Fixed Income

Highlights Fed: The Fed is preparing markets for a taper announcement in Q4 of this year. But we don’t see asset purchase tapering as a catalyst for higher bond yields. Rather, bond yields will move higher as the employment data continue to come in hot. Job growth will be strong enough to reach the Fed’s definition of maximum employment by the end of 2022, and the fed funds rate will rise more quickly than is implied by current market expectations. Duration: The 10-year Treasury yield will reach a range of 2% to 2.25% by the time the Fed is ready to lift rates, near the end of 2022. Strong employment data will catalyze the next significant jump in bond yields, but this may not happen until Q4 of this year. The spread of the delta COVID variant could limit the pace of hiring during the next month or two, and bond market positioning may need to turn more bullish before yields can rise. Labor Market: After July’s strong employment report, we calculate that average monthly nonfarm payroll growth of 431k is required to reach the Fed’s “maximum employment” liftoff criteria by the end of 2022. Feature Chart 1A Tapering Announcement Is Coming It’s finally time to talk about tapering. Several Fed governors and regional presidents made media appearances last week, each one presenting a timeline that sets up a tapering announcement before the end of this year. Federal Reserve Governor Christopher Waller: I think you could be ready to do an announcement by September. That depends on what the next two jobs reports do. If they come in as strong as the last one, then I think you have made the progress you need. If they don’t, then I think you are probably going to have to push things back a couple of months.1 St Louis Fed President James Bullard: I don’t think that we need to continue with these purchases now that we’ve got new risks on the horizon and possibly inflation risks on the horizon. […] What I think we should do here is start sooner and go faster and get finished by the end of the first quarter of next year. We don’t really need the purchases anymore.2 Dallas Fed President Robert Kaplan: As long as we continue to make progress in July (jobs) numbers and in August jobs numbers, I think we’d be better off to start adjusting these purchases soon. Doing so gradually, over a time frame of plus or minus about eight months, will help give ourselves as much flexibility as possible to be patient and be flexible on the fed funds rate.3 Fed Governor Lael Brainard presented the most detailed description of what it will take for the Fed to start paring its asset purchases.4 Since December, the Fed’s criteria for tapering has been “substantial further progress” toward its employment and price stability goals. In December, nonfarm payrolls were about 10 million below pre-pandemic levels (Chart 2A). In her speech, which was given prior to the release of July’s jobs report, Brainard noted that if employment grows at the same rate in Q3 as it did in Q2, then “about two-thirds of the outstanding job losses as of December 2020” would be made up by the end of 2021. That figure rose to 71% after July’s strong jobs number (Chart 2B). Chart 2AConditions For Tapering Chart 2BDefining "Substantial Further Progress" In other words, as long as employment growth stays solid – in the 500k/month range – then the Fed will be well over 50% of the way toward its maximum employment goal by the end of this year. This would certainly count as “substantial further progress”. Our expectation is that Q3 jobs growth will be strong enough for the Fed to make an official taper announcement in Q4, with the actual tapering starting in January 2022.5 There is an outside chance that the Fed will rush to start tapering earlier, but only if long-dated inflation expectations rise to well above the Fed’s target range (Chart 2A, bottom panel). As for market impact, we don’t expect the tapering announcement to move markets all that much. First, we mainly care about asset purchase tapering because it could signal that the Fed intends to move more quickly toward rate hikes (Chart 1). This is the concern that prompted the 2013 taper tantrum. This time around, however, the Fed has tied liftoff to explicit employment and inflation criteria. This forward guidance significantly weakens the signaling power of any tapering announcement. Second, surveys indicate that market participants already anticipate that tapering will start in early-2022 (Tables 1A & 1B). In other words, a Q4 taper announcement shouldn’t be that much of a shock to expectations. Table 1ASurvey Of Market Participants Expected Fed Timeline Table 1BSurvey Of Primary Dealers Expected Fed Timeline Interestingly, Fed Vice-Chair Richard Clarida did manage to shock markets with his speech last week, but only because he went further than just a discussion of tapering. Specifically, Clarida articulated his expected timeline for lifting interest rates: Chart 3Median FOMC Forecasts While, as Chair Powell indicated last week, we are clearly a ways away from considering raising interest rates and this is certainly not something on the radar screen right now, if the outlook for inflation and outlook for unemployment I summarized earlier turn out to be the actual outcomes for inflation and unemployment realized over the forecast horizon, then I believe that these three necessary conditions for raising the target range for the federal funds rate will have been met by year-end 2022.6 What are the economic forecasts that Clarida says would meet the conditions for liftoff by the end of 2022? It turns out that they are very close to the FOMC’s median projections (Chart 3). The Fed’s forecast calls for 3% core PCE inflation in 2021, falling to 2.1% in 2022 and 2023. The Fed also sees the unemployment rate falling to 4.5% by the end of this year, 3.8% by the end of 2022 and 3.5% by the end of 2023. Clarida said that he views this forecast as consistent with overall employment returning to its pre-pandemic levels by the end of 2022. We think Clarida’s expected timeline is reasonable. The Appendix at the end of this report presents different scenarios for when the Fed’s “maximum employment” liftoff condition might be met. We estimate that average monthly nonfarm payroll growth of 431k will get us to maximum employment by the end of 2022, in time for early-2023 liftoff. At least so far, monthly nonfarm payroll growth is tracking well above the 431k threshold. If we compare our (and Clarida’s) forecast to market prices, we conclude that market rate expectations are too low. The overnight index swap curve is priced for Fed liftoff in January 2023 but for not even three 25 basis point rate hikes in total by the end of 2023 (Chart 4). This seems too low if the Fed’s liftoff criteria are in fact met by the end of 2022, as is our expectation. Chart 4Rate Expectations Bottom Line: The Fed is preparing markets for a taper announcement in Q4 of this year. But we don’t see asset purchase tapering as a catalyst for higher bond yields. Rather, bond yields will move higher as the employment data continue to come in hot. Job growth will be strong enough to reach the Fed’s definition of maximum employment by the end of 2022, and the fed funds rate will rise more quickly than is implied by current market expectations. Timing The Move Higher In Yields Our expectation for a return to maximum employment by the end of 2022 implies that bond yields will be significantly higher by then. Specifically, we expect that both the 5-year/5-year forward Treasury yield and the 10-year Treasury yield will be in a range between 2% and 2.25% by the time of the first rate hike (Chart 5). The 2% to 2.25% range is consistent with survey estimates of the long-run neutral fed funds rate. But a big question remains over the timing of the next move higher in yields. Are bond yields poised to jump higher immediately? Or will they remain low for the next few months and move up only in 2022? Our sense is that the catalyst for the next significant jump in bond yields will be surprisingly strong employment data. There is widespread consensus that inflation will be close to the Fed’s target (if not higher) by the end of 2022, but recent concerns about labor supply have increased the uncertainty around employment projections. Ultimately, we think that labor supply constraints will ease and that the unemployment rate will catch up to levels implied by different labor demand indicators (Chart 6). However, this may not happen during the next month or two. Chart 5A Target For Long-Dated Yields Chart 6Labor Demand Is Strong The spread of the Delta coronavirus variant has just started to ramp up in the United States (Chart 7). The UK’s experience with the variant shows that vaccination significantly limits the number of hospitalizations and suggests that economic lockdowns can be avoided. However, it took about one month for the UK’s new case count to peak once the variant started spreading. A similar roadmap could lead to hiring delays in the US during the next month or two, at least until the new case count starts to fall and concerns abate. From a market technical perspective, we also note that bond market positioning remains significantly net short and that bond market sentiment is less bullish than is often the case at major inflection points (Chart 8). This is not the ideal technical set-up for a large immediate jump in bond yields. Chart 7Delta Is A Near-Term Risk To Hiring Chart 8Positioning & Sentiment Bottom Line: The 10-year Treasury yield will reach a range of 2% to 2.25% by the time the Fed is ready to lift rates, near the end of 2022. Strong employment data will catalyze the next significant jump in bond yields, but this may not happen until Q4 of this year. The spread of the delta COVID variant could limit the pace of hiring during the next month or two, and bond market positioning may need to turn more bullish before yields can rise. Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a more or less complete recovery of the labor force participation rate back to February 2020 levels (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 63%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +431k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth continues to print at the same level as last month, then we could anticipate a Fed rate hike by June 2022. Table A2Tracking Toward Fed Liftoff We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bloomberg.com/news/articles/2021-08-02/waller-says-strong-job-reports-may-warrant-september-taper-call?sref=Ij5V3tFi 2 https://www.stlouisfed.org/from-the-president/video-appearances/2021/bullard-washington-post-inflation-tapering 3 https://www.reuters.com/business/finance/exclusive-feds-kaplan-wants-bond-buying-taper-start-soon-be-gradual-2021-08-04/ 4 https://www.federalreserve.gov/newsevents/speech/brainard20210730a.htm 5 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021. 6 https://www.federalreserve.gov/newsevents/speech/clarida20210804a.htm Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

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 Advances in tennis, swimming and the high jump came from challenging the ‘best practices’, and finding better ways of doing these things. The pandemic has challenged the best practices on how we should work, do business, and shop, catalysing better ways of doing these things. The productivity boom could be a super-boom because the current disruption is not in just one sector but across the entire economy. A productivity super-boom means that the economy will take longer to reabsorb the unemployed, and that structural inflation will stay depressed. This means that interest rate hikes will be much later and much shallower than the market is pricing. For equity investors, a productivity super-boom plus the market’s overestimation of Fed rate hikes structurally favours growth sectors versus value sectors. Thereby, it also structurally favours the S&P500 versus the Eurostoxx50. Fractal analysis: stocks versus bonds remains fragile, and the rally in tin is very fragile. Feature Chart of the WeekThe Pandemic Has Catalysed A Productivity Boom “I believe that the (Fosbury) flop was a natural style and I was just the first to find it” – Dick Fosbury, on how he revolutionised the high jump Watching the Tokyo Olympics, the flurry of new world records reassures us that human athletic productivity continues to advance. It does so in three ways: better biology, better technology, and better ways of doing the same thing. Better biology comes from advances in nutrition and healthcare – at least, for those that embrace the advances. Better technology means better equipment. For example, more ergonomic bikes, sharkskin-like swimwear that minimises water resistance, and running shoes that re-channel energy back into the legs. Albeit this raises the contentious issue that technological advances are giving some athletes an unfair and unnatural advantage. Case in point, World Athletics (and the Tokyo Olympics) have banned prototype versions of Nike’s Vaporfly running shoe that was used by Eliud Kipchoge to run the first sub-two hour marathon. The banned prototype shoe, containing triple carbon plates inside thick ultra-compressed foam, is claimed to improve running economy by up to four percent. But if technological advances are giving some athletes an advantage, it follows that they must also be giving some firms and economies an advantage. While this is unfair in sporting competition, it is fair in economic competition. An important implication is that firms and economies that embrace disruptive technologies and innovations – such as working from home – are likely to generate superior long-term productivity growth than firms and economies that do not. Productivity Growth Comes From Finding Better Ways Of Doing The Same Thing Yet, looking at the longer-term ‘productivity growth’ in sport, many of the greatest advances have come not from better biology or better technology, but just from finding better ways of doing the same thing. Tennis, swimming, and athletics provide three excellent examples of such innovation. A tennis ball weighs just 50 grams, so anybody can hit a tennis ball hard. The difficult part is hitting the ball hard and landing it within the 78 foot court. In the 1970s, Bjorn Borg revolutionised tennis by hitting with aggressive topspin on both the forehand and backhand as well as the serve. Meaning that rather than having to approach the net as was the ‘best practice’, Borg could win matches from the baseline. All it required was a different way of holding the racket and using his arms (Figure I-1). Figure I-1Challenging The Best Practice In Tennis Boosted Its Productivity Borg’s revolution has a fascinating backstory. Borg’s father, a table tennis champion, won a tennis racket in a table tennis tournament and gave it to the 9-year old Bjorn. Familiar with table tennis and now armed with a tennis racket, the young Borg’s revolution was to play tennis as if it were table tennis – with its trademark topspin on both wings as well as the serve – albeit on a much bigger ‘table.’ And with a racket that was far too heavy for him that he held with both hands. (He eventually switched to a one-handed forehand but kept his two-handed backhand.) Go back a hundred years, and swimming experienced a similar revolution. Until the 1870s, the best practice for European swimmers was the highly inefficient breaststroke. But in 1873, John Arthur Trudgen emulated the technique used by Native Americans whereby the arms moved in a crawl. Later, the Australian Fred Cavill also emulated the Natives’ flutter kick, and thus made mainstream the front crawl, which has significantly increased swimming speed, or swimming ‘productivity.’ All it required was a different way of moving our arms and legs.     But probably the greatest example of athletic innovation came in the 1968 Mexico Olympics, when Dick Fosbury turned the standard high jumping technique on its head – or, more precisely, on its back – to win the gold medal and smash the world record.   Prior to the 1968 Games, the best practice high jump technique had been the ‘straddle’ which involved jumping forward, twisting the body to navigate the bar, and then landing on your feet. Fosbury changed all that forever. He jumped backwards off the wrong foot, arched his back over the bar, and landed on his back (Figure I-2). Figure I-2Challenging The Best Practice In The High Jump Boosted Its Productivity Just like the tennis topspin and swimming’s front crawl, high jump’s ‘Fosbury flop’ has become the mainstream technique in the sport, taking performance and ‘productivity’ literally to new highs. And just like the tennis topspin and swimming’s front crawl, all it required was a different way of using our existing resources – in this case, jumping backwards rather than forwards. Yet in the case of the innovative Fosbury flop, something else also played an important role – a new environment. Until the 1960s, high jumpers cleared the bar and landed on sawdust, sand, or thin mats. Hence, any innovation in high jump techniques was constrained by having to land on your feet. This changed when Fosbury’s high school became one of the first to install deep foam matting for high jump landing. The Fosbury flop could not have been innovated before the introduction of deep foam matting, because jumping backwards and landing on your back depended on the existence of a soft foam mat for a safe landing. The crucial lesson is that a new environment gives us a chance to challenge beliefs on ‘how things should be done’, a chance to discover new ways of doing the same thing differently, and better. To challenge beliefs on how things should be done, what bigger change in the environment can there be than a global pandemic? The Pandemic Has Catalysed Better Ways Of Doing The Same Thing Just like athletic productivity growth, economic productivity growth comes from better biology (which improves both our physical and intellectual capacity), better technology, and finding better ways of doing the same thing. Of these three drivers, the first two are continuous processes but the third, finding better ways of doing the same thing, gets a massive boost from disruptive changes in the environment such as recessions (Chart of the Week and Chart I-2).   Chart I-2Productivity Surges After Recessions In this regard, any technology that is required already generally exists, but the recession is the necessary catalyst for its wholesale adoption. For example, the mass manufacturing of autos already existed well before the Great Depression, but the Depression was the catalyst for its wholesale adoption. Likewise, word processors existed well before the dot com bust, but the 2000 recession was what finally killed the office typing pool. In the same way, the technology for online shopping and remote meetings has been around for years, but it is the pandemic that has catalysed its wholesale adoption (Chart I-3). Chart I-3The Pandemic Has Accelerated The Shift To Online As Fosbury said, he was just the first to find a more natural style of high jumping, yet it required a change of environment to challenge the best practice. Similarly, it has taken a global pandemic for us to challenge the best practice on how we should work, do business, shop, and interact (Chart I-4). Chart I-4The Pandemic Has Accelerated The Shift To Online It is sub-optimal to work in the office or to shop in-person all the time. It is also sub-optimal to do these things remotely all the time. The optimal way is some hybrid of in-person and remote interactions, which will clearly differ for each person. But the pandemic has given us the opportunity to find this more natural and better way, and thereby to give our productivity a massive boost (Chart I-5). Chart I-5The Pandemic Has Challenged The Best Practice On How To Work The productivity boom could be a super-boom because the current disruption has forced us all to find better ways of doing things. This differentiates the current episode from previous post-recession periods where transformations were focussed in one sector. For example, the 80s recession reshaped manufacturing, the dot com bust changed the technology sector, and the 2008 recession transformed the financial sector. By comparison, the current transformation is penetrating the entire economy. The Investment Conclusion A productivity super-boom carries two important implications for policymakers. It will take longer for the economy to reabsorb the unemployed, and it will keep structural inflation depressed. This means that interest rate hikes will be much later and much shallower than the market is pricing (Chart I-6 and Chart I-7). Chart I-6Rate Hikes Will Be Later Than The Market Is Pricing Chart I-7Rate Hikes Will Be Shallower Than The Market Is Pricing The investment conclusion is to buy any of the US interest rate futures that expire from December 2022 out to June 2024. The earlier contracts have the higher probabilities of expiring in profit while the later contracts have the greater potential upside. An alternative expression is to buy the 30-year T-bond, or to go long the 30-year T-bond versus the 30-year German bund. For equity investors, a productivity super-boom plus the market’s overestimation of Fed rate hikes structurally favours growth sectors versus value sectors. Thereby, it also structurally favours the S&P500 versus the Eurostoxx50. Fractal Analysis Update Global stocks versus bonds (MSCI All Country World versus 30-year T-bond) continue to exhibit the fragility on the 260-day fractal structure that started in mid-March. Since then, and consistent with this fragility, global stocks have underperformed bonds by 6 percent (Chart I-8). Chart I-8Stocks Versus Bonds Remains Fractally Fragile But fragility on a 260-day fractal structure implies elevated risk of a reversal through at least the following six months. On this basis, our recommendation is to remain, at most, neutral to global stocks versus bonds through the summer. Among recent trades, short corn versus wheat, and short marine transportation versus market achieved their profit targets of 12 percent and 16.5 percent respectively, but short Austria versus Chile, and short lead versus platinum hit their stop-losses of 7 percent and 6.4 percent respectively. The 6-month win ratio stands at a very pleasing 71 percent. This week’s recommended trade is to reinitiate the stopped-out metals pair-trade in a modified expression – short tin versus platinum – given the very fragile 130-day and 260-day fractal structure (Chart I-9). Set the profit target and symmetrical stop-loss at 16.5 percent. Chart I-9Tin Is Fractally Fragile   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  

Highlights Chart 1Still Close To Fair Value Treasury yields fell significantly in July, particularly at the long end of the curve. We continue to view this move as an overreaction to mediocre economic data that will be reversed this fall when labor supply constraints ease and employment surprises to the upside. It’s important to note, however, that despite the drop in long-dated yields the 5-year/5-year forward Treasury yield remains within the bounds of its 1.75% to 2.5% fair value range (Chart 1). That is, shorter-maturity Treasury yields have much more upside than long-dated yields on a 6-12 month investment horizon. We expect the next big move in bonds to be a bear-flattening of the yield curve as the market prices in a Fed rate hike cycle that we see starting near the end of 2022. Investors should position for that outcome today by keeping portfolio duration low and by entering yield curve flatteners. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 37 basis points in July, dragging year-to-date excess returns down to +172 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 89 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report looked at what different combinations of Treasury slope and corporate spreads have historically signaled about corporate bond excess returns.1 It shows that tight corporate spreads only correlate with negative excess returns once the 3-year/10-year Treasury slope is below 50 bps. Though we retain a positive view of spread product as a whole, better value can be found outside of the investment grade corporate sector. Specifically, we recommend that investors shift into high-yield corporates, municipal bonds and USD-denominated EM sovereigns and corporates. We also advise investors to favor long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2   Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 34 basis points in July, dragging year-to-date excess returns down to +433 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.2% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.6% through the first six months of the year, well below the estimate generated by our macro model. Another recent report looked at the incremental spread pick-up investors can earn by moving out of investment grade corporates and into junk.4 It concluded that the extra spread available in high-yield is worth grabbing and that B-rated bonds look particularly attractive in risk-adjusted terms.   MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 19 basis points in July, dragging year-to-date excess returns down to -64 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries widened 8 bps in July. The spread is wide compared to recent history, but it remains tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) widened 3 bps in July (panel 3), and it is now starting to look more competitive compared to other similarly risky spread sectors. The conventional 30-year MBS OAS sits at 36 bps, below the 54 bps offered by Aa-rated corporate bonds but above the 20 bps offered by Aaa-rated consumer ABS and the 34 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related Index underperformed the duration-equivalent Treasury index by 34 basis points in July, dragging year-to-date excess returns down to +57 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 149 bps in July, dragging year-to-date excess returns down to -113 bps. Foreign Agencies underperformed the Treasury benchmark by 11 bps on the month, dragging year-to-date excess returns down to +35 bps. Local Authority bonds underperformed by 19 bps in July, dragging year-to-date excess returns down to +372 bps. Domestic Agency bonds outperformed by 2 bps, bringing year-to-date excess returns up to +28 bps. Supranationals performed in line with Treasuries in July, year-to-date excess returns held flat at +26 bps. USD-denominated Emerging Market (EM) Sovereign bonds continue to offer an attractive spread pick-up versus investment grade US corporate bonds with the same credit rating and duration. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico and Russia. A recent report looked at valuation within the investment grade USD-denominated EM corporate space.6 It found that EM corporates are attractively priced relative to US corporate bonds across the entire investment grade credit spectrum. It also found that EM corporates are attractive relative to EM sovereigns within the A and Baa credit tiers. EM sovereigns have the edge in the Aa credit tier. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 37 basis points in July, dragging year-to-date excess returns down to +271 bps (before adjusting for the tax advantage). The economic and policy back-drop is favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 GO munis in the 12-17 year maturity bucket offer a 10% breakeven tax rate versus corporates with the same credit rating and duration. The breakeven tax rate for Revenue munis is just 2% (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 25% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened in July. Bond yields were down across the curve, but by much more at the long end. The 2-year/10-year slope flattened 15 bps to end the month at 105 bps. The 5-year/30-year slope steepened 1 bp to end the month at 120 bps. While we expect the recent decline in bond yields to reverse during the next 6-12 months, we do not think this reversal will coincide with a re-steepening of the 2/10 yield curve. We noted on the first page of this report that the 5-year/5-year forward Treasury yield remains close to its fair value range. Last week’s report demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.17% in one year’s time and 1.36% in five years (Chart 7). While the latter rate has 157 bps of upside if it converges all the way back to its 2018 high, this pales in comparison to the 269 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell.   TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 112 basis points in July, bringing year-to-date excess returns up to +578 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose by 9 bps and 8 bps, respectively, on the month. At 2.43%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.26%, the 5-year/5-year forward TIPS breakeven inflation rate is just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month investment horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation moderates from its extremely high level. This will lead to some modest steepening of the inflation curve (bottom panel). While the inflation curve has some room to steepen, we don’t see it returning to positive territory. An inverted inflation curve is simply more consistent with the Fed’s Average Inflation Target than a positively sloped one. This is because the Fed’s new framework calls for it to attack its inflation target from above rather than from below.  ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 2 basis points in July, dragging year-to-date excess returns down to +37 bps. Aaa-rated ABS underperformed by 3 bps on the month, dragging year-to-date excess returns down to +28 bps. Non-Aaa ABS outperformed by 4 bps, bringing year-to-date excess returns up to +88 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile, pushing the savings rate higher yet again (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum.   Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in July, bringing year-to-date excess returns up to +187 bps. Aaa Non-Agency CMBS performed in-line with Treasuries in July, keeping year-to-date excess returns steady at +82 bps. Non-Aaa Non-Agency CMBS outperformed Treasuries by 16 bps on the month, bringing year-to-date excess returns up to +539 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 28 basis points in July, dragging year-to-date excess returns down to +87 bps. The average index option-adjusted spread widened 5 bps on the month and it currently sits at 34 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of July 30TH, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of July 30TH, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 26 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 26 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of July 30TH, 2021) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 For ideas on how to increase the average spread of a US bond portfolio please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 7 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021.

Highlights The countertrend yield rally is near its end. Despite the deteriorating Chinese credit impulse, the outlook for global growth remains robust. An ample global liquidity backdrop, an inventory restocking cycle, and an upbeat capex outlook will increase aggregate demand and global capacity utilization. In this context, safe-haven bonds have sufficiently rallied. German yields will rise too, because the European yield curve will steepen. European banks will benefit from this trend. Investors should buy European momentum stocks and sell growth stocks. Investors should favor industrial equities and Sweden. Feature On April 12 of this year, we warned that a countertrend rally in bonds was increasingly likely. The decline in the Chinese credit impulse and the increasingly oversold state of Treasuries created the perfect conditions to generate disappointments in a lopsided market. As a corollary, we grew worried about our equity positioning, which calls for a large exposure to pro-cyclical stocks. Consequently, we recommended investors hedge this portfolio bias with some defensive bets. On July 20, Treasury yields fell to as low as 1.13%. Did this level mark the end of the Treasury rally? The bulk of the decline is behind us, and investors with a 12- to 18-month investment horizon should resume shortening portfolio duration. In Europe too, German yields are likely to trend higher. As a result, European financials and momentum stocks should generate significant outperformance in the coming quarters. Industrial equities are also set to shine, which will benefit the Swedish market, our favorite. Should I Stay Or Should I Go? The near-term outlook for Treasuries is currently more complex than it was in April, when forces lined up neatly to warn of an imminent pullback in yields. Technical indicators show that the oversold conditions that prevailed this spring have mostly cleared up. In April, the BCA Composite Technical Indicator for Treasuries reached its most oversold level in more than 20 years, which provided a very reliable buy signal (Chart 1). Now that the 10-year yield has reclaimed its 40-week moving average, the technical indicator is back to neutral. Normally, when bonds are in a cyclical bear market, which is BCA’s House View, the indicator rarely dips significantly into overbought territory. Meanwhile, the Marketvane Bullish Sentiment survey stands at 60%, which indicates that bonds are once again favored by many newsletters, traders, and investors. Chinese credit growth continues to send a bond-bullish signal (Chart 2). Slowing credit growth could hurt Chinese capex, which in turn has the potential to slow the demand for capital at the global level. This risk could still decrease global yields. Chart 1Bonds Are Not Oversold Anymore... Chart 2...But China Still Consistutes A Risk Chart 3A Synchronous Global Upswing The global economic recovery remains sufficiently broad-based to compensate for the risk of a Chinese slowdown. Our Global Synchronicity Indicator shows that manufacturing PMIs among the world’s major economies are all expanding (Chart 3), which usually elevates yields. This is especially important today, because the far-reaching and generalized nature of the current recovery gives more scope to the global economy to withstand a Chinese economic deceleration. Bottom Line: The variables that called for lower yields in early April are currently sending a mixed message. “Go!” The Global Business Cycle Responds Outside of China’s TSF impulse, most economic variables point toward higher yields. Chart 4Financial Liquidity Lifts The Business Cycle Global liquidity conditions remain consistent with higher growth and thus also with rising global interest rates. BCA’s US Financial Liquidity Index still stands near record highs and confirms that the Global Leading Economic Indicator (LEI) will remain at elevated levels (Chart 4). As a result, we expect the current fall in the Global LEI Diffusion Index to be short lived. Any softening in global growth, therefore, will prove to be transitory. Markets are forward looking. The recent decline in yields anticipated the deceleration in the Global LEI. Long-term rates will also increase before the LEI firms anew.  Excess money growth tells a similar story. Historically, an expansion of the global money supply in excess of the demand for credit sends a strong signal that global economic activity is well supported by reflationary policies. It forecasts above-trend industrial production growth, robust international trade and rising global export prices. Currently, excess money growth in the US, Eurozone and Japan has overtaken its post-GFC high and is consistent with higher US and German yields (Chart 5). Global capacity utilization also points toward higher yields. Our US Composite Capacity Utilization indicator is back in the neutral zone after a steep decline in 2020. Furthermore, US industrial capacity utilization is currently back above its structural trend. Most importantly, capacity utilization should be evaluated at the global level. Even when slower-growing economies such as the Euro Area and Japan are included, global capacity utilization is improving enough to be consistent with rising yields (Chart 6). Chart 5Excess Money Points To Higher Yields Chart 6Rising CAPU Lifts Yields Capacity utilization should climb higher in the coming quarters as the world experiences an inventory re-stocking cycle. The US, with its rich data, provides a good example. The sales-to-inventory ratio is at an extremely elevated level and is climbing very rapidly (Chart 7). Meanwhile, the level of inventories is still 1% below its pre-pandemic peak, while GDP overtook it previous high in the second quarter, and business sales are 11% above their 2018 high. The recent rise in inflation highlights the inability of companies to fulfil demand for their goods and services and, consequently, the need to restock. Hence, we expect companies to increase their inventory spending, which will add to demand and to capacity utilization as the adjustment process takes place. Capex will also lift capacity utilization and put upward pressure on yields. US capex intentions are rising swiftly as firms are unable to meet demand (Chart 8, top panel). Our Japanese Capex Indicator reiterates this message, while the European Commission’s Investment Surveys are also recovering (Chart 8 bottom panels). Historically, capex intentions are an excellent, leading indicator of actual investments, hence, the recent poor capex numbers will not last. Chart 7Restocking Ahead! Chart 8Climbing Capex Intentions Everywhere Greater global cash flow growth is also consistent with higher capex. The growth in EBITDA among global companies has bottomed, and it is currently around 14%. Incidentally, this suggests that capex among quoted firms around the world should expand in the second half of the year by a similar amount (Chart 9). Ultimately, robust cash flows finance expansion plans and also send a strong signal to corporate boards that the environment is ripe for investment spending. Already, capital goods orders are strengthening, which confirms the signal from both the capex surveys and profits. This strength portends very strong private capex numbers in the coming quarters and thus, a greater level of demand in the economy (Chart 10). Chart 9Rising Cash Flows Lead To Higher Capex Chart 10Strong Global Orders Public infrastructure plans will create the final boost to global capex. $550 billion of the Biden administration’s infrastructure plan is getting close to bipartisan approval, and the budget reconciliation process might still result in an even bigger package before yearend. In Europe, the EUR800 billion NGEU plan that has been approved by all the EU’s national parliaments also includes large infrastructure spending envelopes to deploy over the coming five years. This context suggests that yields are unlikely to decline much further from current levels, since the oversold conditions that prevailed in March have been purged. Chart 11 shows that specific events are needed to prompt a greater 90-trading day collapse in yields than the one just registered. In 2019 and 2020, the Fed was cutting rates. Today, it is gearing up to raise them. In 2010 and 2011, the European sovereign debt crisis was hurting global growth and creating massive deflationary risks. In 2015, China was mired in deep deflation and devalued the RMB, which exported these negative pressures around the world and lowered yields. By late 2018, the yield curve was moving toward an inversion, which signaled that monetary policy was too tight. Today, none of these conditions are present and, consequently, the odds of a greater decline in yields are low. Chart 11Yields Have Moved Enough Bottom Line: The broad-based nature of the global recovery will limit the decline in yields. Global liquidity conditions remain extremely accommodative, global capacity utilization is improving, and inventories and capex spending will add to demand in the coming quarters. In this context, the recent decline in yields corrected this spring’s oversold condition in the bond market sufficiently. Investment Implications Bonds Investors with an investment horizon of more than six months should reduce their portfolio duration and remove hedges protecting against higher yields. The low in Treasury yields is likely to stay around 1.1%. The exact timing of the rebound is imprecise, and yields could churn for a brief period and retest their recent lows, but the balance of risks points toward a much greater probability of higher yields in the coming six to twelve months, and a limited probability of significantly lower yields from current levels. In fact, the CRB-to-gold ratio, often shown by BCA’s US bond strategists, clearly favors higher yields (Chart 12). Higher yields are not inconsistent with BCA’s view that the current inflation spike is transitory. TIPS yields are at a record low. As global growth recovers and the Fed moves closer to removing some accommodation, real yields will increase (Chart 13, top panel). Meanwhile, 5-year/5-year forward inflation breakeven rates remain well below the 2.5%-to-3% zone that prevailed prior to 2014, when long-term inflation expectations were still well anchored (Chart 13, bottom panel). The Fed is actively aiming to push this inflation expectation measure higher. Chart 12The CRB/Gold Ratio Points To Higher Yields Chart 13TIPS Yields Will Rise Chart 14The European Yield Curve Will Steepen German yields have some upside too, even if the ECB will lag well behind the Fed in terms of both ending its QE program and lifting interest rates. The ECB policy rate mostly anchors the short end of the curve, and the large European excess savings warrant lower Bund yields than those of T-Note. However, the nominal and real terminal rates embedded in the German curve remain lower than at the apex of the European sovereign debt crisis and are extremely low compared to the US. As a result, the European yield curve will steepen, which is confirmed by the comparative strength of the earnings revisions of Europe’s cyclical equity sectors (Chart 14). Equities An environment in which yields rise again should favor financials, industrials, and momentum stocks at the expense of growth stocks. In Europe, banks and financials will be the prime beneficiaries of higher yields. Historically, higher German Bund yields are associated with an outperformance of banks relative to the broad market, because a steeper yield curve boosts net interest margins (Chart 15). European banks also have scope for some re-rating. There is little case to significantly upgrade the sectors’ expected long-term profitability significantly, considering that the European economy remains replete with an excessively large capital stock. Nonetheless, at a price-to-book ratio of 0.6 or 55% below that of US banks and 67% below the European broad market, European banks are also priced as risky investments. However, European NPLs have declined significantly, and the public sector support during the pandemic will limit how high NPLs can rise (Chart 16, top panel). Moreover, European banks are much better capitalized than they once were, which further decreases their riskiness (Chart 16). Additionally, the ECB has allowed banks to pay dividends again. Finally, the fiscal risk sharing created by the NGEU funds and continued bond purchases by the ECB will cap the upside for peripheral yield spreads, which will limit the odds of the emergence of the kind of doom-loop that once plagued the European banking system. UK bank stocks look particularly attractive.   Chart 15European Banks Have Upside Chart 16Less Risky The massive underperformance of European momentum stocks relative to growth stocks is also likely to reverse (Chart 17). As Chart 18 shows, momentum stocks currently trade at an exceptionally large discount to both growth stocks and the European broad market. Most importantly, momentum equities tend to outperform growth stocks in the wake of a rise in German yields (Chart 19). This sensitivity to yields is currently accentuated by the sector bias of momentum stocks. Relative to growth stocks, momentum equities greatest overweights are financials, industrials and materials (Table 1), three sectors that thrive on higher interest rates. Meanwhile, their largest relative underweights are consumer staples and healthcare, two sectors with strong defensive characteristics that benefit from lower yields.  Chart 17Bomned Out Momentum Stocks... Chart 18...Have Become Very Cheap Chart 19Momentum Stocks Outperform When Yields Rise Table 1Sector Biases: Momentum Vs Growth Stocks Chart 20The Capex Outlook Favors Industrials Finally, we recommend investors move more aggressively into industrial equities. Industrials are the best-placed sector to benefit from the rise in global capex and the excess money supply growth. As Chart 20 highlights, even if the rate of growth of global capital goods orders decelerates, industrials should outperform the European broad market as long as the rate of growth remains positive. Nonetheless, the sector’s outperformance could moderate because it has become more expensive than the broad market. However, a stronger profitability compensates for this negative. As a corollary, we continue to favor Swedish equities because of their 38% weight in industrials and 27% allocation to financials. Moreover, their superior return on equity and profit margins, as well as the EUR/SEK’s downside potential, add to Sweden’s allure. The largest risk for industrials remains the slowdown in the Chinese credit impulse. However, the upbeat picture for DM capex and inventory growth counters this negative side. We continue to recommend some hedges against this risk. When it comes to our Sweden overweight, we still advise selling Norway, a position that has worked out well. We also still like selling consumer discretionary equities / long European telecoms to protect portfolios against a greater-than-anticipated global slowdown. Bottom Line: Global safe-haven yields are unlikely to decline significantly from current levels. Instead, they will rise meaningfully in the coming quarters, even in Germany. Consequently, investors with an investment horizon greater than six months should curtail their portfolio duration once again. Higher yields will also benefit European bank equities. We also recommend investors buy European momentum stocks and sell growth stocks. Finally, European industrials are set to shine compared to the rest of the European market, which will give a fillip to Swedish stocks, our favored European market.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Currency Performance Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance

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