Disasters/Disease

Highlights The baht will depreciate further, given the state of the economy and external accounts. Domestic demand was already relapsing, even before the latest surge in COVID-19 cases. Now, the recovery will be delayed more. The authorities have little to offer by way of fiscal or monetary support. Credit to the job-intensive SME sector has collapsed. The balance of payment dynamics remains negative for the currency. Investors should stay short the baht. Dedicated EM asset allocators should continue to be neutral on Thailand within respective equity and domestic bond portfolios. Feature Chart 1Thai Stocks Are Facing Several Headwinds Our negative view on the baht has played out as expected.1 The Thai currency is down 10% versus the dollar since its peak in February of this year. It has also been the worst performer in Asia. The country’s stock market is struggling and going down in both absolute terms and relative to their EM counterparts (Chart 1). Going forward, odds are that the baht will remain weak. A weak currency will continue to stifle both Thai stocks’ and local currency bonds’ relative performance. Investors should stay short the baht and remain neutral Thai equity and local currency bonds within their respective EM portfolios. Relapsing Growth Chart 2Surging New COVID-19 Cases... The latest spike in new COVID-19 cases has dashed hopes for any early recovery of the Thai economy (Chart 2). Earlier this month, the central bank revised down their GDP forecast for 2021 from 1.8% to 0.7%. We concur with this bearish outlook: Private consumption in real terms was languishing as of June this year at 10% below 2019 levels. Car sales, both personal and commercial, are even more downbeat (Chart 3). After the latest surge in new COVID-19 cases, those numbers must have weakened further. Incidentally, the country’s vaccination rate, at 26% of total population (7.5% fully vaccinated), remains low. It could be, therefore, several months before any meaningful recovery in consumer demand takes place. Faced with low demand, the country’s manufacturing and shipment volumes are also weak. They are both breaking down anew from well below the 2019 levels (Chart 4, top panel). Chart 3...Will Further Delay Domestic Demand Recovery Chart 4Manufacturers Are Saddled With High Inventory Amid Weak Orders...   Weak demand also means that businesses are stuck with high inventories. Indeed, there is a widening disparity between inventory levels and shipments (Chart 4, middle panel). Furthermore, order books have slipped back to levels not seen since the height of the COVID-19 scare early last year. The combination of high inventories and tumbling orders does not portend a manufacturing recovery anytime soon (Chart 4, bottom panel). Notably, jobs and wages are also weak. Employment in the manufacturing sector is well below pre-pandemic levels (Chart 5). This trend, in turn, is hurting household income and consumer demand, completing a vicious cycle of depressed demand, weak production, falling employment and household income, and further reduced demand. The softness of the economy is accentuating the disinflationary pressure that was already entrenched. Headline and core CPI in Thailand have stayed mostly below 1% over the past five years — the lower band of the central bank’s inflation target. Now, they are flirting with outright deflation. In fact, if the impact of food and oil prices is excluded, the prices are actually deflating (Chart 6). Chart 5...Which Is Hurting Jobs And Wage Growth Chart 6Thailand Is Flirting With Outright Deflation...   Outright deflation makes it harder for borrowers to service their debts, which then discourages both borrowing and spending — making the recovery much harder. Notably, the banks’ prime lending rates remain high at 5.4%, which means real prime lending rates are quite steep at 5% (deflated by core CPI). This is at a time of very low household income and business revenue growth expectations. This trend is a strong disincentive for borrowing and consuming /capital spending. Little Policy Support What is more concerning for the economy is that policymakers can offer little to boost the economy. Fiscal stimulus has waned: government expenditure, after a surge last year, is now contracting (Chart 7). The budget proposal for the next fiscal year (October 2021 - September 2022) that was passed by the parliament in June 2021 (first reading)2 stipulates a 5.7% cut in nominal spending. Part of the reason is that fiscal deficits have already ballooned to a staggering 8% of GDP — from an average of 2.5% in the past ten years. The IMF estimates that the fiscal thrust will be zero this year, and a negative 2.4% of GDP in 2022 (Chart 7, bottom panel). The monetary policy transmission is also paralyzed. Despite easing by the Bank of Thailand — the policy rate is at an all-time low of 0.5% since May last year — credit growth is dismal. Lenders are wary of rising NPLs and are holding back new credit: The share of impaired loans (NPLs plus Special Mention Loans) of total bank loans has dramatically increased to 10%. In the case of small and medium enterprises (SMEs), that ratio is 20%. By comparison, loss provisions are much lower, at just 5.2% as of June of this year (Chart 8, top panel). Chart 7...Yet, The Government Is Planning To Cut Fiscal Spending Chart 8Sharp Rise In Banks' Stressed Loans Amid Tanking Profits...   Notably, both operating and net profits of banks had already halved (as a % of assets) by June 2021 — as both interest and non-interest incomes dropped. Profits are slated to contract further, since banks will have to make greater provisions in the future as the recent surge in new cases will produce more loan delinquencies (Chart 8, bottom panel). The specter of rising NPLs has prompted banks to retrench loans. In particular, bank credit to SMEs has plunged by a massive 34% from 2019 levels (Chart 9). Before the pandemic, banks’ SME loans made up a significant 30% of GDP. Now, they are down to 21%. Credit retrenchment of this order to the job-intensive SME sector is going to have a significant negative ripple effect. Employment will shrink further as small businesses go bust. Shrinking jobs will dent household income, and, in turn, consumer demand. Incidentally, loans to other business segments are also not rising much. Bank loans to all non-financial corporates are growing rather minimally, at 1.5% year-over-year. Going into the pandemic, the Thai household sector was already highly leveraged. Over the past two decades, banks and other financial institutions have been lending ever more to households, shunning non-financial corporates. Households’ borrowing from banks have now risen to 40% of GDP; and those from other institutions another 50%. These loans had helped boost consumer demand all those years, but now, at a time when incomes are uncertain, households have very limited appetite to borrow more to spend. This means a consumer debt-fueled demand recovery is not in the cards (Chart 10). Chart 9...Induced Banks To Massively Reduce Credit To The Job-Intensive SME Sector Chart 10Thai Households Are Too Indebted To Borrow More And Spend   In brief, Thai businesses are in the middle of a toxic combination of contracting sales, absent fiscal support, slashed credit facilities, and rather high borrowing costs in real terms. Chart 11 shows that corporate profit margins of non-financial firms are struggling at a low level. It is no wonder that businesses are reluctant to invest, expand, and hire. The message is similar when we examined all companies included in the MSCI Thailand stock index. On the one hand, their EPS has fallen to 10-year lows. Thai stock prices, on the other hand, have not yet fallen as much as the shrinking EPS would imply (Chart 12, top panel). The consequence is that the valuations are remarkably stretched—near a 20-year high (Chart 12, bottom panel). Chart 11Low Margins Are Discouraging Thai Firms To Borrow, Invest, Or Hire Chart 12Thai Profits, At A Decade-Low, Are Also A Headwind For Stock Prices   All in all, for Thai share prices to stage a sustainable rally, an economic recovery is essential. The first indications of that usually come from an improving order book. The latter currently shows little glimmer of hope. But investors should keep an eye on this indicator, as Thai stocks’ performance is geared to the ebbs and flows of the business order book (Chart 13). Thailand Needs A Weaker Currency The state of the Thai economy not only warrants exchange rate depreciation, but also needs a much weaker currency to help an economic recovery. The country’s balance of payment is in deficit — for the first time since 2014. A crucial reason is that the baht is still expensive, which continues to weigh on exports. Of all the export-oriented Asian economies, Thai exports recovery has been the weakest (Chart 14). Chart 13Keep An Eye On The Order Book For A Sign In Stock Recovery Chart 14An Expensive Baht Held Back Thai Exports Recovery   The fact that a quarter of Thai exports go to other ASEAN countries — where demand has been and remains weak due to the lingering pandemic — doesn’t help either. As a result, the Thai trade surplus has narrowed significantly, and the current account has slipped into deficit (Chart 15, top and middle panels). The other main external revenue source of Thailand, tourism, continues to be near absent at 0.6% of GDP — a far cry from a high of 12% before the pandemic (Chart 15, bottom panel). What’s more, there is little hope of any recovery in the near future. The government now expects the number of foreign tourists this year to be as low as 0.3 million versus 40 million in 2019. On the capital account front, Thailand continues to hemorrhage both FDI and portfolio capital — just as it did the past several years. Despite that, the baht had remained strong until early this year, as a result of a substantial repatriation of bank deposits by Thai residents and, to a lesser extent, foreign borrowings. Those inflows prevented the Thai baht from depreciating. But such panic-stricken, one-off savings/deposit repatriations by Thai residents will certainly slow materially going forward (Chart 16). Chart 15The Thai Current Account Balance Will Struggle To Stay In Surplus... Chart 16...While The Capital Account Balance Will Slip Deeper Into Deficit...   There’s also little hope that FDI and portfolio inflows will pick up the slack. The reason is that the Thai economy is very weak and the return on capital is low. The latter discourages capital inflows. The fact that the baht continues to be an expensive currency in real terms, and therefore not as competitive as some of its neighbors’, doesn’t help either. The multi-nationals who are planning to re-locate out of China might find some other countries — where the currency is more competitive (such as in India, Malaysia, or the Philippines) — more attractive. Overall, the Thai capital account balance will likely slide deeper into deficit, at a time when the current account will also struggle to stay in surplus. The result will be a further deterioration in the country’s balance of payment, hurting the baht (Chart 17). Considered from another angle, if the return on capital on Thai assets is any guide, the baht could drop much more from its current levels (Chart 18). Chart 17...Putting Downward Pressure On The Baht Chart 18Thai Firms' Low Rates Of Return Point To More Baht Depreciation     The reality is that, given Thailand’s current macro backdrop, a cheaper currency is what the nation needs. That will help boost growth significantly by aiding exports and promoting import substitution. Since foreign trade makes up an impressive 90% of GDP, a boost therein could kickstart the entire economy. Another result of a weaker currency will be higher inflation, something the economy seriously needs. Higher inflation will contribute to lower real interest rates which, in turn, will encourage borrowing and spending. Higher spending and inflation will help achieve higher nominal sales, boost firms’ profits, employment, and eventually, household incomes. All in all, it could allow a productive cycle to unfold. Given all these possible benefits and given that policymakers have few other tools at their disposal at this juncture, chances are the central bank will let the baht depreciate more, albeit in an orderly fashion, in the months to come. What About Bonds? Chart 19Mantain A Neutral Allocation To Thai Domestic Bonds In An EM Basket Thai local currency bonds’ absolute return in US dollar terms, as expected, is highly dependent on the exchange rate (Chart 19, top panel). Given the weak currency outlook, foreign investors should refrain from holding Thai domestic bonds outright. For foreign asset allocators, however, the matter is more nuanced. Thai domestic bonds’ relative return versus that of overall EM did not depend on the baht movement alone. This is because Thailand has been a defensive market owing to the following: a traditionally strong current account, a manageable public debt (now 47% of GDP), and a relatively low holding of bonds by foreign investors (now 12% of total). A robust current account surplus for years meant that during periods of negative growth shocks, the baht often fell less than many other EM currencies — that is, in periods of distress, the baht helped boost the relative performance of Thai bonds vis-à-vis overall EM bonds in US dollar terms. Those periods of distress also saw Thai bond yields fall as the central bank was able to cut rates due to low inflation. In addition, during those periods, local investors moved from equities to government bonds. Since the holdings of local bond investors far outweighed those of foreign investors, Thai bond yields managed to go down, even when some foreign investors dumped EM and Thai domestic bonds. As a result of these factors, Thai bonds outperformed their EM counterparts during the commodity/EM slowdown in 2014-15, and again at the height of the COVID-19-scare in early 2020 — even though the baht fell versus the US dollar during those periods (Chart 19, middle panel). All that said, the reality in the ground has changed somewhat since early last year. The Thai current account is no longer in surplus, and, given the dismal tourism outlook and slowing trade surplus, it will probably stay that way for the foreseeable future. That will keep the baht relatively weak weighing on Thai bonds’ relative performance versus their EM peers. On the other hand, the grim outlook of the Thai economy and looming deflation risk means that Thai bond yields could fall going forward relative to their EM counterparts. That will be a tailwind for Thai domestic bonds’ relative outperformance versus their EM counterparts. There is, therefore, a good chance that the headwind from a relatively weaker baht could be somewhat compensated for by a drop in Thai local yields versus their EM peers. Indeed, the periods of the baht’s weakness usually coincided with Thai bonds’ relative yield compression (Chart 19, bottom panel). This calls for a neutral outlook for relative bond performance going forward. Investment Conclusions Currency: The baht outlook remains precarious. Investors would do well to remain short the baht versus the US dollar. Domestic Bonds: Thai bond yields will go down. The Bank of Thailand will have no choice but to cut rates further. Local investors should stay long bonds. For international dedicated EM fixed-income portfolios, we downgraded Thai bonds in February of this year, from overweight to neutral in an EM bond portfolio, in view of the impending baht weakness. That turned out to be a good decision. Going forward, investors should continue to have a neutral allocation on Thai bonds, as the headwind from the baht will be mitigated by the tailwind from relative bond yield compression. Foreign absolute-return investors, however, should avoid Thai bonds in view of expected currency depreciation. Chart 20A Vulnerable Baht Will Keep Foreign Equity Investors Away Stocks: A struggling economy offers little hope for corporate margins or profits recovery soon. A vulnerable currency makes Thai stocks even less appealing to foreign investors. Without their participation, it will be hard for this market to rise sustainably in absolute terms or outperform their EM counterparts (Chart 20). Thai equities are not cheap either: the P/Book ratio is at par with EM. That said, given the Thai market’s already very steep underperformance versus the EM equity benchmark, from a portfolio strategy point of view, we recommend investors stay neutral this market within an EM equity portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 Please refer to the EMS report “Thailand: Beset By A Vulnerable Baht,” dated February 24, 2021. 2 The budget bill has to pass the second and third readings expected in August before it goes for senate and royal approval.

Highlights Global growth is peaking, which makes it important to monitor the risks for signs that it is time to reduce equity exposure. We are especially focused on five risks: 1) The emergence of vaccine-resistant Covid variants; 2) a possible “goods recession”; 3) higher real bond yields; 4) higher US corporate tax rates; and 5) a weaker Chinese economy and regulatory crackdown. For now, we recommend a modest overweight to global equities. We will likely pare back exposure early next year. Stocks And The Business Cycle Our “golden rule” for asset allocation is to remain bullish on equities unless there is a good reason to think that a recession is around the corner. This rule has strong empirical support. Chart 1 shows that equity bear markets rarely occur outside of major business cycle downturns. Chart 1Recessions And Bear Markets Tend To Overlap Nevertheless, there are different shades of bullishness. Stocks generally perform best coming out of recessions; that is, when the economy is weak but improving. Stocks perform worst when the economy is falling into recession. We are currently in an intermediate phase, where global growth is weakening but still solidly above trend. Historically, stocks have posted positive but uninspiring returns during such phases (Table 1). Table 1The Economic Cycle And Financial Assets Monitoring The Risks In “post peak growth” environments, it is important to monitor the risks for signs that it is time to reduce equity exposure. We are especially focused on five risks:   Risk 1: New Covid Variants Chart 2A New Covid Wave The Delta strain continues to roll through the US and a number of other countries (Chart 2). While the new strain does not seem to be any more deadly than other variants, it is a lot more contagious. CDC internal estimates suggest the R0 for the Delta variant is between 5-to-8, similar to that of chickenpox, and 40% higher than the original strain.1 Countries such as Thailand and Vietnam, which were able to keep the pandemic at bay last year, have succumbed to Delta. In Australia, the 7-day average of new cases has climbed above 300, the highest since last August. China has detected the Delta variant in more than a dozen cities since July 20. Even if the country succeeds in quashing the new variant, it will come at an economic cost. Lockdowns in major Chinese cities could further clog a global supply chain that is still reeling from the dislocations caused by the pandemic. While still vulnerable to the Delta variant, the symptoms of vaccinated individuals tend to be mild and non-life threatening. The Lambda variant, which surfaced in Peru this past December, appears more vaccine-resistant than the Delta variant. Fortunately, it is not as contagious as Delta, and has struggled to propagate outside of South America. The risk is that a new variant emerges which is: 1) highly contagious; 2) vaccine resistant; and 3) as or more lethal than the original strain. Chart 3The Divergence Between Goods And Services Spending Our Assessment: The current suite of vaccines confers substantial protection. While a vaccine-resistant strain could emerge, it is likely that vaccine producers will be able to adjust their formula to keep the virus at bay. As such, we see Covid as only a modest risk to global stocks.   Risk #2: A Goods Recession Even if Covid fades from view, the dislocations caused by the pandemic will persist for a while longer. As we discussed last week, the pandemic induced a major reallocation of spending from services to goods: Overall consumer spending in the US is broadly back to its pre-pandemic trend. However, service spending remains below trend while goods spending is above trend (Chart 3). Retail sales, which are dominated by goods, are also firmly above trend (Chart 4). We do not expect spending on goods to drop off anytime soon. A variety of manufactured goods, ranging from automobiles to major appliances, remain in short supply. The need to fill backorders and replenish inventories will keep production elevated for the next four quarters. However, at some point in the second half of 2022, manufacturers and retailers could find themselves with a glut of goods on their hands. Chart 4AUS Retail Spending Is Well Above Trend (I) Chart 4BUS Retail Spending Is Well Above Trend (II) Manufacturing accounts for only 11% of US GDP. However, goods producers account for about a third of S&P 500 market capitalization. Thus, while a slowdown in spending on goods is unlikely to push the US into recession, it could cause S&P 500 earnings growth to slow sharply, similar to what occurred during the 2015-16 manufacturing recession (Chart 5). Our Assessment: A goods recession represents a threat to both US and overseas stocks, particularly manufacturers and retailers. Most likely, however, that threat will not become visible to investors until next year.   Risk #3: Higher Real Bond Yields Stocks represent a claim on future corporate cash flows. Higher real interest rates reduce the present value of those claims, leading to lower stock prices. Chart 6 shows that there is a strong correlation between the US 10-year TIPS yield and the forward P/E ratio for the stock market. Chart 5The 2015-16 Manufacturing Recession Weighed On Earnings Chart 6Higher Real Rates Would Be A Headwind For Equity Valuations US real yields jumped in the wake of July’s stellar employment report. However, they still remain negative and far below pre-pandemic levels. Looking out, real yields could rise for two diametrically different reasons. On the one hand, an adverse demand shock could drive up real yields by pushing down inflationary expectations. This is precisely what happened during the early days of the pandemic.     Such a deflationary shock could arise if a vaccine-resistant variant emerges or if spending on manufactured goods declines faster than we expect. The failure of the US Congress to pass the infrastructure bill and/or a budget reconciliation bill could also exacerbate fiscal tightening next year. Under current law, fiscal policy will subtract around two percentage points from growth next year (Chart 7). Chart 7After A Strong Boost, Fiscal Thrust Is Turning Negative On the other hand, real yields could rise if an overheated economy prompts the Fed to hike rates more aggressively than markets are discounting. The US 10-year yield tends to track expected policy rates three years out (Chart 8). Chart 810-Year Treasurys Track Expected Policy Rates Three Years Out Chart 9Both The Fed And Market Participants Have Revised Down Their Estimate Of The Neutral Rate Of Interest   An increase in the market’s estimate of the terminal rate could also push up real yields. According to the New York Fed’s survey of primary dealers and market participants, investors think that the fed funds rate will top out at around 2%. Not only is this extremely low by historic standards, but it is also lower than the Fed’s estimate of the terminal rate (Chart 9). In the past, we have made a distinction between the strong- and weak-form versions of secular stagnation. The strong-form version is one where an economy is unable to reach full employment even with zero interest rates. Japan is a good example. The weak-form version is one where the economy can achieve full employment but only in the presence of low positive interest rates (Chart 10). Chart 10Strong- Versus Weak-Form Secular Stagnation In many respects, weak-form secular stagnation is better for equities than the normal state of affairs where the economy is at full employment and interest rates are near their historic average. This is because weak-form secular stagnation allows equity investors to have their cake and eat it too – to enjoy full employment and high corporate profits, all with the persistent tailwind of very low rates. Our Assessment: Our baseline view on the US envisions a goldilocks scenario of sorts: An economy that is hot enough to keep deflationary forces at bay, but not so hot that the Fed has to intervene to raise rates. While there are risks on both sides of this view, they are fairly modest. US households are sitting on nearly $2.5 trillion in excess savings, which should support consumption over the next few years. BCA’s geopolitical team, led by Matt Gertken, thinks that there is an 80% chance that Congress will pass an infrastructure bill. Assuming an infrastructure bill passes, they also see a 65% chance that the Democrats will succeed in pushing through a watered-down $3.5 trillion budget reconciliation bill. Meanwhile, as the July CPI report illustrates, inflationary forces are already starting to die down, which should keep rate expectations from rising too rapidly.   Risk #4: Higher US Corporate Tax Rates Chart 11Bettors Expect US Corporate Tax Rates To Rise, But Not By Much Congress’ passage of a budget reconciliation bill would blunt some of the fiscal tightening slated for next year. However, to pay for the additional spending, Democrats will seek to levy more taxes on corporations and higher-income earners. The Biden Administration is aiming to raise the corporate tax rate from 21% to 28%, bringing it halfway back to the 35% level that prevailed prior to the Trump tax cuts. Joe Manchin, a key swing voter in the Senate, has indicated a preference for 25%. PredictIt, a popular betting site, assigns 31% odds to no tax hike. Among bettors forecasting higher tax rates, the median estimate is around 25% (Chart 11). Analyst estimates do not appear to reflect the prospect of higher taxes. This is not surprising. Chart 12 shows that analysts did not adjust their earnings estimates until shortly after President Trump signed the Tax Cuts and Jobs Act into law on December 22, 2017. Chart 12Analysts Have Not Adjusted Their Earnings Estimates To Reflect The Likelihood Of Higher Taxes Chart 13Until Recently, Companies That Stand To Lose The Most From Higher Taxes Have Fared Well It is more difficult to know what markets are discounting. Chart 13 displays the performance of Goldman‘s “Formerly High Tax” and “Formerly Low Tax” equity baskets. The formerly high-taxed companies gained the most from Trump’s tax cuts and presumably would lose the most if the tax cuts were rolled back. While formerly high-taxed companies have underperformed the market since early May, they are still up relative to their low-taxed peers since the Georgia runoff election, which handed control of the Senate to the Democrats. Moreover, companies that are vulnerable to higher taxes on overseas profits – many of which are in the tech space – have continued to fare well. Our Assessment: BCA’s geopolitical team thinks that corporate taxes will rise more than current market expectations suggest. However, even under our baseline scenario, higher tax rates will only cut earnings-per-share for S&P 500 companies by about 5% in 2022. Given that earnings are expected to rise by 9% next year, this would still leave earnings growth in positive territory.   Risk #5: China The Chinese economy grew at an annualized rate of only 3.5% in the first half of 2021 (Chart 14). While stricter Covid restrictions will weigh on growth in Q3, activity should pick up again in the fourth quarter. Chart 14Chinese Growth Was Weak In The First Half of 2021 The degree to which China’s economy recovers later this year will depend on the overall policy stance. Both credit and money growth fell short of expectations in July. Aggregate social financing declined to CNY 1.06 trillion from CNY 3.7 trillion in June, missing expectations of a CNY 1.7 trillion increase. M2 money growth clocked in at 8.3% year-over-year, below consensus estimates of 8.7%. As of July, local governments had used only 37% of their annual bond issuance quota, compared with 61% over the same period last year and 78% in 2019. BCA Chief China strategist, Jing Sima, thinks that local governments were waiting for a clear signal from the Politburo meeting held on July 30th before issuing new debt. If so, the fiscal stance should turn more expansionary over the coming months. Nevertheless, Beijing continues to send conflicting messages – on the one hand, telling local governments that they need to support growth, while on the other hand admonishing them for wasteful spending. Chart 15Chinese Tech Stocks Have Underperformed Their Global Peers This Year Stepped-up regulation of China’s major internet companies has also unnerved investors. Chinese internet stocks have underperformed the global tech sector by more than 40% since February (Chart 15). Our Assessment: With credit growth back down to its 2018 lows, the authorities are likely to ease policy over the coming months. While the crackdown on internet companies will continue, it is unlikely to spill over to other sectors. Unlike Chinese companies in, say, the telecom or semiconductor sectors, Beijing does not see most online platforms as contributing much to the economy. What they do see are companies with the potential to undermine the authority of the Communist Party (and in the case of online education providers, reduce the birth rate by burdening parents with high educational expenses). Investment Conclusions Chart 16Equities Look More Attractive Than Bonds We will likely pare back equity exposure early next year. For now, however, we recommend that asset allocators maintain a modest overweight to global equities. Growth is slowing but will remain solidly above trend for the remainder of the year. The forward earnings yield on the MSCI All-Country World Index stands at 5.2%. While this is not particularly high in absolute terms, it is still very high in relation to bond yields (Chart 16). Stocks outside the US trade at a still-decent earnings yield of 6.4% (compared to 4.6% in the US). Granted, the earnings performance of many non-US companies leaves much to be desired. Nevertheless, relative valuations largely discount this fact. Moreover, continued above-trend global growth, Chinese stimulus, and rising bond yields should benefit cyclical stocks and value names, which are overrepresented in overseas indices. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  The basic reproduction number, R0 (pronounced “R naught”), corresponds to the average number of people a carrier of the virus will infect in a population with no natural or vaccine-induced immunity.   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights Going into the new crop year, we expect the course of the broad trade-weighted USD to dictate the path taken by grain and bean prices (Chart of the Week). Higher corn stocks in the coming crop year, flat wheat stocks and lower rice stocks will leave grain markets mostly balanced vs the current crop year.  Soybean stocks and carryover estimates from the USDA and International Grains Council (IGC) are essentially unchanged year-on-year (y/y). In the IGC's estimates, changes in production, trade, and consumption for the major grains and beans largely offset each other, leaving carryovers unchanged. Supply-demand fundamentals leave our outlook for grains and beans neutral.  This does not weaken our conviction that continued global weather volatility will tip the balance of price risk in grains and beans over the coming year to the upside. Our strategically bearish USD view also tips the balance of price risk in grains – and commodities generally – to the upside. We believe positioning for higher-volatility weather events and a lower US dollar is best done with index products like the S&P GSCI and the COMT ETF, which tracks a version of the GSCI optimized for backwardation.  Feature Chart of the WeekUSD Will Drive Global Grain Markets Chart 2Opening, Closing Grain Stocks Will Be Largely Unchanged Going into the new crop year, opening and closing stocks are expected to remain flat overall vs the current crop years, with changes in production and consumption largely offsetting each other in grain and bean markets (Chart 2).1 This will leave overall prices a function of weather – which no one can predict – and the path taken by the USD over the coming year. The IGC's forecast calls for mostly unchanged production and consumption for grains and beans globally, with trade volumes mostly flat y/y. This leaves global end-of-crop-year carryover stocks essentially unchanged at 594mm tons. The USDA expects wheat ending stocks at the end of the '21/22 crop year up a slight 0.5%; rice down ~ 4.5%, and corn up ~ 4%. Below we go through each of the grain and bean fundamentals, and assess the impact of COVID-19 on global trade in these commodities. We then summarize our overall view for the grain and bean complex, and our positioning recommendations. Rice The IGC forecasts higher global rice production and consumption, and, since they expect both to change roughly by the same amount, ending stocks are projected to remain unchanged in the '21/22 crop year relative to the current year (Chart 3). The USDA, on the other hand, is expecting global production to increase by ~ 1mm MT in the new crop year, with consumption increasing by ~ 8mm MT. This leaves ending inventories for the new crop year just under 8mm MT below '20/21 ending stocks, or 4.5%. Chart 3Global Rice Balances Roughly Unchanged Corn The IGC forecasts global corn production will rise 6.5% to a record high in the '21/22 crop year, while global consumption is expected to increase 3.6%. Trade volumes are expected to fall ~ 4.2%, leaving global carryover stocks roughly unchanged (Chart 4). In the USDA's modelling, global production is expected to rise 6.6% in the '21/22 crop year to 1,195mm MT, while consumption is projected to rise ~ 2.4% to 1,172mm MT. The Department expects ending balances to increase ~ 11mm MT, ending next year at 291.2mm MT, or just over 4% higher. Chart 4Corn Balances Y/Y Remain Flat Wheat The IGC forecasts global wheat production in the current crop year will increase by ~ 16mm MT y/y, which will be a record if realized. Consumption is expected to rise 17mm MT, with trade roughly unchanged. This leaves expected carryover largely unchanged at ~ 280mm MT globally (Chart 5). The USDA's forecast largely agrees with the IGC's in its ending-stocks assessment for the new crop year. Global wheat production is expected to increase 16.6mm MT y/y in '21/22, and consumption will rise ~ 13mm MT, or 1.7% y/y. Ending stocks for the new crop year are expected to come in at just under 292mm MT, or 0.5% higher. Chart 5Ending Wheat Stocks Mostly Unchanged Soybeans Both the IGC and USDA expect increases in soybean ending stocks for the '21/22 crop year. However, the USDA’s estimates for ending stocks are nearly double the IGC projections.2 We use the IGC's estimates in Chart 6 to depicts balances. USDA - 2021/22 global soybean ending stocks are set to increase by ~3 mm MT to 94.5 mm MT, as higher stocks from Brazil and Argentina are partly offset by lower Chinese inventories. US production is expected to make up more than 30% of total production, rising 6% year-on-year. Chart 6Higher Bean Production Meets Higher Consumption Impact Of COVID-19 On Ags Trade Global agricultural trade was mostly stable throughout the COVID-19 pandemic. China was the main driver for this resilience, accounting for most of the increase in agricultural imports from 2019 to 2020. Ex-China, global agricultural trade growth was nearly zero. During this period, China was rebuilding its hog stocks after an outbreak of the African Swine Flu, which prompted the government to grant waivers on tariffs in key import sectors, which increased trade under the US-China Phase One agreement. As a result, apart from COVID-19, other factors were influencing trade. Arita et. al. (2021) attempted to isolate the impact of COVID on global agricultural trade.3 Their report found that COVID-19 – through infections and deaths – had a small impact on global agricultural trade. Government policy restrictions and reduced mobility in response to the pandemic were more detrimental to agricultural trade flows than the virus itself in terms of reducing aggregate demand. Policy restrictions and lower mobility reduced trade by ~ 10% and ~ 6% on average over the course of the year. Monthly USDA data shows that the pandemic was not as detrimental to agricultural trade as past events. Rates of decline in global merchandise trade were sharper during the Great Recession of 2007 – 2009 (Chart 7). Many agricultural commodities are necessities, which are income inelastic. Furthermore, shipping channels for these types of commodities did not require substantial human interactions, which reduced the chances of this trade being a transmission vector for the virus, when governments declared many industries using and producing agricultural commodities as necessities. This could explain why agricultural trade was spared by the pandemic. Amongst agricultural commodities, the impact of the pandemic was heterogenous. For necessities such as grains or oilseeds, there was a relatively small effect, and in few instances, trade actually grew. For example, trade in rice increased by ~4%. The value of trade in higher-end items, such as hides, Chart 7COVID-19 Spares Ag Trade Chart 8Grains Rallied During Pandemic tobacco, wine, and beer fell during the pandemic. This was further proof of the income inelasticity of many agricultural products which kept global trade in this sector resilient. Indeed, the UNCTAD estimates global trade for agriculture foods increased 18% in 1Q21 relative to 1Q19. Over this period, Bloomberg's spot grains index was up 47.08% (Chart 8). Investment Implications We remain neutral grains and beans based on our assessment of the new crop-year fundamentals. That said, we have a strong-conviction view global weather volatility will tip the balance of price risk in grains over the coming year to the upside. Our strategically bearish USD view also tips the balance of price risk in grains – and commodities generally – to the upside. Weather-induced grain and bean prices volatility is supportive for our recommendations in the S&P GSCI and the COMT ETF, which tracks a version of the GSCI optimized for backwardation. These positions are up 5.8% and 7.9% since inception, and are strategic holdings for us.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish US natural gas prices remain well supported by increased power-generation demand due to heat waves rolling through East and West coasts, lower domestic production and rising exports. The US EIA estimates natgas demand for July rose 3.9 bcf/d vs June, taking demand for the month to 75.8 bcf/d. Exports – pipeline and LNG – rose 0.4 bcf/d to 18.2 bcf/d, while US domestic production fell to 92.7 bcf/d, down 0.2 bcf/d from June's levels. As US and European distribution companies and industrials continue to scramble for gas to fill inventories, we expect natgas to remain well bid as the storage-injection season winds down. We remain long 1Q22 call spreads, which are up ~214% since the position was recommended April 8, 2021 (Chart 9). Base Metals: Bullish Labor and management at BHP's Escondida copper mine – the largest in the world – have a tentative agreement to avoid a strike that would have crippled an already-tight market. The proposed contract likely will be voted on by workers over the next two days, according to reuters.com. Separately, the head of a trade group representing Chile's copper miners said prices likely will remain high over the next 2-3 years as demand from renewables and electric vehicles continues to grow. Diego Hernández, president of the National Society of Mining (SONAMI), urged caution against expecting a more extended period of higher prices, however, mining.com reported (Chart 10). We remain bullish base metals generally, copper in particular, which we expect to remain well-bid over the next five years. Precious Metals: Bullish US CPI for July rose 0.5% month-over-month, suggesting the inflation spike in June was transitory. While lower inflation may reduce demand for gold, it will allow the Fed to continue its expansionary monetary policy. The strong jobs report released on Friday prompted markets and some Fed officials to consider tapering asset purchases sooner than previously expected. The jobs report also boosted an increasing US dollar. A strong USD and an increase in employment were negative for gold prices on Monday. There also were media reports of a brief “flash crash” caused by an attempt to sell a large quantity of gold early in the Asian trading day, which swamped available liquidity at the time. This also was believed to trigger stops and algorithmic trading programs, which exacerbated the move. The potential economic impact of the COVID-19 Delta variant is the only unequivocally supportive development for gold prices. Not only will this increase safe-have demand for gold, but it will also prevent the Fed from being too hasty in tapering its asset purchases and subsequently raising interest rates. Chart 9 Chart 10 Footnotes 1     The wheat crop year in the US begins in June; the rice crop year begins this month; and the corn and bean crop years begin in September. 2     Historical data indicate this difference is persistent, suggesting different methods of calculating ending stocks.  The USDA estimates ending stocks for the '21/22 crop year will be 94.5mm tons, while the IGC is projecting a level of 53.8mm.  3    Please refer to ‘Has Global Agricultural Trade Been Resilient Under Coronavirus (COVID-19)? Findings from an Econometric Assessment. This is a working paper published by Shawn Arita, Jason Grant, Sharon Sydow, and Jayson Beckman in May 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights The rapid spread of the COVID-19 delta variant in Asia will re-focus precious metals markets anew on the possibility of another round of lockdowns and the implications for demand, particularly in Greater China and India, which account for 33% and 12% of global physical demand for gold (Chart of the Week).1 Regulatory crackdowns across various sectors in China will continue to roil markets over coming months.  Policy uncertainty around these crackdowns is elevated in local financial markets, and could spill into global markets.  This will support the USD at the margin, which creates a headwind for gold and silver prices. Ambiguous and contradictory signaling from Fed officials following the July FOMC meeting re its $120-billion-per-month bond-buying program also adds uncertainty to precious-metals and general commodity forecasts. Despite this uncertainty, we remain bullish gold and silver.  More efficacious jabs will become available, which will support the global economic re-opening, particularly in EM economies.  In DM economies, vaccination uptake likely increases as risks become more apparent.  We continue to expect gold to trade to $2,000/oz and silver to trade to $30/oz this year. Feature Markets once again are focused on the possibility lockdowns will follow rising COVID-19 infections and deaths, as the delta variant – the most contagious variant to date – spreads through Asia and elsewhere. Chart of the WeekCOVID-19 Delta Variant Rampages Chart 2COVID-19 Infections, Deaths Rising Infection and death rates are moving higher globally (Chart 2). COVID-19 infections are still rising in 78 countries. Based on the latest 7-day-average data, the countries reporting the most new infections daily are the US, India, Indonesia, Brazil, and Iran. The countries reporting the most deaths each day are Indonesia, Brazil, Russia, India, and Mexico. Globally, more than 42% of infections were in Asia and the Middle East, where ~ 1mm new infections are reported every 4 days. We expect more efficacious jabs will become available, which will support the global economic re-opening, particularly in EM economies. In DM economies, vaccination uptake likely increases as risks become more apparent. China's Regulatory Crackdown Markets also are contending with a regulatory crackdowns across multiple sectors in China, which is part of a years-long reform process initiated by the Politburo.2 Industries ranging from internet, property, education, healthcare to capital markets will have new rules imposed on them under China's 14th Five-Year Plan as part of this process. Our colleagues in BCA's China Investment Service note the pace of regulatory tightening will not moderate in the near term, as policymakers transition from an annual planning cycle focused on setting economic growth targets to a multi-year planning horizon. "This allows policymakers to have a higher tolerance for near-term distress in exchange for long-term benefits," according to our colleagues. The overarching goal of this reform process is to introduce more social equality in the society. Of immediate import for precious metals markets is the potential for spillover effects outside China arising from the policy uncertainty that already is emanating from that market. Uncertainty boosts the USD and gold. This makes its effect uncertain. In our most recent modeling of gold prices, we have found strong two-way feedback between US and Chinese policy uncertainty.3 We also find that broad real foreign exchange rates for the USD and RMB exert a negative influence on gold prices, while higher economic uncertainty pushes gold prices higher (Chart 3). In addition, across markets – Chinese and US economic policy uncertainty – have similar effects, suggesting economic uncertainty across these markets has a similar effect as domestic uncertainty at home (Chart 4).4 Chart 3Domestic Uncertainty, Real FX Rates Strongly Affect Gold Prices... Chart 4...As Do Cross-Border Uncertainty, Real FX Rates This is yet another reason to pay close attention to PBOC and Fed policy innovations and surprises: they affect each other in similar ways within and across borders. Fed Officials Add Uncertainty Following the FOMC meeting at that end of last month, various Fed officials expressed their views of Chair Jerome Powell's post-meeting remarks, or again resumed their campaigns to begin tapering the US central bank's bond-buying program. Chair Powell's remarks reinforced the data-dependency of the Fed in directing its bond buying and monetary accommodation. He emphasized the need to see solid improvement in the jobs picture in the US before considering any lift-off of rates. As to the Fed's bond-buying program, this, too, will depend on progress on reducing unemployment in the US. Powell also reiterated the Fed views the current inflation in the US as transitory, a point that was emphasised by Fed Governor Lael Brainard two days after Powell's presser. Some very important Fed officials, most notably Fed Vice Chair Richard Clarida, are staking out an early position on what will get them to consider reducing the Fed's current accommodative policies, chiefly an "overshoot" of PCE inflation, the Fed's favored gauge, above 3%. Other Fed officials are urging strong action now: St. Louis Fed President James Bullard is adamant that tapering of the Fed's bond-buying program needed to begin in the Autumn and should be done early next year. Bullard is supported by Governor Christopher Waller. The Fed's bond-buying program is more than a year old. Beginning in July 2020, the Fed started buying $80 billion of Treasurys and $40 billion of mortgage-backed securities every month, or ~ $1.6 trillion so far. This lifted the Fed's balance sheet to ~ $8.3 trillion. Thinking about this as a commodity, that's a lot of asset supply removed from the Treasury and MBS market, which likely explains the high cost of the underlying debt instruments (i.e., their low interest rates). It is understandable why the gold market would get twitchy whenever Fed officials insist the winddown of this program must begin forthwith and be done in relatively short order. The loss of that steady stream of buying could send interest rates higher quickly, possibly raising nominal and real interest rates in the process, which, given the sensitivity of gold prices to US real rates would be bearish (Chart 5). While it is impossible to know when the tapering of the Fed's asset-purchase program will end, these occasional choruses of its imminent inauguration add to uncertainty in the US, which also depresses precious metals prices, as Chart 5 indicates. A larger issue attends this topic: economic policy uncertainty is not contained within national borders. Above, we noted there is a two-way feedback between US and China economic policy uncertainty. There also is a long-term relationship in levels of economic policy uncertainty re China and Europe, which makes sense given the trading relationship between these states. Changes in the two measures of economic policy uncertainty exhibit strong co-movement (Chart 6). Chart 5Taper Talk Makes Precious Metals Markets Twitchy Chart 6Economic Policy Uncertainty Goes Across National Borders Investment Implications The increase in COVID-19 infection and re-infection rates, and death rates, is forcing commodity markets to reevaluate demand projections and the likelihood of continued monetary accommodation globally. This ultimately affects the prospects for commodity prices. Conflicting interpretations of the state of local and the global economies increases uncertainty across markets, especially precious metals, which are exquisitely sensitive to even a hint of a change in policy. This uncertainty is compounded when top officials at systematically important central banks provide sometimes-contradictory interpretations of the state of their economies. Despite this uncertainty we remain bullish gold and silver, expecting efficacious vaccines to become more widely available, which will allow the global recovery to regain its footing. We are less sanguine about the prospects for the winding down of the massive monetary accommodation globally, particularly that of the US, where data-dependent policymakers still feel compelled to provide almost-certain policy prescriptions in an increasingly uncertain world.This is a fundamental factor driving global uncertainty. We remain long gold expecting it to trade to $2,000/oz this year, and long silver, expecting it to hit $30/oz.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish While US crude oil inventories rose 3.6mm barrels in the week ended 30 July 2021 gasoline stocks fell 5.3mm barrels, contributing to an overall decline in crude and product inventories in the US of 1.2mm barrels, according to the US EIA's latest tally (Chart 7). US crude and product stocks have been falling throughout the COVID-19 pandemic, and now stand ~ 13% below year earlier levels at 1.7 billion barrels. Crude oil stocks, at 439mm barrels, are just over 15% below year-ago levels. This reflects the decline in US domestic production, which is down 7.1% y/y and now stands at 11.2mm b/d. US refined-product demand, however, is up close to 9% over the January-July period y/y, and stands at 21.2mm b/d. Base Metals: Bullish Workers at the world's largest copper mine, Escondida in Chile, are in government-mediated talks with management that end on Saturday to see if they can avert a strike. There is a chance talks could be extended five days beyond that date, under Chilean law. The mine is majority owned by BHP. Workers at a Codelco-owned mine also voted to strike and will enter government-mediated talks as well. These potential strikes most likely explain why copper prices have been holding relatively steady as other commodities have come under pressure, as markets reassess the odds of a demand slowdown brought about by surging COVID-19 infections, which are hitting Asian markets particularly hard (Chart 8). Chart 7 Chart 8   Footnotes 1     We flagged this risk in our July 8, 2021 report entitled Assessing Risks To Our Commodity Views, which is available at ces.bcaresearch.com. 2     Please see Pricing A Tighter Regulatory Grip published on August 4, 2021 by our China Investment Strategy.  It is available at cis.bcaresearch.com. 3    We measure this using Granger-Causality tests. 4    These broad real FX rates are handy explanatory variables, in that they combine two very important factors affecting gold prices – inflation and broad FX trade-weighted indexes.  Additional modelling also suggests these broad real FX rates for the USD and RMB coupled with US real 2- and 5-year rates also provide good explanatory models for gold prices. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Recent progress on the path to a post-pandemic state and the return to pre-COVID economic conditions has been mixed. The share of vaccinated individuals continues to rise globally, and the number of confirmed UK cases has recently peaked. However, vaccine penetration remains comparatively low in the US, and there has been no meaningful change in the pace of vaccination. Given the emergence of the delta variant as well as vaccine hesitancy in some countries, policymakers currently face a trilemma that is conceptually similar to the Mundell-Fleming Impossible Trinity. The pandemic version of the Impossible Trinity suggests that policymakers cannot simultaneously prevent the reintroduction of pandemic control measures while maintaining a functioning medical system and the complete freedom of individuals to choose whether or not to be vaccinated. Were they to occur, the imposition of renewed pandemic control measures or a dangerous rise in hospitalizations this fall would likely weigh on earnings expectations, at a time when income support for households negatively impacted by the pandemic will be withdrawn. The delta variant of COVID-19 is not vaccine-resistant, meaning that a delta-driven surge in hospitalizations this fall could delay – but not prevent – eventual asset purchase tapering and rate hikes from the Fed. 10-year Treasury yields are well below the fair value implied by a mid-2023 rate hike scenario, underscoring that the recent decline in long-maturity yields is overdone. The recent (slight) tick higher in China’s credit impulse is perhaps a sign that the worst of the credit slowdown has already occurred, but we do not expect a rising trend without a genuine shift toward a looser monetary policy stance. As such, a normalization in services spending in advanced economies remains the likely impulse for global growth over the coming year, at least over the coming 3-6 months. On a 12-month time horizon, we would recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields. However, for investors more focused on the near term, we would note the potential for further underperformance of cyclical sectors, value stocks, international equities, and most global ex-US currencies versus the US dollar – depending heavily on the evolution of the medical situation in the US and the subsequent response from policymakers. Feature Since we published our last report, progress made on the path to a post-pandemic state and the return to pre-COVID economic conditions have been mixed. Encouragingly, Chart I-1 highlights that the share of people who have received at least one dose of COVID-19 vaccine continues to rise outside of Africa, which continues to be impacted by India’s ban on vaccine exports. By the end of September, at least a quarter of the world’s population will have been fully vaccinated against COVID-19, and many more will have received at least one dose. Pfizer’s plan to request emergency authorization for its vaccine for children aged 5-11 by October also stands to raise total vaccination rates in advanced economies even further by the end of the year. In addition, Chart I-2 presents further evidence that the relationship between new cases of COVID-19 and hospitalization has truly been altered. The chart shows that the number of patients in UK hospitals is much lower than what would be implied by the number of new cases, which itself now appears to have peaked at a lower level than that of January. Given that the strain on the medical system is the dominant constraint facing policymakers, a modest rise in hospitalizations implies a durable end to pandemic restrictions and a return to economic normality. Chart I-1Global Vaccination Progress Continues Chart I-2Vaccines Have Truly Altered The Relationship Between Cases And Hospitalizations   However, the risk from the delta variant appears to be higher in the US than in the UK, due to a lower level of vaccine penetration. Only 56% of the US population has received at least one dose of a COVID-19 vaccine, compared with 67% in Israel, 69% in the UK, and 71% in Canada. And thus far, there has been no meaningful change in the pace of vaccination in the US in response to the threat from the delta variant, despite recent exhortations from politicians and media personalities from both sides of the political spectrum. The Impossible Trinity: Pandemic Edition Last year, most investors would have said that the existence of a safe and effective vaccine would likely be enough to durably end the pandemic. But given the development of more dangerous variants of the disease, and the existence of vaccine hesitancy in many countries, policymakers now face a trilemma that is conceptually similar to the concept of the “Impossible Trinity” as described by Mundell and Fleming. The upper portion of Chart I-3 illustrates the standard view of the Impossible Trinity, which posits that policymakers must choose one side of the triangle, while foregoing the opposite economic attribute. For example, most modern economies have chosen “B,” gaining the free flow of capital and independent monetary policy by giving up a fixed exchange rate regime (and allowing currency volatility). By contrast, Hong Kong has chosen side “A,” meaning that its monetary policy is driven by the Federal Reserve in exchange for a pegged currency and an open capital account. The lower portion of Chart I-3 presents the pandemic version of the trilemma, which sees policymakers having to choose two of these three outcomes: No economically-damaging pandemic control restrictions placed on society A functioning medical system The complete freedom of individuals to choose whether or not to be vaccinated Chart I-3Variants And Vaccine Hesitancy Have Created A Difficult Choice For Policymakers In reality, the pandemic version of the Impossible Trinity is likely to be resolved in a fashion similar to how China views the original trilemma,1 which is to distribute a 200% “adoption rate” among the three competing choices. In essence, this means that policymakers will likely partially adopt all three measures with a degree of intensity that will change over time in response to the prevailing circumstances. Chart I-4No Sign Yet Of A Pickup In US Vaccination Rates But Chart I-4 is a clear example of the differences in approach adopted by the US in response to vaccine hesitancy compared to other. So far, attempts to convince vaccine-hesitant Americans to get their shot have relied mostly on “carrot” approaches in an attempt to preserve individual freedom of choice, i.e. side “B” in Chart I-3. As noted above, these measures, so far, have failed, as there has been no noticeable uptick in the pace of vaccine doses administered in the US over the past month. By contrast, France, like several other countries, has begun to use “stick” approaches that push it more toward side “A” of the trilemma. In mid-July, French President Emmanuel Macron announced that French citizens who want to visit cafes, bars or shopping centers must show proof of vaccination or a negative test result. The policy also mandated that French health care and nursing home workers must be vaccinated. The result was a sharp, and thus far sustained, uptick in the pace of doses administered. For equity investors, the risk is that the politically contentious nature of vaccine mandates in the US will cause policymakers to acquiesce to renewed pandemic control measures this fall if the delta variant continues to spread widely over the coming few months (as seems likely). Alternatively, policymakers may allow a dangerous increase in hospitalizations, but this would merely postpone the imposition of control measures – and they would be more severe once reintroduced. Thus, there is a legitimate risk that the spread of the delta variant in the US does weigh on earnings expectations, especially for consumer-oriented services companies, at a time when income support for households negatively impacted by the pandemic will be withdrawn. Bond Yields, Delta, And Slowing Growth Momentum Chart I-5Growth Momentum Has Slowed... Of course, many investors would point to the significant decline in US 10-year bond yields since mid-March as having already acted in response to waning growth momentum. For example, the peak in US bond yields coincided with the March peak in the ISM manufacturing PMI, as well as a meaningful shift lower in the US economic surprise index (Chart I-5). Without a soaring inflation surprise index, the overall economic surprise index for the US would likely already be negative. The takeaway for some investors has been that a decline in yields has been normal given that the economy has passed its point of maximum strength. But there are two aspects of this narrative that do not accord with the data. First, Chart I-6 highlights that growth is peaking from an extremely strong pace, making it difficult to justify the magnitude of the decline in long-term yields over the past few months. And second, Chart I-7 highlights that the decline in the US 10-year yield closely corresponds to delta variant developments in the US. The chart shows that the 10-year yield broke below 1.5% shortly after the effective US COVID-19 reproduction rate (“R0”) began to rise, and the significant decline in yields over the past month began once R0 rose above 1. Chart I-7 does suggest that yields have reacted in response to the growth outlook, but in a different way than the “maximum strength” narrative suggests. Chart I-6…But Growth Itself Remains Quite Strong Chart I-7The Yield Decline Over The Past Month Seems Related To Delta Chart I-810-Year Yields Are Too Low, Even If Variants Delay The Fed While we can identify the apparent trigger for the decline in bond yields since mid-March, we do not agree that the decline is fundamentally justified. The delta variant of COVID-19 is not vaccine-resistant, meaning that a delta-driven surge in hospitalizations this fall could delay – but not prevent – eventual asset purchase tapering and rate hikes from the Fed. For example, Chart I-8 highlights that the 10-year yield is now 60 basis points below its fair value level in a scenario in which the Fed only begins to raise interest rates in mid-2023, underscoring that the recent decline in yields is overdone. And, although it is also true that market-based measures of inflation compensation have eased from their May highs, we have noted in previous reports that the Fed’s reaction function is almost exclusively driven by progress in the labor market back toward “maximum employment” levels – not inflation. Chart I-9 highlights that US real output per worker has grown at a much faster pace since the onset of the pandemic than what occurred on average over the past four economic recoveries, reflecting the success that US fiscal policy has had in supporting aggregate demand as well as constraints on labor supply in services industries. These factors will wane in intensity over the coming year, suggesting that real output per worker is unlikely to rise meaningfully further over that time horizon. Based on consensus market expectations for growth as well as the Fed’s most recent forecasts, a flat trend in real output per worker over the coming year would imply that the employment gap will be closed by Q2 of next year. This would be consistent with the recent trend in high frequency mobility data, such as US air traveler throughput and public transportation use in New York City (Chart I-10), the epicenter of the negative impact on urban core services employment stemming from the pandemic “work from home” effect. Chart I-9Real Output Per Worker Unlikely To Rise Much Further Over The Coming Year Chart I-10High-Frequency Data Points To A Closed Jobs Gap By Mid-2022   A closed employment gap by the middle of next year would imply that the Fed will begin to raise rates sometime in 2H 2022. Even if this were delayed by several months due to delta, Chart I-8 illustrated that 10-year Treasury yields are still too low. No Help From China If the spread of the delta variant over the coming few months does temporarily weigh on developed market economic activity via renewed pandemic control measures, investors should note that the lack of a countervailing growth impulse from China may act as an aggravating factor. Chart I-11 highlights that China’s PMI remains persistently below its 12-month trend, as it has tended to do following a decline in China’s credit impulse. And while some investors were hoping that the PBOC’s recent cut to the reserve requirement ratio represented a pivot in Chinese monetary policy towards sustained easing, Chart I-12 highlights that the 3-month repo rate remains well off its low from last year – and is only modestly lower than it was on average during most of the 2018/2019 period. Chart I-11China Is Slowing, And Policy Has Not Yet Reversed Course Chart I-12The Recent RRR Cut Was Not The Start Of A Dovish PBOC Shift   The recent (slight) tick higher in China’s credit impulse is perhaps a sign that the worst of the credit slowdown has already occurred, but we do not expect a rising trend without a genuine shift toward a looser monetary policy stance. As such, a normalization in services spending in advanced economies remains the likely impulse for global growth over the coming year, at least over the coming three to six months. Investment Conclusions Chart I-13Assets That Benefit From Lower Yields May Remain Well-Bid In The Near Term The unprecedented nature of the pandemic, as well as the unclear impact the delta variant will have given prevailing rates of vaccination in advanced economies, has clouded the near-term economic outlook. It is unlikely that the delta variant of SARS-COV-2 will have a long-lasting impact on economic activity in advanced economies, but it does have the potential to cause the temporary reintroduction of some pandemic restrictions and, thus, modestly delay the transition to a post-pandemic state. While long-term government bond yields are set to rise on a 12-month time horizon, financial assets that are negatively correlated with long-term bond yields could remain well-bid over the next few months. Chart I-13 highlights that cyclical equity sectors have underperformed defensive equity sectors over the past month, and banks have underperformed the overall index. The correlation between long-maturity real Treasury yields and the relative performance of value and growth stocks has also held up, with growth stocks outperforming since the end of March. Global ex-US equities have also underperformed US stocks, and the dollar has modestly risen. On a 12-month time horizon, we would recommend that investors position for a reversal of all these recent moves. However, for investors more focused on the near term, we would note the potential for further underperformance of cyclical sectors, value stocks, international equities, and most global ex-US currencies versus the US dollar – depending heavily on the evolution of the medical situation in the US and the subsequent response from policymakers. This underscores that cyclical investment strategy will be even more data dependent than usual throughout the second half of the calendar year. The pace of nonfarm payrolls growth in the US remains the single most important data release driving US monetary policy, and investors should especially focus on whether jobs growth this fall is consistent with the Fed’s maximum employment objective, as the impact of the delta variant becomes clearer, as constraints to labor supply are removed, and as employees progressively return to work. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst July 29, 2021 Next Report: August 26, 2021 II. The Social Media Magnification Effect: Austerity, Populism, And Slower Growth Investors should view social media as a technological innovation with negative productivity growth. Social media has contributed to policy mistakes – such as fiscal austerity and protectionism – that have acted as shocks to aggregate demand over the past 15 years. The cyclical component of productivity was long lasting in nature during the last economic expansion. Forces that negatively impact economic growth but do not change the factors of production necessarily reduce measured productivity, and repeated policy mistakes strongly contributed to the slow growth profile of the last economic cycle. Political polarization in a rapidly changing world is the root cause of these policy shocks, but social media likely facilitated and magnified them. The risks of additional mistakes from populism remain present, even before considering other risks to society from social media: a reduction in mental health among young social media users, and the role that social media has played in spreading misinformation. A potential revival in protectionist sentiment is a risk to a constructive cyclical view that we will be closely monitoring over the coming 12-24 months. Investors with concentrated positions in social media stocks should be aware of the potential idiosyncratic risks facing these companies from the public’s impression of the impact of social media on society – especially if social media companies come to be widely associated with political gridlock, the polarization of society, and failed economic policies (as already appears to be the case). Investors should view social media as a technological innovation with negative productivity growth. Social media has contributed to policy mistakes – such as fiscal austerity and protectionism – that have acted as shocks to aggregate demand over the past 15 years. Political polarization in a rapidly changing world is the root cause of these policy shocks, but social media likely facilitated and magnified them. While the risk of premature fiscal consolidation appears low today compared to the 2010-14 period, the pandemic and its aftermath could force the Biden administration or Congressional Democrats toward protectionist or otherwise populist actions over the coming year in the lead up to the 2022 mid-term elections. The midterms, for their part, are expected to bring gridlock back into US politics, which could remove fiscal options should the economy backslide. Frequent shocks during the last economic expansion reinforced the narrative of secular stagnation. In the coming years, any additional policy shocks following a return to economic normality will again be seen by both investors and the Fed as strong justification for low interest rates – despite the case for cyclically and structurally higher bond yields. In addition, investors with concentrated positions in social media companies should take seriously the long-term idiosyncratic risks facing these stocks. These risks stem from the public’s impression of the impact of social media on society, particularly if social media comes to be widely associated with political gridlock, the polarization of society, and failed economic policies. A Brief History Of Social Media The earliest social networking websites date back to the late 1990s, but the most influential social media platforms, such as Facebook and Twitter, originated in the mid-2000s. Prior to the advent of modern-day smartphones, user access to platforms such as Facebook and Twitter was limited to the websites of these platforms (desktop access). Following the release of the first iPhone in June 2007, however, mobile social media applications became available, allowing users much more convenient access to these platforms. Charts II-1 and II-2 highlight the impact that smartphones have had on the spread of social media, especially since the release of the iPhone 3G in 2008. In 2006, Facebook had roughly 12 million monthly active users; by 2009, this number had climbed to 360 million, growing to over 600 million the year after. Twitter, by contrast, grew somewhat later, reaching 100 million monthly active users in Q3 2011. Chart II-1Facebook: Monthly Active Users Chart II-2Twitter: Monthly Active Users Worldwide   Social media usage is more common among those who are younger, but Chart II-3 highlights that usage has risen over time for all age groups. As of Q1 2021, 81% of Americans aged 30-49 reported using at least one social media website, compared to 73% of those aged 50-64 and 45% of those aged 65 and over. Chart II-4 highlights that the usage of Twitter skews in particular toward the young, and that, by contrast, Facebook and YouTube are the social media platforms of choice among older Americans. Chart II-3A Sizeable Majority Of US Adults Regularly Use Social Media Chart II-4Older Americans Use Facebook Far More Than Twitter Chart II-5Social Media Has Changed The Way People Consume News As a final point documenting the development and significance of social media, Chart II-5 highlights that more Americans now report consuming news often (roughly once per day) from a smartphone, computer, or tablet other than from television. Radio and print have been completely eclipsed as sources of frequent news. The major news publications themselves are often promoted through social media, but the rise of the Internet has weighed heavily on the journalism industry. Social media has, for better and for worse, enabled the rapid proliferation of alternative news, citizen journalism, rumor, conspiracy theories, and foreign disinformation. The Link Between Social Media And Post-GFC Austerity Following the 2008-2009 global financial crisis (GFC), there have been at least five deeply impactful non-monetary shocks to the US and global economies that have contributed to the disconnection between growth and interest rates: A prolonged period of US household deleveraging from 2008-2014 The Euro Area sovereign debt crisis Fiscal austerity in the US, UK, and Euro Area from 2010 – 2012/2014 The US dollar / oil price shock of 2014 The rise of populist economic policies, such as the UK decision to leave the European Union, and the US-initiated trade war of 2018-2019. Among these shocks to growth, social media has had a clear impact on two of them. In the case of austerity in the aftermath of the Great Recession, a sharp rise in fiscal conservatism in 2009 and 2010, emblematized by the rise of the US Tea Party, profoundly affected the 2010 US midterm elections. It is not surprising that there was a fiscally conservative backlash following the crisis: the US budget deficit and debt-to-GDP ratio soared after the economy collapsed and the government enacted fiscal stimulus to bail out the banking system. And midterm elections in the US often lead to significant gains for the opposition party However, Tea Party supporters rapidly took up a new means of communicating to mobilize politically, and there is evidence that this contributed to their electoral success. Chart II-6 illustrates that the number of tweets with the Tea Party hashtag rose significantly in 2010 in the lead-up to the election, which saw the Republican Party take control of the House of Representatives as well as the victory of several Tea Party-endorsed politicians. Table II-1 highlights that Tea Party candidates, who rode the wave of fiscal conservatism, significantly outperformed Democrats and non-Tea Party Republicans in the use of Twitter during the 2010 campaign, underscoring that social media use was a factor aiding outreach to voters. Chart II-6Tea Party Supporters Rapidly Adopted Social Media To Mobilize Politically Table II-1Tea Party Candidates Significantly Outperformed In Their Use Of Social Media   And while it is more difficult to analyze the use and impact of Facebook by Tea Party candidates and supporters owing to inherent differences in the structure of the Facebook platform, interviews with core organizers of both the Tea Party and Occupy Wall Street movements have noted that activists in these ideologically opposed groups viewed Facebook as the most important social networking service for their political activities.2 Under normal circumstances, we agree that fiscal policy should be symmetric, with reduced fiscal support during economic expansions following fiscal easing during recessions. But in the context of multi-year household deleveraging, the fiscal drag that occurred in following the 2010 midterm elections was clearly a policy mistake. This mistake occurred partially under full Democratic control of government and especially under a gridlocked Congress after 2010. Chart II-7 highlights that the contribution to growth from government spending turned sharpy negative in 2010 and continued to subtract from growth for some time thereafter. In addition, panel of Chart II-7 highlights that the US economic policy uncertainty index rose in 2010 after falling during the first year of the recovery, reaching a new high in 2011 during the Tea Party-inspired debt ceiling crisis. Chart II-7The Fiscal Drag That Followed The 2010 Midterm Elections Was A Clear Policy Mistake Chart II-8Policy Mistakes Significantly Contributed To Last Cycle's Subpar Growth Profile In addition to the negative impact of government spending on economic growth, this extreme uncertainty very likely damaged confidence in the economic recovery, contributing to the subpar pace of growth in the first half of the last economic expansion. Chart II-8 highlights the weak evolution in real per capita GDP from 2009-2019 compared with previous economic cycles, which was caused by a prolonged household balance sheet recovery process that was made worse by policy mistakes. To be sure, the UK and the EU did not have a Tea Party, and yet political elites imposed fiscal austerity. It is also the case that President Obama was the first president to embrace social media as a political and public relations tool. So it cannot be said that either social media or the Republican Party are uniquely to blame for the policy mistakes of that era. But US fiscal policy would have been considerably looser in the 2010s if not for the Tea Party backlash, which was partly enabled by social media. Too tight of fiscal policy in turn fed populism and produced additional policy mistakes down the road. From Fiscal Drag To Populism While social media is clearly not the root cause of the recent rise of populist policies, it has had a hand in bringing them about – in both a direct and indirect manner. The indirect link between social media use and the rise in populist policies has mainly occurred through the highly successful use of social media by international terrorist organizations (chiefly ISIL) and its impact on sentiment toward immigration in several developed market economies. Chart II-9Terrorism And Immigration Likely Contributed To Brexit Chart II-9 highlights that public concerns about immigration and race in the UK began to rise sharply in 2012, in lockstep with both the rise in UK immigrants from EU accession countries and a series of events: the Syrian refugee crisis, the establishment and reign of the Islamic State, and three major terrorist attacks in European countries for which ISIL claimed responsibility. Given that the main argument for “Brexit” was for the UK to regain control over its immigration policies, these events almost certainly increased UK public support for withdrawing from the EU. In other words, it is not clear that Brexit would have occurred (at least at that moment in time) without these events given the narrow margin of victory for the “leave” campaign. The absence of social media would not have prevented the rise of ISIL, as that occurred in response to the US’s precipitous withdrawal from Iraq. The inevitable rise of ISIL would still have generated a backlash against immigration. Moreover, fiscal austerity in the UK and EU also fed other grievances that supported the Brexit movement. But social media accelerated and amplified the entire process.  Chart II-10Brexit Weakened UK Economic Performance Prior To The Pandemic Chart II-10 presents fairly strong evidence that Brexit weakened UK economic performance relative to the Euro Area prior to the pandemic, with the exception of the 2018-2019 period. In this period Euro Area manufacturing underperformed during the Trump administration’s trade war as a result of its comparatively higher exposure to automobile production and its stronger ties to China. Panel 2 highlights that GBP-EUR fell sharply in advance of the referendum, and remains comparatively weak today. Turning to the US, Donald Trump’s election as US President in 2016 was aided by both the direct and indirect effects of social media. In terms of indirect effects, Trump benefited from similar concerns over immigration and terrorism that caused the UK to leave the EU: Chart II-11 highlights that terrorism and foreign policy were second and third on the list of concerns of registered voters in mid-2016, and Chart II-12 highlights that voters regarded Trump as the better candidate to defend the US against future terrorist attacks. Chart II-11Terrorism Ranked Highly As An Issue In The 2016 US Election Chart II-12Voters Regarded Trump As Better Equipped To Defend Against Terrorism Trump’s election; and the enactment of populist policies under his administration, were directly aided by Trump’s active use of social media (mainly Twitter) to boost his candidacy. Chart II-13 highlights that there were an average of 15-20 tweets per day from Trump’s Twitter account from 2013-2015, and 80% of those tweets occurred before he announced his candidacy for president in June 2015. This strongly underscores that Trump mainly used Twitter to lay the groundwork for his candidacy as an unconventional political outsider rather than as a campaign tool itself, which distinguishes his use of social media from that of other politicians. In other words, new technology disrupted the “good old boys’ club” of traditional media and elite politics. Some policies of the Trump administration were positive for financial markets, and it is fair to say that Trump fired up animal spirits to some extent: Chart II-14 highlights that the Tax Cuts and Jobs Act caused a significant rise in stock market earnings per share. But the Trump tax cuts were a conventional policy pushed mostly by the Congressional leadership of the Republican Party, and they did not meaningfully boost economic growth. Chart II-15 highlights that, while the US ISM manufacturing index rose sharply in the first year of Trump’s administration, an uptrend was already underway prior to the election as a result of a significant improvement in Chinese credit growth and a recovery in oil prices after the devastating collapse that took place in 2014-2015. Chart II-13Trump Used Twitter To Lay The Groundwork For His Candidacy Chart II-14The Trump Tax Cuts A Huge Rise In Corporate Earnings   Chart II-15But The Tax Cuts Did Not Do Much To Boost Growth Similarly, Chart II-15 highlights that the Trump trade war does not bear the full responsibility of the significant slowdown in growth in 2019, as China’s credit impulse decelerated significantly between the passage of the Tax Cuts and Jobs Act and the onset of the trade war because Chinese policymakers turned to address domestic concerns. Chart II-16The Trade War Caused An Explosion In Global Trade Uncertainty But Chart II-16 highlights that the aggressive imposition of tariffs, especially between the US and China, caused an explosion in trade uncertainty even when measured on an equally-weighted basis (i.e., when overweighting trade uncertainty, in countries other than the US and China), which undoubtedly weighed on the global economy and contributed to a very significant slowdown in US jobs growth in 2019 (panel 2). Moreover, Chinese policymakers responded to the trade onslaught by deleveraging, which weighed on the global economy; and consolidating their grip on power at home. In essence, Trump was a political outsider who utilized social media to bypass the traditional media and make his case to the American people. Other factors contributed to his surprising victory, not the least of which was the austerity-induced, slow-growth recovery in key swing states. While US policy was already shifting to be more confrontational toward China, the Trump administration was more belligerent in its use of tariffs than previous administrations. The trade war thus qualifies as another policy shock that was facilitated by the existence of social media. Viewing Social Media As A Negative Productivity-Innovation A rise in fiscal conservatism leading to misguided austerity, the UK’s decision to leave the European Union, and the Trump administration’s trade war have represented significant non-monetary shocks to both the US and global economies over the past 12 years. These shocks strongly contributed to the subpar growth profile of the last economic expansion, as demonstrated above. Chart II-17Policy Mistakes, Partially Enabled By Social Media, Reduced Productivity During The Last Expansion Given the above, it is reasonable for investors to view social media as a technological innovation with negative productivity growth, given that it has facilitated policy mistakes during the last economic expansion. Chart II-17 underscores this point, by highlighting that multi-factor productivity growth has been extremely weak in the post-GFC environment. While productivity is usually driven by supply-side factors over the longer term, it has a cyclical component to it – and in the case of the last economic expansion, the cyclical component was long lasting in nature. Any forces negatively impacting economic growth that do not change the factors of production necessarily reduce measured productivity; it is for this reason that measured productivity declines during recessions; and policy mistakes negatively impact productivity growth. The Risk Of Aggressive Austerity Seems Low Today… Chart II-18State & Local Government Finances Are In Much Better Shape Today Fiscal austerity in the early phase of the last economic cycle was the first social media-linked shock that we identified, but the risk of aggressive austerity appears low today. Much of the fiscal drag that occurred in the aftermath of the global financial crisis happened because of insufficient financial support to state and local governments – and the subsequent refusal by Congress to authorize more aid. But Chart II-18 highlights that state and local government finances have already meaningfully recovered, on the back of bipartisan stimulus in 2020, while the American Rescue Plan provides significant additional funding. While it is true that US fiscal policy is set to detract from growth over the coming 6-12 months, this will merely reflect the unwinding of fiscal aid that had aimed to support household income temporarily lost, as a result of a drastic reduction in services spending. As we noted in last month’s report,3 goods spending will likely slow as fiscal thrust turns to fiscal drag, but services spending will improve meaningfully – aided not just by a post-pandemic normalization in economic activity, but also by the deployment of some of the sizable excess savings that US households have accumulated over the past year. Fiscal drag will also occur outside of the US next year. For example, the IMF is forecasting a two percentage point increase in the Euro Area’s cyclically-adjusted primary budget balance, which would represent the largest annual increase over the past two decades. But here too the reduction in government spending will reflect the end of pandemic-related income support, and is likely to occur alongside a positive private-sector services impulse. During the worst of the Euro Area sovereign debt crisis, the impact of austerity was especially acute because it was persistent, and it occurred while the output gap was still large in several Euro Area economies. Chart II-19 highlights that Euro Area fiscal consolidation from 2010-2013 was negatively correlated with economic activity during that period, and Chart II-20 highlights that, with the potential exception of Spain, this austerity does not appear to have led to subsequently stronger rates of growth. Chart II-19Euro Area Austerity Lowered Growth During The Consolidation Phase… Chart II-20…And Did Not Seem To Subsequently Raise Growth   This experiment in austerity led the IMF to conclude that fiscal multipliers are indeed large during periods of substantial economic slack, constrained monetary policy, and synchronized fiscal adjustment across numerous economies.4 Similarly, attitudes about austerity have shifted among policymakers globally in the wake of the populist backlash. Given this, despite the significant increase in government debt levels that has occurred as a result of the pandemic, we strongly doubt that advanced economies will attempt to engage in additional austerity prematurely, i.e., before unemployment rates have returned close-to steady-state levels. …But The Risk Of Protectionism And Other Populist Measures Looms Large The role that social media has played at magnifying populist policies should be concerning for investors, especially given that there has been a rising trend towards populism over the past 20 years. In a recent paper, Funke, Schularick, and Trebesch have compiled a cross-country database on populism dating back to 1900, defining populist leaders as those who employ a political strategy focusing on the conflict between “the people” and “the elites.” Chart II-21 highlights that the number of populist governments worldwide has risen significantly since the 1980s and 1990s, and Chart II-22 highlights that the economic performance of countries with populist leaders is clearly negative. Chart II-21Populism Has Been On The Rise For The Past 30 Years The authors found that countries’ real GDP growth underperformed by approximately one percentage point per year after a populist leader comes to power, relative to both the country’s own long-term growth rate and relative to the prevailing level of global growth. To control for the potential causal link between economic growth and the rise of populist leaders, Chart II-23 highlights the results of a synthetic control method employed by the authors that generates a similar conclusion to the unconditional averages shown in Chart II-22: populist economic policies are significantly negative for real economic growth. Chart II-22Populist Leaders Are Clearly Growth Killers Even After… Chart II-23… Controlling For The Odds That Weak Growth Leads To Populism Chart II-24Inequality: The Most Important Structural Cause Of Populism And Polarization This is especially concerning given that wealth and income inequality, perhaps the single most important structural cause of rising populism and political polarization, is nearly as elevated as it was in the 1920s and 1930s (Chart II-24). This trend, at least in the US, has been exacerbated by a decline in public trust of mainstream media among independents and Republicans that began in the early 2000s and helped to fuel the public’s adoption of alternative news and social media. The decline in trust clearly accelerated as a result of erroneous reporting on what turned out to be nonexistent weapons of mass destruction in Iraq and other controversies of the Bush administration. Chart II-21 showed that the rise in populism has also yet to abate, suggesting that social media has the potential to continue to amplify policy mistakes for the foreseeable future. It is not yet clear what economic mistakes will occur under the Biden administration, but investors should not rule out the possibility of policies that are harmful for growth. The likely passage of a bipartisan infrastructure bill or a partisan reconciliation bill in the second half of this year will most likely be the final word on fiscal policy until at least 2025,5 underscoring that active fiscal austerity is not likely a major risk to investors. Spending levels will probably freeze after 2022: Republicans will not be able to slash spending, and Democrats will not be able to hike spending or taxes, if Republicans win at least one chamber of Congress in the midterms (as is likely). Biden has preserved the most significant of Trump’s protectionist policies by maintaining US import tariffs against China, and the lesson from the Tea Party’s surge following the global financial crisis is that major political shifts, magnified by social media, can manifest themselves as policy with the potential to impact economic activity within a two-year window. Attitudes toward China have shifted negatively around the world because of deindustrialization and now the pandemic.6 White collar workers in DM countries have clearly fared better during lockdowns than those of lower-income households. This has created extremely fertile ground for a revival in populist sentiment, which could force the Biden administration or Congressional Democrats toward protectionist or otherwise populist actions over the coming year, in the lead up to the 2022 mid-term elections. Investment Conclusions In this report, we have documented the historical link between social media, populism, and policy mistakes during the last economic expansion. It is clear that neither social media nor even populism is solely responsible for all mistakes – the UK’s and EU’s ill-judged foray into austerity was driven by elites. Furthermore, we have not addressed in this report the impact of populism on actions of emerging markets, such as China and Russia, whose own behavior has dealt disinflationary blows to the global economy. Nevertheless, populism is a potent force that clearly has the power to harness new technology and deliver shocks to the global economy and financial markets. The risks of additional mistakes from populism are still present, and that is even before considering other risks to society from social media: a reduction in mental health among young social media users, and the role that social media has played in spreading misinformation – contributing to the vaccine hesitancy in some DM countries that we discussed in Section 1 of our report. Two investment conclusions emerge from our analysis. First, we noted in our April report that there is a chance that investor expectations for the natural rate of interest (“R-star”) will rise once the economy normalizes post-pandemic, but that this will likely not occur as long as investors continue to believe in the narrative of secular stagnation. Despite the fact that the past decade’s shocks occurred against the backdrop of persistent household deleveraging (which has ended in the US), these shocks reinforced that narrative, and any additional policy shocks following a return to economic normality will again be seen by both investors and the Fed as strong justification for low interest rates. Thus, while the rapid closure of output gaps in advanced economies over the coming year argues for both cyclically and structurally higher bond yields, a revival in protectionist sentiment is a risk to this view that we will be closely monitoring over the coming 12-24 months. Chart II-25The Underperformance Of Social Media Would Not Excessively Weigh On The Broad Market Second, for tech investors, the bipartisan shift in public sentiment to become more critical of social media companies is gradually becoming a real risk, potentially affecting user growth. Based solely on Facebook, Twitter, Pinterest, and Snapchat, social media companies do not account for a very significant share of the overall equity market (Chart II-25), suggesting that the impact of a negative shift in sentiment toward social media companies would not be an overly significant event for equity investors in general. Chart II-25 highlights that the share of social media companies as a percent of the broad tech sector rises if Google is included; YouTube accounts for less than 15% of Google’s total advertising revenue, however, suggesting modest additional exposure beyond the solid line in Chart II-25. Still, investors with concentrated positions in social media stocks should be aware of the potential idiosyncratic risks facing social media companies as a result of the public’s impression of the impact of social media on society. If social media companies come to be widely associated with political gridlock, the polarization of society, and failed economic policies (as already appears to be the case), then the fundamental performance of these stocks is likely to be quite poor regardless of whether or not tech companies ultimately enjoy a relatively friendly regulatory environment under the Biden administration. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields since last August. The indicator still remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings are pricing in a substantial further rise in earnings per share, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain very strong, and positive earnings surprises have risen to their highest levels on record. Within a global equity portfolio, global ex-US equities have underperformed alongside cyclical sectors, banks, and value stocks more generally. On a 12-month time horizon, we would recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields. But investors more focused on the near term, we would note the potential for further underperformance of cyclical sectors, value stocks, international equities, and most global ex-US currencies versus the US dollar – depending heavily on the evolution of the medical situation in the US and the subsequent response from policymakers. The US 10-Year Treasury yield has fallen sharply since mid-March. This decline was initially caused by waning growth momentum, but has since morphed into concern about the impact of the delta variant of SARS-COV-2 and the implications for US monetary policy. 10-year Treasury yields are well below the fair value implied by a mid-2023 rate hike scenario, underscoring that the recent decline in long-maturity yields is overdone. The extreme rise in some commodity prices over the past several months has eased. Lumber prices have normalized, whereas industrial metals have moved mostly sideways since late-April and agricultural prices remain 13% below their early-May high. We had previously argued that a breather in commodity prices was likely at some point over the coming several months, and we would expect further declines in some commodity prices as supply chains normalize, labor supply recovers, and Chinese demand for metals slows. US and global LEIs remain very elevated, but are starting to roll over. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4US Stock Market Breadth Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see China Investment Strategy Weekly Report “Moderate Releveraging And Currency Stability: An Impossible Dream?” dated September 5, 2018, available at cis.bcaresearch.com 2 Grassroots Organizing in the Digital Age: Considering Values and Technology in Tea Party and Occupy Wall Street by Agarwal, Barthel, Rost, Borning, Bennett, and Johnson, Information, Communication & Society, 2014. 3 Please see The Bank Credit Analyst “July 2021,” dated June 24, 2021, available at bca.bcaresearch.com 4 “Are We Underestimating Short-Term Fiscal Multipliers?” IMF World Economic Outlook, October 2012 5 Please see US Political Strategy Outlook "Third Quarter Outlook 2021: Game Time," dated June 30, 2021, available at usps.bcaresearch.com 6 “Unfavorable Views of China Reach Historic Highs in Many Countries,” PEW Research Center, October 2020.

Highlights Economy – The inevitable deceleration has arrived, but the economy is still growing far faster than trend and will continue to do so through 2022: A wide range of data series shows that US growth has likely peaked but deceleration from way, way above the long-run potential growth rate to way above it is not cause for concern. Markets – Growth worries pulled equities lower for one day last week before investors rushed back in to buy the dip: Stock volatility made a brief return at the beginning of the week before the S&P 500 snapped back to resume taking aim at new highs. Fundamentals supported the reversal as earnings are on a path to blow away expectations for the fifth consecutive quarter. Strategy – Investors should stay the course by overweighting risk assets in multi-asset portfolios: As long as the spread of the Delta variant does not lead to punishing new restrictions, the economy will continue to grow at an extremely rapid clip and the strong-growth, easy-policy backdrop will continue to support equities and credit. Feature The S&P 500 had its worst one-day performance since early April last Monday, shedding 1.6% and sending the VIX above 20 for only the ninth time since it broke into the teens in March (Chart 1). We do not read too much into day-to-day moves in financial markets, but the tumult seems to have resulted from equities’ delayed reaction to investor unease about decelerating growth. It makes intuitive sense that forward-looking markets often assign greater importance to the direction of a key data series than its level. In Wayne Gretzky terms, the level is largely an indication of where conditions have been, while the direction offers more insight into where they are headed. Direction does not always trump level, however, and investors should bear in mind that the current pace of growth is extremely elevated. The Bloomberg consensus of economists is calling for 6.6% real GDP growth in 2021 and 4.2% in 2022. Those figures project a tapering, especially from quarter to quarter (Table 1), but they still represent red-hot growth for an economy with an annual long-term potential growth rate in the range of 1.75% to 2%. They also reflect a gentle tapering, with growth expected to remain comfortably above trend through 2023. Chart 1Lower Highs, Lower Lows Table 12% Is So Last Decade   We are far less concerned about deceleration from high single-digit growth than we would be about sub-trend readings. Falling below trend was the persistent fear in the aftermath of the Global Financial Crisis when economists and investors alike worried that the economy would not be able to stay above stall speed. Growth likely peaked in the second quarter, and supply bottlenecks and wavering confidence in the face of the spread of COVID-19’s Delta variant have brought the economic surprise index back down to earth (Chart 2). To take one example of a series that recently generated a negative surprise, however, we think the month-over-month decline in the ISM non-manufacturing index has less to say about the economy than its fourth straight reading in the 60s, a level it had reached just eight times in the previous 23 years (Chart 3). Chart 2The Economy Is Cooling Off, ... Chart 3... But It's Still Quite Hot   Is The Bond Market Trying To Warn Us? Chart 4Inflation Fears Have Ebbed We did not foresee the steep decline in 10-year Treasury yields that has played out since mid-June and it has led us to ask if underlying economic conditions are weaker than we perceived. Based on the available data, we do not think so. It seems like the rally in long-dated Treasuries can be attributed to an unwinding of inflation fears, concerns about slowing growth and the reversal of a Treasury sell-off that had gone too far too fast. We remain constructive on the economy, assuming vaccine-resistant COVID-19 variants do not emerge, and we still expect the 10-year Treasury yield will end the year north of 1.75%. Inflation fears have cooled considerably, with 10-year TIPS breakevens having retreated to the lower end of the Fed’s desired range, while the 5-year-on-5-year series (the 5-year breakeven five years from now) has dropped out of it (Chart 4). Though we do not expect inflation to become a problem for the economy for another couple of years, we do expect that it will re-emerge as a worry for investors once the primary impediments to labor supply disappear in September, especially if the year-over-year CPI readings continue to come in way above 2%. Our Global Fixed Income Strategy service stresses that investors should watch the mix of components driving inflation. If accelerated wage gains appear to be on their way to becoming entrenched or the rate of growth in rents inflects higher, the transitory inflation narrative might begin to weaken, leading the Fed to dial back accommodation sooner and/or faster than the bond market currently anticipates. Though we are not concerned about a widely anticipated peak in the rate of growth, a revival of COVID-19 after it seemed to have been defanged would throw a spanner into the works. A surge in new infections, even in countries like the UK and the US which have been ahead of the pack in terms of vaccinations, indicates that the Delta variant is especially transmissible. The spike in infections here (Chart 5, top panel) and abroad has apparently dampened economic optimism, helping to push Treasury and other developed world sovereign yields lower. The good news, however, is that the Delta variant does not appear to be particularly lethal (Chart 5, bottom panel) and the leading Pfizer and Moderna vaccines have acquitted themselves well against it. We are watching virus developments carefully, but we do not yet see evidence that suggests new rounds of activity restrictions are in store and we therefore expect virus variants will ultimately have little economic impact. Chart 5The Delta Variant Is More Contagious But Less Serious Aside from the pendulum shifting from too-hot concerns to too-cold concerns, much of the Treasury rally appears to have been a reaction to the speed and extent of the backup in yields. Our Global Fixed Income Strategy colleagues point out that Treasuries became quite oversold in the first quarter. The 10-year yield got as far above its 200-day moving average as it did during the taper tantrum in 2013 (Chart 6, second panel), with both real-money investors (Chart 6, third panel) and speculators (Chart 6, bottom panel) shunning duration. Speculators have trimmed their short positions but the real money has yet to capitulate, suggesting that yields may be able to hang around current levels or edge even lower before returning to a level that better aligns with underlying economic strength, robust inflation readings and the future path of the fed funds rate. Earnings Continue To Crush Expectations Every equity investor is familiar with the earnings season dance. About halfway through the quarter, companies begin to guide analysts’ expectations lower. Analysts duly adjust their estimates down a few percentage points over the ensuing ten weeks before companies begin to report. Company earnings then come in about the level initially expected midway through the quarter and – voila! – three-quarters of S&P 500 constituents beat expectations and the overall index beats by around 3%. The typical pattern looks very much like it did across 2019 (Chart 7, top panel). Chart 6The Treasury Selloff Was Overdone Chart 7Not The Same Old Song-And-Dance Beginning with the second quarter of 2020, when the most stringent lockdown measures meant to stymie the spread of the pandemic were fully in force, the picture has been very different. S&P 500 constituents have barely guided down heading into earnings before proceeding to demolish estimates by close to 20% (Chart 7, bottom panel). The established practice of companies guiding analysts to position the bar at a height they think they can comfortably clear produced a narrow and consistent dispersion of earnings beats across the 32 quarters from 2012 to 2019, with a mean of 3.7% and a standard deviation of 1.4%, all clustered within a narrow 1-to-6% range (Chart 8). Chart 8Blasting Out Of The Old Range Something else entirely has unfolded over the last four quarters, when earnings beat by an average of 19.5%, more than three times above the previous eight years’ peak and five times their mean. Even with the pandemic numbers pushing the mean higher and quadrupling the standard deviation, the four quarters’ beats have been 3.2, 2.2, 1.8 and 3.1 standard deviations above the mean, respectively. With a quarter of the S&P 500 having reported results through last Friday, the second quarter appears to be on a path to extend the blowout streak to five quarters (Chart 7, bottom panel). Investors, conditioned to the S&P 500 unfailingly beating earnings, don’t seem to be cognizant of how unusual the magnitude of the beats has been. Gigantic year-over-year earnings gains, which will peak this quarter, also seem to have obscured how low the bar has been set on a quarter-over-quarter basis. As our US Equity Sector Strategy colleagues have highlighted, year-over-year comparisons that span pandemic-distorted quarters are of limited use. To get a more relevant read, they compare 2021 results to 2019 results. (For the full year, 2021 earnings per share for the S&P 500 are projected to come in 18.2% above 2019, for 8.7% annualized growth). Table 2A Remarkably Low Bar We have been tracking quarter-over-quarter changes and were surprised to see that forward four-quarter earnings were expected to decline 2% from their first-quarter run rate ($196.52, annualized) when the reporting season began, with the second quarter declining by 8% (Table 2). Given manifold signs of economic revival, an 8% sequential contraction strikes us as highly improbable. With real GDP expected to grow by 9% on an annualized quarter-over-quarter basis, or better than 12% in nominal terms, 2% growth seems reasonable, so we see $50 as a more realistic and easily attainable ballpark estimate, which would have earnings beat by 11%. Regardless of where earnings end up, the bar has been set extremely low – the analyst consensus has not forecasted contraction in any forward four-quarter period since 1980 (Chart 9). Our takeaway is that earnings estimates have scope to move higher, taking the S&P 500 with them if multiples don’t contract, or giving valuations a chance to cool if the index moves sideways or turns lower. Chart 9An Odd Time To Call For The First Contraction In 40 Years Investment Implications Our investment strategy recommendations follow from our ongoing analysis of the business cycle, the credit cycle, the monetary policy cycle and (when applicable) the sentiment cycle. Although the consistency of our risk-friendly asset allocation recommendations may have begun to seem boring, nothing in our cycle analysis calls for a change in our views. There is no reason to expect a recession when households are sitting on $2.4 trillion of excess savings, household net worth has advanced at the fastest rate on record, retail inventories have been depleted to record-low levels and payrolls are set to continue expanding at a furious rate over the next year-plus. The credit cycle is set to continue its charmed path, as rising incomes, cash-stuffed households and businesses, and zero interest rate policy suppress borrower distress and keep lenders eager to make loans. Monetary policy may get incrementally less accommodative as asset purchases shrink, but a rate hike is more than a year away. One can make a reasonable argument that the Fed will be unable to lift the fed funds rate to a truly restrictive level in the next policy tightening cycle once it begins to hike rates, even if it’s not our base case. We are certain that monetary policy settings will remain extremely easy well beyond our one-year investment timeframe. Sentiment is generally buoyant, but it is not at extreme levels that would warrant factoring it into our strategy as a contrarian indicator. We will therefore stay the course, while monitoring pandemic developments and keeping a sharp lookout for signs that we’re wrong about inflation or growth. If we are correct that the threat from COVID-19 will remain contained, we expect that earnings revisions will ensure that the next catalyst for equities will be a positive one. The consensus expectation for a decline in the earnings run rate is simply incompatible with observed conditions on the ground. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

Highlights The Delta variant will continue causing jitters but there is much greater evidence today than there was in early 2020 that humanity can curb the virus, both with vaccines and government stimulus. Delta jitters will reinforce the Fed’s dovishness and will, if anything, increase the odds that President Biden passes his mammoth spending package this fall. The very near term could easily see more volatility but by the end of the year the reflationary cast of global policy will have won the day. Tax hikes and rate hikes lurk beyond 2021. There is still no stabilization in US-China policy and the US and its allies have called out China for cyber aggression, signaling a new front of open competition. A cyber event is one of the leading contenders for the next negative shock to the global economy. Structural factors strongly support rising concerns among the global elite about cyber insecurity. Stick to this year’s key themes and views: long gold, long value over growth, long international stocks, long Mexico, long aerospace and defense, and short emerging market “strongmen” regimes. Feature Global equities sank and rose over the past week as investors struggled with “peak growth” in the US and China, the prospect of monetary policy normalization, and other risks on the horizon, including immediate concerns over the Delta variant of COVID-19. The rapid rebound, including for cyclicals like European stocks, suggested that investors are still buying the dip given a very supportive macro and policy backdrop (Chart 1). The BCA House View consists of accommodative policy, economic recovery, a weakening dollar, and the outperformance of cyclical risk assets. We largely agree, with the caveat that there will be “No Return To Normalcy” in the geopolitical realm. Meaning that over the medium and long term the US dollar will remain firmer than expected and cyclical economies and sectors will face headwinds.   Chart 1Equity Market Hits Wall Of Worry The pandemic will have unforeseen consequences, such as social unrest and regime failures, while China’s secular slowdown and the Great Power competition between the US and its rivals will intensify. Not only is China slowing but also President Joe Biden has been confirmed as a China hawk, coopting President Trump’s aggressive stance and courting US allies to pile the pressure on Beijing.    For most of this year the “normalcy” narrative has prevailed. Now investors are becoming fearful of the “abnormalcy” narrative. The US dollar has surprised its doubters on the basis of relative growth and interest rate differentials (Chart 2). Chart 2Dollar Remains Firm, Reflation Indicator Abates Over the next six months, the key point is that until these geopolitical risks boil over and explode, they reinforce the bullish macro view, since government spending will surge to address national challenges. The rich democracies have awoken to the threat posed by malaise at home and autocracy abroad. They have reactivated fiscal policy to rebuild their states and expand the social safety net. They are increasing investments in infrastructure, renewables, and defense. This trend is especially positive for US allied economies, global manufacturers ex-China, commodity prices, and commodity producing emerging markets, at least until the next shock erupts. We discuss the risk of a cyber shock as well as the points above in this report. Policy Responses To The Delta Variant The Delta variant began in India and has now swept the world. So far the variants respond to COVID vaccines, which are being rolled out globally. National and local political leaders will promote vaccination campaigns first – only if hospital systems are clogged will they resort to social restrictions. New infections have risen much faster than hospitalizations and deaths, although the latter are lagging indicators and will eventually follow cases (Chart 3). But financial markets will largely look past the scare, as they looked past the various waves of the original virus over the past 15 months. Today investors have greater evidence of humanity’s ability to curb the virus and can expect government spending to tide over the economy if new restrictions are necessary. New social restrictions should not be ruled out. They are not politically impossible. Public opinion in the developed countries shows that about 77% of people believe restrictions were about right or should have been tighter, while only 23% believe there should have been fewer restrictions (Chart 4). About 40% of Germans oppose the lifting of restrictions even for the vaccinated! Chart 3Delta Variant: A Limited Risk Unless Hospitals Clog Chart 4ANew Lockdowns Not Impossible Chart 4BNew Lockdowns Not Impossible Any financial or economic distress from virus variants will reinforce ultra-accommodative monetary policy. The European Central Bank adopted a symmetric inflation target of 2% as it completed its strategic review, up from a previous goal which simply aimed at inflation just under 2%. It is likely to expand rather than taper asset purchases (Chart 5). At the Fed, the balance of power between hawks and doves on the Federal Open Market Committee reflects the political and geopolitical trends of the day. In the wake of the Great Recession, the doves overwhelmed the hawks (Chart 6). The institution has fully transitioned today – it now aims to generate an inflation overshoot – and it will not jeopardize its new average inflation targeting regime by tightening policy too soon this year or next. Chart 5Central Banks Will Delay Normalization If COVID Crisis Persists Chart 6Doves Firmly In Ascendancy At Federal Reserve The Delta variant makes it more likely that governments will increase fiscal support. The European Union’s Recovery Fund has a modest impact but the EU Commission is not patrolling budget deficits anymore, in the event that new social restrictions set back the recovery. The Democratic Party will pass President Biden’s $3.5-$4.1 trillion American Jobs and Families Plan through Congress by Christmas (with a net deficit increase of $1.3-$2.5 trillion over eight years). Support rates among independents and Democrats suggest Biden will come up with the votes (Chart 7). A renewed sense of crisis will compel any straggling senators. Chart 7ADelta Variant Makes Biden Stimulus Even More Likely To Pass Chart 7BDelta Variant Makes Biden Stimulus Even More Likely To Pass Markets will cheer more government spending as they have done throughout the vast surge in budget deficits across the world, not least in the developed markets, where austerity stunted the recovery in the wake of the Great Recession (Chart 8). Beyond Delta jitters and reactive stimulus, there are clouds forming on the horizon over the medium and long term. Budget deficits will start contracting, central banks will start hiking rates, and taxes will go up (and not only in the US). Geopolitical risks that are suppressed today will erupt later. Bottom Line: The very near term could easily see more volatility but by the end of the year the reflationary cast of global economic policy will have won the day. The bigger problems come clearly into review after the ink dries on the last installment of the great Biden budget blowout. Chart 8Market Will Cheer Another Round Of Government Spending China Policy And Cyber War What might the next major negative shock be? A leading candidate is China, with its confluence of internal and external risks. China’s policymakers opened the floodgates of credit-and-fiscal stimulus to combat the global pandemic in 2020. They quickly shifted to tightening policy to prevent destabilizing asset bubbles. Now they are easing again. Stimulus and growth have both peaked. Authorities are on the verge of overtightening policy but tactical shifts in economic policy often occur in July. Right on cue the State Council ordered across-the-board cuts to bank reserve requirements on July 9. The Politburo’s July meeting on economic policy will bring an even more important policy signal. The concrete impact of the RRR cut should not be overstated. China has been lowering RRRs since late 2011 as its broad money growth has continually declined. The trend is indicative of China’s secular slowdown. A new series of RRR cuts is often attended by a global equity selloff (Chart 9). Chart 9China Blinked - But One RRR Cut Will Not Prevent A Global Selloff Our China Investment Strategy highlights that policy remains restrictive in other areas. Local governments have been told not to borrow if they have hidden debts. Moreover the crackdown on China’s tech sector also continues apace. These regulatory crackdowns are characteristic of the Xi Jinping administration and can continue for a while as it further consolidates power in advance of the twentieth National Party Congress in fall 2022. The US-China conflict is getting worse. The Biden administration took several punitive actions over the past month. It warned businesses against investing in Hong Kong and Xinjiang. It rejected a restart of the strategic and economic dialogue. While a bilateral summit between Biden and Xi Jinping is possible on October 30-31, it is not yet scheduled and would only temporarily improve relations. One of Biden’s more significant recent moves was to orchestrate a joint statement with allies condemning China for aggressive behavior in cyber space.1 A massive cyber attack should be high up on any investor’s list of “gray rhino” events (high-probability, high-impact events). The world has suffered large shocks from global terrorism, financial crisis, and pandemic. Lightning rarely strikes the same place twice. Of course, nobody knows what will cause the next upset. But a devastating cyber event has been underrated in the investment community and that is changing (Table 1). Fed Chair Powell, asked by a reporter what was the chief risk to the global financial system, said “cyber risk.” To quote in full: So you would worry about a cyber event. That's something that many, many government agencies, including the Fed and all large private businesses and all large private financial companies in particular, monitor very carefully, invest heavily in. And that's really where the risk I would say is now, rather than something that looked like the global financial crisis.2 Table 1Cyber Event Underrated In Consensus View Of Global Risks Here are six structural reasons that cyber risk will continue to escalate: Cyber space is one of the truly ungoverned spaces. The US is the preponderant power in cyber space, as elsewhere, but there is no regular order or code of conduct. The US cyber bureaucracy is decentralized and uncoordinated while its opponents are centrally commanded, aggressive, and sophisticated. Great power competition is escalating. The US is struggling with China, Russia, and Iran and all sides seek to intimidate enemies and gain allies. Cyber capabilities enhance essential tasks like spying, sabotage, and information warfare. The tech race is intensifying, with companies and governments investing heavily in innovation and industry, while US export controls exacerbate China’s frantic efforts to obtain advanced tech by any means. The pandemic boosted digital dependency across industry and commerce, creating a “perfect storm” for cyber attacks and hacking.3 The US and its allies are threatening to retaliate more actively against cyber attacks, which may initially lead to an increase in the total number of attacks. In addition, Israel will need to sabotage Iran’s nuclear program if it is not halted by diplomacy. The US is polarized and war-weary yet claiming greater commitment to its allies, a paradox that encourages foreign rivals to use cyber tools to foment US divisions; strike at regional opponents that lack US security guarantees; and test the US commitment to its allies. The current US-Russia negotiations toward a truce against cyber attacks on critical infrastructure are the sole example of a potential structural improvement. The US and Russia could conceivably lay down some rules of the road in cyber space. There may be a basis for an agreement in that already this year the US refrained from blocking the Nordstream II pipeline with Germany while Russia refrained from re-invading Ukraine. However, a Russo-American truce would not dispel the risk of a global cyber surprise. It could even increase the odds. Russia this year alone showed with the Colonial Pipeline hack and the JBS meat-packing hack that its proxies can disrupt critical US infrastructure. It would make sense to agree to a truce so that the US does not demonstrate the same capability against Russia. Even without a truce, Russia does not benefit from provoking massive US cyber attacks. The US is the world’s leading cyber power and has pledged that it will retaliate. Rather Russia will concentrate its efforts closer to home: suppressing dissent, intimidating the former Soviet Union, and testing the US’s willingness to defend its allies. It would be useful for Russia to use cyber attacks to undermine NATO unity and demonstrate that the US is reluctant to defend NATO members’ critical infrastructure. Remember the cyber strike against Estonia in 2007. Hence huge shocks could still emerge in Europe or elsewhere even if the US and Russia make a ceasefire regarding their own critical infrastructure.  The same can be said for China, Iran, and North Korea. Attacks in their neighborhood are even more likely than direct provocations against the United States now that the US is threatening graver consequences. Beijing is concentrating its cyber power on technological acquisition. But it will also try to intimidate its neighbors into neutrality and test America’s commitment to its allies. This applies to markets like Taiwan, South Korea, the Philippines, and Vietnam. Not all cyber attacks would cause a global shock but the danger of Biden’s emphasis on alliances and multilateralism is that the US will be tested and its commitments will expand. Local cyber attacks could escalate if the US believes it must prove its resolve.   Bottom Line: Cyber firms’ share prices have risen since we made our contrarian buy call back in March. True, fundamentals are poor despite the strong geopolitical tailwind. The BCA Equity Analyzer shows that valuations, debt, liquidity, and return on equity have deteriorated relative to the global large cap equity universe (Chart 10). Still, as long as liquidity is ample and geopolitical risk is high we expect cyber firms’ share prices to keep grinding upward. Chart 10Cyber Stocks: Poor Fundamentals But Geopolitics A Secular Driver Investment Takeaways We are sticking with our key themes and views: long gold; long value over growth; long DM-ex-US stocks such as FTSE100 (Chart 11) and European industrials; long US neighbors Mexico and Canada; long defense and cyber stocks; and short the assets of emerging market “strongman” regimes from China and Russia to Brazil, Turkey, and the Philippines. Taking several of our trade recommendations alongside the copper-to-gold ratio, a key measure of global reflation, there could be more near-term downside (Chart 12). Nevertheless these are strategic trades designed to bear rewards over 12 months and beyond. Mainland Chinese investors should book gains on long Chinese 10-year government bonds. We would not rule out a bigger bond rally later given China’s risks at home and abroad, but RRR cuts often lead to a selloff and the signal is that the socialist policy “put” remains in place. Book gains on long Italian / short Spanish equities. This tactical trade is now hitting the top of its range and will likely mean revert. We are still optimistic on European stocks and the euro as a whole and view the German election as a positive catalyst almost regardless of outcome. Chart 11Stay The Course: Long Value Over Growth   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Chart 12Stick To Cyclical Trades Over Near-Term Volatility   Footnotes 1     White House, “The United States, Joined by Allies and Partners, Attributes Malicious Cyber Activity and Irresponsible State Behavior to the People’s Republic of China,” July 19, 2021, whitehouse.gov. 2     “Jerome Powell: Full 2021 60 Minutes Interview Transcript,” CBS News, April 11, 2021, cbsnews.com. 3    Connor Fairman, “2020: Cybercrime’s Perfect Storm,” Council on Foreign Relations, January 20, 2021, cfr.org.