events in Europe in 2022. In talks with clients, we’ve been asked repeatedly about the odds we assign to a Marine Le Pen victory and the market implications. Those concerns are understandable but overrated. Le Pen’s personal approval rating is on the rise, and, in most polls, the far-right candidate beats President Emmanuel Macron in the first round vote, although not the critical second round. Although the same polls see Macron being re-elected, the gap between the two has narrowed considerably since the 2017 election, which Macron won by 66 percent of the vote.   Still, Macron is favored for re-election. He has several strong advantages over Le Pen, and it is unlikely she will be able to close the gap further before the election. Macron’s first term has been eventful. Neoliberal structural reforms started with drums beating in the first 18 months of his term. But the pace and breadth of reform eventually became too ambitious or painful for France to bear, and protests erupted in 2018. First came the “Yellow Vest Movement,” and then came protests against pension reform. Macron tried to compromise and continue with his agenda, but COVID-19 forced his hand. Since then, Macron has focused on crisis management, benefiting from the large state sector’s role as an automatic stabilizer amid the downturn. A second term under President Macron would see a reboot of the structural reforms started in 2017, albeit without single-party rule in the National Assembly. Reforms aimed at reducing the size of the state, and its cost, would go a long way to improve France’s economic competitiveness over the long run. Therefore, the prospect of Macron’s reelection is bullish for France, even though the reality of his second term would be more complex. 2017 All Over Again? Yes And No At first glance, the 2022 election seems to be a repeat of 2017. Le Pen and Macron are likely to face off in the second round and the latter, the Europhile centrist candidate, is likely to win once more. However, everything surrounding this election has changed. The Incumbency Effect One of the major changes is favorable for Macron: he is the incumbent running for re-election. Macron had been part of President Francois Hollande’s government since 2014, so he was still viewed in 2017 as a political neophyte and dark horse candidate. His rapid rise to power, along with that of his upstart party, La République En Marche (LREM), was astounding. Chart 1Pro-Incumbency Effect Favors Macron There is a strong pro-incumbency effect in French presidential elections, especially in the first round (Chart 1). Since 1965, five incumbents have run for re-election, and all have made it to the second round. Importantly, four won first place in the first round, with a six percentage-point margin on average. The chief exception is Nicolas Sarkozy in 2012. The reason for Sarkozy’s loss, however, is well known: he attempted to pass an unpopular pension reform in the teeth of the Euro debt crisis, 12 months before facing re-election. The only other incumbent who failed at re-election was Valerie Giscard d’Estaing, who lost to Francois Mitterrand in 1981, when the whole world was in stagflation and upheaval. The incumbency effect is not as pronounced in the second round (Chart 1, bottom panel). However, when facing a far-right candidate, incumbents win by a wide margin. This was the case in 2002 and 2017. Today, Macron still has a 12-point lead on Le Pen. Macron compares well to his predecessors. Chart 2 shows the approval rating for all presidents sitting in office over the past 40 years. The number of people who intend to vote for Macron has increased, the first time this has happened for an incumbent president since 1988. Only three presidents had a higher approval rating at this stage of their term, albeit from a higher starting point. Macron’s approval rating has increased by 10% since February 2020, when the COVID-19 pandemic hit Europe. Chart 2Macron Compares Well To His Predecessors Table 1Incumbency And Recessions Under The Fifth Republic The shock of the pandemic and recession is the greatest change since 2017, and the biggest challenge facing Macron. Four incumbents have made a bid for re-election that was preceded by a recession within 12-24 months (Table 1). The results are mixed, and it is hard to establish a clear anti-incumbency effect. If anything, the timing and nature of this crisis are likely to help Macron rather than hurt him, since the vaccination campaign and easing of lockdown measures will enable the economy to normalize and improve ahead of April 10-24, 2022, when voters cast their first ballots. Nonetheless, another major shock (of any kind) could undermine the incumbent advantage. Economic Recovery Is The Top Priority While the Macron administration’s handling of the pandemic was questioned, public opinion was never aggressively hostile toward his handling of the economy. Macron was instrumental in securing a major European fiscal stimulus package (and joint debt issuance) with the German Chancellor, Angela Merkel. He enthusiastically adopted the crisis mentality of “whatever it takes” to wage war against COVID-19, enabling the oversized French state to deploy the most generous furlough scheme in Europe, shielding millions of workers and preventing businesses from going under. This will be one of his winning cards. Chart 3The Handling Of The Pandemic Dictates Macron's Popularity His approval rating began to rebound following the end of lockdowns (Chart 3). This trend should strengthen as the French economy reopens, supported by a government that will play an accommodative and reflationary economic role until the election. Public opinion wants him to focus on the labor market and the economic recovery in the months to come, and he will be happy to oblige. Public opinion also views Macron as the most qualified candidate when it comes to economic matters (Table 2). 42% of respondents think that Le Pen is not qualified “at all” on economic matters, her Achilles’ heel, a perception that was already entrenched when Macron crushed her in a televised debate before the second round of the 2017 election. Table 2Macron Is Perceived As The Most Qualified To Oversee The Economic Recovery Europhile Versus Eurosceptic? The central issue of the 2017 election was Europe and France’s role in it. Following the UK’s disruptive Brexit referendum in 2016, and a long tradition of Euroscepticism within her party, Le Pen campaigned on “Frexit” and the abandonment of the euro. Conversely, Macron embraced the EU and the monetary union as he ran for president and committed to having France play a more important role within the bloc if he won. Chart 4Le Pen And The EU: Not The Divorce We Expected Since then, Le Pen has drastically shifted her stance on the EU. She now claims that the benefits of the common currency and single market outweigh the costs. After all, 70% of the French public support the euro and EU membership (Chart 4). Like clockwork, her personal approval ratings have steadily gone up. This strategic shift aligns her with the median voter, and combined with the Covid crisis, it is the only reason to take her candidacy remotely seriously in 2022, despite Macron’s clear advantages. Nevertheless, Le Pen has not yet risen above her 2012 peak in popular support. She failed to do so between 2014 and 2015, when the lingering European debt crisis, the Syrian refugee crisis, multiple terrorist attacks in France, and sluggish economic growth should have boosted her popularity. Her shifting perspective on the euro was therefore necessary and might be just what she needs to break through her 37% ceiling of popular support. Le Pen’s policy agenda is now focusing on protectionism, immigration, and national security. It is a Trumpian mix. However, while her new stance is more mainstream, it also differentiates her less from the other center-right politicians in France, namely Xavier Bertrand, who recently made local electoral gains in Le Pen’s northern industrial base. Macron is as strong an advocate for Europe as ever. He convinced Germany to break the taboo on joint fiscal policy during the pandemic. Now, he is also mounting a bid to become the natural leader of Europe, given that Merkel is stepping down, and her party is likely to lose standing in the German election in September.  France is set to take over the rotating EU Council Presidency in the first half of 2022, under the theme “Recovery, power, belonging,” which provides Macron with a golden opportunity to pitch himself as Europe’s premier statesman and economic steward in the final months of the election campaign. One Thing Hasn’t Changed: The Outcome Of A Macron/Le Pen Duel Most opinion polls give Macron a 10-12 point lead on Le Pen in the second round of the election. This gap is wide enough to reassure investors that it is not a polling error. However, in 2017, Macron’s average lead over Le Pen was 22%, and he won the election with 66% of votes. It is the narrowing of that gap that raises eyebrows among investors. Table 3Ideological Blocs Also Favor Macron Still, Le Pen’s chances at closing the gap are overrated. She is not a political “unknown” anymore and has very little ability to “surprise” voters into rallying around her next year. She will have trouble persuading those who know all about her. Grouping French voters according to ideological blocs, that is, presidential preference by party affiliation, suggests that the biggest threat to Macron is a strong center-right candidate who can beat Le Pen, especially if this should coincide with a revival of the center-left (Table 3). Otherwise, as in 2017, Macron will be able to count on voters from other parties in the second round of the election (Table 4). While both candidates appeal to right-wing constituents and would have to share their ballots, Macron can count on the green EELV party, as well as left-wing voters, to join center-right voters to elect him. Macron has made environmental issues a part of his mandate, which should help him confront a green neophyte such as Le Pen. Table 4Voting Against Le Pen Implies Voting For Macron The results of the regional elections held last month confirm this analysis. The motivation to keep Le Pen and her Rassemblement National (National Rally) party out of power is still strong (see Box 1). The poor showing of the National Rally means she won’t be able to maintain her current momentum in her personal approval ratings.   Box 1 2021 Regional Elections: Bad Omen For Marine Le Pen In Revival Of The Center-Right? The regional elections took place on June 20 and 27. While limited in relevance for the 2022 presidential race, the result of extremely low voter turnout, regional elections offer a gauge of how constituents feel about the political offerings from anti-establishment parties. Le Pen’s party suffered a heavy blow. It had hoped to consolidate power and build momentum ahead of the presidential election, but it failed even to win in its stronghold of Southern France. Meanwhile, Macron’s party (La République En Marche!) also disappointed. This outcome is not surprising; the local elections last year yielded similar results, highlighting the lack of presence at the local and regional levels for the four-year-old party. The surprise came from the center-right. It managed to win seven of the thirteen regions, beating far-right candidates by wide margins. Importantly, Xavier Bertand, Valérie Pécresse, and Laurent Wauquiez, all predicted to run for president next year, held onto their seats.   Chart 5Strong Demographic Base In The Second Round Both candidates’ demographic bases have remained the same. Macron is still popular among Millennials, white collar workers, and the elderly (Chart 5). He also has a strong base in Paris (and the suburbs) as opposed to Le Pen, and he still outperforms Le Pen among rural voters in today’s polls. Macron also scores high among the employees of the public sector—even though he is in favor of a smaller public sector. Furthermore, the unemployed mostly favor him, which reinforces the perception that he is the best candidate to improve the French economy and cut the unemployment rate. What if Le Pen fails to make it into the second round of the election? We discuss this possibility in the next section. Risks To The Base Case Scenario The greatest risks to our view are a setback in the economic recovery, an outperformance from the center-right, and the emergence of a dark horse. The latest developments in the UK and Israel, where a large share of the population is fully vaccinated, suggest that the “Delta” variant of COVID-19 remains a threat, with the potential to send economies back into lockdowns. The consequences would be dire for Macron. His chances at re-election would likely evaporate if his government imposed new lockdown measures. What about presidential candidates other than Le Pen? Our base case scenario that Macron will win is based on two assumptions: (1) the center-left Socialist Party will remain in shambles, and (2) the center-right remains scattered under different banners and will therefore lack unity. There is very little chance that the center-left will make a comeback in time, but the results from the regional elections suggest that the center-right could surprise to the upside (see Box 1), especially if it decides to rally behind a single candidate ahead of the first round. Could this candidate be a dark horse? Former Prime Minister Edouard Philippe or outsider candidate Xavier Bertrand could make formidable opponents to both Macron and Le Pen. Philippe’s personal approval rating currently stands at 50%, the highest among French politicians. He also appeals to constituents of all political leanings (Chart 6). This scenario could reshuffle the likely outcomes of both the first and second round of the election. Both Bertand and Philippe could win over voters who decided to side with Le Pen in 2017, while Philippe can compete with Macron over LREM voters. Additionally, Xavier Bertrand cuts into Le Pen’s support since he has made blue collar workers and the middle-class a priority. However, Macron and Le Pen each enjoy a strong voters’ base. It is necessary to monitor whether Valérie Pécresse (Soyons libres) and Laurent Wauquiez (Les Républicains) can be brought to endorse Xavier Bertrand ahead of the first round in 2022. Chart 6Edouard Philippe: From Ally To Outcast To Challenger? Beyond The Election Aside from the presidency, the outstanding question is the makeup of the National Assembly in 2022. Macron is not likely to enjoy the strong single-party legislative majority of his first term or to gain control of the Senate. Consequently, he will be more constrained in the legislature in a second term. Nonetheless, the demand for a better economy and a healthier job market requires pro-productivity reforms, which the public knows, and Macron has made reform his banner. Other conventional parties will come under pressure to support Macron’s reform agenda, even though that agenda will be less ambitious than it was in his first term. Chart 7Strong Presence Of Right-Leaning Forces Efforts at cutting back the size of the state are still likely, even though the pandemic has helped rather than hurt statism. This is because the French median voter, who never witnessed the degree of neoliberal reform that took place in the Anglo-Saxon world, has grown weary of the economy’s inefficiencies, just as the Anglo-Saxons have grown weary of laissez-faire neoliberalism. Before the pandemic, the French people understood the need to reduce the size of the state. After all, a larger state implies a larger cost burden borne by both households and corporations. When faced with the choice between paying the bill for the government’s fiscal response to COVID-19 (through higher taxes), or undertaking reforms aiming at reducing the size of the state, the French people will pick the former. Moreover, centrist forces will hold sway in the legislature (Chart 7); hence, some kind of budget normalization is expected in 2023 or thereafter. Other structural reforms If Macron wins would include pension reforms. We should also expect measures to push French companies to bring activities back to France, as well as a greater focus on leading France on the green path. Bottom Line: Barring major surprises, President Macron will be re-elected in 2022. There is a risk to our view if a center-right candidate defeats Le Pen to make it to the second round of the election. Either Macron or a center-right presidency would see a continuation of the structural reforms started in 2017, but with a longer process for coalition-building in the National Assembly. Investment Implications The French economy is currently experiencing an economic upswing. Three factors explain this pick-up: ultra-accommodative monetary conditions in Europe, fiscal largesse, and considerable pent-up demand. In 2021, GDP is projected to expand by 5.75% in annual average terms, higher than the Euro Area average of 4.6%. It should then grow by 4% in 2022 and by 2% in 2023. We remain bullish on French equities on a secular basis, as long as the elections result in further incremental structural reforms over time. As the election draws nearer, investors should treat any French OAT/German Bund spread widening as a buying opportunity and purchase the euro on any election-related dip. French Equities The CAC40 and French equities have had a good run since the beginning of the year. In absolute terms, the CAC40 is one of the best performers year-to-date, up +17%, driven by the outperformance of French consumer discretionary and financials equities, both in absolute and relative terms. However, a period of turbulence is appearing on the horizon; the shift in global growth drivers, the beginning of the global liquidity withdrawal, and lingering COVID worries are creating headwinds for the cyclicals-to-defensives ratio this summer. As such, we recently recommended investors downgrade cyclical equities tactically in Europe from overweight to neutral. With 66% in cyclicals, the French MSCI equity index will underperform in this environment, especially relative to the more defensive Spanish market (Table 5). Table 5Cyclicals Versus Defensives In European Markets Chart 8Three Trade Ideas In fact, our Combined Mechanical Valuation Indicator (CMVI) shows that French consumer discretionary equities are expensive relative to both their European and global peers (Chart 8). Regarding the reform theme, we stick with our long French industrial equities / short German industrial equities on a long-term horizon (Chart 8, second and third panel). The idea is that French reforms should suppress unit labor costs and make French exports more competitive vis-à-vis their main competitor, Germany. The latter faces a leftward shift in policy in elections this September. Finally, we recommend investors go long French tech stocks relative to their European counterparts. This sector is cheap (Chart 8, bottom panel), and the French tech sector will be supported by additional government spending of EUR7 billion on digital investments over the next two years. Bond Markets & FX A dovish ECB is consistent with a continued overweight in European peripheral bonds and an underweight stance on French government bonds. Chart 9Just Buy The Dip What is more relevant with respect to the French election is the OAT/Bund spread. In the past, unusually wide spreads between the two represented a euro breakup premium. In early 2017, spreads widened when the approval rating of Le Pen increased (Chart 9). However, since “Frexit” and the abandonment of the euro are no longer part of Le Pen’s agenda, investors should view spread widening as a buying opportunity. Similarly, investors should buy the euro on any election-related dip, particularly following the first round. “Frexit” has been removed from the equation, hence the euro should not weaken on breakup risk this time around. Bottom Line: We remain bullish on French equities within a European portfolio on a secular basis. If our views on the cyclicals-to-defensives ratio materialize in the near-term, highly cyclical French equities will temporarily underperform, unlike the more defensive Spanish market. On a 3- to 12-month horizon, investors should short French consumer discretionary equities relative to both their European and global counterparts. Current valuations suggest that betting on the booming French tech sector at the expense of its European neighbors will be profitable. Once the election draws nearer, investors should treat any French OAT/German Bund spread widening as a buying opportunity and purchase the euro on any election-related dip.   Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com

Highlights Three distinct forces are likely to make South Asia’s geopolitical risks increasingly relevant to global investors. First, India’s tensions with China stem from China’s growing foreign policy assertiveness and India’s shift away from traditional neutrality toward aligning with the US and its allies. This creates a security dilemma in South Asia, just as in East Asia. Second, India’s economy is sputtering in the wake of the COVID-19 pandemic, adding fuel to nationalism and populism in advance of a series of important elections. India will stimulate the economy but it could also become more reactive on the international scene. Third, the US is withdrawing from Afghanistan and negotiating a deal with Iran in an effort to reduce the US military presence in the Middle East and South Asia. This will create a scramble for influence across both regions and a power vacuum in Afghanistan that is highly likely to yield negative surprises for India and its neighbors. Traditionally geopolitical risks in South Asia have a limited impact on markets. India’s growth slowdown and forthcoming fiscal stimulus are more relevant for investors. However, a sharp rise in geopolitical risk would undermine India’s structural advantages as the West diversifies away from China. Stay short Indian banks. Feature Geopolitical risks in South Asia are slowly but surely rising. India-Pakistan and China-India are well-known “conflict-dyads” or pairings. Historically, these two sets have been fighting each other over their fuzzy Himalayan border with limited global financial market consequences. But now fundamental changes are afoot that are altering the geopolitical setting in the region. Specifically, the coming together of three distinct forces could trigger a significant geopolitical event in South Asia. The three forces are as follow: Force #1: Sino-Indian Tensions Get Real About a year ago, Indian and Chinese troops clashed in Ladakh, a disputed territory in the Kashmir region. Following these clashes China reduced its military presence in the Pangong Tso area but its presence in some neighboring areas remains meaningful. Besides the troop build-up along India’s eastern border, China is building more air combat infrastructure in its India-facing western theatre. China’s major air bases have historically been concentrated in China’s eastern region, away from the Indian border (Map 1). Consequently, India has historically enjoyed an advantage in airpower. But China appears to be working to mitigate this disadvantage. Map 1Most Of China’s Major Aviation Units Are Located Away From India Owing to China’s increased military focus along the Sino-India border, India’s threat perception of China has undergone a fundamental change in recent years. Notably, India has diverted some of its key army units away from its western Indo-Pak border towards its eastern border with China. India could now have nearly 200,000 troops deployed along its border with China, which would mark a 40% increase from last year.1 Turning attention to the Indo-Pak border, India’s problems with Pakistan appear under control for now. This is owing to the ceasefire agreement that was renewed by the two countries in February 2021. However, this peace cannot possibly be expected to last. This is mainly because core problems between the two countries (like Pakistan’s support of militant proxies and India’s control over Kashmir) remain unaddressed. History too suggests that bouts of peace between the two warring neighbors rarely last long. These bouts usually end abruptly when a terrorist attack takes place in India. With both political turbulence and economic distress in Pakistan rising, the fragile ceasefire between India and Pakistan could be upended over the next six months. In fact, two events over the last week point to the fragility of the ceasefire: Two drones carrying explosives entered an Indian air force station located in Jammu and Kashmir (i.e. a northern territory that India recently reorganized, to Pakistan’s chagrin). Even as no casualties were reported, this attack marks a turning point for terrorist activity in India as this was the first-time terrorists used drones to enter an Indian military base. Hours later, another drone attack struck an Indian base at the Ratnuchak-Kaluchak army station, the site of a major terrorist attack in 2002. Chart 1China, Pakistan And India Cumulatively Added 41 Nuclear Warheads Over 2020 Given that the ceasefire was agreed recently, any further increase in terrorist activity in India over the next six months would suggest that a more substantial breakdown in relations is nigh. Distinct from these recent tensions, China’s troop deployment along India’s eastern arm and Pakistan’s presence along India’s western arm creates a strategic “pincer” that increasingly threatens India. India is naturally concerned. China and Pakistan are allies who have been working closely on projects including the strategic China-Pakistan Economic Corridor (CPEC). The CPEC is a collection of infrastructure projects in Pakistan that includes the development of a port in Gwadar where a future presence of the People's Liberation Army Navy (PLAN) is envisaged. Gwadar has the potential of providing China land-based access to the Indian Ocean. Trust in the South Asian region is clearly running low. Distinct from troop build-ups and drone-attacks, China, Pakistan, and India cumulatively added more than 40 nuclear warheads over the last year (Chart 1). China is reputed to be engaged in an even larger increase in its nuclear arsenal than the data show.2 From a structural perspective, too, geopolitical risks in the South Asian peninsula are bound to keep rising. When it comes to the conflicting Indo-Pak dyad, India’s geopolitical power has been rising relative to that of Pakistan in the 2000s. However, the geopolitical muscle of the Sino-Pak alliance is much greater than that of India on a standalone basis (Chart 2). Chart 2India Has Aligned With The QUAD To Counter The Sino-Pak Alliance China’s active involvement in South Asia is responsible for driving India’s increasing desire to abandon its historical foreign policy stance of non-alignment. India’s membership in the Quadrilateral Security Dialogue (also known as the QUAD, whose other members include the US, Japan, and Australia) bears testimony to India’s active effort to develop closer relations with the US and its allies (Chart 2). India’s alignment with the US is deepening China’s and Pakistan’s distrust of India. Conventional and nuclear military deterrence should prevent full-scale war. But the regional balance is increasingly fluid which means geopolitical risks will slowly but surely rise in South Asia over the coming year and years. Force #2: A Growth Slowdown Alongside India’s Loaded Election Calendar The pandemic has hit the economies of South Asia particularly hard. South Asia historically maintained higher real GDP growth rates relative to Emerging Markets (EMs). But in 2021, this region’s growth rate is set to be lower than that of EM peers (Chart 3). History is replete with examples of a rise in economic distress triggering geopolitical events. South Asia is characterized by unusually low per capita incomes (Chart 4) and the latest slowdown could exacerbate the risk of both social unrest and geopolitical incidents materialising. Chart 3South Asian Economies Have Been Hit Hard By The Pandemic Chart 4South Asia Is Characterized By Very Low Per Capita Incomes To complicate matters a busy state elections calendar is coming up in India. Elections will be due in seven Indian states in 2022. These states account for about 25% of India’s population. State elections due in 2022 will amount to a high-stakes political battle. During state elections in 2021, the ruling Bharatiya Janata Party (BJP) was the incumbent in only one of the five states. In 2022, the BJP is the incumbent party in most of the states that are due for elections, which means it has the advantage but also has a lot to lose, especially in a post-pandemic environment. Elections kick off in the crucial state of Uttar Pradesh next February. Last time this state faced elections Prime Minister Narendra Modi was willing to go to great lengths to boost his popularity ahead of time. Specifically, he upset the nation with a large-scale and unprecedented de-monetization program. Given the busy state election calendar in 2022, we expect the BJP-led central government to focus on policy actions that can improve its support among Indian voters. Two policies in particular are likely to come through: Fiscal Stimulus Measures To Provide Economic Relief: India has refrained from administering a large post-pandemic stimulus thus far. As per budget estimates, the Indian central government’s total expenditure in FY22 is set to increase only by 1% on a year-on-year basis. But the expenditure-side restraint shown by India’s central government could change. With elections and a pandemic (which has now claimed over 400,000 lives in India), the central government could consider a meaningful increase in spending closer to February 2022. Map 2Northern India Views Pakistan Even More Unfavorably Than Rest Of India India’s Finance Minister already announced a fiscal stimulus package of $85 billion (amounting to 2.8% of GDP) earlier this week. Whilst this stimulus entails limited fresh spending (amounting to about 0.6% of India’s GDP), we would not be surprised if the government follows it up with more spending closer to February 2022. Assertive Foreign Policy To Ward-Off Unfriendly Neighbors: India’s northern states are known to harbor unfavorable views of Pakistan (Map 2). The roots of this phenomenon can be traced to geography and the bloody civil strife of 1947 that was triggered by the partition of British-ruled India into the two independent dominions of India and Pakistan. Given the north’s unfavorable views of Pakistan and given looming elections, Indian policy makers may be forced to adopt a far more aggressive foreign policy response, to any terrorist strikes from Pakistan or territorial incursions by China. This kind of response was observed most recently ahead of the Indian General Elections in April-May 2019. An Indian military convoy was attacked by a suicide-bomber in early February 2019 and a Pakistan-based terrorist group claimed responsibility. A fortnight later the Indian air force launched unexpected airstrikes across the Line of Control which were then followed by the Pakistan air force conducting air strikes in Jammu and Kashmir. While the next round of Pakistani and Indian general elections is not due until 2023 and 2024, respectively, it is worth noting that of the seven state elections due in India in 2022, four are in the north (Uttar Pradesh, Punjab, Uttarakhand, and Himachal Pradesh). Force #3: Power Vacuum In Afghanistan The final reason to be wary of the South Asian geopolitical dynamic is the change in US policy: both the Iran nuclear deal expected in August and the impending withdrawal from Afghanistan in September. The US public has now elected three presidents on the demand that foreign wars be reduced. In the wake of Trump and populism the political establishment is now responding. Therefore Biden will ultimately implement both the Iran deal and the Afghan withdrawal regardless of delays or hang-ups. But then he will have to do damage control. In the case of Iran, a last-minute flare-up of conflict in the region is likely this summer, as the US, Israel, Saudi Arabia, and Iran underscore their red lines before the US and Iran settle down to a deal. Indeed it is already happening, with recent US attacks against Iran-backed Shia militias in Syria and Iraq. A major incident would push up oil prices, which is negative for India. But the endgame, an Iranian economic opening, is positive for India, since it imports oil and has had close relations with Iran historically. In the case of Afghanistan, the US exit will activate latent terrorist forces. It will also create a scramble for influence over this landlocked country that could lead to negative surprises across the region. The first principle of the peace agreement between the US and Afghanistan states that the latter will make all efforts to ensure that Afghan soil is not used to further terrorist activity. However, the enforceability of such a guarantee is next to impossible. Notably, the US withdrawal from Afghanistan will revive the Taliban’s influence in the region. This poses major risks for India, which has a long history of being targeted by Afghani terrorist groups. The Taliban played a critical role in the release of terrorists into Pakistan following the hijacking of an Indian Airlines flight in 1999. Furthermore, the Haqqani network, which has pledged allegiance to the Taliban, has attacked Indian assets in the past. Any attack on India deriving from the power vacuum in Afghanistan would upset the precarious regional balance. Whilst there are no immediate triggers for Afghani groups to launch a terrorist attack in India, the US withdrawal will trigger a tectonic shift in the region. Negative surprises emanating from Afghanistan should be expected. Investment Conclusions Chart 5Indian Banks Appear To Have Factored In All Positives We reiterate the need to pare exposure to Indian assets on a tactical basis. India’s growth engine is likely to misfire over the second half of the Indian financial year. Macroeconomic headwinds pose the chief risk for investors, but major geopolitical changes could act as a negative catalyst in the current context. So we urge clients to stay short Indian Banks (Chart 5). Financials account for the lion’s share of India’s benchmark index (26% weight). India could opt for an unexpected expansion in its fiscal deficit soon. Whilst we continue to watch fiscal dynamics closely, we expect the fiscal expansion to materialize closer to February 2022 when India’s most populous state (i.e. Uttar Pradesh) will undergo elections. Over the long run, India’s sense of insecurity will escalate in the context of a more assertive China, stronger Sino-Pakistani ties, and a power vacuum in Afghanistan. For that reason, New Delhi will continue to shed its neutrality and improve relations with the US-led coalition of democratic countries, with an aim to balance China. This process will feed China’s insecurity of being surrounded and contained by a hegemonic American system. This security dilemma is a source of South Asian geopolitical risk that will become more globally relevant over time. China’s conflict with the US and western world should create incentives for India to attract trade and investment. However, its ability to do so will be contingent upon domestic political factors and regional geopolitical factors.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Sudhi Ranjan Sen, ‘India Shifts 50,000 Troops to China Border in Historic Move’, Bloomberg, June 28, 2021, bloomberg.com. 2 Joby Warrick, “China is building more than 100 missile silos in its western desert, analysts say,” Washington Post, June 30, 2021, washingtonpost.com.