Economy

Highlights Yield curves have flattened considerably in the major economies since April. Slowing global growth, the perception that the Fed is turning more hawkish, and technical factors have contributed to flatter yield curves. Looking out, we expect the forces pushing down bond yields to abate, with the US 10-year Treasury yield ultimately rising to 1.8%-to-1.9% by the end of the year. Shrinking output gaps, rebounding inflation expectations, and stepped-up Treasury issuance should all push yields higher. Higher yields will benefit bank shares at the expense of tech stocks. Investors should favor value over growth and non-US equities over their US peers. We are closing our long global energy stocks/short copper miners trade. In its place, we are opening a trade to go long the December 2022 Brent futures contract at a price of $66.50/bbl. Flatter Yield Curves Yield curves have flattened considerably in the major economies since April. The US 10-year yield has fallen to 1.31% (and was down to as low as 1.25% intraday last Thursday) from a recent peak of 1.74% on March 31st. The US 2-year yield has risen 7 bps over this period, which has translated into 50 bps of flattening in the 2/10 yield curve. The German bund curve has flattened by 20 bps, the UK curve by 28 bps, the Canadian curve by 52 bps, and the Australian curve by 57 bps. Even the Japanese yield curve has managed to flatten by 13 bps (Chart 1). Chart 1AYield Curves In The Major Economies Have Flattened Since April (I) Chart 1BYield Curves In The Major Economies Have Flattened Since April (II) Chart 2US Economic Surprise Index Is Near A Post-Pandemic Low Three major factors account for the recent bout of yield-curve flattening: Slowing growth: Decelerating growth is usually accompanied by a flatter yield curve. Chinese growth peaked late last year. US growth peaked around March, with the Citi Economic Surprise Index falling to a post-pandemic low last week (Chart 2). European growth will peak over the course of this summer (Table 1). The emergence of the Delta variant has amplified growth concerns. Table 1Growth Is Peaking, But At A Very High Level Fears that the Fed is turning more hawkish: About one-third of the flattening in the US yield curve occurred in the two days following the June FOMC meeting. The shift in the median Fed forecast towards a 2023 rate hike was interpreted by many market participants as a signal that the Fed was unwilling to tolerate a prolonged inflation overshoot (Chart 3). As a result, short-term rate expectations moved up while long-term rate expectations declined (Chart 4). Chart 3The Fed Dots Have Shifted Towards An Earlier Rate Hike Chart 4Markets Saw The June FOMC Meeting As A Turning Point Chart 5Treasury Cash Balances Are Declining Technical factors: Investors were positioned very bearishly on bonds earlier this year, helping to set the stage for a short-covering rally. Meanwhile, with yet another debt ceiling showdown looming in Congress, the Treasury department began to slash T-bill issuance, drawing on its cash balances at the Fed instead (Chart 5). Treasurys, which were already in short supply due to the Fed’s QE program, became even scarcer. All this happened at a time when seasonal factors normally turn bond bullish (Chart 6). Chart 6Seasonality In Markets How these three factors evolve over the coming months will dictate the path of bond yields, with important implications for stocks and currencies. Let’s examine each in turn. Global Growth Will Slow, But Remain Firmly Above Trend Chart 7High Vacancies Suggest Strong Demand For Labor While global growth will continue to decelerate, it will remain well above trend. This is important because ultimately, it is the size of the output gap that determines the timing and magnitude of rate hikes. In the US, the high level of job vacancies suggests that there is no shortage of labor demand (Chart 7). What is missing are willing workers. As we noted in our Third Quarter Strategy Outlook, labor shortages should ease in the fall as expanded unemployment benefits expire, schools reopen, and immigration picks up. The recent rapid decline in initial unemployment claims is consistent with an acceleration in job gains over the coming months (Chart 8). The share of small businesses planning to increase hiring also jumped in June to the highest level in the 48-year history of the NFIB survey (Chart 9). Chart 8Declining Unemployment Claims Point To Further Strong Employment Growth Chart 9Small US Businesses Are Keen To Hire Delta Risk In the US, 32,000 new Covid cases were reported on Wednesday. This pushed the 7-day average to 25,000, double the level it was the first week of July. According to the CDC, more than 90% of US counties with high case counts had vaccination rates below 40% (Map 1). As is in other countries, the highly contagious Delta variant accounts for the majority of new US infections. Map 1AUS Covid Vaccination Coverage Map 1BUS Covid Infection Trends Chart 10Vaccine Makers Are On Track To Produce Over 10 Billion Doses In 2021 The latest Covid wave will slow US economic activity, but probably not by much. The CDC estimates that over 99% of recent US Covid deaths have been among the non-vaccinated population. Vaccinated people have little to fear from the Delta strain and hence, will likely continue to go on with their daily lives. Non-vaccinated people, in most cases, are presumably not very concerned about contracting the virus, so they too will go on with their daily lives. Thus, it is difficult to see how the Delta strain will lead to major behavioral changes. And politically, it will be difficult for governments to legislate lockdowns when everyone who wants a vaccine has been able to receive one. Outside the US, the Delta strain will cause more havoc. Nevertheless, there is a light at the end of the tunnel. Globally, vaccine makers are set to produce over 10 billion doses this year (Chart 10). Many of these vaccines will make their way to emerging economies, which have struggled to obtain adequate supplies. That should help boost EM growth. China Policy Support Chinese retail sales, industrial production, and fixed asset investment all rose faster than expected in June. Yesterday’s solid activity data followed strong trade numbers released earlier this week. Chart 11Chinese Credit Growth Should Stabilize In The Second Half Of The Year Chinese policy is turning more stimulative, which should continue to support growth. Effective this Thursday, the PBOC cut its reserve requirement ratio by 0.5 percentage points, releasing about RMB 1 trillion of liquidity into the banking system. It was the first such cut since April 2020. Total social financing, a broad measure of Chinese credit, rose by RMB 3.7 trillion in June, well above consensus estimates of RMB 2.9 trillion. Credit growth has fallen sharply since last October and is currently running near its 2018 lows (Chart 11). Looking out, Chinese credit growth should pick up modestly as local governments issue more debt. As of June, local governments had used only 28% of their annual bond issuance quota, compared with 61% over the same period last year and 65% in 2019. The proceeds from local government bond sales will likely flow into infrastructure spending, which has been tepid in recent years (Chart 12). Increased infrastructure spending will boost metals prices. With that in mind, we are closing our long global energy stocks/short copper miners trade for a gain of 8.5%. In its place, we are opening a trade to go long the December 2022 Brent futures contract at a price of $66.50/bbl. As Chart 13 shows, BCA’s Commodity and Energy service expects oil prices to keep rising in contrast to market expectations of a price decline. Chart 12China: Weak Infrastructure Spending Should Pick Up Chart 13Oil Prices Have Further Upside The Fed Will Stay Dovish Chart 14Excluding Pandemic-Affected Sectors, Core CPI Has Not Surged As Much As Headline Measures Market participants overreacted to the shift in the Fed’s dot plot. The regional Fed presidents tend to be more hawkish than the Board of Governors. Jay Powell himself probably penciled in one hike for 2023. Lael Brainard, who may end up replacing Powell next year, likely projects no hikes for 2023. Granted, inflation has surged. The CPI rose 5.4% year-over-year in June, above expectations of 4.9%. Core CPI inflation clocked in at 4.5%, surpassing expectations of 4.0%. However, most of the increase in the CPI continues to be driven by a few pandemic-affected sectors. Excluding airfares, hotels, and vehicle prices, the core CPI rose by a modest 2.5% in June. The level of the CPI outside these pandemic-affected sectors is still below trend, suggesting little imminent need for monetary tightening (Chart 14). Many input prices have already rolled over (Chart 15). The price of lumber, which at one point was up 93% from the start of 2021, is now down for the year. Steel prices are well off their highs. So too are memory chip prices. Even used car auction prices are starting to decline (Chart 16). Chart 15Input Prices Have Rolled Over Chart 16Used Car Prices Have Probably Peaked   Chart 17Both The Fed And Market Participants Have Revised Down Their Estimate Of The Neutral Rate Of Interest Chart 18Inflation Expectations Have Fallen Back Below The Fed's Target Zone   Despite the widespread perception that US monetary policy is ultra-accommodative, current policy rates are only two percentage points below both the Fed’s and the market’s estimates of the terminal rate (Chart 17). Given the zero lower bound constraint on nominal policy rates, tightening monetary policy prematurely could be a grave mistake.Market-based inflation expectations are signaling the need for easier, not tighter, monetary policy. After rising earlier this year, the 5-year/5-year forward TIPS breakeven inflation rate has fallen back below the Fed’s comfort zone (Chart 18). It is highly unlikely that the Fed will commence tapering if long-term inflation expectations remain below target. More likely, the Fed will ramp up its dovish rhetoric over the coming months, allowing inflation expectations to recover. This should put some upward pressure on long-term bond yields. Technical Factors Are Turning Less Bond Friendly Chart 19Investors Were Heavily Short Bonds Earlier This Year While seasonal factors should remain bond bullish over the remainder of the year, other technical factors are turning less supportive. Investors surveyed by J.P. Morgan increased duration exposure over the past four weeks, after having cut it to the lowest level since 2017 (Chart 19). Traders also cut short positioning on the 30-year bond by two-thirds from record levels. Treasury issuance should normalize by the fall. While the obligatory brinkmanship over the debt ceiling is likely to extend beyond the August 1st deadline, BCA’s chief political strategist Matt Gertken believes that Democrats will ultimately be able to raise the ceiling. Senate Democrats may end up using the reconciliation process to both raise the debt ceiling and pass President Joe Biden’s $3.5 trillion American Jobs and Families Plan with 51 votes along. They are also likely to move forward on passing Biden’s proposed $600 billion in traditional infrastructure, with or without Republican support. The combination of increased Treasury supply and more fiscal spending should translate into higher bond yields. Higher Bond Yields Favor Value Stocks We expect the US 10-year Treasury yield to move back up to 1.8%-to-1.9% by the end of the year. Bond yields in other markets will also rise, but less so than in the US, given the relatively “high beta” status of US Treasurys (Chart 20). In contrast to tech stocks, banks usually outperform when bond yields are rising (Chart 21). The recent pickup in US consumer lending should also help bank shares (Chart 22). Chart 20US Treasuries Have A Higher Beta Than Most Other Government Bond Markets Chart 21Bank Shares Thrive In A Rising Yield Environment Chart 22Recent Pickup In US Consumer Lending Will Help Bank Shares Chart 23Outperformance Of Tech Stocks Not Backed By Trend In Earnings Estimates Chart 24Non-US Stocks And Value Stocks Typically Perform Best When The Dollar Is Falling     It is worth noting that the outperformance of tech stocks over the past six weeks has not been mirrored in relative upward revisions to earnings estimates (Chart 23). Without the tailwind from relatively fast earnings growth, tech names will lag the market over the remainder of 2021. The US dollar usually weakens when growth momentum rotates from the US to the rest of the world, which is likely to occur in the second half of this year. A dovish Fed will put further downward pressure on the greenback. Non-US stocks and value stocks typically perform best when the dollar is falling (Chart 24). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Special Report

Highlights With geopolitical risks increasing around China, India is attracting greater attention from global investors. India’s youthful demographics also mark a stark contrast with China. While this demographic dividend is real, its benefits should not be overstated. India is young but socially complex, which will create unique social conflicts and policy risks. In particular, the country faces structurally large budget deficits. Regional political differences could slow down reforms. Lastly, competition with China will increase India’s own geopolitical risks. Macroeconomic and (geo)political factors, not youth alone, will determine India’s equity market returns. The bullish long-term view faces near-term challenges. Feature Map 1 PreviewIndia’s Demographic Dividend Can Be Overstated “Independence had come to India like a kind of revolution; now there were many revolutions within that revolution … All over India scores of particularities that had been frozen by foreign rule, or by poverty or lack of opportunity or abjectness, had begun to flow again.” – Sir VS Naipaul, India: A Million Mutinies Now (Vintage, 1990) What is well known is that India is populous, young, and boasts a high GDP growth rate. India is also largely free of internal conflicts. Its democratic framework is seen as a pressure valve that can release social tensions. India’s hefty 58% cross-cycle premium to Emerging Markets (EM) is often attributed to the fact that India is younger than its peers, especially China. In this report we highlight that India’s demographic advantage is real but should not be overstated. For instance, India’s northern region can be likened to a demographic tinderbox. It accounts for about 45% of India’s population and is also younger than the national average. However, per capita incomes in this region are lower than the national average and to complicate matters, this region is crisscrossed by several social fault lines. This heterogeneity and economic backwardness in India’s population is the reason why the trend-line of India’s demographic dividend will not be linear. Its diverse population’s attempt to break out of its poverty will spawn unique policy risks. The North Is A Demographic Tinderbox, The South Is Prosperous But Ageing India will soon be the most populous country in the world (Chart 1). India’s median age is a decade lower than that of China to boot (Chart 2). Some emerging market investors fret about India’s low per capita income but India holds the promise of lifting individual incomes over time. This is because its GDP growth rate has been higher than that of its peers (Chart 3). Chart 1India Will Soon Be The Most Populous Country Chart 2India Is A Decade Younger Than China Chart 3India’s Per Capita Income Is Low, But GDP Growth Rate Is High However, the “demographic dividend” narrative oversimplifies India’s investment case. India is young but also socially heterogenous and its median voter is poor. This complicates India’s development process and makes its demographic dividend trend-line non-linear. India’s social complexity is best understood if India is characterized as an amalgamation of three major regions: the North, the South (which we define to include the western region), and the East. Each of these parts are unique and have distinctive socio-demographic identities. India hence is more comparable to a continent like Europe than a country like the US. Like the European Union, India is a union of multiple social, religious, and ethnic groups. It straddles a vast geography and represents a very wide spectrum of interests. India’s South is more like a middle-income Asian country such as Sri Lanka or Vietnam whilst India’s East is more like a poor Latin American economy with latent social unrest. Understanding the heterogeneity of India’s vast populace is key to get a better sense of why an investment strategy for India must be nuanced and tactical in its approach, even if the overarching strategic view is constructive. The key features of each of these three regions can be summarized as follows: Region #1: The North This region comprises the triangular area between Jammu & Kashmir, Rajasthan and Jharkhand. This is the largest landmass in India stretching from the Himalayas to the fertile Gangetic plains of central India. Ethnically most of the population here is of Indo-Aryan descent. A lion’s share of this region’s population remains engaged in agriculture and allied activities. The North accounts for about 45% of the nation’s total population and is a demographic tinderbox. Per capita incomes are low and one in five persons falls in the age group of 15-24 years. To complicate matters, wage inflation in the farm sector, which employs a large majority of the populace in this region, has been slowing. If job creation in the non-farm sector stays insufficient then it will fan fires of social instability. The North includes states like Uttar Pradesh and Punjab which have seen a steady increase in small but notable socio-political conflicts in the recent past. Issues that triggered social conflict ranged from inter-religious marriages to resistance to amending farmer-friendly laws. Region #2: The South India’s South constitutes the large inverted-triangular region on the map and spans the area between Gujarat, Kerala, and West Bengal. We include India’s western region in this category because of its socio-economic similarities with the southern peninsula. Together the South and West account for the entirety of India’s peninsular coastline and for about 40% of total population. Historically, the South has seen far fewer external invasions and its social fabric is more homogenous than that of the North. This region is characterized by high per capita incomes, balanced gender ratios (Chart 4), and higher literacy ratios (Chart 5). Socio-political conflicts in this region are less common as compared to the North. Chart 4India’s South Has Healthy Gender Ratios Compared To North Chart 5India’s South Is More Educated Than The Rest Of India The state of Kerala is an exception in this region. The social fabric in this state is unusual, with Hindus accounting for only 55% of its population (versus the national average of 80%). The high degree of religious heterogeneity in this southern Indian state could perhaps be the reason why the state has lately seen a rise of small but significant incidences of social conflict. Unlike India’s young North, the median age of the population in India’s South is likely to be higher than the national average. Whilst India’s South is clearly young by global standards, this region will have to deal with problems of an ageing population before India’s North or East. The Southern region in India even today relies on migrant workers from India’s North. Region #3: The East This region is the youngest and the smallest of the three, as it accounts for the remaining 15% of India’s population. The region is young but must contend with low per capita incomes and very high degrees of religious diversity. Muslims, Christians, and other religions account for 20% of India’s population nationally but +50% of the population in India’s East. By virtue of sharing borders with countries like Bangladesh, Nepal, and Myanmar, this region is often the entry point for migration into India. It is historically the least stable of the three regions owing to its heterogeneity and the steady influx of migrants. To conclude, India is young but is also socially complex. Whilst a youthful population yields economic advantages, if this young population lacks economic opportunity then social dissatisfaction and associated risks can be a problem. Furthermore, history suggests that if a region’s populace is young but poor and diverse, then it often spawns the rise of identity politics, which takes policymakers’ attention away from matters of economic development. Social Complexity Index To better represent India’s demographic granularities, we created a Social Complexity Index (SCI), as shown in Map 1. Map 1India’s North Is A Demographic Tinderbox; South Is Prosperous But Ageing The SCI for Indian states is created by adding a layer of socio-economic data over the demographic data. It uses three sets of variables: Economic well-being of a state as proxied by state-level per capita incomes. The lower the incomes, the greater the risk of social instability. This is because India’s per capita income is low to start with and if pockets have incomes that are substantially lower than the national average then the associated economic duress can be significant. Religious diversity in a state as measured by creating a Herfindahl-Hirschman Index of religious diversity in the state. The greater the religious diversity the greater the social complexity is expected to be. Youthfulness of a state as measured by population in the age group of 15-24 years relative to the total population. The greater the youth population ratio, the more complex are the social realities likely to be. If a state is exposed unfavorably to all three of the above stated parameters then such a state is deemed to have a high degree of social complexity and hence could be exposed to a higher risk of social conflicts and/or policy risks. Our Social Complexity Index (SCI) (Map 1) shows how parts of India are young but also socially complex. Why does this matter? This matters because a diverse, young and vast population’s attempt to develop will create policy risks. Policy Impact: Left-Leaning Economics, Right-Leaning Politics To be sure, governments in India will stay focused on creating large-scale jobs, a big concern for India’s median voter (Chart 6). However, given the time involved in building consensus for any major reform, progress on economic reforms (and hence job creation) will remain slow. India’s large population and democratic framework render the reform process more acceptable, but also less nimble. This contrasts with the speed of reforms executed by East Asian countries in the 1970s-90s, which turned them into export powerhouses. Two recent examples illustrate the problem of slow reform in India: Implementation of GST: Goods and services tax (GST) was a major reform that India embraced in 2017. However, the creation of a nation-wide GST was first mooted in 2000 and it took seventeen years for this reform to pass into law. Even in its current form India’s GST does not cover all products. It excludes large categories like petroleum products and electricity owing to resistance from state governments. Industrial sector growth: Despite India’s consistent efforts to grow its industrial sector as a source of large-scale, low-skill jobs, the share of this sector in India’s GDP has remained static for three decades (Chart 7). The services sector has grown rapidly in India over this period but its ability to absorb low-skill workers on a large scale is fundamentally restricted since (1) the sector needs mid-to-high skill workers and (2) the sector generates fewer jobs per unit of GDP owing to high degrees of productivity in the sector. Chart 6India’s Median Voter Worries Greatly About Job Creation Chart 7India’s Industrial Sector Stuck In A Rut, India’s Workforce Is Connected And Aware India’s inability to reform rapidly and create jobs on a large-scale will trigger policy risks. This factor is more relevant now than ever. In the 1990s, India was a small, closed economy that was just opening up. Hence slow reforms were acceptable as they yielded high growth off a low base. By contrast India’s masses today are at the forefront of connectivity (Chart 7). Slow job growth in a young country with high degrees of connectivity will have to be managed in the short term by responding to other needs of India’s median voter. This process might delay painful structural reforms necessary to improve productivity and hence create policy risks in the interim. What policy-risks is India exposed to? We highlight three policy risks that investors must brace for: Policy Risk #1: Structurally Large Budget Deficits Despite being young, India’s fiscal deficit has been large and as such comparable to that of countries that have an older demographic profile (Chart 8). Chart 8Despite India’s Youth, Its Fiscal Deficit Has Been Comparable To That Of Older Countries Chart 9Unlike China, The Majority Of India’s Citizenry Lives On Less Than US$10 A Day Whilst India’s fiscal deficit will rise and fall cyclically, it will remain elevated on a structural basis as India’s median voter is young but poor (Chart 9). This median voter will keep needing government support to tide over her economic duress. These fiscal transfers are likely to assume the form of transfer payments, food subsidies and a large interest burden on the exchequer who will need to borrow funds in the absence of adequate tax revenue growth. Two manifestations of this fiscal quagmire that India must contend with include: Revenue expenditure for India’s central government accounts for 85% of its total expenditure, with only 15% being set aside for more productive capital expenditure. Within central government revenue expenditure, 40% is foreclosed by food-subsidies, transfer payments, and interest payments. Can India’s fiscal deficit be expected to structurally trend lower? Only if India embraces big-ticket tax reforms. This appears unlikely given that India’s central tax revenue to GDP ratio has remained static at 10% of GDP for two decades owing to its inability to widen its tax base. Policy Risk #2: Foreign Policy Will Turn Rightwards India’s northern states are known to harbor unfavorable views of Pakistan. These are more unfavorable than the rest of India (Map 2). Geopolitical tension will persist due to a confluence of factors. Map 2Northern India Views Pakistan Even More Unfavorably Than Rest Of India India may be forced to adopt a far more aggressive foreign policy response and shed its historical stance of neutrality. This will be done to respond to tectonic shifts in geopolitics as well as the preferences of India’s north that accounts for about 45% of India’s population. China’s active involvement in South Asia will accentuate this phenomenon whereby India tilts towards abandoning its historical foreign policy stance of non-alignment. An aggressive foreign policy stance will engender fiscal costs as well as diverting attention away from internal reform. The adoption of a more aggressive foreign policy stance will necessitate the maintenance of high defense spending when these scarce resources could be used for boosting productivity through spends on soft as well as hard infrastructure. Despite having low per capita incomes, India already is the third largest military spender globally. In 2022, India’s central government plans to allocate ~15% of its budget for defense, which is the same allocation that productivity-enhancing capital expenditure as a whole will attract. Since it will be politically untenable to cut social spending, defense spending will simply add to the budget deficit. Policy Risk #3: Regional Differences Could Get Amplified Over Time India’s northern states typically lag on human development indicators (Charts 4 and 5). Owing to their large population, these states have also lagged smaller states in the east more recently on vaccination rates, which could be a symptom of deeper problems of managing public services in highly populous states (Chart 10). Chart 10India’s Northern States Lagging On Vaccinations, Smaller Eastern States Are Leading Whilst such differences between India’s more populous and less populous states are commonplace, these tensions could grow over the next few years. In specific, it is worth noting that a delimitation exercise in India is due in 2026. Delimitation refers to the process of redrawing boundaries for Lok Sabha seats to reflect changes in population. India’s Northern states are likely to receive an increased allocation of seats in India’s lower house (i.e. the Lok Sabha) beginning in 2026, despite poor performance on human development indicators. This is because India’s North accounted for 40% of seats in India’s lower house and accounted for 41% of its population in 1991. Owing rapid population growth, this region’s population share rose to 44% by 2011 and the ratio could rise further. Given that a review of the allocation of Lok Sabha seats is due in 2026, it is highly likely that India’s northern states get allocated more seats at this review. A change in political influence of different regions will have two sets of implications. Firstly, reforms that require a buy-in from all Indian states (such as GST implementation in 2017) could become trickier to implement if states that have delivered improvements in human development have to contend with a decline in political influence. Secondly, the rising political influence of India’s more populous states in the North could reinforce the trend of a less neutral and more aggressive foreign policy stance that we expect India to assume. Investment Conclusions Indian equity markets have historically traded at a hefty premium to Emerging Markets (EMs). This premium is often attributed to India’s youthful demographic structure. However academic literature has shown that realizing benefits associated with a youthful demographic structure is dependent on a country’s institutions and requires the productive employment of potential workers. It has also been shown, both theoretically and empirically, that there is nothing automatic about the link from demographic change to economic growth.1 Country-specific studies have also shown that it is difficult to find a robust relationship between asset returns on stocks, bonds, or bills, and a country’s age structure.2 An analysis of equity market returns generated by young EMs confirms that a youthful demographic structure can aid high equity returns but the geopolitical setting and macroeconomic factors matter too. Moreover, history confirms that each young country spawns a new generation of winners and losers. Fixed patterns in terms of top performing or worst performing sectors are not seen across young and populous EMs. The rest of this section highlights details pertaining to these two findings. Investment Implication#1: Youth Does Not Assure High Equity Market Returns China in the nineties, Indonesia & Brazil in the early noughties and India over the last decade had similar demographic features (see Row 1, 2 and 3 in Table 1). Table 1Leader And Laggard Sectors Can Vary Across Young, Populous Countries However, it is worth noting that these four EMs delivered widely varying returns even when their demographic features were similar (see Row 5, 6 and 7 in Table 1). In real dollarized terms equity returns ranged from a CAGR of -22% to 8% for these four countries. The variation in returns can be attributed to differences in macroeconomic and geopolitical factors. Brazil’s period of political stability in the early 2000s along with its relatively high per capita incomes were potentially responsible for Brazil’s youthful demography translating into high equity market returns. At the other end of the spectrum, equity returns in China were the lowest despite a young demography owing to low per capita incomes and economic restructuring prevalent in the nineties. Investment Implication#2: Each Young Country Spawns A New Generation Of Winners And Losers Given that a young populace is expected to display a higher propensity to consume, sectors like consumer staples, consumer discretionary, and financials are expected to outperform in young countries. However, a cross-country analysis suggests that a young country does not necessarily throw up any consistent patterns of sector performance. Sectoral performance patterns too appear to be affected by demographics along with macroeconomic and geopolitical factors. Similarities in the profile of top performing sectors in India, China, Brazil and Indonesia when these countries were young are few and far between (see Row 9, 10 and 11 in Table 1). No patterns or similarities are evident even in the profile of worst performing sectors in India, China, Brazil and Indonesia when they had similar demographic features (see Row 12, 13 and 14 in Table 1). Even India’s own experience confirms that: There exists no correlation between India’s equity market returns and its demographic structure. India was at its youngest in the nineties and yet its peak equity market returns were achieved in the subsequent decade (see Row 4, 5 & 6 in Table 2). High domestic growth combined with the emergence of political stability potentially allowed India’s youth to translate into high equity market returns over 2000-2010. Table 2Youth Is Not A Sufficient Condition For A Market To Deliver High Returns There exists no pattern in terms of top or worst performing sectors in India as it has aged over the last three decades (see Row 8 to 13 in Table 2). Healthcare for instance was the top performing sector in India in the 1990s when India’s median age was only 21 years. Industrials as a sector have featured as one of the worst performing sectors in India in the 1990s as well as the late noughties despite India’s youthful age structure. This could be attributed to the fact that India’s growth model pivoted off service sector growth while industrial sector development has lagged. Bottom Line: History suggests that a youthful demographic structure is a necessary but not a sufficient condition for an emerging market like India to deliver high equity market returns. Besides demographics, domestic macroeconomic and regional geopolitical factors create a deep imprint on equity returns’ patterns too. India faces a geopolitical tailwind as its economy develops and China’s risks increase. Nevertheless, owing to India’s heterogeneity and poverty, its road to realizing its demographic dividend will be paved with policy risks. Even as India’s lead on the demographic front is expected to continue, tactical underweights on this EM too are warranted from time to time.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 David Bloom et al, "Global demographic change: dimensions and economic significance", NBER Working Paper No. 10817, September 2004, nber.org. 2 James M Poterba, "Demographic Structure and Asset Returns" The Review of Economics and Statistics, Vol. 83, No. 4, November 2001, The MIT Press.

Highlights Global oil demand will remain betwixt and between recovery and relapse through 3Q21, as stronger DM consumer spending and increasing mobility wrestles with persistent concerns over COVID-19-induced lockdowns in Latin America and Asia. These concerns will be allayed as vaccines become more widely distributed, and fears of renewed lockdowns – and their associated demand destruction – recede.  Going by US experience – which can be tracked on a weekly basis – as consumer spending rises in the wake of relaxed restrictions on once-routine social interactions, fuel demand will follow suit (Chart of the Week). OPEC 2.0 likely will agree to return ~ 400k b/d monthly to the market over the course of the next year and a hal. For 2021, we raised our average forecast to $70/bbl, and our 2H21 expectation to $74/bbl. For 2022 and 2023, we expect Brent to average $75 and $78/bbl. These estimates are highly sensitive to demand expectations, particularly re containment of COVID-19. Feature For every bit of good news related to the economic recovery from the COVID-19 pandemic, there is a cautionary note. Most prominently, reports of increasing demand for refined oil products like diesel fuel and gasoline in re-opening DM economies are almost immediately offset by fresh news of renewed lockdowns, re-infections in highly vaccinated populations, and fears a new mutant strain of the coronavirus will emerge (Chart 2).1 In this latter grouping, EM economies feature prominently, although Australia this week extended its lockdown following a flare-up in COVID-19 cases. Chart of the WeekUS Product Demand Revives As Economy Reopens Chart 2COVID-19 Infection And Death Rates Keep Markets On EdgeOur expectation on the demand side is unchanged from last month – 2021 oil demand will grow ~ 5.4mm b/d vs. 2020 levels, while 2022 and 2023 consumption will grow 4.1 and 1.6mm b/d, respectively (Chart 3). These estimates reflect the slowing of global GDP growth over the 2021-23 interval, which can be seen in the IMF's and World Bank's GDP estimates, which we use to drive our demand forecasts.2 Weekly data from the US seen in the Chart of the Week provide a hint of what can be expected as DM and EM economies re-open in the wake of relaxed restrictions on once-routine social interactions. Demand for refined products – e.g., gasoline, diesel fuel and jet fuel – will recover, but at uneven rates over the next 2-3 years. The US EIA notes the recovery in diesel demand, which is included in "Distillates" in the chart above, has been faster and stronger than that of gasoline and jet fuel. This is largely because it reflects the lesser damage done to freight movement and activities like mining and manufacturing. The EIA expects 4Q21 US distillate demand to come in 100k b/d above 4Q19 levels at 4.2mm b/d, and to hit an all-time record of 4.3mm b/d next year. US gasoline demand is not expected to surpass 2019 levels this year or next, in the EIA's forecast. This is partly due to improved fuel efficiencies in automobiles – vehicle-miles travelled are expected to rise to ~ 9mm miles/day in the US, which will be slightly higher than 2019's level. Jet fuel demand in the US is expected to return to 2019 levels next year, coming in at 1.7mm b/d. Chart 3Global Oil Demand Forecast Remains Steady Quantifying Demand Risks We use the recent uptick in COVID-19 cases as the backdrop for modelling demand-destruction scenarios in this month’s oil balances (Chart 2). We consider different scenarios of potential demand destruction caused by the resurgence in the pandemic (Table 1). Last year, demand fell by 9% on average, which we take to be the extreme down move over an entire year. In our simulations, we do not expect demand to fall as drastically this time. Table 1Demand-Destruction Scenario Outcomes We modelled two scenarios – a 5% drop in demand (our low-demand-destruction scenario) and an 8% drop in demand (our high-demand-destruction scenario). A demand drop of a maximum of 2% made nearly no difference to prices, and so, we did not include it in our analysis. In both cases, demand starts to fall by September and reaches its lowest point in October 2021. We adjusted changes to demand in the same proportion as changes in demand in 2020, before making estimates converge to our base-case by end-2022. The estimates of price series are noticeably distinct during the period of the simulation (Chart 4). Starting in 2023, the low-demand-destruction prices and base-case prices nearly converge, as do their inventory levels. Prices and inventory levels in the high-demand-destruction case remain lower than the base-case during the rest of the forecast sample. OPEC 2.0 and world oil supply were kept constant in these scenarios. World oil supply is calculated as the sum of OPEC 2.0 and Non-OPEC 2.0 supply. Non-OPEC 2.0 can be broken down into the US, and Non-OPEC 2.0, Ex-US countries. Examples of these suppliers are the UK, Canada, China, and Brazil. OPEC 2.0 can be broken down into Core-OPEC 2.0 and the cohort we call "The Other Guys," which cannot increase production. Core-OPEC 2.0 includes suppliers we believe have excess spare capacity and can inexpensively increase supply quickly. Chart 4Brent Forecasts Rise As Global Economy Recovers COVID-19 Demand Destruction Scenarios OPEC 2.0 Remains In Control We continue to expect the OPEC 2.0 producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia to maintain its so-far-successful production policy, which has kept the level of supply below demand through most of the COVID-19 pandemic (Chart 5). This allowed OECD inventories to fall below their pre-COVID range, despite a 9% loss of global demand last year (Chart 6). We expect this discipline to continue and for OPEC 2.0 to continue restoring its market share (Table 2). Chart 5OPEC 2.0 Production Policy Kept Supply Below Demand Chart 6...And Drove OECD Inventories Down Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Our expectation last week the KSA-UAE production-baseline impasse will be short-lived remains intact. We expect supply to be increased after this month at a rate of 400k b/d a month into 2022, per the deal most members of the coalition signed on to prior to the disagreement between the longtime GCC allies. This would, as the IEA notes, largely restore OPEC 2.0's spare capacity accumulated via production cutbacks during the pandemic of ~ 6-7mm b/d by the end of 2022 (Chart 7). It should be remembered that most of OPEC 2.0's spare capacity is held by Gulf Cooperation Council (GCC) states, which includes the UAE. The UAE's official baseline production number (i.e., its October 2018 production level) likely will be increased to 3.65mm b/d from 3.2mm b/d, and its output in 2H21 and 2022 likely will be adjusted upwards. As one of the few OPEC 2.0 members that actually has invested in higher production and can increase output meaningfully, it would, like KSA, benefit from providing barrels out of this spare capacity.3 Chart 7OPEC 2.0 Spare Capacity Will Return As we noted last week, we do not think this impasse was a harbinger of a breakdown in OPEC 2.0's so-far-successful production-management strategy. In our view, this impasse was a preview of how negotiations among states with the capacity to raise production will agree to allocate supply in a market starved for capital in the future. This is particularly relevant as US shale producers continue to focus on providing competitive returns to their shareholders, which will limit supply growth to that which can be done profitably. We see the "price-taking cohort" – i.e., those producers outside OPEC 2.0 exemplified by the US shale-oil producers – remaining focused on maintaining competitive margins and shareholder priorities. This means maintaining and growing dividends, and returning capital to shareholders will have priority as the world transitions to a low-carbon business model (Chart 8).4 For 2021, we raised our average forecast to $70/bbl on the back of higher prices lifting the year-to-date average so far, and our 2H21 expectation to $74/bbl. For 2022 and 2023, we expect Brent to average $75 and $78/bbl (Chart 9). These estimates are highly sensitive to demand expectations, which, in turn, depend on the global success in containing and minimizing COVID-19 demand destruction, as we have shown above. Chart 8US Shale Producers Focus On Margins Chart 9Raising Our Forecast Slightly Investment Implications In our assessment of the risks to our views in last week's report, we noted one of the unintended consequences of the unplanned and uncoordinated rush to a so-called net-zero future will be an improvement in the competitive position of oil and gas. This is somewhat counterintuitive, but the logic goes like this: The accelerated phase-out of conventional hydrocarbon energy sources brought about policy, regulatory and legal imperatives already is reducing oil and gas capex allocations within the price-taking cohort exemplified by US shale-oil producers. This also will restrict capital flows to EM states with heavy resource endowments and little capital to develop them. Our strong-conviction call on oil, gas and base metals is premised on our view that renewables and their supporting grids cannot be developed and deployed quickly enough to make up for the energy that will be foregone as a result of these policies. Capex for the metals miners has been parsimonious, and brownfield projects continue to dominate. Greenfield projects can take more than a decade to develop, and there are few in the pipeline now as the world heads into its all-out renewables push. In a world where conventional energy production is being forced lower via legislation, regulation, shareholder and legal decisions, higher prices will ensue even if demand stays flat or falls: If supply is falling, market forces will lift oil and gas prices – and the equities of the firms producing them – higher. As for metals like copper and their producers, if supply is unable to keep up with demand, prices of the commodities and the equities of the firms producing them will be forced to go higher.5 This call underpins our long S&P GSCI and COMT ETF commodity recommendations, and our long MSCI Global Metals & Mining Producers ETF (PICK) recommendation. We will look for opportunities to get long oil and gas producer exposure via ETFs as well, given our view on oil and metals spans the next 5-10 years.   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 growth in large-scale solar capacity will exceed the increase in wind generation for the first time ever in 2021-22. The EIA forecasts 33 GW of solar PV capacity will be added to the US grid this year and next, with small-scale solar PV increasing ~ 5 GW/yr. The EIA expects wind generation to increase 23 GW in 2021-22. The EIA attributed the slow-down in wind development to the expiration of a $0.025/kWH production tax credit at the end of 2020. Taken together, solar and wind generation will account for 15% of total US electricity output by the end of 2022, according to the EIA. Nuclear power will account for slightly less than 20% of US generation in 2021-22, while hydro will fall to less than 7% owing to severe drought in the western US. At the other end of the generation spectrum, coal will account for ~ 24% of generation this year, as it takes back incremental market share from natural gas, and ~ 22% of generation in 2022. Base Metals: Bullish Iron ore prices continue to trade above $215/MT in China, even as demand is expected to slow in 2H21. Supply additions from Brazil, which ships higher quality 65% Fe ore, have been slower than expected, which is supporting prices (Chart 10). Separately, the Chinese government's auction of refined copper earlier this month cleared the market at $10,500/MT, or ~ $4.76/lb. Spot copper has been trading on either side of $4.30/lb this month, which indicates the Chinese market remains well bid. Precious Metals: Bullish The 13-year record jump in the US Consumer Price Index reported this week for the month of June is bullish for gold, as it produced weaker real rates and sparked demand for inflation hedges. Fed Chair Powell continued to stick to the view that the recent rise in inflation is transitory. The Fed’s dovish outlook will support gold prices and likely will lead to a weaker US dollar, as it reduces the possibility that US interest rates will rise soon. A falling USD will further bolster gold prices (Chart 11). Chart 10 Chart 11     Footnotes 1     We highlighted this risk in last week's report, Assessing Risks To Our Commodity Views, which is available at ces.bcaresearch.com. Two events – in the Seychelles and Chile, where the majority of the populations were inoculated – highlight re-infection risk. Re-infections in Indonesia along with lockdowns following the spread of the so-called COVID-19 Delta variant also are drawing attention. Please see Euro 2020 final in UK stokes fears of spread of Delta variant, published by The Straits Times on July 11, 2021. The news service notes that in addition to the threats super-spreader sporting events in Europe present, "The rapid spread of the Delta variant across Asia, Africa and Latin America is exposing crucial vaccine supply shortages for some of the world's poorest and most vulnerable populations. Those two factors are also threatening the global economic recovery from the pandemic, Group of 20 finance ministers warned on Saturday." 2     Please see the recently published IMF World Economic Outlook Reports and the World Bank Global Economic Prospects. 3    If, as we suspect, KSA and the UAE are playing a long game – i.e., a 20-30-year game – this spare capacity will become more valuable as investment capex into oil production globally slows. Please see The $200 billion annual value of OPEC’s spare capacity to the global economy published by kapsarc.org on July 17, 2018. 4    Please see Bloomberg's interview with bp's CEO Bernard Looney at Banks Need ‘Radical Transparency,’ Citi Exec Says: Summit Update, which aired on July 13, 2021. In addition to focusing on margins and returns, the company – like its peers among the majors – also is aiming to reduce oil production by 20% by 2025 and 40% by 2030. 5    This turn of events is being dramatically played out in the coal markets, where the supply of metallurgical coals is falling as demand increases. Please see Coal Prices Hit Decade High Despite Efforts to Wean the World Off Carbon published by wsj.com on June 25, 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Special Report

In lieu of next week’s report, I will be presenting the quarterly Counterpoint webcast titled ‘Where Is The Groupthink Wrong? And How To Profit From It.’ I do hope you can join. We will then take a summer break, so our next report will come out on August 5. Highlights The quantum theory of finance describes the strange quantum effects of ultra-low inflation, of ultra-low interest rates, and of ultra-low probabilities. The key finding of the quantum theory of finance is that when inflation and interest rates get ultra-low, inflation becomes completely insensitive to monetary policy, while risk-asset valuations become hyper-sensitive to monetary policy. The hyper-sensitivity of $500 trillion of global risk-assets to bond yields means that the ultimate low in the US T-bond yield is still to come. Given the hyper-sensitivity of equity valuations to bond yields and the demand for US assets during bond market rallies, it also means that the structural bull market in equities and the structural bull market in the US dollar are both still intact. Feature Feature ChartNear The Lower Bound In Bond Yields, Potential Losses Are Greater Than Potential Gains When things get ultra-small, the laws of physics undergo a radical shift. Classical physics breaks down, and we must to turn to an alternative theory to explain and predict the physical world. That theory is the quantum theory of physics. In this updated Special Report we propose that, just as there is the quantum theory of physics, there is The Quantum Theory Of Finance. When inflation and interest rates get ultra-low, the laws of economics and finance undergo a radical shift. And we must turn to the alternative theory to explain and predict the economic and financial world. In the physical world, the allowable values of a physical system appear to be continuous, with all values permitted. In fact, the permitted values occur in discrete ‘quanta’. At ultra-small scales, these quantum effects become the dominant driver of physical systems and form the foundation of the quantum theory of physics. Likewise, in the economic and financial world of ultra-low inflation and interest rates, quantum effects become the dominant drivers of the system. These quantum effects take three forms: The quantum effects of ultra-low inflation. The quantum effects of ultra-low interest rates. The quantum effects of ultra-low probabilities. The Quantum Effects Of Ultra-Low Inflation Even though inflation is continuous mathematically, we do not perceive it as such psychologically. Instead we perceive inflation as ‘quantum states’ of either price stability or price instability. A recent IFO paper points out that households’ inflation perceptions are “more in line with the imperfect information view prevailing in social psychology than with the rational actor view assumed in mainstream economics.”1 And in Real-Feel Inflation: Quantitative Estimation of Inflation Perceptions, Michael Ashton confirms that “it would be challenging for a consumer to distinguish 1 percent inflation from 2 percent inflation – that fine of a gradation in perception would be extremely unusual to find.”2 There are several reasons why we perceive inflation imprecisely: We do not recognise quality change and substitution adjustments. We tend to feel inflation asymmetrically, noticing goods whose prices are rising, but noticing less goods whose prices are falling. This is the classic attribution bias: higher prices are inflation, lower prices are “good shopping.” Items whose prices are volatile tend to draw more attention, and give more opportunities for these asymmetries to compound. We notice the price changes of small, frequently purchased items more than the price changes of large infrequently purchased items. We perceive the cost of homeownership as the monthly mortgage payment, and not the imputed cost of owners’ equivalent rent (OER). Yet OER is the largest single item in the US core CPI basket, weighted at 30 percent. The result of these biases is that we perceive inflation intuitively, as a quantum state rather than as a precise number within a continuum. The quantum effects of ultra-low inflation mean that policymakers can take an economy from the state of price instability to the state of price stability, and vice-versa, but they cannot sustainably hit an arbitrary inflation target within the quantum state, such as 2 percent (Chart I-2). Chart I-2Mission Impossible: 2 Percent Inflation The Quantum Effects Of Ultra-Low Interest Rates Policymakers accept that there exists an interest rate, at around -1 percent, below which there would be an exodus of bank deposits. Hence, this marks the lower bound of policy interest rates. When policy interest rates are at, or near, this lower bound, central banks can turn to a second strategy: they can promise to keep the policy rate ultra-low for an extended period. Thereby they can pull down the long bond yield towards the lower bound too. To do this, they must convince the market that their promise is genuine. Enter quantitative easing (QE) which, in the words of the ECB’s former Chief Economist Peter Praet, is nothing more than “a signalling channel which reinforces the credibility of forward guidance on (ultra-low) policy rates.” Once forward guidance plus QE has taken bond yields close to their lower bound, we start to see the quantum effects of ultra-low interest rates. Specifically, the bond investor is left with a highly asymmetric payoff – the bond price can fall much more than it can rise. Witness the performance of Swiss bonds through the past three years. The worst drawdowns have far exceeded the best gains (Feature Chart, Chart I-3 and Chart I-4). Chart I-3Swiss Bonds Offer Small Potential Gains... Chart I-4...But Big Potential Losses This asymmetric payoff is technically known as negative skew and it starts to take effect when bond yields decline to around 2 percent above their lower bound. So, if the lower bound for the 10-year T-bond yield is -0.5 percent, the negative skew in its payoffs would start to take effect at around 1.5 percent. One important implication of the quantum effect of ultra-low interest rates is that the asymmetry of bond payoffs becomes very similar to the asymmetry of equity and other risk-asset payoffs (Chart I-5). This is important because, as we describe in the next section, it is the skew of an asset’s payoff that establishes its absolute and relative riskiness. Chart I-5Equities Can Suffer Bigger Short-Term Losses Than Short-Term Gains (Negative Skew) The Quantum Effects Of Ultra-Low Probabilities We are very bad at comprehending low probabilities. For example, we cannot distinguish a 1 in a 1000 risk from a 1 in a 100 risk, even though the second risk is ten times greater than the first. This is what Daniel Kahneman’s and Amos Tversky’s Nobel prize winning Prospect Theory called the ‘quantal effect’ of ultra-low probabilities. Kahneman and Tversky discovered that our fears and hopes come in quanta rather than in a continuum, with the result that we overweight the tail-events in a payoff distribution. “Because people are limited in their ability to comprehend and evaluate extreme probabilities, highly unlikely events are either ignored or over-weighted.” If the payoff distribution is symmetric, then our overweighting of the positive and negative tails cancels out, meaning there is no impact on the value of the payoff (Figure I-1). However, if the payoff distribution is skewed, then the longer tail dominates our perceived value of the payoff. Figure I-1In A Symmetric Payoff, We Overestimate The Big Gain And the Big Loss Equally, So It Cancels Out A lottery payoff has an extreme positive skew. There exists a miniscule chance of winning a fortune. As we overweight this highly unlikely event, we overvalue the lottery ticket relative to its expected payoff (Figure I-2). And this explains the existence of the multi-billion dollar lottery industry. Figure I-2In A Positively-Skewed Payoff (Lottery), We Overestimate The Big Gain, So We Overpay Conversely, the payoff from equities has a negative skew. As we overweight the tail-event of losing a lot of money, we undervalue this negatively skewed payoff (Figure I-3). In other words, we demand a higher return from a negatively skewed payoff relative to a symmetrical payoff, such as the payoff from bonds when yields are not ultra-low. And this explains the existence of the so-called ‘equity risk premium.’ Figure I-3In A Negatively-Skewed Payoff (Risk-Assets), We Overestimate The Big Loss, So We Demand A ‘Risk Premium’ Crucially though, at ultra-low bond yields – when both equity and bond payoffs carry the same negative skew – we no longer demand a higher return from equities versus bonds. As the equity risk premium compresses, the return demanded from equities and other risk-assets collapses to the ultra-low bond yield. Put another way, the valuation of risk-assets soars. The Quantum Theory Of Finance, The Past And The Future The key finding of the quantum theory of finance is this. When inflation and interest rates get ultra-low, inflation becomes completely insensitive to monetary policy, while risk-asset valuations become hyper-sensitive to monetary policy. This is the story of the past decade, and most likely the story of the coming years. For over a decade now, central banks have fixated on hitting their 2 percent inflation targets when the quantum effects of ultra-low inflation make such a target unachievable. In their misguided fixation, the unleashing of trillions of dollars of QE has taken bond yields to unprecedented lows which has driven risk-asset valuations to unprecedented highs, and made them hyper-sensitive to the slightest move in bond yields (Chart I-6 and Chart I-7). Chart I-6Real Estate Prices Have Massively Outperformed Rents Chart I-7Equity Prices Have Massively Outperformed Profits Yet to be clear, though policymakers cannot consistently hit the 2 percent inflation target, they could certainly take the economy back to price instability – if they pursued ultra-loose monetary policy combined with ultra-loose fiscal policy aggressively enough for long enough. But if a major economy were to take this road – intentionally or accidentally – the $500 trillion valuation of global risk-assets that is premised on ultra-low inflation and ultra-low interest rates would collapse. As we have previously written, this means that The Road To Inflation Ends At Deflation and the ultimate low in the T-bond yield is still to come. Alternatively, another deflationary shock could take us to this ultimate low in the T-bond yield more directly. Given the hyper-sensitivity of equity valuations to bond yields and the massive portfolio inflows into US assets during shocks, this also means that the structural bull markets in equities and the structural bull market in the US dollar are both still intact. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Please see Households’ Inflation Perceptions and Expectations: Survey Evidence from New Zealand, IFO Working Paper, February 2018 available at https://www.ifo.de/DocDL/wp-2018-255-hayo-neumeier-inflation-perceptions-expectations.pdf 2 Please see Real-Feel Inflation: Quantitative Estimation of Inflation Perceptions by Michael Ashton, National Association for Business Economics available at https://link.springer.com/content/pdf/10.1057/be.2011.35.pdf Fractal Trade Update We are pleased to report that long USD/CAD achieved its 3.7 percent profit target, and short building materials (PKB) versus healthcare (XLV) achieved its 15 percent profit target. Combined with other successes, this lifts the 6-month win ratio to an all-time high of 76 percent, comprising 12.3 winners versus just 3.9 losers. This week, we present two new candidates for countertrend reversal. First, the strong recent rally in Australian 30-year bonds has reached fragility on its 65-day fractal structure. The recommended trade is to short Australian versus Canadian 30-year bonds, setting the profit-target and symmetrical stop-loss at 3.9 percent. Second, the strong recent rally in lead versus platinum has also reached fragility on its 65-day fractal structure. The recommended trade is to short lead versus platinum, setting the profit-target and symmetrical stop-loss at 6.4 percent. Chart I-8Short Australian Vs, Canadian 30-Year Bonds Chart I-9Short Lead Vs. Platinum Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area   Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations   Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Highlights The August 1 deadline for Congress to raise the debt ceiling will come and go but the looming debt showdown will not replay the 2011-13 crisis. It is not a major risk to the bull market.  The Biden administration still has the political capital to pass a signature piece of legislation via budget reconciliation by end of year.  The tax component of the plan may bring a negative surprise but the market is likely to be more concerned over inflation expectations, eventual Fed rate hikes, and the 2022 fiscal cliff.  The Delta variant of COVID-19 is spreading rapidly in Republican-leaning states but the existence of effective vaccines presents an immediate solution. Any substantial new jitters over the pandemic will increase monetary and fiscal stimulus.  Stay long value over growth stocks despite near term risks and setbacks. Reassess if technical support is broken. Feature The Democratic Party is attempting to achieve two major things before Congress goes on recess in early August. The first is a $1.2 trillion bipartisan infrastructure package – which will take longer than that and may never pass. The second is a $2-$6 trillion budget resolution that will contain reconciliation instructions to enable the Senate to pass President Joe Biden’s proposed $2.5-$4.1 trillion American Jobs and Families Plan with 51 votes. Democrats may very well achieve this resolution before going on recess but that is the very problem when it comes to negotiations with Republicans. Even though divisions within Republican ranks make bipartisanship more likely to succeed than usual, investors should not bet on it. A partisan reconciliation process virtually guarantees both that Democrats pass their next spending bill without major disappointments for the market and that the debt ceiling is not a substantial risk to the bull market. The real risk for investors is that the markets have mostly priced the Democrats’ stimulus spending and will increasingly turn to tax hikes and especially Fed rate hikes. While we expect dovish surprises from the Fed, the strong 4.5% year-on-year growth in core consumer prices, in the context of booming consumer sentiment (Chart 1), suggests the opposite. Chart 1Consumer Confidence Still Rebounding The Debt Ceiling Is Not A Significant Risk To The Bull Market Investors are increasingly concerned about the US debt ceiling, or statutory limit on the national debt, which comes due on August 1. But the debt ceiling does not pose a significant risk to the bull market this time around. The US is not in the same political context as it was in 2011-13 when debt showdowns roiled markets. Investors’ concerns are understandable, of course. In the wake of the Great Recession, congressional Democrats and Republicans quarreled over the debt ceiling, resulting in notable disinflationary episodes in which stocks fell while Treasuries and the dollar rallied (Chart 2). A close look at the debt showdowns of summer 2011 and winter 2012-13 reveals that the “risk off” phase occurred immediately in the first case and over the succeeding month in the second case (Chart 3). The implication is that the whole period from September to December of 2021 could be at risk from any new debt showdown. To understand why risk is not substantial this year one needs to understand what the debt ceiling is. Chart 2ABiden Will Fare Better Than Obama On Debt Ceiling Chart 2BBiden Will Fare Better Than Obama On Debt Ceiling Chart 3A Close Look At Debt Ceiling Showdowns, 2011-13 The debt ceiling is a legislative instrument intended to constrain the US’s public debt. Congress must authorize a higher debt limit to enable the Treasury Department to make debt payments. Legislating a higher debt ceiling is not the same as legislating government spending. Congress spends money through the annual appropriations process. Government spending amidst recurring budget deficits requires new debt issuance to provide the funds to be spent. But debt in excess of the statutory limit must be authorized by raising the limit. The last time Congress expanded the debt ceiling was in August 2019, leaving August 1, 2021 as the next deadline. Theoretically it is unpopular for congressmen to increase the allowance for their own profligate policies and as such the debt ceiling acts a curb on deficits and debt. In reality the two political parties usually pull together the 60 votes needed in the Senate to raise or suspend the limit and prevent the federal government from defaulting on debt payments that come due. The reason is that, if the debt limit were not raised, the government would default on debt payments and be forced to halt social security payments, civil servant wages, and other essential payments. A failure to write checks to seniors and military veterans would be extremely unpopular and both the president’s party and the opposition party would suffer for it (Chart 4). Chart 4ABoth President And Congress To Suffer From Any Debt Showdown Chart 4BBoth President And Congress To Suffer From Any Debt Showdown This does not mean that 10 Senate Republicans can easily be found to join 50 Democrats, thus reaching 60 votes in the Senate to raise the debt limit. The battle is likely to extend well into the fall, pushing up against Treasury Secretary Janet Yellen’s warning that the Treasury could run out of funds before Congress returns in mid-September. The battle will likely extend into October and create fears of a default.  Getting 10 Republicans is difficult. It will not occur as part of a compromise infrastructure package, even though this package already has 11 Republicans supporting it. First, the bipartisan infrastructure deal may fail anyway because Republicans know that Democratic leadership, whether they admit it or not, will tie the deal to the passage of their larger budget reconciliation bill later this fall. Since Republicans oppose the reconciliation bill they may not be able to save face if they vote for an infrastructure deal that enables it. And Democrats do not have any reason to compromise on a bipartisan deal if they think it will destroy their larger reconciliation ambitions. Second, if a bipartisan infrastructure deal comes together, Republicans will insist that the debt ceiling is kept separate. They will not want to link themselves and their infrastructure spending with the bulging national debt. Rather they will want to force the Democrats to link their massive social spending with the national debt. Democrats may accept this trade off since the Biden administration wants a bipartisan deal – as long as they are given guarantees from moderate Senate Democrats that the latter  will support the reconciliation bill. Public opinion is not generally distressed when it comes to federal budget deficits and the national debt. Only 3% of Americans cite these as the most important problem facing the country today – obviously people are more concerned with the general economic recovery and unemployment (Chart 5). However, voters clearly believe debt is one of the country’s problems, with 43% saying they are “very concerned” about debt growth, including 45% of independents. Republicans are under significant pressure on these issues, which is why only moderates would conceivably vote to raise the debt limit and even then would only raise it if forced to choose between doing so and triggering a national default (Chart 6). Brinkmanship is to be expected. Chart 5Voters Say Recovery More Important Than Debt Chart 6Yet Concern About Debt Is Not Negligible While public opinion generally favors infrastructure spending, support for infrastructure falls when it is explicitly linked to increases in national debt. Only 39% of voters, and 30% of independents, think it is acceptable to increase the debt to pay for infrastructure, according to a recent Ipsos/Reuters poll (Chart 7). About 60% of Democrats agree with this statement and 22% of Republicans. The implication – as we have long argued – is that investors should not bet on a bipartisan deal. They should bet on the partisan reconciliation process. Chart 7Democrats Support More Debt For Infrastructure … Others Do Not Support for extreme deficit spending is likely to wane as the economy recovers and the sense of crisis abates. Support for emergency COVID-19 fiscal relief was very high early this year (Chart 8). Yet even at the height of the lockdowns there was a non-negligible group of voters who claimed to care about deficits (Chart 9). Fortunately for the Biden administration, the window of opportunity has not yet closed. The rise in the Delta variant of COVID-19 is generating higher hospitalization rates and renewed concerns about the pandemic, which will help support additional stimulus measures (Table 1). There is still time to pass a major spending bill on infrastructure and/or social welfare before the end of the year. Chart 8Support For COVID Relief Was Very High Chart 9Yet Voters Showed Some Concern About Deficits Even At Height Of Crisis Table 12022 Swing States Struggling With COVID-19 Ultimately Democrats control both chambers of Congress and will be able to vote with party discipline on raising the debt ceiling. They can raise the debt ceiling with a simple majority vote if they include it in their upcoming budget reconciliation bill. This is the main reason why investors should look through any financial market jitters: there is a clear escape hatch if Republicans obstruct. The only reason we do not exclude the possibility of Republican cooperation entirely is that Republicans are in such desperate need of a lifeline following President Trump’s defeat and the post-election riot on Capitol Hill. Indeed, the last time Republicans saw anywhere near such low levels of partisan identification was in 2013, after House Republicans brought the US to the brink of defaulting on its debt (Chart 10). The Senate Republicans are divided, not unified in willingness to trigger a default, and we can count at least 10 Senate Republicans who will capitulate if necessary to prevent a default. Chart 10Republicans Need A Lifeline … Infrastructure May Be It Of course, Senate Republicans could refuse to raise the debt ceiling anyway. But the crucial difference is that Congress is not gridlocked. Democrats, as the ruling party, would suffer in the event of a default and they have the reconciliation process to prevent that from happening. (We have also maintained that they will eventually water down or abolish the Senate filibuster, which would open another way to lift the debt ceiling, although so far they have not succeeded in doing so.) Bottom Line: There are reasons for investors to be increasingly risk averse – tax hikes, eventual Fed rate hikes, the 2022 fiscal cliff, global growth sputters – but the debt ceiling is not one of them. Any major stock market jitters that emerge because of the debt ceiling should be ignored if they are not attended by more significant risks. Biden’s Political Capital Still Sufficient For One More Big Bill All year we have maintained that President Biden will get at least one signature bill passed in addition to the huge COVID-19 relief bill, the American Rescue Plan, passed at the beginning of the year. This view is based in our reading of his political support and capability, as evinced in our Political Capital Index, which we update weekly in the Appendix. This view is on track and we maintain high conviction. Nevertheless readers should be aware that Biden’s support will wobble over the coming months and US economic policy uncertainty will rebound from post-pandemic lows. This week’s update of the Political Capital Index shows some chinks in Biden’s armor that will likely get wider over the coming months, though we do not expect them to prevent the bill from passing. First, while political polarization has subsided from recent peaks in 2020, our polarization indicators are starting to rebound from post-election lows. Our polarization proxy (the gap in partisan approval of the president) will eventually find a floor considering the historically high structural polarization in the country. Meanwhile economic sentiment polarization and the Philly Fed Partisan Conflict Index climbed from their respective lows in the first half of the year, as Congress bickered over Biden’s next reconciliation bill (Chart 11). The upcoming partisan battles over infrastructure, the debt ceiling, budget appropriations, voting rights, guns, the Hyde amendment (abortion), a possible government shutdown, and the midterm elections will revive polarization even if it does not surpass 2020 peaks. Partisanship will ensure the passage of a reconciliation bill but then it will reduce Biden’s ability to pass legislation afterwards.    Chart 11Polarization Still Historically Elevated Second, Biden’s approval rating is rebounding a bit in July from its low point in June but the legislative process – as well as looming foreign policy challenges and other negative surprises – will weigh on his approval, at least until his infrastructure bill passes (Chart 12). Over the medium term, strong consumer sentiment and a recovering economy will prevent Biden’s approval rating from falling to President Trump’s levels, at least until a major mistake or negative shock occurs. Nevertheless presidents tend to have low approval ratings in the modern era due to partisanship and so far Biden is no exception. Chart 12ABiden Approval Will Suffer Till Infrastructure Passes Chart 12BBiden Approval Will Suffer Till Infrastructure Passes Third, while small business continues to be more concerned with wages and inflation than with Biden’s legislative agenda, concerns about higher taxes are gradually emerging. The business community may finally be internalizing Biden’s American Jobs Plan, which will include a corporate tax hike and possibly also individual tax hikes (Chart 13). The stock market is unlikely to ignore Biden’s corporate tax hikes forever, even if they only cause a one-off hit to earnings of 8%-10%. We expect negative tax surprises from the reconciliation process. The small business community’s opposition to Biden’s agenda is well known, and limited in impact, but it will increasingly detract from his political capital on the margin. Fourth, the economy is beginning to decelerate albeit from a very high rate of growth. The manufacturing PMI and its employment component have fallen from their highs in the first half of the year while the ratio of new orders to inventories was flat in June. The non-manufacturing sector showed the same trend with non-manufacturing business activity and new orders-to-inventories coming down from earlier heights. Non-manufacturing employment ticked down though it will likely rebound soon as enhanced federal unemployment benefits expire (Chart 14). Capex intentions softened a bit. Chart 13Small Biz Wakes Up To Inflation, Tax Hikes Chart 14Economy To Decelerate From Highs Still, the unemployment rate continued its decline in June and household and business balance sheets are strong as the economic recovery continues. Biden’s ability to pass his spending plans will ensure that the government contribution to growth remains robust in the coming years, after a soft patch in 2022 as the infrastructure plan is gradually rolled out. Most of these indicators show improvement relative to November, which gives Biden a store of political capital.  Bottom Line: Polarization and policy uncertainty are likely to rebound as the economy decelerates, albeit from rapid growth. Ultimately Biden is likely to pass a signature government spending plan by the end of the year, which will give his approval rating a boost. But given thin margins in Congress, and the looming 2022 midterm elections, Biden’s political capital will largely be exhausted after the second half of this year. Fiscal policy will likely be frozen in place for several years after that. Investment Takeaways The debt ceiling is not a major risk to the bull market, though congressional brinkmanship is inevitable. We are prepared for more volatility and near-term equity setbacks but jitters arising solely from the debt ceiling should be looked through.. Investors should stay focused on the high likelihood that Biden and the Democrats will pass a reconciliation bill that will add about $1.3-$2.5 trillion to the budget deficit over eight years. Disappointments in the bill (higher taxes, lower spending) pose a greater risk to the stock market than the debt ceiling. This bill will solidify the economic recovery but also exact a one-off toll on corporate earnings and hasten concerns over rising inflation expectations and Fed rate hikes. Furthermore a fiscal cliff looms in 2022 as budget deficits normalize from extreme levels. Until new stimulus is secured, this fiscal cliff poses a much greater risk than debt ceilings or a possible government shutdown. The Delta variant of the COVID-19 virus is threatening to clog hospitals and thus poses a risk of forcing authorities to tighten social restrictions, especially in Republican-leaning states where vaccination rates are lower (Chart 15). However, we expect vaccinations to rise – and meanwhile highly vaccinated areas will remain free to conduct business. As long as vaccines remain effective, any scare over variants of the virus will be limited. A selloff is possible but would trigger new bouts of monetary and fiscal stimulus. Chart 15Red States Will Have To Increase Vaccination We will maintain our cyclical orientation of favoring value stocks over growth stocks, although this trade faces an immediate and critical test that could trigger a revaluation (Chart 16). Tactically it should be clear from this report that rising policy uncertainty and other near-term risks are abounding. Chart 16A Test For Value Versus Growth   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Appendix Table A1USPS Trade Table Table A2Political Risk Matrix Chart A1Presidential Election Model Chart A2Senate Election Model Table A3Political Capital Index Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets Footnotes