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Highlights From a credit perspective, the five largest banks have turned the page on the pandemic: The big banks have returned to their pre-COVID lending standards and, ex-Wells Fargo, have released 70% of the loan-loss reserves they built up in the first half of 2020. Households have a ton of dry powder to support consumption and they’re deploying it with gusto: Consumers have begun to give their plastic a workout, with first half 2021 debit and credit card spending surging well beyond first half 2019 levels. Unfortunately for bank earnings, however, consumers are paying off their balances every month and businesses are still awash in liquidity: Expectations about a second-half lending pickup are mixed. Households and businesses have plenty of cash on hand and it is unclear when they will again need to borrow. Credit performance is stellar: Banks are disappointed that the appetite for new loans is so weak, but ample cash and soaring collateral values have shrunk delinquencies and charge-offs to extremely low levels. What The Banks See Chart 1New Delinquency Lows In All Categories Another quarterly earnings season began last week with the systemically important banks (BAC, C, JPM and WFC) and USB leading the way. We review their results and their calls for insight into the broad macro backdrop as revealed by the actions and intentions of their household and business customers, borrower performance, lender willingness and the overall state of the financial system. The banks differed on whether business and consumer lending demand will revive before the year is out, but they were unanimous in the view that fiscal transfers have stunted consumer borrowing and that businesses won’t need to borrow until they work through their own excess cash holdings. The flood of cash in the system is supporting outstanding credit performance (Chart 1) and every bank released loan loss reserves and foresees releasing more if the expansion continues to follow its current course. We took the banks’ observations as confirmation of our view that the economy is in very good shape and is poised to grow far above trend well into 2022. Household spending has come roaring back, reviving the prospects for industries that languished throughout the pandemic, like dining, travel, lodging and entertainment. Businesses have raised plenty of cash from lenders and investors, but they’ve also been generating it via more efficient operations. They will help keep the momentum going as they hire, invest, and restock depleted inventories to meet surging demand. The outlook for the banks’ own stocks is not as clear. Outsized income from lumpy streams like trading and debt and equity underwriting will slow, despite full investment banking pipelines, and most of the benefit from unwinding last year’s buildup of bad debt reserves, except at Wells Fargo, has already been realized (Table 1). The banks cannot unleash their full earnings potential until loan demand recovers and interest rates rise, and their net interest income prospects were top of mind for the analyst community. We do expect the banks will get some relief as longer duration Treasury yields back up to reflect inflation’s stirrings and the economy’s strength, but we are not counting on a major inflection in lending demand. Absent a backup in yields, we do not yet see a catalyst for the five biggest banks to outperform the S&P 500 over the rest of the year. Table 1Not Many More Reserves Left To Release Households Are Spending (Chart 2), … Chart 2Consumption Is Back In A Big Way ... [C]onsumer spending from our own customers … is not only much higher than … in 2020, which you would expect, but is notably 22% higher … compared to 2019. (Moynihan, BAC CEO) [C]ombined debit and credit [card] spend was up 45% year-on-year, and more importantly up 22% versus the more normal pre-COVID second quarter of 2019. (Barnum, JPM CFO) [T]he pump is primed. … The pandemic is kind of in [consumers’] rearview mirror … and they’re raring to go. (Dimon, JPM CEO) In Branded Cards, total purchase sales were up 40% versus last year and, importantly, up 11% versus the second quarter of 2019. And in Retail Services, purchase sales also grew versus … second quarter 2019[.] So, the good news is that we’re continuing to see the recovery in spend. (Mason, C CFO) Weekly debit card spend was up every week compared to 2019 during the second quarter and areas hardest hit by the pandemic have recovered, including travel, up 11%; entertainment, up 38%; and restaurant spending, up 28% during the week ending June 25th, compared with 2019. Consumer credit card spending activity continued to increase, up 13% in the second quarter, compared to 2019. As of the week ended June 25th, travel … was the only category that has not fully rebounded to [2Q19] levels. (Scharf, WFC CEO) Sales volume trends … are encouraging. As of the end of June, total sales volumes across each of the three payments businesses exceeded comparable 2019 levels. Certain pandemic-impacted spend categories continue to lag, in particular corporate travel and entertainment. However, consumer travel and hospitality spend volumes are rebounding faster than we expected, and the pace of improvement in recent weeks has accelerated a bit. (Dolan, USB CFO) … They’re Just Not Borrowing (Yet) (Chart 3) Chart 3... While Credit Card Debt Has Been Left Behind [Mortgage balances] are only modestly down this quarter as our origination volumes are finally overcoming the payoffs. We are pleased with the trajectory through the period and that feeds into the second half of the year, … [when it will be] good to start with a trend that has reversed the past quarters’ declines. (Moynihan, BAC) [People’s behavior hasn’t changed;] [t]hey just have more cash, and so they paid off their credit cards, which is a completely responsible thing for them to do. And when they can get out and spend more money, which is starting to happen, I think you’ll see them use these lines[.] … So we’ll see where it goes, but the good news is it’s going in a different direction. (Moynihan, BAC) [W]e … believe that the … acceleration and pickup in spend is going to translate to … loan growth in [credit] card[s], but we think that pay rates are going to remain quite elevated at a minimum through the end of this year [because of households’ cash buffers (Chart 4)]. So as a result, we don’t really see revolving … balances increasing meaningfully this year[.] (Barnum, JPM) Chart 4A Mountain Of Excess Savings Looking ahead, we expect the growth in purchase sales to translate into loan growth by the end of the year as stimulus moderates and consumers return to more normal payment patterns. (Mason, C) [W]hile it’s hard to predict exactly what will happen during the second half, … we are seeing signs of green shoots with modest growth … compared to the first quarter in auto, other consumer [and] credit card. (Santomassimo, WFC CFO) You’re seeing a little bit of growth in card [balances]; although [spending] has really picked up, it hasn’t quite translated into bigger volumes given the payment rates … are still really high. I think they’ll come down and normalize eventually, but they’re still pretty high. (Santomassimo, WFC) We do expect consumer lending to get a little bit stronger, because of [consumer spending]. … [W]e saw some nice growth in the credit card space right at the end of June. And while [payment rates] continue to be elevated, I think the fact that they’re not increasing … will help credit card balances as well. And … also when we think about loan growth, auto lending continues to be very strong. (Dolan, USB) Businesses Are In Limbo [E]xcluding the PPP loan forgiveness, middle-market lending and our business banking team [serving companies with annual revenues of $5 million to $50 million] finally had a month of growth in June, the first since March 2020. (Moynihan, BAC) [O]n the commercial side, it’s really [credit] line usage. Honestly, it can’t go any lower – maybe it can, but theoretically it can’t because it’s been stuck here for a good four or five quarters. (Moynihan, BAC) [O]ur commercial committed exposures … grew quarter-over-quarter [and are] above [their] pre-pandemic level, so [businesses] are getting ready to borrow more. [R]evolver utilization is still at historic lows, but we would expect that to move up as the economy improves … [and] inventories are built across various industries. … Some of the inventory building has been hampered by trucking and ocean liner [bottlenecks, but] you could start to see it [once] some of those kinks are worked out. (Donofrio, BAC CFO) I’ve learned a lot more about ports from our customers than I ever thought I would, [and] it’s going to take a while [to iron out supply chain kinks]. … [E]verybody talks about the chip [shortage], … but it really comes down to the efficient operations of ports … and having people to work and unload the ships (Chart 5). [I]t’s still constraining, but it’s getting incrementally better, [and most of our contacts] are saying it’ll all be [resolved by] the end of the year. And we’ll see it [in lending]. (Moynihan, BAC) Chart 5US Ports Are Still Trying To Clear Backlogs C&I loans were down 1% quarter-on-quarter with lower [credit line] utilization partially offset by new middle market loan activity. (Barnum, JPM) [T]he second the economy starts to grow, … you’re going to see [middle market] loans go up because inventory, receivables and capital expenditures [will need to be financed]. (Dimon, JPM) The general view from our [business] clients is optimistic in terms of the go-forward environment. (Mason, C) [O]ne never wants to jinx these things, but we really have a fabulous pipeline heading into the second half of the year around the world and it gives you a good sense of confidence and continued momentum. (Fraser, C CEO) [T]he [investment banking] pipeline remains very strong. We expect M&A activity and the IPO markets to remain active and investment banking fees … to be up year-on-year. (Barnum, JPM) We saw investment banking close this quarter with record pipelines. (Moynihan, BAC) In the commercial bank, loans are still down and utilization rates are pretty low on a historic basis [for] lots of reasons – high liquidity, supply chain issues, demand for product in certain industries … and we haven’t really seen [loan demand] inflect yet, … [but there are] lots of good conversations. So I think people are really thinking about investments and building inventory levels over the coming quarters, but [it] will take some time before it starts to translate into loan growth. (Santomassimo, WFC) [I]t’s going to take a little bit of time for C&I [lending] to develop simply because of the amount of liquidity that customers have and are continuing to generate. (Dolan, USB) [A]cross our markets, … middle market customers are certainly much more optimistic today than they were even a quarter or two quarters ago. That usually translates into making longer-term … investments. … I do think that the supply chain is impacting it to some extent, but I think that’s more transitory. (Dolan, USB) Banks Are Ready, Willing (Chart 6) And Able (Chart 7) Chart 6Open For Business [Our] deposits are $1.9 trillion and [our] loans are $900 billion and change, and that difference has got to be put to work. And the reality is we generated $80 billion [of] deposit growth, and we got to put it to work. And that’s what we do. (Moynihan, BAC) [W]e’re going to get deposits. [They’re] going to fund loan growth. Whatever is left over will probably go in securities, but then we still have a bunch of excess liquidity, so that can be deployed as well, either in the near term or long term, depending on how we balance liquidity against capital and earnings. (Donofrio, BAC) One of the significant things that’s going on is we’ve really finished unwinding all of our credit pullbacks from the [global financial] crisis. So we’re fully back in the [home mortgage] correspondent channel. (Barnum, JPM) Chart 7Finally Putting In A Bottom? Chart 8Chrome Is The Most Precious Metal We started to tighten our credit policies in March 2020 in response to the pandemic and we have now essentially returned back to pre-COVID levels or policies, however, we continue to be thoughtful of the much higher asset prices in areas like residential real estate and auto (Chart 8). (Santomassimo, WFC) I think we mentioned this last quarter but we’re now back to fundamentally the credit box that we had on a pre-pandemic level really across all the product categories. (Dolan, USB) Investment Implications We remain bullish on the economy and risk assets as we look out six to twelve months. As the banks highlighted, consumer spending is roaring, businesses cannot go much longer without ramping up spending and hiring to meet burgeoning demand and credit performance is spectacular as borrowers and lenders are flush with cash. The S&P 500 is expensive at between 21 and 22 times forward four-quarter earnings, but the analyst consensus is projecting a highly unusual drop in earnings from the prior quarter’s annualized run rate and we expect the second quarter will produce another sizable beat along the lines of the last four quarters. Prospective returns on “safe” investment alternatives are unappealing and we continue to recommend that investors with one-year timeframes overweight equities. Chart 9Losing Ground As for the SIFI banks themselves, we think their significant outperformance versus the overall market has come to an end (Chart 9, top panel). They were ridiculously inexpensive when we were bulled up on them last spring and summer (Table 2) amidst wildly exaggerated potential credit losses but there’s no re-rating or credit performance catalyst on the horizon now. We disagree with our Counterpoint colleagues’ contention that banks are in the midst of a secular earnings decline but we do expect they will find themselves hemmed in over the rest of the year by the overabundance of capital in the financial system. As we noted last quarter, traditional intermediation isn’t very rewarding when every creditworthy borrower has more money than he or she needs. We are comfortable staying on the neutral sidelines with our US Equity Strategy team.1   Table 2Big Bank Valuations Have Mostly Normalized Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Our Global Investment Strategy team is calling for banks to outperform the overall market, as reiterated in its latest publication.

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

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

In yesterday’s Sector Insight report we stripped out the base effect from SPX earnings growth. Today, we repeat this exercise and look at a two-year annualised growth rate for US headline CPI as well as some of its categories. Using 2019 as a benchmark year reveals that the headline number is at 3%, sitting on par with the 2011 level – a sharp contrast to the regular 12-month YoY CPI rate (6%) that is close to pre-GFC highs. In fact, the key food & energy categories also appear contained despite the former perking up during the pandemic (Chart 1). 2021/2020 comparison of food and energy prices yields 2.4% and 7.5% YoY inflation respectively. There are also exceptions: The used cars category is clearly accelerating (19%) even compared to 2019, albeit it is just a small component of the headline CPI number. For completion purposes, Chart 2 on the next page also shows data for some of the pandemic-scared industries including airlines and shelter, for which prices are still below pre-pandemic highs. Bottom Line: While optically the 2021 US inflation is surging, our analysis suggests that numbers are exaggerated by the base effect from the pandemic. Chart 1 Chart 2