Economic Growth

Highlights The decline in the US and UK July services PMIs underscores that pandemic control measures are not the only manner by which COVID-19 impacts the services sector of the economy. A slowdown in Q3 growth in advanced economies from the Delta surge is now all but inevitable. The fact that highly-vaccinated advanced economies have experienced a sharp rise in new cases due to the Delta variant underscores that true herd immunity, as envisioned for most of the pandemic, will likely prove elusive. Consequently, investors need to shift their framework from the idea of herd immunity to that of “NAHRI”: the non-accelerating hospitalization rate of immunity. The vaccination rate is the most obvious indicator of progress towards NAHRI, but immunity from previous infections is also an important contributor. Reasonable estimates of unreported COVID-19 infections suggest that investors have good reason to believe that the US and most other major advanced economies will be above NAHRI, or at least very close to it, at some point in Q4. On a 6-12 month time horizon, economic growth in advanced economies, as well as the trend in financial markets, is not likely to be driven by the Delta variant of COVID-19. Extremely easy monetary policy, pent up savings, and robust revenue growth will support economic growth and the trend in stock prices – despite the fact that analyst earnings expectations are clearly too high. The recent underperformance of China-sensitive assets has been driven by a regulatory crackdown by Chinese authorities on new economy companies, which reflects new socio-political and economic shifts. Chinese stocks are now oversold and could bounce in the near-term, but we would still recommend favoring developed market equities within a global ex-US equity allocation until Chinese policy turns reflationary. Investors should continue to favor stocks versus bonds in a multi-asset portfolio over the coming year, with the proviso that the impact from the Delta variant is likely to cause a near-term growth disappointment. High single-digit earnings growth, coupled with some pressure on multiples, continues to point to mid-single-digit returns from US equities. Within a global equity allocation, we would recommend that investors favor global ex-US stocks, whose outperformance is not dependent on that of EM. Value versus growth, and small caps versus large, will likely benefit from an uptrend in long-maturity bond yields. We recommend that investors favor short USD positions, in response to a likely downtrend in the dollar over the coming year. Feature Chart I-1Meaningful Vaccination Progress Continues Everywhere Except Africa Over the past month, the Delta variant-driven phase of the pandemic has continued to worsen in several advanced economies, arrayed against a continual improvement in the immunity of the world’s population. Chart I-1 highlights that, outside of Africa, the share of the population that is fully vaccinated against COVID-19 is rising at a robust pace of roughly 10 percentage points per month. But in advanced economies with elevated rates of vaccination compared to the rest of the world, new confirmed cases of COVID-19 accelerated in August, driven in most cases by the Delta variant. Chart I-2 highlights that in the UK, the epicenter of the Delta surge, new cases have begun to rise again after having peaked in late July. UK hospitalizations remain low relative to what has occurred since the onset of the pandemic (panel 2 of Chart I-2), but the US has experienced a more significant rise due to its comparatively low vaccination rate. In addition, reflecting a disparity in vaccination rates within the US that we have highlighted, has a strong political dimension.1 Chart I-3 illustrates that ICU capacity utilization (relative to peak staffed ICU beds) has risen sharply in red states, back above its all-time high. ICU usage in blue states is also rising, but it remains 10 percentage points below its prior peak. Chart I-2UK Hospitalizations Remain Stable, Despite Elevated Case Counts Chart I-3Lowly Vaccinated US States Are Suffering The Most From Delta   When discussing the pandemic and its economic impact in past Bank Credit Analyst reports, we have emphasized the importance of hospitalizations as the core driver of policymaker decisions about pandemic control measures. In turn, we have focused on control measures as an important driver of economic activity because these measures clearly impede households’ ability to consume many services. Chart I-4Surging Cases Impact Services Activity, Even Without Pandemic Control Measures But Chart I-4 underscores that control measures are not the only manner by which the pandemic impacts the services sector of the economy. The chart highlights that the Markit services PMI has fallen sharply in July and August in both the US and UK economies, two countries that have few or no pandemic control measures still in place. This is strong evidence that fear and general risk aversion among some consumers is affecting services spending. Given that hospitalizations have remained relatively well controlled in the UK, this also suggests that the impact on consumer sentiment is emerging mostly from new case counts rather than from published hospitalization rates. Chart I-5 highlights that the University of Michigan's Index of Consumer Sentiment fell sharply in August to essentially a 10-year low, providing further evidence that a slowdown in Q3 growth in advanced economies from the Delta surge is now all but inevitable. Chart I-6 highlights that this has not yet been reflected in consensus expectations for growth, suggesting that near-term growth disappointments are likely. Chart I-5A Q3 Growth Slowdown Is Now All But Inevitable... Chart I-6...Which Is Not Currently Reflected In Consensus Expectations For Growth   Shifting Focus From Herd Immunity To NAHRI The fact that highly vaccinated advanced economies have experienced a sharp rise in new cases due to Delta underscores that true herd immunity, as envisioned for most of the pandemic, will likely prove elusive. This point was underscored earlier this month in public comments by the head of the Oxford Vaccine Group,2 who noted that even relatively small rates of transmission from “breakthrough cases” of vaccinated individuals means that anyone who is unvaccinated will likely be exposed to COVID-19 at some point over the coming months or years. From an economic standpoint, this may not be problematic if the spread of the disease among the unvaccinated is slow, as it would allow hospitals time to process COVID patients without risking an overrun of the system (and thus would likely not necessitate a response from policymakers). But the lack of an achievable herd immunity is clearly a risk if community transmission of the Delta variant is high among unvaccinated individuals, even in a scenario where overall vaccination rates are elevated. Consequently, investors need to shift their framework from the idea of herd immunity to that of “NAHRI”: the non-accelerating hospitalization rate of immunity. This concept is borrowed from the idea of NAIRU (the non-accelerating inflation rate of unemployment), and signifies the point at which sufficient immunity has been reached in a country – either through vaccination or past infection – that results in a stable pace of COVID-19 hospitalizations in the absence of any pandemic control measures or precautionary behavior on the part of consumers. Once NAHRI is reached with no control measures and a pre-pandemic rate of interpersonal contact, the pandemic will be effectively over. Chart I-7The US Vaccination Rate Has Picked Up Modestly One clear difficulty with this perspective is that NAHRI is unknown, making it challenging to determine how close a given economy is to a stable pace of COVID-related hospitalization. The experience of the UK over the past month, with an elevated case count yet stable hospitalizations, may suggest that they are close or approaching a stable-hospitalization immunity rate, although investors will still need to watch the UK closely over the coming weeks to confirm if this is the case. The vaccination rate is the most obvious indicator of progress toward NAHRI, and on this front the US has further to go. Chart I-7 highlights that while the pace of first doses administered in the US has risen over the past two months in response to the Delta wave, it will still take until the end of October or early November for the US to reach levels that have been attained by other advanced economies. The introduction of widespread vaccination mandates, as well as the incentive effects of vaccination passports, might raise this rate over the coming weeks. This is even more likely given the FDA's full approval of the Pfizer/BioNTech vaccine this week. But; immunity from previous infections will also contribute to reaching NAHRI, which raises the question of how many unreported COVID-19 infections have occurred since the onset of the pandemic. This is especially important given recent evidence that a previous COVID-19 infection among those who are unvaccinated appears to provide as much protection against the Delta variant as double-dose vaccination does for those without a previous infection (Chart I-8). Chart I-8A Previous COVID-19 Infection Appears To Offer Strong Protection Against The Delta Variant In the US, the Center for Disease Control estimates that from February 2020 to May 2021 only 1 in 4.2 COVID-19 infections were reported, suggesting that there were approximately 120 million total infections during that period. That would be quite positive for the economic outlook if accurate, as it would imply that the true immunity rate in the US is probably much closer to NAHRI than the vaccination rate would imply. However, it is also possible that the Center's estimate is too high, which is what some surveys of Americans seem to suggest. In mid-to-late February, a Pew Research survey reported that 25% of US adults had either tested positive for COVID-19, tested positive for antibodies against the SARS-COV-2 virus, or were confident that they already contracted the virus. This compares with 8.5% of the US population with a confirmed case of COVID-19 at that time, suggesting that the true ratio of reported cases to total infections is closer to 1:3. Chart I-9 highlights what the true US immunity rate might look like compared with the published vaccination rate based on different estimates of unreported infections. The chart highlights that a 1:3 ratio of reported cases to total infections implies an additional 10 percentage points of immunity, which would bring US first-dose vaccination rates in line with those of other DM countries. When combined with a slow but still ongoing rise in first doses administered, as well as emergency use eligibility of children under 12 years old targeted by the end of September, investors have good reason to believe that the US and most other major advanced economies will be above NAHRI, or at least very close to it, at some point in Q4. Chart I-9The True US Immunity Rate May Be A Lot Higher Than The Vaccination Rate Would Suggest A Permanent Shift In Consumer Behavior? The inability to reach true herd immunity, combined with the recent slowdown in services activity in response to a surge in cases from the Delta variant, raises the issue of whether altered consumer behavior will persist beyond the next few months. Chart I-10A Positive Sign That The Delta Wave May Be Abating In our view, the answer is: probably not. First, Chart I-10 makes the simple point that the transmission rate is already falling in advanced economies, suggesting that fears of a complete explosion in new cases beyond previous highs are unfounded. Second, the behavior of consumers over the past two months has been reasonable, but is unlikely to continue once nations begin to approach NAHRI. The Delta variant is still relatively new, and its higher transmissibility, as well as its seemingly higher hospitalization rate for those who are unvaccinated, has understandably given some consumers pause over the past few months (even those who are vaccinated). This is likely especially true among adults with young children in their household, given that they are not currently able to receive a vaccine and given a significant rise in pediatric cases that has occurred in some countries. But the reality is that the world will have to live with the existence of COVID-19 permanently, which consumers, investors, and policymakers will all soon come to accept and normalize. It will become endemic, and receiving annual booster shots against the disease may become a permanent ritual for people around the world. In advanced economies, once most or all individuals who wish to be vaccinated have had the chance to receive their shot, it seems unlikely that periodic waves of rising cases among the unvaccinated will be seen as a threat to individual health, especially if the increase in hospitalizations is limited and the viability of the health care system is not under threat. Beyond Delta: The Economy And Financial Markets In A Year’s Time On a 6-12 month time horizon, economic growth in advanced economies, as well as the trend in financial markets, is not likely to be driven by the Delta variant of COVID-19. Instead, the cyclical investment outlook will continue to depend on the factors that we have discussed in several previous reports: Extremely Easy Monetary Policy: Chart I-11 illustrates the 10-year US Treasury yield relative to trend nominal GDP growth. The chart highlights that long-maturity US government bond yields have not been this low relative to trend growth since the late-1970s, which will continue to support domestic demand even if growth moderates over the coming year. Excess Savings: A waning growth impulse from fiscal policy will likely weigh on real goods spending, which is roughly 10 percent higher than its pre-pandemic trend (Chart I-12). But services spending, which accounts for about 70% of overall consumer spending, is still 5% below its pre-COVID trend and will be supported by the deployment of a significant amount of excess savings that have accumulated over the course of the pandemic. Some of these excess savings have probably been deployed to pay down debt, but a sizeable portion likely remains to support services spending. Chart I-13 highlights that the gap in spending is fairly broad-based across different services categories, underscoring that a recovery in services spending is not overly-dependent on the return of a particular type of consumer spending behavior. Chart I-11US Monetary Policy Is Extraordinarily Easy Chart I-12Pent-Up Savings Will Support Services Spending   Robust Revenue Growth: The equity market is likely to be supported by strong revenue growth over the coming year, even if it modestly disappoints current expectations. Chart I-14 presents bottom-up analysts’ expectations for S&P 500 sales per share growth over the coming year, alongside a proxy for nominal growth expectations (12-month forward expectations for real GDP growth plus 2 percentage points). The chart highlights that, while expectations for sales growth are modestly above what our proxy would suggest, nominal growth expectations are the strongest they have been in over a decade. Chart I-13Missing Services Spending Is Broad- Based Across Spending Categories Chart I-14S&P 500 Revenue Growth Is Likely To Be Strong Over The Coming Year...   On the latter point, while revenue growth will likely support the equity market, expectations for earnings are now clearly too high. Chart I-15 highlights that bottom-up analysts are calling for 18% earnings growth over the coming year – after what has already been a very impressive earnings recovery – and for profit margins to expand by a full percentage point from what is already a new high. Chart I-16 presents a long-term perspective on corporate profit margins, highlighting how stretched they have become even relative to the uptrend of the past three decades. Chart I-15...Even Though Earnings Expectations Are Clearly Too High Chart I-16US Profit Margins Are Very Elevated, Even Given The Past Three Decade's Uptrend     Chart I-17 highlights that earnings expectations usually disappoint, given the perennial optimism of bottom-up analyst expectations. The chart shows that they historically disappoint on the order of 5 percentage points, but that a 10 percentage point miss would not be so uncommon. Thus, EPS growth that is in line with the revenue growth proxy shown in Chart I-14 will not likely weigh on investor sentiment. China And EM Stocks As a final point about the macro and cyclical investment outlook, Chart I-18 highlights that our Market-Based China Growth Indicator has fallen below the boom/bust line for the first time since the middle of last year. We highlighted in last month’s report that China would not likely provide the global economy with a growth impulse until Chinese policy turns reflationary, and financial assets that are sensitive to Chinese economic growth are now flashing a warning sign. We therefore continue to believe that a normalization in services spending in advanced economies remains the likely impulse for global growth over the coming year. Chart I-17A 10% Earnings Miss Over The Coming Year Would Not Be Unprecedented Chart I-18Chinese Growth Proxies Are Performing Poorly   However, at least a part of the recent underperformance of China-sensitive assets has been driven by the spectacular underperformance of broadly-defined tech stocks in China since late-May (Chart I-19). The selloff in Chinese tech stocks has been triggered by a regulatory crackdown by Chinese authorities on new economy companies, which reflects new socio-political and economic shifts in China – which are thus not likely to be transitory. Still, Chinese stocks are now oversold even in absolute terms (Chart I-20), raising the question of whether EM stocks overall are due for a bounce. Chart I-19Some Of The Recent EM Underperformance Reflects The Chinese Regulatory Crackdown Chart I-20Chinese Stocks Are Oversold In Absolute Terms     In the short term, the answer is yes, but over a 6-12 month time horizon we would still recommend favoring developed market equities within a global ex-US equity allocation. First, while policy from China may eventually act as a catalyst for EM equities, BCA’s China strategists do not believe that Chinese policymakers have yet reached the “pain point” that would signal regulatory and monetary policy easing. Second, China and EM more generally is comparatively tech heavy, and thus will face headwinds on a relative basis if value outperforms growth over the coming year (as we expect). Chart I-21EM Stocks Do Not Offer A Compelling Value Catalyst Versus DM Ex-US Third, Chart I-21 highlights that EM stocks offer no compelling value proposition relative to DM ex-US equities. EM stocks are modestly cheap on a 12-month forward P/E basis (trading at a 13% discount), but this has been true historically – with the exception of a brief period from mid-2007 to mid-2008. Relative to the past decade, EM valuation is at roughly average levels versus global ex-US stocks, suggesting that Chinese policy and sector performance trends are likely to be the key drivers for EM performance relative to non-US equities. Investment Conclusions Chart I-22Favor DM Ex-US Vs. US, And Value Vs. Growth, Over The Coming Year In Section 2 of this month’s report, we explain why the Fed’s maximum employment criterion is likely to be reached earlier than investors and the Fed itself expects. This suggests that equity multiples may come under pressure over the coming year as long-maturity government bond yields rise. However, we noted above that earnings are likely to grow at a high single-digit pace, and that this is likely to support the uptrend in US stock prices as developed economies approach or surpass the non-accelerating hospitalization rate of immunity from COVID-19 and the world continues to move toward to a post-pandemic state. In combination with our expectation of rising government bond yields, investors should thus continue to favor stocks versus bonds in a multi-asset portfolio over the coming year, with the proviso that the impact from Delta is likely to cause a near-term growth disappointment. On a 12-month time horizon, high single-digit earnings growth coupled with some pressure on multiples continues to point to mid-single-digit returns from US equities. Within a global equity allocation, we would recommend that investors favor global ex-US stocks. The outperformance of the latter is not dependent on the outperformance of emerging markets, as Chart I-22 highlights that DM ex-US equities now trade at close to a 30% discount relative to their US counterparts – an extreme reading that partially reflects the extraordinary discount of global value versus growth stocks (panel 2). The trend in value versus growth is strongly correlated with the trend in financials versus broadly-defined technology stocks, and rising long-maturity bond yields favor the earnings of the former and weigh on the multiples of latter. Chart I-23 highlights that global small cap stocks may also outperform over the coming year, given their fairly strong correlation with long-maturity bond yields since the start of the pandemic. Finally, as we have noted in previous reports, the US dollar is a reliably counter-cyclical currency over 12-month periods. The recent bounce in the US dollar in the face of rising stock prices has deviated from this relationship, but only modestly so (Chart I-24). A similar deviation occurred in Q1 of this year, and was resolved with the dollar, not stock prices, moving lower. Consequently, we recommend that investors favor short USD positions, in response to a likely downtrend in the dollar over the coming year. Chart I-23Small Cap Stocks Will Likely Outperform If Long-Maturity Bond Yields Rise Chart I-24A Pro-Risk Investment Stance Argues For A Dollar Downtrend   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst August 26, 2021 Next Report: September 30, 2021 II. The Return To Maximum Employment: It May Be Faster Than You Think When defining maximum employment, many investors focus on the state of the labor market that prevailed as of February 2020. However, the US labor market was beyond maximum employment levels at the onset of the COVID-19 pandemic, suggesting that the Fed is likely to raise interest rates before the unemployment rate falls back to 3.5%. This assumes that the Fed deems the ongoing recovery in the labor market to be “broad-based and inclusive,” given revisions to the FOMC’s Statement on Longer-Run Goals and Monetary Policy Strategy last August. The extraordinary nature of the COVID-19 pandemic has indeed had an outsized impact on some demographic segments of the labor market, but most of these effects already have or are likely to be reversed as the overall unemployment rate continues to fall. A permanent decline in the participation rate, relative to pre-pandemic levels, is likely given ongoing demographic trends. Even if the recent behavioral impact of retirements is overdone, the demographic impact of retirement on the participation rate suggests that the Federal Reserve may hit its maximum employment objective by next summer, barring a long-lasting impact on US economic activity from the Delta variant of COVID-19. In a 2H 2022 rate hike scenario, the fair value of the 10-year Treasury yield will be 2.2%-2.3% next year, which the market is not priced for. This underscores that investors should maintain a short duration position within a fixed-income portfolio, and that equity investors should favor value over growth stocks on a 12-month time horizon. The cyclical outlook for monetary policy in the US rests heavily, if not exclusively, on the length of time needed to return to maximum employment. In this report, we argue that a complete return to the state of the labor market as of February 2020 is probably not required for the Fed’s maximum employment objective to be met, because the jobs market was likely beyond maximum employment at that time. In addition, we highlight that the broad-based and inclusive nature of the Fed's maximum employment objective is objective will not delay the first Fed rate hike beyond what the trajectory of the unemployment rate would suggest, as the odds of a persistent negative impact on demographic segments of the labor market no longer seem meaningful. In fact, the one partial exception that we can identify – retirement – argues for an earlier return to maximum employment. We conclude by noting that a first Fed rate hike is possible by the middle of next year, barring a long-lasting impact on US economic activity from the Delta variant of COVID-19 or if the Fed’s inflation liftoff criteria are no longer met. Normalized levels of inflation expectations, as well as reasonable estimates of a closed output gap over the coming year, suggest that inflation itself will remain liftoff-consistent barring a significant shock to growth or a major disinflationary/deflationary supply-side event. A 2022 rate hike is not currently reflected in market pricing, underscoring that investors should remain short duration within a fixed-income portfolio. Equity investors should expect a meaningful rise in stock market volatility as long-maturity yields rise over the coming year, and should favor value over growth stocks once fears of the likely impact of the Delta variant on near-term economic growth abate. Defining “Maximum Employment” Chart II-1Last Cycle, Rates Began To Rise Before Maximum Employment Was Reached Last September, the Fed’s official shift to an average inflation targeting regime represented a significant break from how the Fed conducted monetary policy in the past. The shift replaced what was previously a “symmetric” 2% inflation target with the goal of achieving inflation that averages 2% over time, meaning that monetary policy is no longer strictly forward-looking. According to the Fed's previous framework, monetary policy should start to tighten before the economy reaches its full employment level, in anticipation that further declines in the unemployment rate will likely lead to accelerating inflation. For example, during the last economic cycle, the Fed began to raise interest rates in December 2015, when the unemployment rate stood at 5% (Chart II-1). But the Fed's new regime implies that the onset of tightening should begin later, the criteria for which was explicitly laid out in the September 2020 FOMC statement: “The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.” In addition, while the Fed’s statutory mandate from Congress has always included the pursuit of maximum employment as an objective of monetary policy, revisions to the FOMC’s Statement on Longer-Run Goals and Monetary Policy Strategy last August explicitly noted that the maximum level of employment is a “broad-based and inclusive goal.” This has left many investors questioning when the Fed’s maximum employment criterion will be reached, with some market participants believing that a complete return to the state of the labor market that prevailed as of February 2020 will be required before the Fed lifts interest rates. But there are three arguments suggesting that the US labor market was beyond maximum employment levels at the onset of the COVID-19 pandemic: 1. Chart II-2 highlights that the February 2020 unemployment rate ranked at the 5th percentile of its post-WWII history, and was at its lowest level since the late-1960s. While it is true that the unemployment rate would have been higher for most of the last economic expansion based on December 2007 age-adjusted participation rates, Chart II-3 highlights that this effect had waned by the end of 2019. This underscores that the pre-pandemic unemployment rate likely reflected very low labor market slack. Chart II-2The US Labor Market Was Likely Beyond Maximum Employment Levels Prior To The Pandemic 2. The February 2020 unemployment rate stood at 3.5%, which is at the very low end of the Fed’s NAIRU estimates, and meaningfully below the CBO’S long- and short-term NAIRU projections (Chart II-4). Given that NAIRU estimates signify the level of unemployment that is consistent with a steady inflation rate, this implies that 3.5% is likely below the “maximum employment” unemployment rate. Chart II-3The Part Rate Had Mostly Normalized Just Prior To COVID-19 Chart II-4A 3.5% Unemployment Rate Is Likely Below NAIRU Chart II-5Wage Growth Accelerated In Response To A Sub-4% Unemployment Rate 3. The pre-pandemic trend in wage growth also supports the notion that the labor market was past maximum employment levels at that time. Chart II-5 highlights that average hourly earnings and the Atlanta Fed’s median wage growth tracker were both accelerating in 2018/2019, and Chart II-6 highlights that real average hourly earnings growth of production and nonsupervisory employees was close to its 90th percentile historically at the end of 2019. This underscores that the Fed is likely to raise interest rates before the unemployment rate falls back to 3.5%, assuming that the ongoing recovery in the labor market is deemed by the Fed to be “broad-based and inclusive.”   Chart II-6Real Average Hourly Earnings Growth Was At Its 90th Percentile Historically Prior To COVID-19 Breadth, Inclusivity, And Participation Chart II-7The "She-cession" Is Over The extraordinary nature of the COVID-19 pandemic has indeed had an outsized impact on some demographic segments of the labor market, but most of these effects have already reversed or are likely to as the overall unemployment rate continues to fall. And as we highlight below, the one partial exception that we can identify – retirement – in fact argues for an earlier return to maximum employment. We focus our demographic segment analysis on four main categories: 1. employment by gender; 2. race; 3. wage level and education; and 4. the impact on labor force participation from retirement. Gender Chart II-7 highlights the impact of the pandemic on the US labor market by gender. In 2020, the impact of the pandemic fell disproportionately on women. The unemployment rate rose close to 13 percentage points for women from February to April of last year, versus a 10 percentage point rise for men. In addition, the recovery in the participation rate last year was less robust for women, who disproportionately cited family responsibilities as the basis for not participating in the labor force. However, Chart II-7 also highlights that the disproportionate labor market impact of the pandemic on women is now over, with the female unemployment rate closer to its pre-pandemic level than for men, with a similar recovery in the participation rate. The difference in wage growth, relative to February 2020 levels, is also now smaller for women than for men. Thus, barring the development of a new divergence over the coming year, there is no longer any basis for the Federal Reserve to distinguish between men and women in the labor market recovery. Chart II-8Black Unemployment And Labor Force Participation Has Mostly Normalized Race Chart II-8 highlights the impact of the pandemic on the US labor market by race. In this case, it is clear that a disproportionately negative effect on Black employment persisted for longer than it did for women. But it is also clear that the Black unemployment rate is now roughly the same magnitude above its February 2020 level as is the case for the overall unemployment rate. In June, the Black labor force participation rate had actually recovered more than the overall participation rate, although it did decline meaningfully in July. The Black labor force participation rate has shown itself to be highly volatile since the onset of the pandemic, and we doubt that the July reading marks a decoupling from the overall participation rate. It is also true that median non-white wage growth has decelerated significantly more than median white wage growth during the pandemic, but this has occurred from a very elevated starting point. Median non-white wage growth was growing a full percentage point above median white wage growth just prior to the pandemic, compared with a half a percentage point below today. This deceleration has likely occurred as a lagged impact from the larger rise in Black unemployment noted above, which has now dissipated – suggesting that nonwhite wage growth is not likely to meaningfully lag over the coming year. Two additional points highlight that Black unemployment, labor force participation, and wages are likely to be highly correlated with overall labor market trends over the coming year. First, Chart II-9 highlights that in 2019 Black workers were underrepresented in management / professional and natural resources / construction / maintenance occupations, and overrepresented in service and production / transportation / material moving occupations. Given that services spending remains below its pre-pandemic trend, it is likely that the Black unemployment rate will continue to decline as the gap in leisure and hospitality and other services employment closes further relative to pre-pandemic levels. Chart II-9Black Unemployment Will Fall As Services Spending Recovers Second, Table II-1 highlights that Black survey respondents to the Census Bureau’s Household Pulse Survey located in New York and California are reporting lower and only modestly higher levels, respectively, of lost employment income than is the case for Black workers in the US overall. Given that services employment in these two states, particularly New York, are the most likely to be negatively impacted by persistent “work-from-home” effects, Table II-1 suggests that Black services employment is not likely to lag gains in overall services employment. Wage Level And Education Chart II-10 highlights wage growth for those with a high school diploma or less, for low-skilled workers, and for those in the lowest average wage quartile, and Charts II-11A & II-11B highlight the impact of the pandemic on the unemployment and participation rates by education. Table II-1No Evidence Of A Negative “Work-From- Home” Effect On Black Unemployment Chart II-10Wage Growth By Education And Skill Level Is Largely Unchanged Chart II-11AThe Least Educated Workers Still Need To See More Job Gains… Chart II-11B…But This Will Occur As Services Spending Improves     On the wage front, Chart II-10 makes it clear that there are no major negative differences between those with limited education, limited skills, or limited pay and the overall trend in wage growth relative to pre-pandemic levels. Reflecting a shortage of workers in some services industries, wages for 1st quartile wage earners and low-skilled workers are accelerating, and are poised to reach their highest level since 2008. On the employment and participation front, Charts II-11A & B show that the job market recovery has been less pronounced for high school graduates and those with less than a high school diploma. But, we believe – with high conviction – that this reflects the industry composition of the existing employment gap, which skews heavily towards service and leisure & hospitality. These jobs tend to require less formal education and training, and to offer less pay. Given this, and similar to the case for Black employment, low education employment growth is unlikely to meaningfully diverge from the trend in overall services employment over the coming year. The Impact Of Retirement On Labor Force Participation Chart II-12Most Of The Pandemic Decline In Labor Force Participation Has Occurred Due To Retirement Chart II-12 presents a breakdown of the change in overall labor force participation from Q4 2019 to Q2 2021 by nonparticipation category. The chart is based off the Atlanta Fed’s Labor Force Participation Dynamics dataset, and employs some Bank Credit Analyst estimates to seasonally adjust the impact of some categories in the first half of this year and to align it with the actual change in the published monthly seasonally-adjusted participation rate. The chart underscores that, while family responsibilities and those who are not in the labor force but who want a job (the shadow labor force) have been important contributors to the decline in labor force participation since the onset of the pandemic, retirement has been the single most important factor driving the participation rate lower. This sharp drop in labor force participation from retirement likely reflects the decision of some older workers to bring forward their retirement date by a year or two, although a recent study from the Kansas City Fed suggests that the non-demographic component of the recent surge in retirements has mainly been driven by a decline in the number of retirees rejoining the labor force.3 But demographic effects are important, and Chart II-13 highlights that the participation rate has fallen at a rate of roughly 30 basis points per year on average since 2008, reflecting the aging of the population. Chart II-13 is consistent with the age-adjusted participation rate that we showed in Chart II-3 above, and underscores that, even though the recent decline in the participation rate due to retirement is overdone, a permanent decline relative to pre-pandemic levels is likely the result of ongoing demographic trends. In our view, the Federal Reserve is unlikely to regard a demographically-driven decline in the overall participation rate as evidence that the labor market recovery has fallen short of the Fed’s maximum employment objective. It is possible that a return of the working age participation rate to its pre-pandemic level will be viewed as a condition for maximum employment, but Chart II-14 highlights that progress on this front is already more advanced. Chart II-13A Full Recovery To The Pre-Pandemic Labor Force Participation Rate Is Unlikely Chart II-14The Working Age Participation Rate Has Recovered More Than The Overall Part Rate   A lower overall participation rate results in a faster decline in the unemployment rate for any given level of employment growth. Given that there are minimal-to-no remaining labor market divergences along other demographic dimensions of the labor market that aren’t simply correlated with the overall unemployment rate, the implication of a permanently lower participation rate is that the Federal Reserve is likely to hit its maximum employment objective earlier than market participants, and the Fed itself, are currently expecting. Timing The Return To Maximum Employment, And The First Fed Rate Hike Table II-2 presents the average monthly nonfarm payroll growth that will be required to reach a 3.8% unemployment rate, a level that Fed Vice Chair Richard Clarida recently affirmed would in his view likely constitute maximum employment.4 The values shown in the table assume the trend participation rate shown in Chart II-13 above, as well as a recent average of monthly population growth. Table II-2The Return To Maximum Employment May Be Faster Than You Think The table highlights that the unemployment rate is likely to fall to 3.8% following the creation of roughly 4.3 million additional jobs. If the monthly change in nonfarm payrolls continues to grow at its average over the past 3 months, this threshold will be met in January 2022 – essentially a full year before the Fed and market participants expect interest rates to begin to rise. Based instead on a simple linear trend of nonfarm payrolls since late last year, the unemployment rate is likely to fall to 3.8% by sometime next summer. As we highlighted above, the Fed has been explicit that its conditions for raising the funds rate are the following: Labor market conditions have reached levels consistent with the Committee's assessments of maximum employment Inflation has risen to 2 percent Inflation is on track to moderately exceed 2 percent for some time. Currently, the second and third conditions for liftoff are present, suggesting that a first rate hike is possible by the middle of next year, barring a long-lasting impact on US economic activity from the Delta variant of COVID-19. We agree that inflation will slow significantly from its current pace over the coming year as pandemic-induced supply-side factors wane, which some investors have noted may put the Fed’s inflation criteria back into play. But we doubt that the Fed will narrowly focus on the year-over-year growth rate in the core PCE deflator – which will be strongly influenced by base effects next year from this year’s comparatively elevated price level – when judging its second and third liftoff criteria. Instead, the Fed is likely to focus on the prevailing “run rate” of inflation that excludes prices experiencing any disinflationary effects of supply-chain normalization. Chart II-15 illustrates one important reason that the Fed’s inflation criteria will remain “checked” over the coming year. The chart shows that the pandemic, especially last year’s fiscal response to it, has “normalized” important measures of inflation expectations (based on an interval of 2004 to today). We noted in a report earlier this year that inflation is determined by both the degree of economic slack and inflation expectations, a framework that the Fed and many economists refer to as the “modern-day Phillips Curve.”5 Chart II-15The Fed’s Inflation Liftoff Criteria Are Likely To Stay “Checked” Many investors feel that the Phillips Curve has failed to predict weak inflation over the past decade, but we noted in our report that this perception is due to a singular focus on the economic slack component of the modern-day version of the curve – to the exclusion of inflation expectations – and a failure to consider the lasting impact of sustained periods of a negative output gap on those expectations. Chart II-16A Closed Output Gap Will Support Liftoff-Consistent Inflation Chart II-16 highlights that both market and Fed economic projections imply a positive output gap within the next 12 months, suggesting that inflation itself will remain liftoff-consistent barring a significant shock to growth or a major disinflationary/deflationary supply-side event. Declines in the prices of goods that have surged as a result of the disruption of global supply chains could potentially lower inflation expectations over the coming year, but our sense is that this is only likely in a scenario in which the prices of these goods fall below their pre-pandemic levels (which we do not currently expect). Investment Implications      There are three key investment implications of a potentially faster return to maximum employment than is currently anticipated by investors and the Fed. First, Chart II-17 highlights that the market is not priced for a first Fed rate hike by next summer, and Table II-3 highlights that a sizeable majority of respondents to the New York Fed’s Survey of Primary Dealers do not expect a single rate hike in 2022. Chart II-18 highlights that the fair value of the 10-year Treasury yield a year from today is 2.2%-2.3% in a 2H 2022 rate hike scenario, underscoring that a short duration stance is warranted within a fixed-income portfolio over the coming year – barring a long-lasting impact on economic activity from the Delta variant of COVID-19. Chart II-17The Market Is Not Fully Priced For A Quick Return To Maximum Employment Table II-3Market Participant Surveys Show No Hike Expectations Next Year Chart II-18Investors Should Maintain A Short-Duration Fixed-Income Stance Second, while a 2.2%-2.3% 10-year Treasury yield would not necessarily be negative for stock prices on a sustained basis, Chart II-19 shows that it would bring the equity risk premium (ERP) within its 2002-2007 range. The level of the 10-year yield that is consistent with that range has fallen relative to pre-pandemic levels and is now clearly below the trend rate of economic growth, due to a significant run-up in equity market multiples. This underscores that stocks are the most dependent on T.I.N.A., “There Is No Alternative,” than at any other point since the global financial crisis. It is unclear what ERP investors will require to contend with the myriad risks to the longer-term economic outlook, many of which are political or geopolitical in nature and which did not exist in the early 2000s. Chart II-19Now, Stocks Are Increasingly Dependent On Low Bond Yields Consequently, there are meaningful odds that equities will experience a “digestion phase” at some point over the coming year as long-maturity bond yields rise – potentially trading flat-to-down in absolute terms for several weeks or months. It is also possible that stocks will experience a more malicious sell-off, if it turns out that equity investors require a structurally higher risk premium than what prevailed prior to the global financial crisis. This is not our base case view. We continue to recommend an overweight stance toward equities in a multi-asset portfolio. But it is a risk that warrants monitoring over the coming year. Finally, rising bond yields clearly favor value over growth stocks on a 12-month time horizon. In the US, the sizeable recent bounce in growth stocks has occurred alongside a renewed decline in the 10-year Treasury yield, which itself has been driven by renewed fears about the economic impact of the Delta variant. Thus, growth stocks may remain well bid relative to value in the very near term. But on a 12-month time horizon, value stocks are likely to outperform their growth peers, as long duration tech sector valuation comes under pressure and financial sector earnings benefit from higher interest rates. 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 retreated below the boom/bust line, although this mostly reflects the use of producer prices to deflate money growth. In nominal terms, the supply of money continues to grow. Still, the retreat in the indicator over the past year highlights that the monetary policy stance is likely to shift in a tighter direction over the coming year. Forward equity earnings are pricing in a substantial further rise in earnings per share, and there is no meaningful sign of waning forward earnings momentum. Bottom-up analyst earnings expectations are now almost certainly too high, but stocks are likely to be supported by robust revenue growth over the coming year. 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. The US 10-Year Treasury yield has fallen sharply since mid-March, but may be in the process of bottoming. 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 late-2022 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 almost fully normalized, whereas the 3-month rate of change in industrial metals prices is now close to zero. An eventual slowdown in US goods spending, coupled with eventual supply-chain normalization and the absence of a significant reflationary impulse from Chinese policy, will likely weigh on commodity prices at some point over the coming 6-12 months. 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 The Bank Credit Analyst "July 2021," dated June 24, 2021, available at bca.bcaresearch.com 2 “Herd immunity a ‘mythical’ goal that will never be reached, says Oxford vaccine head”, The Telegraph, August 10, 2021. 3 What Has Driven the Recent Increase in Retirements? by Jun Nie and Shu-Kuei X. Yang, Federal Reserve Bank of Kansas City Economic Bulletin, August 11, 2021. 4 Outlooks, Outcomes, and Prospects for U.S. Monetary Policy, by Fed Vice Chair Richard H. Clarida, At the Peterson Institute for International Economics, Washington, D.C. (via webcast), August 4, 2021 5 Please see The Bank Credit Analyst Special Report "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated 18 December, 2020, available at bca.bcaresearch.com

Highlights The post-pandemic investment phase is just a continuation of the post-credit boom investment phase. This is because the pandemic has just accelerated the pre-existing shifts to a more remote way of working, shopping and interacting as well as the de-carbonisation of the economy. Combined with no new credit boom, these ongoing trends will structurally weigh on the profits of old economy sectors, consumer prices, and bond yields. At the same time, these trends are a continuing structural tailwind for the profits in those sectors that facilitate the shift to a more digital and cleaner world. Our high-conviction recommendation is to stay structurally overweight growth sectors versus old economy sectors… …and to stay structurally overweight the US stock market versus the non-US stock market. Fractal analysis: PLN/USD, Hungary versus Emerging Markets, and sugar versus soybeans. Feature Chart of the WeekUS And Non-US Profits Go Their Starkly Separate Ways Many people use the US stock market as a proxy for the world stock market. Intuitively, this makes sense, because the US stock market is the largest in the world, and the S&P 500 and Dow Jones Industrials are well-known indexes that we can monitor in real time. In contrast, world equity indexes such as the MSCI All Country World are less familiar and do not move in real time. Yet to use the US stock market as a proxy for the world stock market is a mistake. Although the US comprises makes up half of the world stock market capitalisation, the other half is so different – the non-US yan to the US yin – that the US cannot represent the world. As we will now illustrate. US Profits Have Doubled While Non-US Profits Have Shrunk Over the past ten years, US and non-US stock market profits have gone their starkly separate ways. While US profits have nearly doubled, non-US profits languish 10 percent below where they were in 2011! (Chart of the Week) While US profits have nearly doubled, non-US profits languish 10 percent below where they were in 2011. Of course, in any comparison of this sort, a key issue is the starting point. In this first part of our analysis, we are defining the starting point as the point at which profits had recouped all their global financial crisis losses. For both US and non-US profits this point was in March 2011 (Chart I-2 and Chart I-3). Chart I-2Comparing Profit Growth Since The Full Recovery From The Financial Crisis Chart I-3Comparing Valuation Expansion Since The Full Recovery From The Financial Crisis Because the issue of the starting point of the analysis is contentious, we will look at a much earlier starting point later in the report. But first, here are the decompositions of the US and non-US stock market moves from March 2011. US stock market profits are up 93 percent, while the multiple paid for those profits (valuation) is up 75 percent. Compounding to a total price gain of 235 percent (Chart I-4). Chart I-4US Profits Up 93 Percent, Valuation Up 75 Percent Non-US stock market profits are down -9 percent, while the multiple paid for those profits is up 38 percent. Compounding to a total price gain of a measly 25 percent (Chart I-5). Chart I-5Non-US Profits Down -9 Percent, Valuation Up 38 Percent The aggregate world stock market profits are up 24 percent, while the multiple paid for those profits is up 57 percent. Compounding to a total price gain of 94 percent (Chart I-6). Chart I-6World Profits Up 24 Percent, Valuation Up 57 Percent The Post-Credit Boom Phase Favours The US Over The Non-US Stock Market In the post-credit boom phase, several important features of stock market performance are worth highlighting. In absolute terms, valuation expansion has lifted US stocks by twice as much as non-US stocks, 75 percent versus 38 percent. Yet even the 75 percent expansion in the US stock market valuation has played second fiddle to the 93 percent expansion in US stock market profits. Absent valuation expansion, non-US stocks would stand lower today than in 2011. But for non-US stocks, whose structural profit growth has been non-existent, valuation expansion has been the only instrument for structural gains. Indeed, absent valuation expansion, non-US stocks would stand lower today than in 2011. And absent valuation expansion at a world level, the world stock market would lose three quarters of its ten-year gain. What can explain the startling performance differential between US and non-US stocks on both profit and valuation expansions? As we have argued before, most of the difference does not come from the underlying (US versus non-US) economies, but instead comes from the company and sector compositions of the stock markets. The US stock market is heavily over-weighted to global growth companies and sectors – such as technology and healthcare (Chart I-7) – which, by definition, have experienced structural growth in their profits. In contrast, the non-US stock market is heavily over-weighted to global old economy companies and sectors – such as financials, energy, and resources (Chart I-8) – whose profits have stagnated, or entered structural downtrends (Chart I-9). Chart I-7The US Stock Market Is Heavily Over-Weighted To Growth Sectors Chart I-8The Non-US Stock Market Is Heavily Over-Weighted To Old Economy Sectors   Chart I-9Old Economy Sector Profits Have Gone Nowhere At the same time, when bond yields decline, companies whose profits are growing (and time-weighted into the distant future) see a greater increase in their net present values. Hence, companies in the global growth sectors have experienced a larger valuation expansion than those in the old economy sectors. In this way, the US stock market has outperformed the non-US stock market on both profit growth and valuation expansion. The key question is, will these post-credit boom trends continue? The answer depends on whether the post-pandemic world marks a new phase for investment, or whether it is just a continuation of the post-credit boom phase. The Post-Pandemic Phase Is A Continuation Of The Post-Credit Boom Phase Let’s now address the issue of the starting point of our analysis by panning out to 1990. This bigger picture from 1990 shows three distinct phases for investors (Chart I-10 and Chart I-11). Chart I-10Since 1990, There Have Been Three Distinct Investment Phases Chart I-11The Post-Pandemic Investment Phase Is A Continuation Of The Post-Credit Boom Phase The first phase was the 1990s build-up to the dot com boom. This phase clearly favoured growth sectors, and thereby the US stock market versus the non-US stock market. The second phase was the early 2000s credit boom. This phase clearly favoured sectors that facilitated the credit boom or benefited from its spending – notably, the old economy sectors of financials, energy, and resources. Thereby it favoured the non-US stock market versus the US stock market. The third and most recent phase is the post-credit boom phase. This phase has flipped the leadership back to growth sectors as the absence of structural credit growth has stifled financials as well as the capital-intensive old economy sectors that had previously benefited from the credit boom. Additionally, the structural disinflation that has comes from weak credit growth has dragged down bond yields and – as already discussed – given a much bigger boost to growth sector valuations. Since 1990, there have been three distinct phases for investors: the dot com boom; the credit boom; and the post-credit boom. Now we come to the key question. Did 2020 mark the end of the post-credit boom phase and the start of a new ‘post-pandemic’ phase? On the evidence so far, the answer is an emphatic no. Crucially, there is no new credit boom. A still highly indebted private sector is neither willing nor able to borrow. And although public sector debt surged during the pandemic, governments are now keen to temper or rein in deficits. In any case, Japan teaches us that government borrowing – which is bond rather than bank financed – does nothing for the banks or the broader financial sector. An equally important question is, has the pandemic reversed the societal and economic trends of the post-credit boom phase? The answer is no. Quite the contrary, the pandemic has accelerated the pre-existing shifts to a more remote way of working, shopping and interacting as well as the de-carbonisation of the economy. Combined with no new credit boom, these ongoing trends are structurally disinflationary for the profits of old economy sectors as well as for consumer prices. Thereby, they will continue to weigh on bond yields. At the same time, the trends are a continuing structural tailwind for the profits in those sectors that facilitate and enable the shift to a more digital and cleaner world. While we are open to the evolving evidence, the post-pandemic investment phase seems an extension of the post-credit boom phase. This means that structurally, there is no reason to flip out of growth sectors back to old economy sectors. It also means that structurally, there is no reason to switch from US to non-US stocks. Fractal Analysis Update This week’s fractal analysis highlights three potential countertrend moves based on fragile fractal structures. First, the recent rally in the US dollar could meet near-term resistance given its weakening 65-day fractal structure. A good way of playing this would be long PLN/USD (Chart I-12). Chart I-12PLN/USD Could Rebound Second, the strong outperformance of Hungary versus Emerging Markets – largely driven by one stock, OTP Bank – has become a crowded trade based on its 130-day fractal structure. This would suggest underweighting Hungary versus the Emerging Markets index (Chart I-13). Chart I-13Underweight Hungary Versus EM Finally, the sugar price has skyrocketed as extreme weather has disrupted output in the world’s top producer, Brazil. Given that supply bottlenecks ultimately ease, a recommended trade would be to short sugar versus soybeans, using ICE versus CBOT futures contracts (Chart I-14). Set the profit target and symmetrical stop-loss at 8 percent. Chart I-14Short Sugar Versus Soybeans Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights China’s new plan for “common prosperity” is a long-term strategic plan to bulk up the middle class that will strengthen China – if it is implemented successfully. The record on implementing reforms is mixed. Large budget deficits to provide subsidies for households and key industries are inevitable. But fiscal reforms will be more difficult. Implementation will proceed gradually and some provinces will move faster than others. Cyclically, the common prosperity plan will not be allowed to interfere with the post-pandemic economic recovery. Beijing will have to ease monetary and fiscal policy to secure the recovery. But large debt levels create a limit on the ability to push through key reforms. Macro policy easing is beneficial for the rest of the world but Chinese investors must deal with a rise in uncertainty and an anti-business turn in the policy environment. Beijing has centralized political power to move rapidly on reforms. However, centralization creates new structural problems while antagonizing foreign nations. Feature Chinese President Xi Jinping laid out a plan on August 18 for “common prosperity” in China that will help guide national policy over the coming decades. The plan seeks to reduce social and economic imbalances and hence strengthen China and reinforce the Communist Party’s rule. The plan confirms our top key view for the year – China’s confluence of internal and external risks – as well as our long-running theme that Chinese domestic political risk is greater than it looks because of underlying problems like inequality and weak governance. The market has woken up to these views and themes (Chart 1). Now Beijing is turning to address these problems, which is positive if it follows through. But investors will have to cope with new policies and laws that reverse the pro-business context of recent decades. In this report we review the new plan and its implications in the context of overall Chinese economic policy. The chief investment takeaway is that while China will push forward various reforms, Beijing cannot afford to self-inflict an economic collapse. Monetary and fiscal policy will ease over the coming 12 months. As such China policy tightening will not short-circuit the global recovery. However, Chinese corporate earnings and the renminbi will not benefit from the country’s anti-business turn. Chart 1Market Wakes Up To China's Political Risk What Is In The Common Prosperity Plan? The first thing to understand about Beijing’s new plan for “common prosperity” is that it is aspirational: it contains few specific targets or concrete policies. It builds on existing policy goals set for 2049, the hundredth anniversary of the People’s Republic. Implementation will be gradual. The plan is consistent with the Xi administration’s previous emphasis on improving the country’s quality of life and tackling systemic risks. It takes aim at social immobility, income and wealth inequality, poor public services, a weak social safety net, and other problems that did not receive enough attention during China’s rapid growth phase over the past forty years. Left unattended, China’s socioeconomic imbalances could fester and eventually destabilize the regime. From the beginning, the Xi administration has tackled the most pressing popular concerns to try to rebuild the party’s legitimacy, increase public support, and avoid crises. Crackdowns on pollution and excessive debt are prime examples. China does indeed suffer from high income inequality and low social mobility, as we have highlighted in key reports. It is comparable to the United States as well as Italy, Argentina, and Chile, all of which have suffered from significant social and political upheaval in recent memory (Chart 2). By contrast, Japan, Germany, and Australia have been relatively politically stable. Chart 2China Risks Social Unrest Like The Americas Table 1 summarizes the common prosperity plan. The key takeaways are the long 2049 deadline, the emphasis on “mixed ownership” in the corporate sphere (retaining a big role for state control and state-owned enterprises but attracting private capital), the redistribution of household income (reform the tax code), the establishment of property rights, the censorship of media/discourse, and the need to reduce rural disparity. The most important point of all is that Beijing intends to grow the size and wellbeing of the middle class – the foundation of a country’s strength. Table 1China’s “Common Prosperity” Plan For 2049 Coastal China today has reached Taiwanese and Korean levels of per capita income and has slightly exceeded their levels of wealth inequality (Chart 3). These countries witnessed social unrest and regime change in the 1980s due to such problems. The urban-rural gap is even more problematic in China due to its large rural population and territory. The Chinese public is expected to become more demanding as it evolves. Hence Beijing is pledging to redistribute wealth, grow the middle class, speed up income growth among the poorest, reduce rural disparities, expand access to elderly care, medicine, and housing, and establish a better legal framework for business. These goals are positive in principle, especially for household sentiment, social stability, and political support for the administration. But they also entail a higher tax/wage/regulation environment for business and corporate earnings. The question for investors centers on implementation. Chart 3China's Wealth Disparities Outstrip Comparable Neighbors What About Vested Interests? Table 1 above shows that the super-committee that issued the common prosperity plan also addressed China’s ongoing battle against financial risk. The financial policy statement was neither new nor surprising but it highlights something important: “preventing risks” will have to be balanced with “ensuring stable growth.” This balancing of reform and growth is essential to Chinese government and will guide the implementation of the common prosperity plan just as it has guided President Xi’s crackdown on shadow banking. This is an especially pertinent point today, as Beijing runs the risk of overtightening monetary, fiscal, and regulatory policies. While Beijing’s vision of a better regulated, more heavily taxed, and higher-wage society should not be underrated, reform initiatives will be delayed if they threaten to derail the post-pandemic recovery. Time and again the Xi administration has ruled against a rapid, resolute, and disruptive approach to reform, such as the “assault phase of reform” spearheaded by Premier Zhu Rongji in the late 1990s. In the plan’s own words: “achieving common prosperity will be a long-term, arduous, and complicated task and it should be achieved in a gradual and progressive manner.” Having said that, the pattern of reform has been a vigorous launch, a market riot, and then backtracking or delay. This means markets face more volatility first before things settle down. An initial volley of policy actions should be expected between now and spring of 2023, when the National People’s Congress solidifies the plans of the twentieth National Party Congress in fall 2022. As with the ongoing regulatory crackdown on Big Tech, the market may experience a technical rebound but the political assessment suggests government pressure will be sustained for at least the next 12 months. We do not recommend bottom feeding in Chinese equities. Will the reforms be effective over time? When the Xi administration took power in 2012-13, it issued a visionary policy document calling for wide-ranging reforms to China’s economy (“Decision on Several Major Questions About Deepening Reform”).1 Over the past decade these reforms have had mixed success. Rhodium Group maintains a reform tracker to monitor progress – the results are lackluster (Table 2). Some core principles, such as the claim that China would make market forces “decisive” in allocating resources, have been totally reversed. Table 2China’s Progress On Reforms Over Past Decade While China’s government model is absolutist, there are still social and economic limits on what the government can achieve. Beijing cannot raise a nationwide property tax, estate tax, and capital gains tax overnight just to reduce inequality. In fact, the long saga of the property tax tells a very different story. Beijing is limited in how it can tax the bubbling property sector because Chinese households store their wealth in houses and because any sustained price deflation would lead to a national debt crisis. Officials have pledged to advance a nationwide property tax in the past three five-year plans with little progress. A serious effort to impose the tax in 2014 was only implemented in two provinces, notably Shanghai’s tax on second or third homes owned by the same household.2 The common prosperity plan entails that the government will revive the property tax but the rollout will still be gradual and step-by-step reform. The tax will focus on major urban areas, not minor ones where population decline could weigh on prices. The government work report in early 2023 will be a key watchpoint for where and when the property tax will be levied but there can be little doubt that it will gradually be levied for top-tier cities. Other aspects of the common prosperity plan will be implemented with provincial trial runs. It all begins with a “demonstration zone,” namely Zhejiang province, a wealthy coastal state where President Xi Jinping once served as party secretary and first army secretary. Zhejiang is expected to make some progress by 2025 and achieve most the goals by 2035 (in keeping with Xi’s 2035 strategic vision). The Zhejiang plan includes concrete numerical targets and as such sheds light on the broader national plan and how other provinces will implement it. The most important target is the desire to have 80% of the population earn an annual disposable income of CNY 100,000-500,000 ($15,400-77,000). The labor share of output should be greater than 50%, compared to a national average of 35%-40%. The urbanization rate should hit 75%, up from 72%. Urban incomes should be capped at just short of twice that of rural income. Enrollment rates in higher education will go up, life expectancy should reach above 80 years, pollution should be further controlled, and the unemployment rate should stay below 5.5%. A host of other goals, ranging from technology to fertility and the social safety net, are shown in Table 3. Table 3China: Zhejiang Province As Bellwether For “Common Prosperity” Plan Some of the plan’s intentions will be undermined by Chinese governance. It is difficult to improve social fairness and property rights in the context of autocracy because the central and local governments create distortions and cannot be held to account for their own mistakes and abuses. The immediate political context of the common prosperity plan should not be missed: the president is outlining a bright future to justify the fact that he will not step down from power as earlier term limits required in fall 2022. The president’s 2035 vision implies an important strategic window in which to accomplish ambitious goals but the lack of checks and balances suggests that the next 14 years could be very similar to the last 10 years, in which arbitrary and absolutist decisions govern policy. The problem is highlighted by China’s recent 10-point plan on government under rule of law, which is undercut by the arbitrary actions of regulators in the tech crackdown (see Appendix). In other words, while social stability may improve in many ways, the shift away from consensus rule, toward rule of a single person, will increase policy uncertainty and create new governance problems at the same time that could produce greater instability over the long run. Having said all that, it is essential to acknowledge that a comprehensive plan to grow the middle class and expand the social safety net could be very positive for China if implemented. A Global Social Justice Race? If investors are thinking that the Xi administration’s calls for “social fairness and justice” and big new investments in “elderly care, medical security, and housing supply” resemble those of US President Joe Biden in his American Families Plan, then they are right. But while the US is already at historic levels of social division after failing to deal with inequality, China is attempting to learn from the US’s problems and rebalance society before polarization, factionalization, and social unrest occur. The Communist Party tends to take major action in response to American crises. Beijing’s crackdown on extremism and domestic terrorism in the early 2000s followed from the September 11 attacks. Its crackdown on local government debt and shadow banking stemmed from the 2008 financial crisis. And its crackdown on Big Tech, social media, and inequality today responds to the rise of populism in the US and Europe. The fact that deindustrialization has led to political crises in the developed world, and that social media companies can both exacerbate social unrest and silence a sitting president, is not lost on the Chinese administration. Unfortunately, China’s approach will probably escalate conflict with the West. First, Beijing is coupling its new social agenda with an aggressive campaign of military modernization and technological acquisition. It is doubling down on advanced manufacturing as its future economic model. The liberal democracies will not only be forced to defend their own political systems and governance models but will also be pressured into more hawkish stances on foreign, trade, and defense policy toward China. So far China is still attractive to foreign investors but the combination of socialist policy, import substitution, and foreign protectionism should put a cap on investment flows over time (Chart 4). What is the net effect of social largesse at home and great power competition abroad? Larger budget deficits. Fiscal expansionism is the key mechanism for the US and China to reboot their economies, reduce social pressures, secure supply chains, and compete with other each other. And expansionary fiscal policies will boost inflation expectations on the margin. One thing is clear: China’s regime will be imperiled if instead of common prosperity and “national rejuvenation” it gets economic collapse. Beijing is already seeing capital outflows reminiscent of the crisis period in 2014-15 when aggressive reforms triggered a collapse in risk appetite and a stock market crash (Chart 5). The implication is that monetary and fiscal easing will accompany the reform agenda. Chart 4China's New Policies Will Deter Foreign Investment Chart 5Capital Flight And Capital Controls A Risk If Implementation Aggressive That would be marginally positive for global growth and EM countries that export to China. Investors in China, however, will have to deal with greater policy uncertainty as China attempts to redistribute wealth while waging a cold war abroad. Investment Takeaways None of Beijing’s social goals can be met if overall growth and job creation slow too much. Reforms are constantly subject to the ultimate constraint of maintaining overall stability. Already in 2021 Beijing is verging on excessive monetary and fiscal policy tightening (Chart 6). The Politburo signaled in July that it would take its foot off the brakes but policy uncertainty is still wreaking havoc in the equity market and overall animal spirits are downbeat. We expect policy to ease over the coming year to ensure stability ahead of the twentieth national party congress. This would be marginally good news for global growth, contingent on the effects of the global pandemic. Of course we cannot deny that more bad news for global risk assets may be necessary in the very near term to prompt the policy easing that we expect. Policymakers will backtrack on various policies when the market revolts or when the risk of debt-deflation rears its ugly head. Corporate and even household debt have expanded so much in recent years that Chinese policymakers have their hands tied when they try to push reforms too aggressively (Chart 7). A Japanese-style combination of a shrinking and graying population could create a feedback loop with debt deleveraging in the event of a sharp drop in asset prices. On the whole we maintain a pessimistic outlook on Chinese currency and assets. Chart 6China Runs Risk Of Overtightening Policy Chart 7Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com     Appendix Table A1China: 10-Point Guidelines On Government Under Rule Of Law (2021-25) Footnotes 1     See Arthur R. Kroeber, “Xi Jinping’s Ambitious Agenda for Economic Reform in China,” Brookings, November 17, 2013, brookings.edu. 2     Chongqing’s property tax only affects luxury houses. Shenzhen and Hainan are the next pilot projects.

Highlights US crude oil output will continue its sharp recovery before leveling off by mid-2022, in our latest forecast (Chart of the Week). The recovery in US production is led by higher Permian shale-oil production, which is quietly pushing toward pre-COVID-19 highs while other basins languish. Permian output in July was ~ 143k b/d below the basin's peak in Mar20, and likely will surpass its all-time high output in 4Q21. Overall US shale-oil output remains ~ 1.1mm b/d below Nov19's peak of 9.04mm b/d, but we expect it to end the year at 7.90mm b/d and to average 8.10mm b/d for 2022. We do not expect US crude oil production to surpass its all-time high of 12.9mm b/d of Jan20 by the end of 2023. Instead, exploration & production (E&P) companies will continue to prioritize shareholders' interests. This means larger shares of free cashflow will go to shareholders, and not to drilling for the sake of increasing output. While our overall balances estimates remain largely unchanged from last month, we have taken down our expectation for demand growth this year by close to 360k b/d and moved it into 2022, due to continuing difficulties containing the COVID-19 Delta variant. Our Brent crude oil forecasts for 2H21, 2022 and 2023 remain largely unchanged at $70, $73 (down $1) and $80/bbl. WTI will trade $2-$3/bbl lower. Feature Chart 1US Crude Recovery Continues Global crude oil markets are at a transition point. The dominant producer – OPEC 2.0 – begins retuning 400k b/d every month to the market from the massive 5.8mm b/d of spare capacity accumulated during the COVID-19 pandemic. For modeling purposes, it is not unreasonable to assume this will be a monthly increment returned to the market until the accumulated reserves are fully restored. This would take the program into 2H22, per OPEC's 18 July 2021 communique issued following the meeting that produced this return of supply. Thereafter, the core group of the coalition able to increase and sustain higher production – Kuwait, the UAE, Iraq, KSA and Russia – is expected to meet higher demand from their capacity.1 There is room for maneuver in the OPEC 2.0 agreement up and down. We continue to expect the coalition to make supply available as demand dictates – a data-dependent strategy, not unlike that of central banks navigating through the pandemic. This could stretch the return of that 5.8mm b/d of accumulated spare capacity further into 2H22 than we now expect. The pace largely depends on how quickly effective vaccines are distributed globally, particularly to EM economies over the course of this year and next. US Shale Recovery Led By Permian Output While OPEC 2.0 continues to manage member-state output – keeping the level of supply below that of demand to reduce global inventories – US crude oil output is quietly recovering. We expect this to continue into 1H22 (Chart 2). Chart 2Permian Output Recovers Strongly The higher American output in the Lower 48 states primarily is due to the continued growth of tight-oil shale production in the low-cost Permian Basin (Chart 3). This has been aided in no small part by the completion of drilled-but-uncompleted (DUC) wells in the Permian and elsewhere. Chart 3E&Ps Favor Permian Assets Since last year’s slump, the rig count has increased; however, compared to pre-pandemic levels, the number of rigs presently deployed are not sufficient to sustain current production. The finishing of DUC wells means that, despite the low rig count during the pandemic, shale oil supply has not dipped by a commensurate amount. This is a major feat, considering shale wells’ high decline rates. Chart 4US Producers Remain Focused On Shareholder Priorities DUCS have played a large role in sustaining overall US crude oil production. According to the EIA, since its peak in June 2020, DUCs in the shale basins have fallen by approximately 33%. As hedges well below the current market price for shale producers roll off, and DUC inventories are further depleted, we expect to see more drilling activity and the return of more rigs to oil fields. We do not expect US crude oil output to surpass its all-time high of 12.9mm b/ of Jan20 by the end of 2023. Instead, exploration & production (E&P) companies will continue to prioritize shareholders' interests. This means only profitable drilling supporting the free cashflow that allows E&Ps to return capital to shareholders will receive funding. US oil and gas companies have a long road back before they regain investors' trust (Chart 4).   Demand Growth To Slow We expect global demand to increase 5.04mm b/d y/y in 2021, down from last month's growth estimate of 5.4mm b/d. We have taken down our expectation for demand growth this year by ~ 360k b/d and moved it into 2022, because of reduced mobility and local lockdowns due to continuing difficulties in containing the COVID-19 Delta variant, particularly in Asia (Chart 5).2 We continue to expect the global rollout of vaccines to increase, which will allow mobility restrictions to ease, and will support demand. This has been the case in the US, EU and is expected to continue as Latin America and other EM economies receive more efficacious vaccines. Thus, as DM growth slows, EM oil demand should pick up (Chart 6). Chart 5COVID-19 Delta Variant's Spread Remains Public Health Challenge Chart 6EM Demand Growth Will Offset DM Slowdown Net, we continue to expect demand for crude oil and refined products to grind higher, and to be maintained into 2023, as mobility rises, and economic growth continues to be supported by accommodative monetary policy and fiscal support. If anything, the rapid spread of the Delta variant likely will predispose central banks to continue to slow-walk normalizing monetary policy and interest rates. Global Balances Mostly Unchanged Chart 7Oil Markets To Remain Balanced Although we have shifted part of the demand recovery into next year, at more than 5mm b/d of growth, our 2021 expectation is still strong. This is expected to continue next year and into 2023 although not at 2021-22 rates. Continued production restraint by OPEC 2.0 and the price-taking cohort outside the coalition will keep the market balanced (Chart 7). We expect OPEC 2.0's core group of producers – Kuwait, the UAE, Iraq, KSA and Russia – will continue to abide by the reference production levels laid out in 18 July 2021 OPEC communique. Capital markets can be expected to continue constraining the price-taking cohort's misallocation of resources. These factors underpin our call for balanced markets (Table 1), and our view inventories will continue to draw (Chart 8). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23Our balances assessment leaves our price expectations unchanged from last month, with Brent's price trajectory to end-2023 intact (Chart 9). We expect Brent crude oil to average $70, $73 and $80/bbl in 2H21, 2022 and 2023, respectively. WTI is expected to trade $2-$3/bbl lower over this interval. Chart 8Inventories Will Continue To Draw Chart 9Brent Prices Trajectory Intact   Investment Implications Balanced oil markets and continued inventory draws support our view Brent and refined-product forward curves will continue to backwardate, even if the evolution of this process is volatile. As a result, we remain long the S&P GSCI and the COMT ETF, which is optimized for backwardation. We continue to wait for a sell-off to get long the SPDR S&P Oil & Gas Exploration & Production ETF (XOP ETF).   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 The US EIA expects natural gas inventories at the end of the storage-injection season in October to be 4% below the 2016-2020 five-year average, at 3.6 TCF. At end-July, inventories were 6% below the five-year average (Chart 10). Colder-than-normal weather this past winter – particularly through the US Midwest and Texas natural gas fields – affected production and drove consumption higher this past winter, which forced inventories lower. Continued strength in LNG exports also are keeping gas prices well bid, as Asian and European markets buy fuel for power generation and to accumulate inventories ahead of the coming winter. Base Metals: Bullish The main worker’s union at Chile's Escondida mine, the largest in the world, and BHP reached an agreement on Friday to avoid a strike. The mine is expected to constitute 5% of total mined global copper supply for 2021. China's refined copper imports have been falling for the last three months (Chart 11). Weak economic data – China reported slower than expected growth in retail sales and manufacturing output for July – contributed to lower import levels.  Precious Metals: Bullish Gold has been correcting following its recent decline, ending most days higher since the ‘flash crash’ last Monday, facilitated by a drop in real interest rates. The Jackson Hole Symposium next week will provide insights to market participants regarding the Fed’s future course of action and if it is in fact nearing an agreement to taper asset purchases. According to the Wall Street Journal, some officials believe the program could end by mid-2022 on the back of strong hiring reports. This was corroborated by minutes of the FOMC meeting which took place in July, which suggested a possibility to begin tapering the program by year-end. While the Fed stressed there was no mechanical relationship between the tapering and interest rate hikes, this could be bearish for gold, as real interest rates and the bullion move inversely. On the other hand, political uncertainty and a potential economic slowdown in China will support gold prices. Ags/Softs: Neutral Grain and bean crops are in slightly worse shape this year vs the same period in 2020, according to the USDA. The Department reported 62% of the US corn crop was in good to excellent condition for the week ended 15 August 2021, compared to 69% for the same period last year. 57% of the soybean crop was in good-to-excellent shape for the week ending on the 15th vs 72% a year ago. Chart 10 Chart 11 Footnotes 1 Please see our report of 22 July 2021, OPEC 2.0's Forward Guidance In New Baselines, which discusses the longer-term implications of this meeting and the subsequent communique containing the OPEC 2.0 core group's higher reference production levels. It is available at ces.bcareserch.com. 2 S&P Global Platts notes China's most recent mobility restrictions throughout the country will show up in oil demand figures in the near future. We expect similar reduced mobility as public health officials scramble to get more vaccines distributed. Please see Asia crude oil: Key market indicators for Aug 16-20 published 16 August 2021 by spglobal.com. Investment Views and Themes Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed In 2021 Summary of Closed Trades

Highlights Alternative energy is priced to deliver spectacular long-term earnings growth, but this will be a very tough ask. While alternative energy will take a greater share of the energy pie, the pie itself is shrinking, as is its price. At its current valuation, alternative energy does not meet the conditions to be in a long-term investment portfolio. As the Ethereum network becomes the ‘go to’ place to implement and execute smart contracts or decentralised finance, such services will have to be paid in ETH giving the token an economic value. ETH should certainly form a small part of a long-term investment portfolio. A near-term combination of valuation and technical constraints means that stocks will struggle to outperform ultra-long bonds. Fractal analysis: India versus China. Feature Chart of the WeekThe World Is Using Much Less Energy Per Unit Of Economic Output Alternative Energy Blues Alternative energy is the meme theme of the moment. Hardly a day passes without some exhortation to save the planet, by substituting fossil fuels with cleaner forms of energy. Yet this year, alternative energy stocks have performed dismally. Since January, the sector is down 30 percent in absolute terms, and almost 40 percent versus the broad market. Begging the question, how can one of the biggest themes of the moment be one of the worst investment performers? Last year, the forward earnings of the alternative energy sector rose by 35 percent, helped by post-pandemic stimulus measures that targeted the clean energy industry. But as investors fell in love with this meme theme, the bigger story was that the valuation paid for the sector skyrocketed from 13 times forward earnings to a nosebleed 42 times, an increase of 220 percent (Chart I-2 and Chart I-3). Chart I-2Alternative Energy Earnings Rose... Chart I-3...But The Valuation Skyrocketed To put the 42 into context, the peak multiple of the tech sector has reached ‘only’ 29 this cycle, meaning that alternative energy was trading at a near 50 percent premium even to the daddy of growth sectors! This year, as investors have pared back the nosebleed valuation, the alternative energy sector has underperformed. Nevertheless, it is still trading at a 25 percent premium to tech, meaning that its profits will have to deliver spectacular long-term growth to justify the sky-high valuation. Is this likely? We are not convinced. The world is using less energy per unit of economic output. A fundamental rule of long-term investment is that you shouldn’t own any sector whose sales are shrinking as a share of the economy. The problem for alternative energy is that it is, ultimately, energy (Chart I-4). And the world is using less energy per unit of economic output. Chart I-4Alternative Energy And Traditional Energy Show Similar Earnings Profiles In 1995, every $1000 of real GDP used 157 kilograms of oil equivalent energy. Today, that has plunged to 109 kilograms. Meaning that over the past 25 years, the world economy has reduced its energy intensity by 30 percent.1 And the downtrend persists (Chart I-1). Granted, over the past 25 years, the share of the energy pie taken by non-fossil fuels has increased from 13.4 to 16.9 percent, of which renewables have increased from 0.6 to 5.7 percent. But the marginal prices of wind, solar, and geothermal power generation are collapsing. As a recent report from the International Renewable Energy Agency (IRENA) points out: Generation costs for onshore wind and solar photovoltaics (PV) have fallen between 3 percent and 16 percent yearly since 2010 – far faster than anything in our shopping baskets or household budgets… (and) auction results show these favourable cost trends continuing through the 2020s.2 Given that the alternative energy market is competitive rather than monopolistic or oligopolistic, a large part of these massive cost savings will be passed on to end-users. Constituting a long-term boon to consumers rather than to alternative energy profits. To repeat, with the alternative energy sector still trading at a 25 percent premium to tech, it must deliver spectacular long-term earnings growth. But this will be a very tough ask. Energy sector profits tightly track the value of energy produced, meaning volume times price (Chart I-5). The risk is that while alternative energy will take a greater share of the energy pie, the pie itself is shrinking, as is its price. Chart I-5Energy Sector Profits Tightly Track The Value Of Energy Produced (Volume Times Price) We conclude that with an ambiguous outlook for long-term earnings growth, alternative energy does not meet the conditions to be in a long-term investment portfolio at its still nosebleed valuation multiple of 32 times forward earnings.  Now let’s turn to an investment that you should have in a long-term investment portfolio. The London Hard Fork Is A Boon For The Ethereum Network The Ethereum network’s London hard fork – an event that passed under most radar screens – marks the shape of things to come for the blockchain and the cryptocurrency space. Crucially, it signals an ongoing sea-change that favours the Ethereum network’s users at the expense of its cryptocurrency miners. For those interested in the nerdy details, we direct you to Ethereum Improvement Protocol (EIP) 1559. But to cut to the chase, the fork has drastically reduced the profitability of Ethereum mining while “ensuring that only ETH can ever be used to pay for transactions on Ethereum, cementing the economic value of ETH within the Ethereum platform.” Only ETH can ever be used to pay for transactions on Ethereum, cementing the economic value of ETH within the Ethereum platform. The statements of intent address, and will ultimately alleviate, two of the biggest investment concerns about cryptocurrencies – first, that cryptocurrency mining is a prodigious user of energy, particularly dirty energy; and second, that as cryptocurrencies cannot be readily exchanged for goods and services, they have no value other than that from other investors believing they have value. Addressing the first concern, mining becomes irrelevant if the blockchain users employ the skin in the game ‘proof-of-stake’ protocol to validate transactions rather than the energy-intensive ‘proof-of-work’ protocol that relies on external miners. Which is where Ethereum is headed with the fully proof-of-stake Ethereum 2.0. Addressing the second concern, if the Ethereum network becomes the ‘go to’ place to implement and execute smart contracts or decentralised finance, then such services will have to be paid in ETH, giving the tokens an economic value. Hence, the key structural question is, which blockchain networks will become the go to places for decentralised intermediation? Ethereum is an excellent candidate. Note that the lending arm of the EU, the European Investment Bank, has effectively endorsed the Ethereum network by issuing a €100 million digital bond on it. And although the principal “is expected to be repaid in euros”, the intermediators get paid in ETH. Crucially, the token of a successful blockchain network will become the de-facto currency of the network, exchangeable for intermediation services on that network. With a value independent of speculative investments, investors can also justifiably own these tokens as a ‘digital gold.’ Clearly, cryptocurrencies experience a higher volatility than gold, but this can be adjusted through position sizing. To equalise drawdowns in digital gold versus gold, investors should own $1 of cryptocurrency for every $3 of gold (Chart I-6). On this relative risk basis, cryptocurrencies should constitute at least one quarter ($3.8 trillion) of the $15 trillion ‘anti-fiat’ market that gold currently dominates.  Chart I-6Cryptocurrency Drawdowns Are Becoming Less Severe Therefore, if Ethereum became the dominant cryptocurrency based on its network size, it would command a market capitalisation of at least $1.9 trillion, a more than five-fold increase from today. ETH should certainly form a small part of a long-term investment portfolio. Stocks Versus Bonds Face A Double Constraint Since mid-March the world stock market (MSCI All Country World Index) has rallied by 10 percent, but the ultra-long bond (30-year T-bond) has done even better, rallying by 14 percent. Hence stocks to bonds have drifted gently lower, for which there are two reasons. First, the valuation of the most highly-rated parts of the stock market have reached the limit that has held in the post-GFC era. Specifically, tech’s earnings yield premium versus the 10-year T-bond has reached its 2.5 percent lower bound (Chart I-7). Chart I-7Tech Reached Its Post-GFC Valuation Limit Versus Bond Yields Second, the groupthink in overweighting stocks versus bonds reached an extreme. All investors up to 260-day investment horizons are already in the trade, and this level of extreme groupthink correctly signalled stocks versus bonds major-tops in 2010 and 2013 (as well as major-bottoms in 2008 and 2020) (Chart I-8). Chart I-8The Groupthink In Overweighting Stocks Versus Bonds Reached An Extreme This near-term combination of valuation and technical constraints means that stocks will struggle to outperform ultra-long bonds. In the near term, stocks will struggle to outperform ultra-long bonds. Nevertheless, if bonds rally, it will support stocks. But if bonds sell off, it will undermine stocks. The implication of the above is that a bond sell-off – should it even occur – will be self-limiting. As we explained last week in Stocks, Not The Economy, Will Set The Upper Limit To Bond Yields, the upper limit to the 10-year T-bond yield is 1.8 percent. India Trading At A Precarious Premium This week’s fractal analysis highlights that the spectacular outperformance of India versus China has reached the limit of fragility on its 260-day fractal structure that marked previous major-tops in 2014, 2016, and 2019 (as well as major bottoms in 2015, 2018, and 2020) (Chart I-9). Chart I-9The Outperformance Of India Versus China Is Fragile In effect, as China’s tech sector has recently corrected, tech stocks in India are now trading at a precarious 60 percent premium to those in China (Chart I-10). Chart I-10India Is Trading At A Precarious Premium To China The recommended trade is to short India versus China (MSCI indexes), setting the profit target and symmetrical stop-loss at 19 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Source: World Bank, and BP Statistical Review of World Energy 2021 2 Source: Renewable Power Generation Costs In 2019, International Renewable Energy Agency Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Highlights A critical aspect of the diffusion of global geopolitical power – “multipolarity” – is the structural rise of India. India will gain influence in the coming five years as a growing importer of goods, services, oil, and capital. Trade with China is a positive factor in Sino-Indian relations but it will not be enough to offset the build-up of strategic tensions. Indo-Russian relations will also wane. India’s slow transition to green energy will give it greater sway in the Middle East but will not remove its vulnerability if the region destabilizes anew over Iran. Sino-Indian tensions have already affected capital flows, with the US building on its position as a major foreign investor. Feature Chart 1Sino-Pak Alliance’s Geopolitical Power Is Thrice That Of India India’s geopolitical power pales in comparison to that of the China-Pakistan alliance (Chart 1). India is traditionally an independent and “non-aligned” power that has managed conflicts with its neighbors by influencing either Russia or America to display a pro-India tilt. This strategy has held India in good stead as it helps create the illusion of a “balance of power” in the South Asian region. Structural changes are now afoot: Sino-Pakistani assertiveness toward India continues. But in a break from the past India’s Modi-led Bhartiya Janata Party (BJP) has been constrained to adopt a far more assertive stance itself. Russo-Indian relations face new headwinds. Russia has been a close historical partner of India. But Russia under President Vladimir Putin has courted closer ties with China, while the US has tried to warm up with India since President Bush. Under Presidents Trump and Biden, the US is taking a more confrontational approach to Russia and China and will continue to court India. Against this backdrop the key question is this: In a multipolar world, how will India’s relations with the Great Powers evolve over the next five years? Will the alliances of the early 2000s stay the same or will they change? And if they change, what will it mean for global investors? In this special report we provide a helicopter view of India’s relations with key countries. We do so by examining India’s trade and capital flows with the world. A country’s power to a large extent is a function not only of its population and military strength but also of the business interests it represents. India today is the second largest arms importer globally (guns), fifth largest recipient of global FDI flows (capital) and third largest importer of energy (oil). Looking at the trajectory of these business relations, we quantify the magnitude and sources of India’s geopolitical power over the next five years and its investment implications. Trade: India’s Imports Not Enough To Offset China Tensions “The 11th Law of Power - Learn to Keep People Dependent on You. To maintain your independence, you must always be needed and wanted. The more you are relied on, the more freedom you have.” – Robert Greene, The 48 Laws of Power1 A small and closed economy in the 1980s, India today is large and open. Since India lacked industrial capabilities, and was energy-deficient to start with, its import needs grew manifold over this period. India’s current account deficit has increased by nine times from 1980 to 2019. The magnitude of India’s appetite for imports is such that its current account deficit is the fifth largest in the world today (Chart 2). Chart 2India Is The Fifth Largest Importer Of Goods And Services Given its lack of domestic energy and industrial capabilities, India’s role as a client of the world will only become more pronounced as it grows. In fact, India appears all set to become the third largest importer of goods and services globally over the next five years (Chart 3). Chart 3India Will Become The Third Largest Net Importer, After US And UK, By 2026 Global history suggests that the client is king. The rise and fall of empires have been driven by the strength of their economies and militaries. Great powers import lots of goods and resources – and tend to export arms. The UK’s geopolitical decline over the nineteenth century, and America’s rise over the twentieth, were linked to their respective status as importers within the global economy. India’s rise as a large global importer will prove to be a key source of diplomatic leverage over the next five years. For example, India’s high appetite for imports from China will give India much-needed leverage in bilateral relations. Also, India’s slow transition to green energy continued reliance on oil will strengthen its bargaining power vis-à-vis oil producers. But these trends also bring challenges. Structurally, Sino-Indian tensions are rising and trade will not be enough to prevent them. Meanwhile dependency on the volatile Middle East is a geopolitical vulnerability. China: India’s Growing Might As A Consumer Increases Leverage Vis-à-Vis China China’s rising assertiveness in South Asia and India’s own inclination to adopt an assertive foreign policy stance will lead to structurally higher geopolitical tensions in the region. So, is a full-blooded confrontation between the two nigh? No. First, Sino-Indian wars have always been constrained by geography: they are separated by the Himalayas, which help to keep their territorial disputes contained, driving them toward proxy battles rather than direct and total war. Second, India, Pakistan, and China are nuclear-armed powers which means that war is constrained by the principle of mutually assured destruction. This principle is not absolute – world history is filled with tragedy. There are huge structural tensions lurking in the combination of China’s Eurasian strategy and growing Sino-Indian naval competition that will keep Sino-Indian geopolitical risks elevated. Nevertheless, the bar to a large-scale war remains high. In the meantime, India’s growing might as a consumer could act as a much-needed deterrent to conflict. The last two decades saw America’s share in Chinese exports decline from a peak of 21% to 17% today. With US-China relations expected to remain fraught under Biden and with the US looking to revive its strategic anchor in the Pacific and shore up its domestic manufacturing strength, China’s trade relations with America will continue to deteriorate regardless of which party holds the White House. Against such a backdrop, China will try to build stronger trading ties with countries like India whose share in China’s exports has been growing (Chart 4). After excluding Hong Kong, India today is the eighth-largest exporting destination for China. While it only accounts for 3% of China’s exports, this ratio is comparable to that of larger exporting partners like Vietnam (4% share in China’s exports), South Korea (4%), Germany (3%), Netherlands (3%), and the UK (3%). In other words, China’s need for India is underrated and growing. There are two problems with Sino-Indian trade going forward. First, the strategic tensions mentioned above could prevent trade ties from improving. Over the past decade, Sino-Indian maritime and territorial disputes have escalated while Sino-Indian trade has merely grown in line with that of other emerging markets (Chart 5). China’s rising import dependency has led it to develop both a navy and an overland Eurasian strategy. The Eurasian strategy threatens India’s security in border areas of South Asia, while India’s own naval rise and alliances heighten China’s maritime supply insecurity. These trends may or may not prevent trade from living up to its potential, but they could result in strategic conflict regardless. Chart 4Amongst Top Chinese Export Clients, India’s Importance Has Increased Chart 5India’s Imports From China Have Broadly Grown In Line With Peers Second, the trade relationship itself is imbalanced. India imports heavily from China but sells little into China. China is responsible for more than a third of India’s trade deficit. At the same time, India increasingly shares the western world’s concern about network security in a world where cheap Chinese hardware could become integral to the digital economy. If Sino-Indian diplomacy cannot redress trade imbalances, then trade will generate new geopolitical tensions rather than resolve other ones. One should expect China to court India in the context of rising American and western strategic pressure. Yet China has failed to do so. Why? Because China’s economic transition – falling export orientation and declining potential GDP – is motivating a rise in nationalism and an assertive foreign policy. Meanwhile India’s own economic difficulties – the need to create jobs for a growing population – are generating an opposing wave of nationalism. Thus, while Sino-Indian trade will discourage conflict on the margin, it may not be enough to prevent it over the long run. Oil: As India Lags On Green Transition, Its Significance As An Oil Consumer Will Rise Whilst renewable energy’s share of India’s energy mix is expected to grow, the pace will be slow. Moreover, India’s increased reliance on green energy sources over the next decade will come at the expense of coal and not oil (Chart 6). Consequently, India’s reliance on oil for its energy needs is expected to stay meaningful. Chart 6India’s Reliance On Oil Will Persist For The Next Decade And Beyond Chart 7India’s Importance As An Oil Client Has Been Rising The International Energy Agency (IEA) forecasts that India’s net dependence on imported oil for its overall oil needs will increase from 75% today to above 90% by 2040. But India’s relative importance as an oil client will also grow as most large oil consumers will be able to transition to green energy faster than India. In fact, data pertaining to the last decade confirms that this trend is already underway. India’s share of the global oil trade has been rising (Chart 7). In particular, India has taken advantage of Iraq’s rise as a producer after the second Gulf War and has marginally increased imports from Saudi Arabia (Chart 8). Chart 8India’s Importance As A Client Has Been Rising For Top Oil Exporters Iran is the country most likely to gain from this dynamic in the coming years – if the US and Iran strike a deal to curb Iran’s nuclear program in exchange for the US lifting economic sanctions. India has maintained stable imports from the Middle East over the past decade despite nominally eliminating imports of oil from Iran (Chart 9). Chart 9India Has Maintained Stable Imports From The Middle East However, while India will have greater bargaining power between OPEC and non-OPEC suppliers, dependency on the unstable Middle East is always a geopolitical liability. If the US and Iran fail to arrive at a deal, a regional conflict is likely, in which case India’s slow green transition and vulnerability to supply disruptions will become a costly liability. Bottom Line: India’s growing importance to both Chinese manufacturers and global oil producers will give it leverage in trade negotiations. However, ultimately, national security will trump economics when it comes to China, while India will remain extremely vulnerable to instability in the Middle East. Guns: Indo-Russian Relations Weaken “When the war broke out [between India & Pakistan in 1971], the Soviet Union cast aside all pretentions of neutrality and non-partisanship… the Russians were in no hurry to terminate the fighting since their interest was better served by the continuation of hostilities leading to an India victory … The factors that decisively determined the outcome of the war were: first, Soviet military assistance to India; secondly the USSR’s role in the UN Security council; and thirdly, Russia strategy to prevent a direct Chinese intervention in the war.” – Zubeida Mustafa, "The USSR and the Indo-Pakistan War"2 The true origins of Russia’s pro-India tilt can be traced back to 1971. The former Soviet Union’s support for India played a critical role in helping India win the Indo-Pakistan war of 1971. Half a century later the Indo-Russia relationship persists, but its intensity has declined and will continue declining over the next few years. We see three reasons: America’s withdrawal from Iraq and Afghanistan will allow the US to focus more intently on its rivalry with China and Russia – a dynamic that is reinforcing China’s and Russia’s move closer together. Meanwhile India’s relationship with the US continues to improve. The China-Pakistan alliance continues to strengthen. Beyond cooperation on China’s ambitious Belt and Road Initiative, Pakistan shares a deep relationship with China based on defense and trade (Chart 10). Hence India is distrustful of closer Russo-Chinese relations. In light of this strategic re-alignment, Russia may see value in developing a closer defense relationship with China. Trading relations between Russia and India are minimal even today. Hence unlike in the case of China, there exists no backstop on weakening of Russo-Indian relations. Less than 1.5% of India’s merchandise imports come from Russia and less than 1% of India’s exports go to Russia. Russia’s share of Indian oil imports has grown in recent years but only to 1.4% of total. Meanwhile the US share of India’s imports has catapulted to 5.7% since the US became an exporter. Any removal of Iran sanctions will come at the cost of other Middle Eastern exporters, not these two alternatives to the risky Persian Gulf, but Russia’s share is still small. Now the backbone of Indo-Russia relations has been their arms trade. However, India’s reliance on Russia for arms could decline over the next five years. India today is Russia’s largest arms client accounting for 23% of its arms sales (Chart 10). However, second in line is China which accounts for 18% of Russia’s arms sales. Given that Russia’s share in global arms exports has been declining (Chart 11), Russia will be keen to reverse or at least halt this trend. Russia can do so most easily by selling more arms to India or to China. Even as China appears to be increasingly focused on developing indigenous arms production capabilities, for reasons of strategy, China appears like a better client for Russia to bank on for the next decade. After all, in 1989, when western countries imposed an arms embargo against China in response to events at Tiananmen Square, Russia became the prime supplier of arms to China. Chart 10India Is A Key Client For Russia, As Is China By contrast, for reasons of strategy India appears like a less promising client to bank on for Russia. India’s import demand for arms has been declining while China’s demand is increasing (Chart 12). India under the Modi-led Bhartiya Janata Party (BJP) has been reducing its reliance on imported arms. Last month, for example, the Indian Ministry of Defense (MoD) said that it has set aside 64% of the defense capital budget for acquisitions from domestic companies.3 This is an increase of 6% over last year, which was the first time such a distinction between domestic and foreign defense expenditure was made. Whilst it will take years for India to develop its domestic arms production capabilities, India’s inward tilt is worrying for traditional suppliers like Russia. Chart 11Among Top Arms Exporters, Russia Is Losing Market Share Chart 12India’s Appetite For Arms Imports Is Falling Moreover, Russia is aware that the situation is rife for US-India arms trade to strengthen given that India is starting to display a pro-US tilt. Groundwork for a sound defense relationship with India has already been laid out by the US as evinced by: Foundational agreements: India and the US signed the Communications, Compatibility, and Security Agreement (COMCASA) in 2018 and the Basic Exchange and Cooperation Agreement (BECA) in 2020. Sanction exemptions: The US had applied sanctions on Turkey under the Countering America's Adversaries Through Sanctions Act (CAATSA) for Ankara’s purchase of Russia’s S-400 missile defense system in 2020. The US has threatened India with CAATSA sanctions for buying S-400 missile defense systems from Russia but has not applied these sanctions to India (at least not yet). Not applying CAATSA sanctions to India allows the US to strengthen its strategic relations with India that can help further the American goal of creating a counter to China in Asia. Bottom Line: India-Russia relations will remain amicable, but this relationship is bound to fade over the next five years as the US counters China and Russia. Limited backstops exist for Indo-Russia ties. Economic ties between India and Russia are minimal, as India is cutting back on arms imports and only marginally increasing oil imports. Capital: China Investment Down, US Investment Up “America has no permanent friends or enemies, only interests.” – Henry Kissinger, Former US Secretary of State India’s economic growth rates could be higher if it did not have to deal with the paradox of plentiful savings alongside capital scarcity. Even as Indian households are known to be thrifty, only a limited portion of their savings is available for being borrowed by small firms. Almost a quarter of bank deposits are blocked in government securities. More than a third of adjusted net bank credit must be made available for government-directed lending. With what is left, banks prefer lending the residual funds to large top-rated corporates. It is against this backdrop that foreign direct investment (FDI) flows provide much needed succor to Indian corporates, particularly capital-guzzling start-ups. FDI inflows into India have become a key source of funding for Indian corporates over the last decade with annual FDI flows often exceeding new bank credit. Correspondingly, for FDI investors, India provides the promise of high returns on investment in an emerging market that offers political stability. India emerged as the fifth largest FDI destination globally in 2020. Amongst suppliers of FDI into India (excluding tax havens like Cayman Islands), the US and China have been top contributors. Whilst China has been a leading investor into the Indian start-up space, geopolitical tensions have translated into regulatory barriers that prevent Chinese funds from investing in India. Separately, as Indo-US relations improve, the symbiotic relationship between capital-rich US funds and capital-hungry Indian start-ups should strengthen. In fact, in 2020 itself, Chinese private equity (PE) and venture capital (VC) investments into India shrank whilst American investments into India doubled, according to Venture Intelligence (Chart 13). Distinct from Chinese funds’ restrained ability to invest in Indian firms, Indian tech start-ups could potentially benefit from reduced global investor appetite in Chinese tech stocks owing to China’s regulatory crackdown and breakup with the United States. China’s foreign policy assertiveness and domestic policy uncertainty may lead to a reallocation of FDI flows away from China and into India. China (including Hong Kong) has been a top host country for FDI, attracting 4x times more funds than India (Chart 14). However, India’s ability to absorb these reallocated funds over the next five years will be a function of sectoral competencies. For instance, India’s information and communications technology (ICT) sector appears best positioned to benefit from this trend. But the same may not be the case for sectors like manufacturing that traditionally attract large FDI flows in China yet are relatively underdeveloped in India. On the goods’ front, given that India’s comparative advantage lies in the production of capital-light, labor-light and medium-tech intensive products, pharmaceuticals and chemicals could be two other industries that attract FDI flows in India. Chart 13Chinese PE/VC Investments Into India In 2020 Slowed Significantly Chart 14China Has Been A Top Host Country For FDI, Attracting 4x More Flows Than India Bottom Line: Whilst trade between India and China has not been affected much by geopolitical tensions, capital flows have been. Given that the US historically has been a top FDI contributor in India, and given improving Indo-US relations, FDI investment into India from the US appears set to rise steadily over the next five years, particularly into the ICT sector. Investment Conclusions China-India geopolitical tensions are here to stay and will be a recurring feature of South Asia’s geopolitical landscape. However, a growing trade relationship could discourage conflict, especially if it becomes more balanced. It may not be enough to prevent conflict forever but it is an important constraint to acknowledge. India’s current account deficit will remain vulnerable to swings in oil prices, but it may be able to manage its energy bill better as its bargaining power relative to oil suppliers improves. The problem then will become energy insecurity, particularly if the US and Iran fail to normalize relations. As India and Russia explore new alignments with USA and China respectively, the historic Indo-Russia relationship will weaken. It will not collapse entirely because Russia provides a small but growing alternative to Mideast oil. US-India business interests may deepen as India considers joint ventures with American arms manufacturers and American funds court India’s capital-hungry information and communications technology sector. Against this backdrop we reiterate our constructive strategic view on India. However, for the next 12 months, we remain worried about near-term geopolitical and macro headwinds that India must confront.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 (Viking Press, 1998). 2 Mustafa, Zubeida. "The USSR and the Indo-Pakistan War, 1971" Pakistan Horizon 25, No. 1 (1972): 45-52. 3 Ajai Shukla, "Local procurement for defence to see 6% hike this year: Govt to Parliament" Business Standard, July 2021.

Highlights Since 2008, the 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. Based on the current technology earnings yield of 3.8 percent, and the 10-year T-bond yield at 1.3 percent, stock markets are on the edge of rationality. But at the limit, the elastic can briefly stretch by around 0.5 percent before it eventually snaps back. Hence, the 10-year T-bond yield could make a brief trip to 1.8 percent before reversing. The labour market participation rate for African Americans dropped sharply in July to 2.3 percent below its pre-pandemic benchmark level. The weakest performing demographic group could set the employment condition for the Fed’s lift-off, making it later than the market is pricing. The next shock will drive down the T-bond yield to its ultimate low, and the stock market’s valuation to its ultimate high. Fractal analysis: NOK/GBP, Hong Kong versus the world, and Netherlands versus New Zealand. Feature Chart of the WeekSince 2008, The 10-Year T-Bond Yield Has Struggled to Exceed the Earnings Yield On Tech (Minus A Constant Of 2.5 Percent) Since 2008, a remarkable financial relationship has held true. The 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. The 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. T-bond yield ≤ technology forward earnings yield – 2.5% (Chart I-1). The upshot is that whenever, as now, the yields on tech and other high-flying growth stocks have become depressed – which is to say highly valued – the upper limit to the bond yield has been established not by the economy, but by the financial markets. On the occasions that the bond yield has attempted to breach its stock market-set upper limit, it has unleashed a self-correcting sequence of events. It has pulled up the tech sector earnings yield, which is to say pulled down the tech sector’s valuation and price. Then, to contain and reverse this sharp sell-off, the bond yield has quickly unwound its short-lived spike. Stock Markets Are On The Edge Of Rationality Earlier this year in The Rational Bubble Is Turning Irrational we highlighted that the T-bond yield was at its stock market-set upper limit. And in the subsequent six months, the markets have behaved exactly as predicted. First, tech stocks declined sharply through February-March. Then, bond yields declined sharply through May-July, allowing tech stocks to claw back their declines and then reach new highs. Indeed, since mid-February, the T-bond yield and tech stocks have moved as a near-perfect mirror image (Chart I-2). Chart I-2The T-Bond Yield And Tech Stocks Have Moved As A Near-Perfect Mirror Image In the long run, a depressed earnings yield relative to the bond yield – which is to say a high valuation – can normalise as earnings go up. But in the short term, the adjustment must come from either the equity price declining or the bond yield declining. Or some combination of the two. With the tech earnings yield now at 3.8 percent – and assuming the post-GFC 2.5 percent minimum gap still holds true – it would set the upper limit of the 10-year T-bond yield at 1.3 percent, close to where it is trading today. Still, at the limit, the elastic can briefly stretch before it eventually snaps back. Over the last thirteen years, the maximum stretch has been around 0.5 percent. This means that, based on the current earnings yield of the tech sector, the 10-year T-bond yield could make a brief trip to 1.8 percent before reversing. For equity investors, a higher T-bond yield would support the value versus growth trade. But given that it would be a brief trip, the opportunity would not be cyclical (12-month) but merely tactical (3-month), as has been the case over the past ten years. Since 2012, cyclical opportunities to overweight value versus growth have been virtually non-existent, but there have been several good tactical opportunities (Chart I-3 and Chart I-4). Chart I-3Cyclical Opportunities To Overweight Value Versus Growth Have Been Virtually Non-Existent... Chart I-4...But There Have Been Several Good Tactical Opportunities We await a fractal signal that T-bonds are overbought to initiate this tactical trade. Stay tuned. The Truth About The Jobs Recovery At first glance, last week’s US employment report appeared strong. The unemployment rate continued its plunge from 14.8 percent in April 2020 to 5.4 percent in July 2021, constituting the fastest jobs recovery of all time. But the first glance doesn’t tell the true story.   Unlike in previous recessions, the number of workers put on furlough or ‘temporary layoff’ surged and then plunged as the pandemic let rip and then was brought under control. Hence, to get the true story of the jobs recovery, we must strip out the furloughed workers and focus on the unemployment rate based on those ‘not on temporary layoff’ (Chart I-5). Chart I-5To Get The True Story Of The Jobs Recovery, Focus On Those 'Not On Temporary Layoff' Based on this truer measure of labour market slack, the pace of the current recovery in jobs looks remarkably like the recoveries that followed previous downturns in 1974/75, the early 1980s, the early 1990s, dot com bust, and the GFC. The true story is that the US is little more than a third of the way on the journey to full employment (Chart I-6). Chart I-6The Pace Of The Current Jobs Recovery Looks Remarkably Like Previous Recoveries This is significant, because unlike in previous recoveries, the Federal Reserve is now explicitly targeting full employment before it lifts the policy interest rate. Furthermore, the employment recovery must be broad and inclusive of minority demographic groups, which adds further conditionality for the Fed. While the market is focussing on the aggregate employment market, it is the weakest performing demographic group that could set the condition for the Fed’s lift-off. On this note, the labour market participation rate for African Americans dropped sharply in July to 2.3 percent below its pre-pandemic benchmark level (Chart I-7). This raises an interesting point. While the market is focussing on the aggregate employment market, it is the weakest performing demographic group that could set the condition for lift-off, if the Fed stays true to its promise of inclusivity. Which would push back lift-off to later than the market is pricing. Chart I-7The Labour Market Participation Rate For African Americans Dropped Sharply In July Shocks Do Not Have A Cycle According to the recovery in jobs then, we are still ‘early cycle.’ Some people argue that early cycle implies that a recession is a distant prospect, that stocks only underperform in a recession, and therefore that the bull market in stocks has further to run. The investment conclusion is right, but the reasoning is wrong, on two counts. First, nobody can predict the precise timing of recessions or shocks. Second, recessions or shocks do not have a ‘cycle.’ Shocks can come in quickfire succession such as the back-to-back GFC in 2008 and the euro debt crisis which started in 2010, or the back-to-back votes for Brexit and Trump in 2016 (Chart I-8). Chart I-8Shocks Do Not Have A Cycle Yet, while we cannot predict the precise timing of shocks, The Shock Theory Of Bond Yields tells us that we can predict their statistical distribution very accurately. The upshot is that in any 5-year period, the probability of (at least) one shock is an extremely high 81 percent, and in any 10-year period, it is a near-certain 96 percent.  Given the tight feedback from bond yields to stocks and then back to bond yields, we can say with high conviction that the next shock will drive down the T-bond yield to its ultimate low. This will happen directly from a deflationary shock, or indirectly from an initially inflationary shock that drives up bond yields through the upper limit set by stock valuations. The resulting sharp correction in stocks will then cause bond yields to reverse to the ultimate low. The next shock will drive down the T-bond yield to its ultimate low, and the stock market’s valuation to its ultimate high. In turn, the ultimate low in the T-bond yield will mark the ultimate high in the stock market’s valuation, and the end of the structural bull market in stocks. Until then, long-term investors should own stocks. Fractal Analysis Update This week’s fractal analysis highlights three recent price moves that are at risk of reversal because of fragile fractal structures. First, the recent sell-off in NOK/GBP has become fragile on its 65-day fractal structure implying a likelihood of a countertrend move based on similar recent signals (Chart I-9). Chart I-9NOK/GBP Is Oversold Second, the sell-off following China’s aggressive crackdown on its technology and private education sectors has created fragility in Hong Kong’s relative performance on its composite 65-day/130-day fractal dimension. Assuming the worst of the policy crackdown is over, this would imply a countertrend reversal based on similar signals over the past decade. The recommended trade is long Hong Kong versus developed world (MSCI indexes), setting the profit target and symmetrical stop-loss at 4 percent (Chart I-10). Chart I-10Hong Kong Versus The World Is Oversold Finally, the massive outperformance of tech-heavy Netherlands versus healthcare and utility-heavy New Zealand has reached the limit of fragility on its 260-day fractal structure that signalled major turning points in 2011, 2015, 2016, and 2018 (Chart I-11). Hence the recommended trade is short Netherlands versus New Zealand, setting the profit target and symmetrical stop-loss at 13 percent. Chart I-11Netherlands Versus New Zealand Is Overbought   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Dear client,  In addition to this abridged Strategy Report, we are sending a report written by Arthur Budaghyan, Chief Strategist of BCA’s Emerging Market Investment service. Arthur shares his thoughts on the future of Chinese TMT stocks, a subject we trust you will find insightful and beneficial. Jing Sima China Strategist Highlights Wealth and income inequality may be the most important contributors to rising populism in the past three decades. China has its share of increasing populism; reducing income inequality and improving social welfare are core principles of President Xi’s reform agenda. July’s economic data continues to indicate a softening in China’s economy. However, the magnitude of the slowdown is within policymakers’ pain threshold while the economy remains supported by strong external demand. For now, stay underweight in Chinese stocks within a global equity portfolio.  Policy stance has yet to turn reflationary. Feature Populism Takes Root BCA's China Investment Strategy has argued that China is accelerating the pace of its structural reforms; addressing income inequality is at the core of the current administration’s reform agenda. Wealth and income inequality may be the most important structural cause of rising global populism and political polarization (Chart 1). The severity of income inequality in China is illustrated in Chart 2. It is noteworthy that China, whose political and economic ideology is based on creating a classless society, has found itself not far behind the US in terms of a widening wealth and income gap. Chart 1Populism Has Been On The Rise Globally For The Past 30 Years Chart 2The Great Gatsby Curve Paints A Not-So-Great Equality Picture Of China The relationship between inequality and intergenerational income mobility is captured in the "Great Gatsby Curve" – a concept based on a research paper by economist Miles Corak and later introduced by Alan Krueger, the late professor and Chairman of the Council Economic Advisers, during his speech at the Center for American Progress in 2012.1 The US has experienced a sharp rise in wealth and income inequality since the 1980s. On the eve of the Global Financial Crisis, income inequality in the US was as sharp as it had been since the time of "The Great Gatsby” novel set in the 1920s. After three decades of rapid industrialization and economic expansion, China also faces the challenge of escalating income inequality and discontent among middle-class households. Populism, defined as political stances that emphasize the idea of "the people", often benefits middle-class households, but not big business or corporate earnings (“the elite”). An increase in populist governments is usually positively correlated with rising number of antitrust investigations, since populist leaders tend to pander to popular outcries against big corporations by limiting or breaking up the corporations. In the US, the rise of Reaganism/neoliberalism in the 1980s led to a big drop in antitrust cases – a trend that was sustained for nearly three decades as the free-market Washington Consensus pushed against antitrust and other populist stances (Chart 3). However, the tide turned in 2016 when the US elected a populist president for first time, and antitrust threats started reemerging (Chart 4). Chart 3Antitrust Reinforcement In The US Has Been On A Secular Decline In The Past Two Decades… Chart 4...But Antitrust Noise Is Getting Louder In The US (And Lately In China) Both China and the US have transitioned towards larger government involvement in the economy.  More restrictions on private enterprise and a greater redistribution of wealth will be forthcoming. In the US, there has been a shift towards a larger share of labor compensation versus capital in the country’s national income (Chart 5). In China, the “dual circulation” economic goal set by the 14th Five Year Plan, coupled with an economic divorce between the Middle Kingdom and the US, requires that China expands its domestic market. However, that expansion is constrained by its relatively low labor share (Chart 6). The external and internal challenges are fertile ground for rising and sustaining populism. Thus, reforms that promote the bargaining power of workers at the expense of corporate earnings will likely become a secular trend in China. Chart 5Labor Makes A Comeback Versus Capital In The US... Chart 6...And In China Too Checking In On The Data China’s economic data continues to soften as evidenced by a slew of new numbers published last weekend. On the growth front, the contraction in the volume of imports in the past two months reflects the sagging domestic economy, despite elevated commodity prices supporting the value of total imports (Chart 7). Global demand for Chinese goods, on the other hand, remains strong compared with the historical norm, and continues to offset weaknesses in China’s old economy sectors. Meanwhile, Chinese producers face persistent inflationary pressures stemming from elevated global commodity prices and a broken price transmission to pass on inflation to domestic consumers (Chart 8). Instead of stimulating demand in the near term, Chinese policymakers will likely address supply-side issues by releasing strategic reserves and curbing raw material exports, and relaxing domestic production restrictions. Chart 7Strong External Demand Continues To Offset Domestic Economic Weaknesses Chart 8Inflationary Pressures On Producers Remains Elevated We expect that Beijing will need greater economic pain before it decides to stimulate the economy more substantially. Monetary conditions have eased since earlier this year on the back of rising inflation, falling real interest rates and recently a breather in the RMB’s ascent (Chart 9). Nonetheless, as we noted in a previous report, a decisive rebound in the rate of credit expansion requires clear easing signals from China’s top leadership for local governments and corporates to ramp up leverage again. The July Politburo meeting pledged more fiscal support for the economy this year. Meanwhile, policymakers have intensified their tough regulatory stances on private-sector businesses and oversight on the public-sector’s balance sheet. Hence, the current policy backdrop does not suggest any imminent or meaningful reflationary measures. Chart 9A Meaningful Rebound In Credit Growth Requires More Than Monetary Easing Chart 10War Against Delta-Variant Remains A Risk The COVID-19 Delta-variant remains the biggest risk to our view. The mutated virus has spread to 14 provinces in China and triggered the strictest pandemic-control measures since Q1 last year. The drag on the service sector’s activities and employment will be substantial if measures are maintained for more than a month (Chart 10). In this case, the leadership may need to step in with policy supports to stabilize the economy and sentiment. For now, the pullback of stimulus and ongoing regulatory tightening since Q4 last year continue to dominate China’s financial assets. Thus, investors should maintain an underweight allocation to Chinese equities within a global equity portfolio.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1Krueger, Alan (12 January 2012). "The Rise and Consequences of Inequality in the United States" (PDF).  Market/Sector Recommendations Cyclical Investment Stance

Highlights Investors have grown enamored with online retailers (AMZN), payment processing companies (V, MA, PYPL, SQ), and social media companies (FB, SNAP). All three sectors are likely to experience headwinds over the next 12 months as life returns to normal following the pandemic. Looking further out, market saturation, increased competition, and heightened regulation all pose risks to these sectors. Internet companies in general, and social media firms in particular, will face increased scrutiny not just for their monopolistic practices, but for the mental harm they are causing young people. Just like cigarettes are heavily regulated due to their addictive qualities, the same could happen to social media. We think there is a 50/50 chance that governments will start restricting social media usage only to adults over the age of 18 by the end of the decade, a move that could decimate the sector. Global Growth Will Remain Above Trend Investors are worried about growth again. Globally, the number of Covid cases is on the rise due to the proliferation of the Delta variant (Chart 1). The ISM manufacturing index dropped to 59.5 in July, down from a high of 64.7 in March. Both of China’s manufacturing PMIs have fallen, with the new orders component of the Caixin index dipping below the 50 line. The European PMIs have also come off their highs (Chart 2). Chart 1Number Of Covid Cases On The Rise Globally Due To The Delta Variant Chart 2Manufacturing PMIs Are Off Their Highs     Growth concerns have registered in financial markets (Chart 3). After climbing to 1.74% in March, the US 10-year Treasury yield has fallen back to 1.22%. Cyclical equity sectors have underperformed defensives. Growth-sensitive currencies such as the Swedish krona and the Australian dollar have weakened. We are more upbeat about global growth prospects than the consensus. As the experience of the UK demonstrates, there is little will to impose lockdowns in countries with ample access to vaccines. Strict social distancing restrictions remain a fact of life in countries lacking adequate vaccine supplies. However, the situation should improve later this year as vaccine production increases (Chart 4). Chart 3Financial Markets Trim Growth Expectations Chart 4Over 10 Billion Vaccine Doses Will Be Produced This Year   Households in developed economies are sitting on US$5 trillion in excess savings, half of which reside in the United States (Chart 5). Inventories are at record low levels, which should support production over the coming quarters (Chart 6). Chart 5Households Flush With Excess Savings Chart 6Record Low Inventories Will Provide A Boost To Production     Chinese policy should turn more stimulative, as the recent cut to bank reserve requirements foreshadows. With credit growth back down to 2018 lows, policymakers can afford to give the economy some juice. The 6-month credit impulse has already turned up (Chart 7). From Goods To Services While global growth should remain well above trend for the next 12 months, the composition of that growth will shift in ways that could meaningfully affect equities. As Chart 8 illustrates, aggregate US consumption has returned to its pre-pandemic trend. However, spending on goods is 11% above trend while spending on services is still 6% below trend. Chart 7Chinese Policy Is Turning More Stimulative Chart 8The Divergence Between Goods And Services Spending   Households typically cut spending on durable goods during recessions, while services serve as the ballast for the economy. The opposite happened during the pandemic. As the global economy recovers, goods spending will slow while services spending will stay robust. This is critical for online retailers such as Amazon, which derive the bulk of their e-commerce revenue from selling goods. Even after its disappointing Q2 earnings report, analysts still expect Amazon to grow e-commerce sales by 17% in 2022 (Chart 9). Such a goal may be difficult to achieve, given that core US retail sales currently stand 13% above their trendline (Chart 10). Chart 9AAnalysts’ Great Expectations May Be Dashed (I) Chart 9BAnalysts’ Great Expectations May Be Dashed (II) Chart 10AUS Retail Spending Is Well Above Trend (I) Chart 10BUS Retail Spending Is Well Above Trend (II) Chart 11Screen Time Is Moderating If e-commerce spending slows, shares of payment processing companies could disappoint. Likewise, social media companies could suffer as people start going out more often. After spiking during the height of the pandemic, growth in data usage has returned to normal (Chart 11). Long-Term Risks Looking beyond the post-pandemic recovery, all three equity sectors face structural challenges that are not being fully discounted by investors. The first is market saturation. Close to three-quarters of US households have Amazon Prime accounts. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, Google and Facebook generate about 60% of all online advertising revenue. Competition is another challenge. Companies such as Amazon, Facebook, and Google dominate their respective markets. As they look for further growth, they will invariably invade each other’s turf. The result might benefit consumers, but it is unlikely to help the bottom line if it means more competitive pressures. Moreover, it is not just competition from within the tech industry that may disrupt incumbent firms. Consider payment processors. Like most other central banks, the Fed is planning to launch its own digital currency. Widely available, free-to-use Central Bank Digital Currencies (CBDCs) could thwart the ability of Visa and MasterCard to skim 2%-to-3% off of every transaction. Regulatory Pressures In recent years, tech companies have faced increased scrutiny over their alleged monopolistic practices. In contrast to Chinese tech firms, which have fallen under the thumb of the authorities, US companies have been able to evade harsh measures. Just last month, a US federal court judge dismissed a case filed by more than 40 state attorneys general arguing that Facebook’s acquisitions of Instagram and WhatsApp had harmed competition. In the past, evidence that companies were setting prices well above marginal costs could be used to build a case for anti-trust enforcement. Such cases are more difficult to argue today because so many online services are given away for free. Nevertheless, governments are likely to become more adept in pursuing regulatory actions. Rather than focusing simply on pricing policies, regulators are increasingly looking at the ways big tech companies use vendor data in the case of Amazon and user data in the case of Facebook and Google to maintain market dominance. Public contempt for tech companies is fueling a political backlash. According to a Gallup poll conducted earlier this year, only 34% of Americans held a favorable view of tech companies such as Amazon, Facebook, and Google, down from 46% in 2019; 45% had an unfavorable opinion, up from 33% in 2019. The shift in public sentiment over the past two years has been entirely driven by Independent and Republican voters, many of whom feel that tech companies are unfairly censoring their opinions (Table 1). The same poll revealed that the majority of Americans – including the majority of Republicans – now favor increased regulation of tech companies. Table 1American Views On Big Tech A Drug Worse Than Nicotine? Social media companies are among the most loathed within the tech sector. A Pew Research Center study conducted last year revealed that more than six times as many Americans had a negative opinion of social media as a positive one (Chart 12). The public’s disdain for social media is increasingly going beyond traditional concerns over privacy. As psychologists Jonathan Haidt and Jean Twenge recently argued in the New York Times, there is growing evidence that the pervasive use of social media is harming the mental health of the nation’s youth. The share of students reporting high levels of loneliness has more than doubled in both the US and abroad over the past decade (Chart 13). Chart 12Social Media Increasingly Vilified Chart 13Alone In The Crowd In 2019, the last year for which comprehensive data is available, nearly a quarter of girls between the ages of 12 and 17 reported experiencing a major depressive episode over the prior year, up from 12% in 2011 (Chart 14). Academic studies have shown that adolescents who use Facebook and Instagram frequently feel greater anxiety and unease than those who do not. Just like cigarettes are heavily regulated due to their addictive qualities, the same could happen to social media. Facebook and most other social media companies already restrict access to those under the age of 13, although enforcement is generally spotty. We assign a 50/50 chance that governments start restricting social media usage only to adults over the age of 18 by the end of the decade, a move that could decimate the sector. Priced For Perfection The seven companies in the three high-flying sectors mentioned in this report trade at 91-times forward earnings compared to the S&P 500’s aggregate multiple of 22. They also trade at an average price-to-sales ratio of 16 compared to 3.2 for the broader market (Chart 15). Chart 14The Rise In Depression Rates Coincided With Increased Social Media Usage Chart 15Trading At A High Multiple To Sales   Such valuations can be justified only if these companies grow earnings-per-share by nearly 30% per year over the next five years, as analysts currently expect (Chart 16). However, as noted above, that may be too high a hurdle to clear. Higher bond yields represent another threat to valuations. Growth stocks are much more sensitive to changes in discount rates than value stocks. Chart 17show that tech stocks have generally outperformed the S&P 500 over the past four years whenever bond yields were falling. We expect bond yields to rebound over the coming months, with the 10-year yield rising to 1.8% by early next year. Tech is likely to lag the market in that environment. Chart 16Long-Term Growth Estimates May Be Too Optimistic For These High-Fliers Chart 17Higher Bond Yields Could Hurt Tech Stocks   Trade Update Our long EM equity trade got stopped out last Tuesday before recouping some of its losses in subsequent days. We continue to expect EM stocks to bounce back later this year. That said, in keeping with this report, we see more upside for “traditional” EM sectors such as banks, industrials, energy, and materials than for EM tech (especially Chinese tech). Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights China’s July Politburo meeting signaled that policy is unlikely to be overtightened. The Biden administration is likely to pass a bipartisan infrastructure deal – as well as a large spending bill by Christmas. Geopolitical risk in the Middle East will rise as Iran’s new hawkish president stakes out an aggressive position. US-Iran talks just got longer and more complicated. Europe’s relatively low political risk is still a boon for regional assets. However, Russia could still deal negative surprises given its restive domestic politics. Japan will see a rise in political turmoil after the Olympic games but national policy is firmly set on the path that Shinzo Abe blazed. Stay long yen as a tactical hedge. Feature Chart 1Rising Hospitalizations Cause Near-Term Jitters, But UK Rolling Over? Our key view of 2021, that China would verge on overtightening policy but would retreat from such a mistake to preserve its economic recovery, looks to be confirmed after the Politburo’s July meeting opened the way for easier policy in the coming months. Meanwhile the Biden administration is likely to secure a bipartisan infrastructure package and push through a large expansion of the social safety net, further securing the American recovery. Growth and stimulus have peaked in both the US and China but these government actions should keep growth supported at a reasonable level and dispel disinflationary fears. This backdrop should support our pro-cyclical, reflationary trade recommendations in the second half of the year. Jitters continue over COVID-19 variants but new cases have tentatively peaked in the UK, US vaccinations are picking up, and death rates are a lot lower now than they were last year, that is, prior to widescale vaccination (Chart 1). This week we are taking a pause to address some of the very good client questions we have received in recent weeks, ranging from our key views of the year to our outstanding investment recommendations. We hope you find the answers insightful. Will Biden’s Infrastructure Bill Disappoint? Ten Republicans are now slated to join 50 Democrats in the Senate to pass a $1 trillion infrastructure bill that consists of $550 billion in new spending over a ten-year period (Table 1). The deal is not certain to pass and it is ostensibly smaller than Biden’s proposal. But Democrats still have the ability to pass a mammoth spending bill this fall. So the bipartisan bill should not be seen as a disappointment with regard to US fiscal policy or projections. The Republicans appear to have the votes for this bipartisan deal. Traditional infrastructure – including broadband internet – has large popular support, especially when not coupled with tax hikes, as is the case here. Both Biden and Trump ran on a ticket of big infra spending. However, political polarization is still at historic peaks so it is possible the deal could collapse despite the strong signs in the media that it will pass. Going forward, the sense of crisis will dissipate and Republicans will take a more oppositional stance. The Democratic Congress will pass President Joe Biden’s signature reconciliation bill this fall, another dollop of massive spending, without a single Republican vote (Chart 2). After that, fiscal policy will probably be frozen in place through at least 2025. Campaigning will begin for the 2022 midterm elections, which makes major new legislation unlikely in 2022, and congressional gridlock is the likely result of the midterm. Republicans will revert to belt tightening until they gain full control of government or a new global crisis erupts. Table 1Bipartisan Infrastructure Bill Likely To Pass Chart 2Reconciliation Bill Also Likely To Pass Chart 3Biden Cannot Spare A Single Vote In Senate Hence the legislative battle over the reconciliation bill this fall will be the biggest domestic battle of the Biden presidency. The 2021 budget reconciliation bill, based on a $3.5 trillion budget resolution agreed by Democrats in July, will incorporate parts of the American Jobs Plan that did not pass via bipartisan vote (such as $436 billion in green energy subsidies), plus a large expansion of social welfare, the American Families Plan. This bill will likely pass by Christmas but Democrats have only a one-seat margin in the Senate, which means our conviction level must be medium, or subjectively about 65%. The process will be rocky and uncertain (Chart 3). Moderate Democratic senators will ultimately vote with their party because if they do not they will effectively sink the Biden presidency and fan the flames of populist rebellion. US budget deficit projections in Chart 4 show the current status quo, plus scenarios in which we add the bipartisan infra deal, the reconciliation bill, and the reconciliation bill sans tax hikes. The only significant surprise would be if the reconciliation bill passed shorn of tax hikes, which would reduce the fiscal drag by 1% of GDP next year and in coming years. Chart 4APassing Both A Bipartisan Infrastructure Bill And A Reconciliation Bill Cannot Avoid Fiscal Cliff In 2022 … Chart 4B… The Only Major Fiscal Surprise Would Come If Tax Hikes Were Excluded From This Fall’s Reconciliation Bill Chart 5Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing There are two implications. First, government support for the economy has taken a significant step up as a result of the pandemic and election in 2020. There is no fiscal austerity, unlike in 2011-16. Second, a fiscal cliff looms in 2022 regardless of whether Biden’s reconciliation bill passes, although the private economy should continue to recover on the back of vaccines and strong consumer sentiment. This is a temporary problem given the first point. Monetary policy has a better chance of normalizing at some point if fiscal policy delivers as expected. But the Federal Reserve will still be exceedingly careful about resuming rate hikes. President Biden could well announce that he will replace Chairman Powell in the coming months, delivering a marginally dovish surprise (otherwise Biden runs the risk that Powell will be too hawkish in 2022-23). Inflation will abate in the short run but remain a risk over the long run. Essentially the outlook for US equities is still positive for H2 but clouds are forming on the horizon due to peak fiscal stimulus, tax hikes in the reconciliation bill, eventual Fed rate hikes (conceivably 2022, likely 2023), and the fact that US and Chinese growth has peaked while global growth is soon to peak as well. All of these factors point toward a transition phase in global financial markets until economies find stable growth in the post-pandemic, post-stimulus era. Investors will buy the rumor and sell the news of Biden’s multi-trillion reconciliation bill in H2. The bill is largely priced out at the moment due to China’s policy tightening (Chart 5). The next section of this report suggests that China’s policy will ease on the margin over the coming 12 months. Bottom Line: US fiscal policy is delivering, not disappointing. Congress is likely to pass a large reconciliation bill by Christmas, despite no buffer in the Senate, because Democratic Senators know that the Biden presidency hangs in the balance. China’s Khodorkovsky Moment? Many clients have asked whether China’s crackdown on private business, from tech to education, is the country’s “Khodorkovsky moment,” i.e. the point at which Beijing converts into a full, autocratic regime where private enterprise is permanently impaired because it is subject to arbitrary seizure and control of the state. The answer is yes, with caveats. Yes, China’s government is taking a more aggressive, nationalist, and illiberal stance that will permanently impair private business and investor sentiment. But no, this process did not begin overnight and will not proceed in a straight line. There is a cyclical aspect that different investors will have to approach differently. First a reminder of the original Khodorkovsky moment. After the Soviet Union’s collapse, extremely wealthy oligarchs emerged who benefited from the privatization of state assets. When President Putin began to reassert the primacy of the state, he arbitrarily imprisoned Khodorkovsky and dismantled his corporate energy empire, Yukos, giving the spoils to state-owned companies. Russia is a petro state so Putin’s control of the energy sector would be critical for government revenues and strategic resurgence, especially at the dawn of a commodity boom. Both the RUB-USD and Russian equity relative performance performed mostly in line with global crude oil prices, as befits Russia’s economy, even though there was a powerful (geo)political risk premium injected during these two decades due to Russia’s centralization of power and clash with the West (Chart 6). Investors could tactically play the rallies after Khodorkovsky but the general trend depended on the commodity cycle and the secular rise of geopolitical risk. Chart 6Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer President Xi Jinping is a strongman and hardliner, like Putin, but his mission is to prevent Communist China from collapsing like the Soviet Union, rather than to revive it from its ashes. To that end he must reassert the state while trying to sustain the country’s current high level of economic competitiveness. Since China is a complex economy, not a petro state, this requires the state-backed pursuit of science, technology, competitiveness, and productivity to avoid collapse. Therefore Beijing wants to control but not smother the tech companies. Hence there is a cyclical factor to China’s regulatory crackdown. A crackdown on President Xi Jinping’s potential rivals or powerful figures was always very likely to occur ahead of the Communist Party’s five-year personnel reshuffle in 2022, as we argued prior to tech exec Jack Ma’s disappearance. Sackings of high-level figures have happened around every five-year leadership rotation. Similarly a crackdown on the media was expected. True, the pre-party congress crackdowns are different this time around as they are targeted at the private sector, innovative businesses, tech, and social media. Nevertheless, as in the past, a policy easing phase will follow the tightening phase so as to preserve the economy and the mobilization of private capital for strategic purposes. The critical cyclical factor for global investors is China’s monetary and credit impulse. For example, the crackdown on the financial sector ahead of the national party congress in 2017 caused a global manufacturing slowdown because it tightened credit for the entire Chinese economy, reducing imports from abroad. One reason Chinese markets sold off so heavily this spring and summer, was that macroeconomic indicators began decelerating, leaving nothing for investors to sink their teeth into except communism. The latest Politburo meeting suggests that monetary, fiscal, and regulatory policy is likely to get easier, or at least stay just as easy, going forward (Table 2). Once again, the month of July has proved an inflection point in central economic policy. Financial markets can now look forward to a cyclical easing in regulation combined with easing in monetary and fiscal policy over the next 12-24 months. Table 2China’s Politburo Prepares To Ease Policy, Secure Recovery Despite all of the above, for global investors with a lengthy time horizon, the government’s crackdown points to a secular rise of Communist and Big Government interventionism into the economy, with negative ramifications for China’s private sector, economic freedoms, and attractiveness as a destination for foreign investment. The arbitrary and absolutist nature of its advances will be anathema to long-term global capital. Also, social media, unlike other tech firms, pose potential sociopolitical risks and may not boost productivity much, whereas the government wants to promote new manufacturing, materials, energy, electric vehicles, medicine, and other tradable goods. So while Beijing cannot afford to crush the tech sector, it can afford to crush some social media firms. Chart 7China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China’s equity market profile looks conspicuously like Russia’s at the time of Khodorkovsky’s arrest (Chart 7). Chinese renminbi has underperformed the dollar on a multi-year basis since Xi Jinping’s rise to power, in line with falling export prices and slowing economic growth, as a result of economic structural change and the administration’s rolling back Deng Xiaoping’s liberal reform era. We expect a cyclical rebound to occur but we do not recommend playing it. Instead we recommend other cyclical plays as China eases policy, particularly in European equities and US-linked emerging markets like Mexico. Bottom Line: The twentieth national party congress in 2022 is a critical political event that is motivating a cyclical crackdown on potential rivals to Communist Party power. Chinese equities will temporarily bounce back, especially with a better prospect for monetary and fiscal easing. But over the long run global investors should stay focused on the secular decline of China’s economic freedoms and hence productivity. What Happened To The US-Iran Deal? Our second key view for 2021 was the US strategic rotation from the Middle East and South Asia to Asia Pacific. This rotation is visible in the Biden administration’s attempt to withdraw from Iraq and Afghanistan while rejoining the 2015 nuclear deal with Iran. However, Biden here faces challenges that will become very high profile in the coming months. The Biden administration failed to rejoin the 2015 deal under the outgoing leadership of the reformist President Hassan Rouhani. This means a new and much more difficult negotiation process will now begin that could last through Biden’s term or beyond. On August 5, President Ebrahim Raisi will take office with an aggressive flourish. The US is already blaming Iran for an act of sabotage in the Persian Gulf that killed one Romanian and one Briton. Raisi will need to establish that he is not a toady, will not cower before the West. The new Israeli government of Prime Minister Naftali Bennett also needs to demonstrate that despite the fall of his hawkish predecessor Benjamin Netanyahu, Jerusalem is willing and able to uphold Israel’s red lines against Iranian nuclear weaponization and regional terrorism. Hence both Iran and its regional rivals, including Saudi Arabia, will rattle sabers and underscore their red lines. The Persian Gulf and Strait of Hormuz will be subject to threats and attacks in the coming months that could escalate dramatically, posing a risk of oil supply disruptions. Given that the Iranians ultimately do want a deal with the Americans, the pressure should be low-to-medium level and persistent, hence inflationary, as opposed to say a lengthy shutdown of the Strait of Hormuz that would cause a giant spike in prices that ultimately kills global demand. Short term, the US attempt to reduce its commitments in Iraq and Afghanistan will invite US enemies to harass or embarrass the Biden administration. The Taliban is likely to retake control of Afghanistan. The US exit will resemble Saigon in 1975. This will be a black eye for the Biden administration. But public opinion and US grand strategy will urge Biden to be rid of the war. So any delays, or a decision to retain low-key sustained troop presence, will not change the big picture of US withdrawal. Long term, Biden needs to pivot to Asia, while President Raisi is ultimately subject to the Supreme Leader Ali Khamenei, who wants to secure Iran’s domestic stability and his own eventual leadership succession. Rejoining the 2015 nuclear deal leads to sanctions relief, without requiring total abandonment of a nuclear program that could someday be weaponized, so Iran will ultimately agree. The problem will then become the regional rise of Iranian power and the balancing act that the US will have to maintain with its allies to keep Iran contained. Bottom Line: The risk to oil prices lies to the upside until a US-Iran deal comes together. The US and Iran still have a shared interest in rejoining the 2015 deal but the time frame is now delayed for months if not years. We still expect a US-Iran deal eventually but previously we had anticipated a rapid deal that would put downward pressure on oil prices in the second half of the year. What Comes After Biden’s White Flag On Nord Stream II? Our third key view for 2021 highlighted Europe’s positive geopolitical and macro backdrop. This view is correct so far, especially given that China’s policymakers are now more likely to ease policy going forward. But Russia could still upset the view. Italy has been the weak link in European integration over the past decade (excluding the UK). So the national unity coalition that has taken shape under Prime Minister Mario Draghi exemplifies the way in which political risks were overrated. Italy is now the government that has benefited the most from the overall COVID crisis in public opinion (Chart 8). The same chart shows that the German government also improved its public standing, although mostly because outgoing Chancellor Angela Merkel is exiting on a high note. Her Christian Democrat-led coalition has not seen a comparable increase in support. The Greens should outperform their opinion polling in the federal election on September 26. But the same polling suggests that the Greens will be constrained within a ruling coalition (Chart 9). The result will be larger spending without the ability to raise taxes substantially. Markets will cheer a fiscally dovish and pro-European ruling coalition. Chart 8European Political Risk Limited, But Rising, Post-COVID The chief risk to this view of low EU political risk comes from Russia. Russia is a state in long-term decline due to the remorseless fall in fertility and productivity. The result has been foreign policy aggression as President Putin attempts to fortify the country’s strategic position and frontiers ahead of an even bleaker future. Chart 9German Election Polls Point To Gridlock? Now domestic political unrest has grown after a decade of policy austerity and the COVID-19 pandemic. Elections for the Duma will be held on September 19 and will serve as the proximate cause for Russia’s next round of unrest and police repression. Foreign aggressiveness may be used to distract the population from the pandemic and poor economy. We have argued that there would not be a diplomatic reset for the US and Russia on par with the reset of 2009-11. We stand by this view but so far it is facing challenges. Putin did not re-invade Ukraine this spring and Biden did not impose tough sanctions canceling the construction of the Nord Stream II gas pipeline to Germany. Russia is tentatively cooperating on the US’s talks with Iran and withdrawal from Afghanistan. The US gave Germany and Russia a free point by condoning the NordStream II. Now the US will expect Germany to take a tough diplomatic line on Russian and Chinese aggression, while expecting Russia to give the US some goodwill in return. They may not deliver. The makeup of the new German coalition will have some impact on its foreign policy trajectory in the coming years. But the last thing that any German government wants is to be thrust into a new cold war that divides the country down the middle. Exports make up 36% of German output, and exports to the Russian and Chinese spheres account for a substantial share of total exports (Chart 10). The US administration prioritizes multilateralism above transactional benefits so the Germans will not suffer any blowback from the Americans for remaining engaged with Russia and China, at least not anytime soon. Russia, on the other hand, may feel a need to seize the moment and make strategic gains in its region, despite Biden’s diplomatic overtures. If the US wraps up its forever wars, Russia’s window of opportunity closes. So Russia may be forced to act sooner rather than later, whether in suppressing domestic dissent, intimidating or attacking its neighbors, or hacking into US digital networks. In the aftermath of the German and Russian elections, we will reassess the risk from Russia. But our strong conviction is that neither Russian nor American strategy have changed and therefore new conflicts are looming. Therefore we prefer developed market European equities and we do not recommend investors take part in the Russian equity rally. Chart 10Germany Opposes New Cold War With Russia Or China Bottom Line: German and European equities should benefit from global vaccination, Biden’s fiscal and foreign policies, and China’s marginal policy easing (Chart 11). Eastern European emerging markets and Russian assets are riskier than they appear because of latent geopolitical tensions that could explode around the time of important elections in September. Chart 11Geopolitical Tailwinds To European Equities What Comes After The Olympics In Japan? Japan is returning to an era of “revolving door” prime ministers. Prime Minister Yoshihide Suga’s sole purpose was to tie up the loose ends of the Shinzo Abe administration, namely by overseeing the Olympics. After the games end, he will struggle to retain leadership of the Liberal Democratic Party. He will be blamed for spread of Delta variant even if the Olympics were not a major factor. If he somehow retains the party’s helm, the October general election will still be an underwhelming performance by the Liberal Democrats, which will sow the seeds of his downfall within a short time (Chart 12). Suga will need to launch a new fiscal spending package, possibly as an election gimmick, and his party has the strength in the Diet to push it through quickly, which will be favorable for the economy. For the elections the problem is not the Liberal Democrats’ popularity, which is still leagues above the nearest competitor, but rather low enthusiasm and backlash over COVID. Abe’s retirement, and the eventual fall of Abe’s hand-picked deputy, does not entail the loss of Abenomics. The Bank of Japan will retain its ultra-dovish cast at least until Haruhiko Kuroda steps down in 2023. The changes that occurred in Japan from 2008-12 exemplified Japan’s existence as an “earthquake society” that undergoes drastic national changes suddenly and rapidly. The paradigm shift will not be reversed. The drivers were the Great Recession, the LDP’s brief stint in the political wilderness, the Tohoku earthquake and Fukushima nuclear crisis, and the rise of China. The BoJ became ultra-dovish and unorthodox, the LDP became more proactive both at home and abroad. The deflationary economic backdrop and Chinese nationalism are still a powerful impetus for these trends to continue – as highlighted by increasingly alarming rhetoric by Japanese officials, including now Shinzo Abe himself, regarding the Chinese military threat to Taiwan. In other words, Suga’s lack of leadership will not stand even if he somehow stays prime minister into 2022. The Liberal Democrats have several potential leaders waiting in the wings and one of these will emerge, whether Yuriko Koike, Shigeru Ishiba, or Shinjiro Koizumi, or someone else. The popular and geopolitical pressures will force the Liberal Democrats and various institutions to continue providing accommodation to the economy and bulking up the nation’s defenses. This will require the BoJ to stay easier for longer and possibly to roll out new unorthodox policies, as with yield curve control in the 2010s. Japan has some of the highest real rates in the G10 as a result of very low inflation expectations and a deeply negative output gap (Chart 13). Abenomics was bearing fruit, prior to COVID-19, so it will be justified to stay the course given that deflation has reemerged as a threat once again. Chart 12Japan: Back To Revolving Door Of Prime Ministers Chart 13Japan To Keep Fighting Deflation Post-Abe Bottom Line: The political and geopolitical backdrop for Japan is clear. The government and BoJ will have to do whatever it takes to stay the course on Abenomics even in the wake of Abe and Suga. Prime ministers will come and go in rapid succession, like in past eras of political turmoil, but the trajectory of national policy is set. We would favor JGBs relative to more high-beta government bonds like American and Canadian. Given deflation, looming Japanese political turmoil, and the secular rise in geopolitical risk, we continue to recommend holding the yen. These views conform with those of BCA’s fixed income and forex strategists. Investment Takeaways China’s policymakers are backing away from the risk of overtightening policy this year. Policy should ease on the margin going forward. Our number one key forecast for 2021 is tentatively confirmed. Base metals are still overextended but global reflation trades should be able to grind higher. The US fiscal spending orgy will continue through the end of the year via Biden’s reconciliation bill, which we expect to pass. Proactive DM fiscal policy will continue to dispel disinflationary fears. Sparks will fly in the Middle East. The US-Iran negotiations will now be long and drawn out with occasional shows of force that highlight the tail risk of war. We expect geopolitics to add a risk premium to oil prices at least until the two countries can rejoin the 2015 nuclear deal. Germany’s Green Party will surprise to the upside in elections, highlighting Europe’s low level of geopolitical risk. China policy easing is positive for European assets. Russia’s outward aggressiveness is the key risk.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com