Currencies

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

Dear Client, This week, in lieu of our regular report, I am sending you a special report written by my colleague Jonathan LaBerge, chief strategist of our flagship The Bank Credit Analyst service. Jonathan argues that investors should see social media as a technological innovation that harms productivity. While Jonathan concedes that social media was not the main driver of policy uncertainty and political risk over the past decade, he makes a good case that it plays an aggravating role. He warns that social media and political polarization still pose risks to the macroeconomic outlook in the coming years, while also highlighting idiosyncratic risks threatening social media stocks. We trust that you will find this report insightful. We will resume regular publication next week. All very best, Matt Gertken   Vice President Geopolitical Strategy US Political Strategy BCA Research Highlights 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). Feature 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 1 and 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. Social media usage is more common among those who are younger, but Chart 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 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 1Facebook: Monthly Active Users The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth Chart 2Twitter: Monthly Active Users Worldwide The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth Chart 3A Sizeable Majority Of US Adults Regularly Use Social Media A Sizeable Majority Of US Adults Regularly Use Social Media A Sizeable Majority Of US Adults Regularly Use Social Media Chart 4Older Americans Use Facebook Far More Than Twitter The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth As a final point documenting the development and significance of social media, Chart 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. Chart 5Social Media Has Changed The Way People Consume News The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth 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 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 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 6Tea Party Supporters Rapidly Adopted Social Media To Mobilize Politically Tea Party Supporters Rapidly Adopted Social Media To Mobilize Politically Tea Party Supporters Rapidly Adopted Social Media To Mobilize Politically Table 1Tea Party Candidates Significantly Outperformed In Their Use Of Social Media The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth 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.1 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 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 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 7The Fiscal Drag That Followed The 2010 Midterm Elections Was A Clear Policy Mistake The Fiscal Drag That Followed The 2010 Midterm Elections Was A Clear Policy Mistake The Fiscal Drag That Followed The 2010 Midterm Elections Was A Clear Policy Mistake 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 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. Chart 8Policy Mistakes Significantly Contributed To Last Cycle's Subpar Growth Profile Policy Mistakes Significantly Contributed To Last Cycle's Subpar Growth Profile Policy Mistakes Significantly Contributed To Last Cycle's Subpar Growth Profile 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 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 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. Chart 9Terrorism And Immigration Likely Contributed To Brexit Terrorism And Immigration Likely Contributed To Brexit Terrorism And Immigration Likely Contributed To Brexit Chart 10Brexit Weakened UK Economic Performance Prior To The Pandemic Brexit Weakened UK Economic Performance Prior To The Pandemic Brexit Weakened UK Economic Performance Prior To The Pandemic 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 11 highlights that terrorism and foreign policy were second and third on the list of concerns of registered voters in mid-2016, and Chart 12 highlights that voters regarded Trump as the better candidate to defend the US against future terrorist attacks. Chart 11Terrorism Ranked Highly As An Issue In The 2016 US Election The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth Chart 12Voters Regarded Trump As Better Equipped To Defend Against Terrorism The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth 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 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. Chart 13Trump Used Twitter To Lay The Groundwork For His Candidacy Trump Used Twitter To Lay The Groundwork For His Candidacy Trump Used Twitter To Lay The Groundwork For His Candidacy Chart 14The Trump Tax Cuts A Huge Rise In Corporate Earnings The Trump Tax Cuts A Huge Rise In Corporate Earnings The Trump Tax Cuts A Huge Rise In Corporate Earnings 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 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 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 15But The Tax Cuts Did Not Do Much To Boost Growth But The Tax Cuts Did Not Do Much To Boost Growth But The Tax Cuts Did Not Do Much To Boost Growth Similarly, Chart 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. But Chart 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. Chart 16The Trade War Caused An Explosion In Global Trade Uncertainty The Trade War Caused An Explosion In Global Trade Uncertainty The Trade War Caused An Explosion In Global Trade Uncertainty 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. 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 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. Chart 17Policy Mistakes, Partially Enabled By Social Media, Reduced Productivity During The Last Expansion Policy Mistakes, Partially Enabled By Social Media, Reduced Productivity During The Last Expansion Policy Mistakes, Partially Enabled By Social Media, Reduced Productivity During The Last Expansion Chart 18State & Local Government Finances Are In Much Better Shape Today State & Local Government Finances Are In Much Better Shape Today State & Local Government Finances Are In Much Better Shape Today The Risk Of Aggressive Austerity Seems Low 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 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,2 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 19 highlights that Euro Area fiscal consolidation from 2010-2013 was negatively correlated with economic activity during that period, and Chart 20 highlights that, with the potential exception of Spain, this austerity does not appear to have led to subsequently stronger rates of growth. Chart 19Euro Area Austerity Lowered Growth During The Consolidation Phase… The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth Chart 20…And Did Not Seem To Subsequently Raise Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower 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.3 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 21 highlights that the number of populist governments worldwide has risen significantly since the 1980s and 1990s, and Chart 22 highlights that the economic performance of countries with populist leaders is clearly negative. Chart 21Populism Has Been On The Rise For The Past 30 Years The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth 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 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 22: populist economic policies are significantly negative for real economic growth. Chart 22Populist Leaders Are Clearly Growth Killers Even After… The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth Chart 23… Controlling For The Odds That Weak Growth Leads To Populism The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth 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 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 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. Chart 24Inequality: The Most Important Structural Cause Of Populism And Polarization Inequality: The Most Important Structural Cause Of Populism And Polarization Inequality: The Most Important Structural Cause Of Populism And Polarization 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 2025,4 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.5 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. 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 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 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 25. Chart 25The Underperformance Of Social Media Would Not Excessively Weigh On The Broad Market The Underperformance Of Social Media Would Not Excessively Weigh On The Broad Market The Underperformance Of Social Media Would Not Excessively Weigh On The Broad Market 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   Footnotes 1     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. 2     Please see The Bank Credit Analyst “July 2021,” dated June 24, 2021, available at bca.bcaresearch.com 3    “Are We Underestimating Short-Term Fiscal Multipliers?”,IMF World Economic Outlook, October 2012 4    Please see US Political Strategy Outlook "Third Quarter Outlook 2021: Game Time," dated June 30, 2021, available at usps.bcaresearch.com 5    “Unfavorable Views of China Reach Historic Highs in Many Countries,” PEW Research Center, October 2020.

Highlights Globalization is recovering to its pre-pandemic trajectory. But it will fail to live up to potential, as the “hyper-globalization” trends of the 1990s are long gone. China was the biggest winner of hyper-globalization. It now faces unprecedented risks in the context of hypo-globalization. Global investors woke up to China’s domestic political risks this year, which include arbitrary regulatory crackdowns on tech and private business. While Chinese officials will ease policy to soothe markets, the cyclical and structural outlook is still negative for this economy. Growth and stimulus have peaked. Political risk will stay high through the national party congress in fall 2022. US-China relations have not stabilized. India, the clearest EM alternative for global investors, is high-priced relative to China and faces troubles of its own. It is too soon to call a bottom for EM relative to DM. Feature Global investors woke up to China’s domestic political risk over the past week, as Beijing extended its regulatory crackdown to private education companies. Our GeoRisk Indicator shows Chinese political risk reaching late 2017 levels while the broad Chinese stock market continued this year’s slide against emerging market peers (Chart 1). Chart 1China: Domestic Political Risk Takes Investors By Surprise Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) A technical bounce in Chinese tech stocks will very likely occur but we would not recommend playing it. The first of our three key views for 2021 is the confluence of internal and external headwinds for China. True, today’s regulatory blitz will pass over like previous ones and the fast money will snap up Chinese tech firms on the cheap. The Communist Party is making a show of force, not destroying its crown jewels in the tech sector. However, the negative factors weighing on China are both cyclical and structural. Until Chinese President Xi Jinping adjusts his strategy and US-China relations stabilize, investors do not have a solid foundation for putting more capital at risk in China. Globalization is in retreat and this is negative for China, the big winner of the past 40 years. Hypo-Globalization Globalization in the truest sense has expanded over millenia. It will only reverse amid civilizational disasters. But the post-Cold War era of “hyper-globalization” is long gone.1 The 2010s saw the emergence of de-globalization. In the wake of COVID-19, global trade is recovering to its post-2008 trend but it is nowhere near recovering the post-1990 trend (Chart 2). Trade exposure has even fallen within the major free trade blocs, like the EU and USMCA (Chart 3). Chart 2Hypo-Globalization Hypo-Globalization Hypo-Globalization Chart 3Trade Intensity Slows Even Within Trade Blocs Trade Intensity Slows Even Within Trade Blocs Trade Intensity Slows Even Within Trade Blocs Of course, with vaccines and stimulus, global trade will recover in the coming decade. We coined the term “hypo-globalization” to capture this predicament, in which globalization is set to rebound but not to its previous trajectory.2 We now inhabit a world that is under-globalized and under-globalizing, i.e. not as open and free as it could be. A major factor is the US-China economic divorce, which is proceeding apace. China’s latest state actions – in diplomacy, finance, and business – underscore its ongoing disengagement from the US-led global architecture. The US, for its part, is now on its third presidency with protectionist leanings. American and European fiscal stimulus are increasingly protectionist in nature, including rising climate protectionism. Bottom Line: The stimulus-fueled recovery from the global pandemic is not leading to re-globalization so much as hypo-globalization. A cyclical reboot of cross-border trade and investment is occurring but will fall short of global potential due to a darkening geopolitical backdrop. Still No Stabilization In US-China Relations Chart 4Do Nations Prefer Growth? Or Security? Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) A giant window of opportunity is closing for China and Russia – they will look back fondly on the days when the US was bogged down in the Middle East. The US current withdrawal from “forever wars” incentivizes Beijing and Moscow to act aggressively now, whether at home or abroad. Investors tend to overrate the Chinese people’s desire for economic prosperity relative to their fear of insecurity and domination by foreign powers. China today is more desirous of strong national defense than faster economic growth (Chart 4). The rise of Chinese nationalism is pronounced since the Great Recession. President Xi Jinping confirmed this trend in his speech for the Communist Party’s first centenary on July 1, 2021. Xi was notably more concerned with foreign threats than his predecessors in 2001 and 2011 (Chart 5).3 China has arrived as a Great Power on the global stage and will resist being foisted into a subsidiary role by western nations. Chart 5Xi Jinping’s Centenary Speech Signaled Nationalist Turn Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) Meanwhile US-China relations have not stabilized. The latest negotiations did not produce agreed upon terms for managing tensions in the relationship. A bilateral summit between Presidents Biden and Xi Jinping has not been agreed to or scheduled, though it could still come together by the end of October. Foreign Minister Wang Yi produced a set of three major demands: that the US not subvert “socialism with Chinese characteristics,” obstruct China’s development, or infringe on China’s sovereignty and territorial integrity (Table 1). The US’s opposition to China’s state-backed economic model, export controls on advanced technology, and attempts to negotiate a trade deal with the province of Taiwan all violate these demands.4 Table 1China’s Three Demands From The United States (July 2021) Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) The removal of US support for China’s economic, development – recently confirmed by the Biden administration – will take a substantial toll on sentiment within China and among global investors. US President Joe Biden and four executive departments have explicitly warned investors not to invest in Hong Kong or in companies with ties to China’s military-industrial complex and human rights abuses. The US now formally accuses China of genocide in the Xinjiang region.5 Bottom Line: There is no stabilization in US-China relations yet. This will keep the risk premium in Chinese currency and equities elevated. The Sino-American divorce is a major driver of hypo-globalization. China’s Regulatory Crackdown President Xi Jinping’s strategy is consistent. He does not want last year’s stimulus splurge to create destabilizing asset bubbles and he wants to continue converting American antagonism into domestic power consolidation, particularly over the private economy. Now China’s sweeping “anti-trust” regulatory crackdown on tech, education, and other sectors is driving a major rethink among investors, ranging from Ark-founder Cathie Wood to perma-bulls like Stephen Roach. The driver of the latest regulatory crackdown is the administration’s reassertion of central party control. The Chinese economy’s potential growth is slowing, putting pressure on the legitimacy of single-party rule. The Communist Party is responding by trying to improve quality of life while promoting nationalism and “socialism with Chinese characteristics,” i.e. strong central government control and guidance over a market economy. Beijing is also using state power and industrial policy to attempt a great leap forward in science and technology in a bid to secure a place in the sun. Fintech, social media, and other innovative platforms have the potential to create networks of information, wealth, and power beyond the party’s control. Their rise can generate social upheaval at home and increase vulnerability to capital markets abroad. They may even divert resources from core technologies that would do more to increase China’s military-industrial capabilities. Beijing’s goal is to guide economic development, break up the concentration of power outside of the party, prevent systemic risks, and increase popular support in an era of falling income growth. Sociopolitical Risks: Social media has demonstrably exacerbated factionalism and social unrest in the United States, while silencing a sitting president. This extent of corporate power is intolerable for China. Economic And Financial Risks: Innovative fintech companies like Ant Group, via platforms like Alipay, were threatening to disrupt one of the Communist Party’s most important levers of power: the banking and financial system. The People’s Bank of China and other regulators insisted that Ant be treated more like a bank if it were to dabble in lending and wealth management. Hence the PBoC imposed capital adequacy and credit reporting requirements.6 Data Security Risks: Didi Chuxing, the ride-sharing company partly owned by Uber, whose business model it copied and elaborated on, defied authorities by attempting to conduct its initial public offering in the United States in June. The Communist Party cracked down on the company after the IPO to show who was in charge. Even more, Beijing wanted to protect its national data and prevent the US from gaining insights into its future technologies such as electric and autonomous vehicles. Foreign Policy Risks: Beijing is also preempting the American financial authorities, who will likely take action to kick Chinese companies that do not conform to common accounting and transparency standards off US stock exchanges. Better to inflict the first blow (and drive Chinese companies to Hong Kong and Shanghai for IPOs) than to allow free-wheeling capitalism to continue, giving Americans both data and leverage. Thus Beijing is continuing the “self-sufficiency” drive, divorcing itself from the US economy and capital markets, while curbing high-flying tech entrepreneurs and companies. The party’s muscle-flexing will culminate in Xi Jinping’s consolidation of power over the Politburo and Central Committee at the twentieth national party congress in fall 2022, where he is expected to take the title of “Chairman” that only Mao Zedong has held before him. The implication is that the regulatory crackdown can easily last for another six-to-12 more months. True, investors will become desensitized to the tech crackdown. But health care and medical technology are said to be in the Chinese government’s sights. So are various mergers and acquisitions. Both regulatory and political risk premia in different sectors can persist. The current administration has waged several sweeping regulatory campaigns against monopolies, corruption, pollution, overcapacity, leverage, and non-governmental organizations. The time between the initial launch of one of these campaigns and their peak intensity ranges from two to five years (Chart 6). Often, but not always, central policy campaigns have an express, three-year plan associated with them. Chart 6ABeijing Cracked Down On Monopolies, Corruption, Pollution... Beijing Cracked Down On Monopolies, Corruption, Pollution... Beijing Cracked Down On Monopolies, Corruption, Pollution... Chart 6B...NGOs, Overcapacity, And Leverage ...NGOs, Overcapacity, And Leverage ...NGOs, Overcapacity, And Leverage Chart 7China Tech: Buyer Beware China Tech: Buyer Beware China Tech: Buyer Beware The first and second year mark the peak impact. The negative profile of Chinese tech stocks relative to their global peers suggests that the current crackdown is stretched, although there is little sign of bottom formation yet (Chart 7). The crackdown began with Alibaba founder Jack Ma, and Alibaba stocks have yet to arrest their fall either in absolute terms or relative to the Hang Seng tech index. Bottom Line: A technical bounce is highly likely for Chinese stocks, especially tech, but we would not recommend playing it because of the negative structural factors. For instance, we fully expect the US to delist Chinese companies that do not meet accounting standards. The Chinese Government’s Pain Threshold? The government is not all-powerful – it faces financial and economic constraints, even if political checks and balances are missing. Beijing does not have an interest in destroying its most innovative companies and sectors. Its goal is to maintain the regime’s survival and power. China’s crackdown on private companies goes against its strategic interest of promoting innovation and therefore it cannot continue indefinitely. The hurried meeting of the China Securities Regulatory Commission with top bankers on July 28 suggests policymakers are already feeling the heat.7 In the case of Ant Group, the company ultimately paid a roughly $3 billion fine (which is 18% of its annual revenues) and was forced to restructure. Ant learned that if it wants to behave more like a bank athen it will be regulated more like a bank. Yet investors will still have to wrestle with the long-term implications of China’s arbitrary use of state power to crack down on various companies and IPOs. This is negative for entrepreneurship and innovation, regardless of the government’s intentions. Chart 8China's Pain Threshold = Property Sector China's Pain Threshold = Property Sector China's Pain Threshold = Property Sector Ultimately the property sector is the critical bellwether: it is a prime target of the government’s measures against speculative asset bubbles. It is also an area where authorities hope to ease the cost of living for Chinese households, whose birth rates and fertility rates are collapsing. While there is no risk of China’s entire economy crumbling because of a crackdown on ride-hailing apps or tutoring services, there is a risk of the economy crumbling if over-zealous regulators crush animal spirits in the $52 trillion property sector, as estimated by Goldman Sachs in 2019. Property is the primary store of wealth for Chinese households and businesses and falling property prices could well lead to an unsustainable rise in debt burdens, a nationwide debt-deflation spiral, and a Japanese-style liquidity trap. Judging by residential floor space started, China is rapidly approaching its overall economic pain threshold, meaning that property sector restrictions should ease, while monetary and credit policy should get easier as necessary to preserve the economic recovery (Chart 8). The economy should improve just in time for the party congress in late 2022. Bottom Line: China will be forced to maintain relatively easy monetary and fiscal policy and avoid pricking the property bubble, which should lend some support to the global recovery and emerging markets economies over the cyclical (12-month) time frame. China’s Regulation And Demographic Pressures Is the Chinese government not acting in the public interest by tamping down financial excesses, discouraging anti-competitive corporate practices, and combating social ills? Yes, there is truth to this. But arbitrary administrative controls will not increase the birth rate, corporate productivity, or potential GDP growth. First, it is true that Chinese households cite high prices for education, housing, and medicine as reasons not to have children (Chart 9). However, price caps do not attack the root causes of these problems. The lack of financial security and investment options has long fueled high house prices. The rabid desire to get ahead in life and the exam-oriented education system have long fueled high education prices. Monetary and fiscal authorities are forced to maintain an accommodative environment to maintain minimum levels of economic growth amid high indebtedness – and yet easy money policies fuel asset price inflation. In Japan, fertility rates began falling with economic development, the entrance of women in the work force, and the rise of consumer society. The fertility rate kept falling even when the country slipped into deflation. It perked up when prices started rising again! But it relapsed after the Great Recession and Fukushima nuclear crisis (Chart 10, top panel). Chart 9China: Concerns About Having Children Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) China’s fertility rate bottomed in the 1990s and has gradually recovered despite the historic surge in property prices (Chart 10, second panel), though it is still well below the replacement rate needed to reverse China’s demographic decline in the absence of immigration. A lower cost of living and a higher quality of life will be positive for fertility but will require deeper reforms.8 Chart 10Fertility Fell In Japan Despite Falling Prices Fertility Fell In Japan Despite Falling Prices Fertility Fell In Japan Despite Falling Prices At the same time, arbitrary regulatory crackdowns that punish entrepreneurs are not likely to boost productivity. Anti-trust actions could increase competition, which would be positive for productivity, but China’s anti-trust actions are not conducted according to rule of law, or due process, so they increase uncertainty rather than providing a more stable investment environment. China’s tech crackdown is also aimed at limiting vulnerability to foreign (American) authorities. Yet disengagement with the global economy will reduce competition, innovation, and productivity in China. Bottom Line: China’s demographic decline will require larger structural changes. It will not be reversed by an arbitrary game of whack-a-mole against the prices of housing, education, and health. India And South Asia Chart 11China Will Ease Policy... Or India Will Break Out China Will Ease Policy... Or India Will Break Out China Will Ease Policy... Or India Will Break Out Global investors have turned to Indian equities over the course of the year and they are now reaching a major technical top relative to Chinese stocks (Chart 11). Assuming that China pulls back on its policy tightening, this relationship should revert to mean. India faces tactical geopolitical and macroeconomic headwinds that will hit her sails and slow her down. In other words, there is no great option for emerging markets at the moment. Over the long run, India benefits if China falters. Following the peak of the second COVID-19 wave in May 2021, some high frequency indicators have showed an improvement in India’s economy. However, activity levels appear weaker than of other emerging markets (Chart 12). Given the stringency levels of India’s first lockdown last spring, year-on-year growth will look faster than it really is. As the base effect wanes, underlying weak demand will become evident. Moreover India is still vulnerable to COVID-19. Only 25% of the population has received one or more vaccine shots which is lower than the global level of 28%. The result will be a larger than expected budget deficit. India refrained from administering a large dose of government spending in 2020 (Chart 13). With key state elections due from early 2022 onwards, the government could opt for larger stimulus. This could assume the form of excise duty cuts on petroleum products or an increase in revenue expenditure. These kinds of measures will not enhance India’s productivity but will add to its fiscal deficit. Chart 12Weak Post-COVID Rebound In India – And Losing Steam Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) Chart 13India Likely To Expand Fiscal Spending Soon Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) Such an unexpected increase in India’s fiscal deficit could be viewed adversely by markets. India’s fiscal discipline tends to be poorer than that of peers (see Chart 13 above). Meanwhile India’s north views Pakistan unfavorably and key state elections are due in this region. Consequently, Indian policy makers may be forced to adopt a far more aggressive foreign policy response to any terrorist strikes from Pakistan or territorial incursions by China over August 2021. The US withdrawal from Afghanistan poses risks for India as it has revived the Taliban’s influence. India has a long history of being targeted by Afghani terrorist groups. And its diplomatic footprint in Afghanistan has been diminishing. Earlier in July, India decided temporarily to close its consulate in Kandahar and evacuated about 50 diplomats and security personnel. As August marks the last month of formal US presence in Afghanistan, negative surprises emanating from Afghanistan should be expected. Bottom Line: Pare exposure to Indian assets on a tactical basis. Our Emerging Markets Strategy takes a more optimistic view but geopolitical changes could act as a negative catalyst in the short term. We urge clients to stay short Indian banks. Investment Takeaways US stimulus contrasts with China’s turmoil. The US Biden administration and congressional negotiators of both parties have tentatively agreed on a $1 trillion infrastructure deal over eight years. Even if this bipartisan deal falls through, Democrats alone can and will pass another $1.3-$2.5 trillion in net deficit spending by the end of the year. Stay short the renminbi. Prefer a balance of investments in the dollar and the euro, given the cross-currents of global recovery yet mounting risks to the reflation trade. A technical bounce in Chinese stocks and tech stocks is nigh. China’s policymakers are starting to respond to immediate financial pressures. However, growth has peaked and structural factors are still negative. The geopolitical outlook is still gloomy and China’s domestic political clock is a headwind for at least 12 more months. Prefer developed market equities over emerging markets (Chart 14). Emerging markets failed to outperform in the first half of the year, contrary to our expectation that the global reflation trade would lift them. China/EM will benefit when Beijing eases policy and growth rebounds. Chart 14Emerging Markets: Not Out Of The Woods Yet Emerging Markets: Not Out Of The Woods Yet Emerging Markets: Not Out Of The Woods Yet Stay short Indian banks and strongman EM currencies, including the Turkish lira, the Brazilian real, and the Philippine peso. The biggest driver of EM underperformance this year is the divergence between the US and China. But until China’s policy corrects, the rest of EM faces downside risks.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Dani Rodrik, The Globalization Paradox: Democracy and the Future of the World Economy (New York: Norton, 2011). 2 See my "Nationalism And Globalization After COVID-19," Investments & Wealth Monitor (Jan/Feb 2021), pp13-21, investmentsandwealth.org. 3 Our study of Xi’s speech is not limited to this quantitative, word-count analysis. A fuller comparison of his speech with that of his predecessors on the same occasion reveals that Xi was fundamentally more favorable toward Marx, less favorable toward Deng Xiaoping and the pro-market Third Plenum, utterly silent on notions of political reform or liberal reform, more harsh in his rhetoric toward the outside world, and hawkish about the mission of reunifying with Taiwan. 4 The Chinese side also insisted that the US stop revoking visas, punishing companies and institutes, treating the press as foreign agents, and detaining executives. It warned that cooperation – which the US seeks on the environment, Iran, North Korea, and other areas – cannot be achieved while the US imposes punitive measures. 5 See US Department of State, "Xinjiang Supply Chain Business Advisory," July 13, 2021, and "Risks and Considerations for Businesses Operating in Hong Kong," July 16, 2021, state.gov. 6 Top business executives are also subject to these displays of state power. For example, Alibaba founder Jack Ma caricatured China’s traditional banks as “pawn shops” and criticized regulators for stifling innovation. He is now lying low and has taken to painting! 7 See Emily Tan and Evelyn Cheng, "China will still allow IPOs in the United States, securities regulator tells brokerages," CNBC, July 28, 2021, cnbc.com. Officials are sensitive to the market blowback but the fact remains that IPOs in the US have been discouraged and arbitrary regulatory crackdowns are possible at any time. 8 Increasing social spending also requires local governments to raise more revenue but the central government had been cracking down on the major source of revenues for local government: land sales and local government financing vehicles. With the threat of punishment for local excesses and lack of revenue source, local governments have no choice but to cut social services, pushing affluent residents towards private services, while leaving the less fortunate with fewer services. As with financial regulations, the central government may backpedal from too tough regulation of local governments, but more economic and financial pain will be required to make it happen. The Geopolitics Of The Olympics The 2020 Summer Olympics are currently underway in Tokyo, even though it is 2021. The arenas are mostly empty given the global pandemic and economic slowdown. Every four years the Summer Olympics create a golden opportunity for the host nation to showcase its achievements, infrastructure, culture, and beauty. But the Olympics also have a long history of geopolitical significance: terrorist acts, war protests, social demonstrations, and boycotts. In 1906 an Irish athlete climbed a flag pole to wave the Irish flag in protest of his selection to the British team instead of the Irish one. In 1968 two African American athletes raised their fists as an act of protest against racial discrimination in the US after the assassination of Martin Luther King Jr. In 1972, the Palestinian terrorist group Black September massacred eleven Israeli Olympians in Munich, Germany. In 1980 the US led the western bloc to boycott the Moscow Olympics while the Soviet Union and its allies retaliated by boycotting the 1984 Los Angeles Olympics. In 2008, Russia used the Olympics as a convenient distraction from its invasion of Georgia, a major step in its geopolitical resurgence. So far, thankfully, the Tokyo Olympics have gone without incident. However, looking forward, geopolitics is already looming over the upcoming 2022 Winter Olympics in Beijing. Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) How the world has changed. The 2008 Summer Olympics marked China’s global coming-of-age celebration. The breathtaking opening ceremony featured 15,000 performers and cost $100 million. The $350 million Bird’s Nest Stadium showcased to the world China’s long history, economic prowess, and various other triumphs. All of this took place while the western democratic capitalist economies grappled with what would become the worst financial and economic crisis since the Great Depression. In 2008, global elites spoke of China as a “responsible stakeholder” that was conducting a “peaceful rise” in international affairs. The world welcomed its roughly $600 billion stimulus. Now elites speak of China as primarily a threat and a competitor, a “revisionist” state challenging the liberal world order. China is blamed for a lack of transparency (if not virological malfeasance) in handling the COVID-19 pandemic. It is blamed for breaking governance promises and violating human rights in Hong Kong, for alleged genocide in Xinjiang, and for a list of other wrongdoings, including tough “Wolf Warrior” diplomacy, cyber-crime and cyber-sabotage, and revanchist maritime-territorial claims. Even aside from these accusations it is clear that China is suffering greater financial volatility as a result of its conflicting economic goals. Talk of a diplomatic or even full boycott of Beijing’s winter games is already brewing. Sponsors are also second-guessing their involvement. More than half of Canadians support boycotting the winter games. Germany is another bellwether to watch. In 2014, Germany’s president (not chancellor) boycotted the Sochi Olympics; in 2021, the EU and China are witnessing a major deterioration of relations. Parliamentarians in the UK, Italy, Sweden, Switzerland, and Norway have asked their governments to outline their official stance on the winter games. In the age of “woke capitalism,” a sponsorship boycott of the games is a possibility. This is especially true given the recent Chinese backlash against European multinational corporations for violating China’s own rules of political correctness. A boycott which includes any members of the US, Norway, Canada, Sweden, Germany, or the Netherlands would be substantial as these are the top performers in the Winter Olympics. Even if there is no boycott, there is bound to be some political protests and social demonstrations, and China will not be able to censor anything said by Western broadcasters televising the events. Athletes usually suffer backlash at home if they make critical statements about their country, but they run very little risk of a backlash for criticizing China. If anything, protests against China’s handling of human rights will be tacitly encouraged. Beijing, for its part, will likely overreact, as these days it not only controls the message at home but also attempts more actively to export censorship. This is precisely what the western governments are now trying to counteract, for their own political purposes. The bottom line is that the 2008 Beijing Olympics reflected China’s strengths in stark contrast with the failures of democratic capitalism, while the 2022 Olympics are likely to highlight the opposite: China’s weaknesses, even as the liberal democracies attempt a revival of their global leadership.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Section II: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights The decline in US Treasury yields has once again reduced the appeal of US paper, relative to foreign developed and emerging market bonds. Historically, lower US bond yields relative to other markets has been dollar bearish. The caveat is that if declining yields are due to a flight to safety, the dollar initially benefits due to US bond inflows. The academic research on which yields matter for currencies is mixed. Historically, short rates have mattered more. But with short-term interest rates anchored at zero, there is evidence investors are moving out the curve. Our bias is that looking across the yield curve will provide a more accurate picture of the countries that will benefit from bond inflows. More importantly, it is the sum of portfolio flows that drive a currency. This means equity flows will be important as well. Feature Global bond yields have rolled over, driven by the long end of the curve. The US 10-year yield has fallen from a high of 1.74% at the end of March to 1.29% today. While other bond yields have rolled over, the move has been more pronounced in the US. For example, the spread between the US 10-year Treasury and the 10-year German bund has narrowed from 200bps to 175bps. Given the correlation between relative interest rates – especially in real terms – and the dollar, a rare divergence has opened up in favor of short dollar positions (Chart I-1). A fall in yields can be driven by prospects of either slowing growth, lower inflation expectations, or a combination of the two. In the case of the US and to a certain extent the eurozone, the culprit behind lower yields has been a drop in both the real and the nominal component. This suggests that the markets are worried about central banks becoming too hawkish at the exact moment global growth is set to slow. Across maturities, the US yield curve has thus flattened (Chart I-2). Chart I-1Real Yields And Currencies Have Diverged Real Yields And Currencies Have Diverged Real Yields And Currencies Have Diverged Chart I-2Flattening Yield Curves Flattening Yield Curves Flattening Yield Curves A few questions arise from the setup above. How do you trade the dollar in the current environment? What is the future path for yields, especially relative yields? Should investors focus on a specific maturity as a signal for future currency moves? Finally, are yields the key driver of currencies in the current environment or should investors focus on other factors as well? Explaining Recent Dollar Strength Chart I-3Rising Demand For Hedges Rising Demand For Hedges Rising Demand For Hedges If the decline in rates globally has been led by the US, then why has the dollar remained strong? The first reason is rising safe-haven demand, especially as global growth peaks. Usually, as a counter-cyclical currency, the dollar benefits in a risk-off environment. The latest Treasury International Capital (TIC) data show that foreign inflows into US bonds have been part of the reason for the decline in Treasury yields since March. A reset in equity markets has also been a driver. The DXY index has been very closely correlated with the put-call ratio in the US, and increased demand for hedges, including long dollar positions, have benefited the greenback (Chart I-3). This has been consistent with the outperformance of the more defensive US equity market. The third reason has been a slowdown in relative economic momentum between the G10 and the US. Chart I-4 shows that the Citigroup economic surprise index for the euro area relative to the US remains strong but has rolled over. The story is similar using relative PMIs between the US and the rest of the G10. Relative economic performance has usually tended to dictate currency movements in the near term. Chart I-4Relative Economic Momentum Is Slowing Relative Economic Momentum Is Slowing Relative Economic Momentum Is Slowing Finally, as we highlighted a fortnight ago, the dollar was oversold and due for a tactical bounce. Leveraged funds have been covering their short positions in recent weeks, while speculators are now long the dollar (Chart I-5). Chart I-5Speculators Are Now Long The Dollar Speculators Are Now Long The Dollar Speculators Are Now Long The Dollar Going forward, most of these trends should reverse. While the Delta variant of COVID-19 is raging across countries, hospitalizations are low, and thus the case for renewed lockdowns is weak. Meanwhile, non-US growth should regain the upper hand, especially in countries like Japan where vaccinations are ramping up quite fast. Global yields should also rise, as output gaps close and inflation remains well anchored.             The Dollar And Interest Rates: Real Versus Nominal? As Chart 1 highlights, it is important to think about relative rates when looking for the next move in the dollar. The historical evidence is that there is little correlation between the dollar and the absolute level or direction of bond yields. Over the last few decades, global bond yields have collapsed while the dollar has undergone rolling bull and bear markets. Currencies react more to the path of relative real rates than nominal rates. By definition, a currency is the mechanism by which prices are equalized across borders. Rising inflation lowers the purchasing power of a currency, which in turn forces the currency to adjust lower in a globally competitive pricing system. Across the G10, there has been a longstanding relationship between real interest rate differentials and the path of the currency (Chart I-6). Chart I-6Negative Real Rates In The US Across The Curve Negative Real Rates In The US Across The Curve Negative Real Rates In The US Across The Curve Chart I-7The US Sports A Very Negative ##br##Real Yield Which Rates Matter For Currencies? Which Rates Matter For Currencies? Importantly, US real rates, especially at the short end of the curve, are very depressed. In fact, compared to other G10 countries, the US sports one of the worst 2-year real yields (Chart I-7). Based on the historical precedent illustrated in Chart I-6, a significant increase in US real rates is required to allow the dollar to rise on a structural basis. What About Hedged Yields? It is true that hedged yields in the US are positive for foreign investors. For example, hedged 10-year US yields for German bond investors provide 97 bps of pickup. For a Japanese investor, the yield pickup in the US is 96 bps, and for a British investor, it is 73 bps (Chart I-8A, Chart I-8B, Chart I-8C). Chart I-8BUS Hedged Yields For Japanese Investors US Hedged Yields For Japanese Investors US Hedged Yields For Japanese Investors Chart I-8AUS Hedged Yields For Euro Investors US Hedged Yields For Euro Investors US Hedged Yields For Euro Investors Chart I-8CUS Hedged Yields For British Investors US Hedged Yields For British Investors US Hedged Yields For British Investors   However, there is little correlation between the hedged yields and currency performance, and for good reason: Under covered interest rate parity, a hedged yield will be an arbitrage opportunity, which should be duly uncovered by efficient markets. This arbitrage window for hedged yields disappears if you extend the maturity of your hedging, as economic theory suggests. For example, hedging a 10-year bond with a 3-month currency forward can lead to massive losses as you roll over these contracts. This is because the cost of hedging in the short term tends to have wild fluctuations. For example, hedging in euros for a German investor buying Treasurys was over 300bps at the end of 2018. This wiped out the positive spread between the two bonds.  Many investors do not hedge currency exposure. In fact, the “least regrets” approach of hedging 50% of currency exposure has been quite popular.1 Therefore, focusing on the real yield, rather than the hedged or nominal yield (Chart I-9), has been a far more robust solution in gauging the direction of currencies. By definition, a hedged yield means buying a currency at spot and selling it forward. This should be currency neutral, and especially, arbitrage away the yield differential. Chart I-9Hedged Yields And Currencies: No Correlation Hedged Yields And Currencies: No Correlation Hedged Yields And Currencies: No Correlation Which Bond Yields Matter? The academic evidence suggests that short-term interest rates matter more for currencies, especially when policy is close to the zero bound. According to a BIS paper,2  not only has the FX impact of monetary policy grown significantly in the last few years, but short maturity bonds have had the strongest impact. Moreover, at a lower level of interest rates, the foreign-exchange impact is greater as the adjustment burden falls onto the exchange rate. Looking purely through the lens of the US dollar, our view is more nuanced. Foreign inflows into US long-term Treasurys have been improving tremendously, while flows into T-bills are relapsing (Chart I-10). This suggests longer-term rates have been a bigger driver of inflows into the US, and, more recently, the dollar rally. It is similar to what occurred at beginning of the dollar bull market last decade. Admittedly, the picture shifted over time, with shorter term flows becoming increasingly important as the Fed began to hike interest rates. Taking a step back, bond investors tend to span the duration spectrum, with pension funds investing in bonds many years out. As 1-year and 2-year yield differentials are not meaningfully different across countries (Chart I-11), this curtails the appeal of short-term paper. If inflation differentials are considered, it reduces the appeal of US paper even further. Chart I-10Long-Term Versus Short-Term Flows Long-Term Versus Short-Term Flows Long-Term Versus Short-Term Flows Chart I-11Narrow Gap In Short Term Yields Narrow Gap In Short Term Yields Narrow Gap In Short Term Yields Let’s not forget quantitative easing. If a central bank explicitly targets a bond yield near zero, like in Japan or Australia, that makes it difficult for that same yield tenor to generate positive inflows or send a reliable signal about the economy. This suggests a better method is looking at a spectrum of indicators, including yields at various maturities. Charts I-12 plots the yield differentials across maturities and countries. It shows that currencies have been correlated across the relative yield maturity spectrum. As such, we recommend investors monitor both short- and long-term yields in evaluating currency decisions. Chart I-12AYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12BYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12CYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12DYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12EYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12FYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12GYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12HYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12IYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities    Other Asset Classes There are multiple drivers of exchange rates. Bond yields are just one of them. Equity and other flows also matter. It is the sum of portfolio flows that drive a currency. In fact, inflows into US equities and agency bonds have been the bigger drivers of the US dollar this year (Chart I-13). Outside the US, the correlation between interest rates and the currency can be very weak. The Canadian dollar is much more correlated with terms of trade than with real interest rate differentials. Rising oil prices attract inflows into Canadian corporate bonds and equities, which are positive for the currency. The key point is that flows tend to gravitate to capital markets with the highest expected returns. As such, monitoring flows other than government bond purchases is important. We expect that yields will be higher on a cyclical horizon. This will be beneficial for cyclical stocks, especially banks. This will also be beneficial for flows into non-US bourses, that have a higher weighting of cyclical stocks..  In short, the US equity market has become very tech heavy. Rising interest rates will hurt higher duration sectors such as technology and health care. At the margin, this hurts the relative performance of US equities (Chart I-14). Given that equity inflows have been a key driver of the US dollar, this will also hurt at the margin Chart I-13Agency Bonds And Equity Purchases Have Driven US Inflows Agency Bonds And Equity Purchases Have Driven US Inflows Agency Bonds And Equity Purchases Have Driven US Inflows Chart I-14US Valuations Benefit From ##br##Lower Rates US Valuations Benefit From Lower Rates US Valuations Benefit From Lower Rates   Concluding Thoughts US real interest rates have deteriorated relative to the rest of the world. As such, it will require a significant rise in US real rates to seriously question a dollar bearish view. Meanwhile, a modest rise in global rates will also be bearish for US stocks compared to non-US bourses. US rates are usually high beta, and so could rise more in an improving growth environment. But relative rates are correlated to relative growth. As such, if non-US growth picks up relative to the US, like the IMF expects, this will provide a modest fillip to non-US yields (Chart I-15). US real rates are also very negative, so the bar to create a genuine dollar rally is very high. Finally, the market still expects the Federal Reserve to lead the hiking cycle. This means that there is still potential for an upside surprise in interest rates outside the US, compared to within (Chart I-16). Chart I-15Relative Bond Yields And Relative Economic Momentum Relative Bond Yields And Relative Economic Momentum Relative Bond Yields And Relative Economic Momentum Chart I-16The Market Is Still Relatively Hawkish On The Fed The Market Is Still Relatively Hawkish On The Fed The Market Is Still Relatively Hawkish On The Fed   Housekeeping Our long Scandinavian basket was triggered at our buy point of a -2% pullback from July 9th levels. As such, we are now short EUR/NOK, USD/NOK, EUR/SEK, and USD/SEK. We were also stopped out of our long silver/short gold position for a small loss. We will be looking to reopen this trade in the coming weeks.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Michenaud, S., and  Solnik, B., , “Applying regret theory to investment choices: Currency hedging decisions,” Journal of International Money and Finance 27, 2008, 677-694. 2 Ferrari, Massimo, Kearns, Jonathan and Schrimpf, Andreas, “Monetary policy’s rising FX impact in the era of ultra-low rates,” Bank of International Settlements, April 2017. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Data out of the US this week was mixed: June retail sales came in better than expected. The control group rose 1.1% month on month, versus a -1.4% decline in May. For July, the University of Michigan survey showed inflation expectations continue to edge higher, but the sentiment of current conditions and expectations was well below consensus. Inflows into US assets reversed in May, with net outflows of $30.2bn. Existing home sales rose by 1.4% month on month in June to 5.9 million units. The US dollar DXY index rose modestly this week. Technically, the dollar is now approaching overbought territory. Our intermediate-term indicator has broken above 60, speculators are now long the dollar and sentiment on the greenback has turned up at a time when real rates remain negative in the US. This suggests much optimism is in the price. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Data out of the eurozone this week was robust: The trade balance came it at €9.4bn for May. Final June CPI was in line with expectations – 1.9% for headline and 0.9% for core. The ECB kept rates unchanged in their July 22 meeting, but added to their framework of forward guidance. The euro fell by 40bps this week. Following Christine Lagarde’s Bloomberg interview last week, the ECB made some policy changes. First, they will allow for an inflation overshoot should this be consistent with longer-term inflation at 2%. They will also likely extend the PEPP beyond the March deadline, so no tapering before then. Finally, interest rates are expected to remain negative as far as the eye can see. This is nudging the euro towards becoming a low-beta currency. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 There was some positive news out of Japan this week: Exports rose 48.6% year on year in June. Imports also expanded at a 32.7% year-on-year pace, signaling rising domestic demand momentum. National CPI for June was in line with expectations. The core measure was at 0.2%. Supermarket sales continued to improve in June. The yen was down 0.3% against the dollar this week. The yen is the most shorted developed-market currency, and our intermediate-term indicator is at bombed-out levels. This is occurring at a time when domestic data is on the mend. This is bullish from a contrarian perspective. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 There was some mixed data out of the UK this week: Rightmove house prices rose 5.7% year on year in July. The CBI survey was softer than expected in July. Total orders fell from 19 to 17, while the component of selling prices and business optimism fell 4 and 5 points respectively. The pound fell by 0.5% against the US dollar this week. Momentum on the pound continues to suggest near-term downside. Our intermediate term indicator is still blasting downward, and speculators are cutting their long positions from very aggressive levels. This suggests continued near-term downside in cable. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 There was scant data out of Australia this week: NAB business confidence for Q2 fell from 19 to 17. The RBA minutes confirmed that the central bank will stay dovish in the near term. The AUD fell by 0.7% this week against the USD, the worst performing G10 currency. COVID-19 will continue to dictate near-term developments in Australia, with the latest lockdowns having slowed economic activity. Speculators have started shorting the AUD on this basis (in addition to the risk of a decline in metal prices). In the end, if the COVID-19 crisis proves transient, it will create a coiled spring response for the AUD. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The was scant data out of New Zealand this week: Credit card spending rose 6.3% year on year in June. The performance services index rose from 56.1 to 58.6 in June. The NZD was down 23bps versus the US dollar this week. Last week’s rally in the NZD, following the signal that the RBNZ will end QE this week, is fizzling. From a technical standpoint, speculators are neutral the NZD, but our intermediate-term indicator has not yet bottomed out. We are long CHF/NZD, as a reset in global asset prices could increase currency volatility and benefit the pair. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Data out of Canada this week has been robust: June housing starts came in at 282.1K versus expectations of 270K. Foreigners continued to accumulate Canadian securities in June, to the tune of C$20bn. House prices remain on fire. The Teranet/National Bank index rose 16% year on year in June. The Bloomberg Nanos Confidence index held steady at 66.3. The CAD rose by 0.2% this week, performing better than other G10 currencies. The longer-term outlook for the loonie is clearly positive as the BoC will hike interest rates ahead of the Federal Reserve. Near term, USD/CAD could retest the 1.28 level as our intermediate-term indicator continues to work off overbought conditions. Ultimately, we will be selling this pair between 1.28 and 1.30. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: Exports fell 3% month on month in June. However, watches continued to sell well, with exports rising 71% year on year. Total sight deposits were unchanged at CHF 712 bn for the week of July 16. The Swiss franc was down 0.2% this week. A rebound in global bond yields is a threat to franc long positions. However, we believe the period of volatility in both economic data and equity markets is not over. As such, the franc will benefit from safe-haven inflows. We are long the CHF/NZD cross on this basis. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Data out of Norway is improving: Industrial confidence came in at 11.3 for Q2, from 8.6 the previous quarter. The NOK was down by 0.5% this week against the dollar. This triggered our limit-buy on Scandinavian currencies at the -2% trigger level we had originally been targeting. As such, we are now short EUR/NOK and USD/NOK. With real yields in Norway much higher than in the US or Europe, portfolio flows should benefit the NOK. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden have been somewhat mixed: There is a slight upward revision to the Bloomberg economic forecasts. GDP growth is now expected to be 4% year on year in 2021, from a previous estimate of 3.5%. However, CPI was revised down 10bps to 1.7% this year, and 1.4% next year, considering the disappointing CPI print last week. The SEK was down 20bps this week. The SEK remains one of our most potent plays on a global growth recovery. Historically, the SEK has correlated very well with global growth variables and relative economic growth between Sweden and the rest of the world. This week, our limit-buy on Scandinavian currencies was triggered. As such, we are now short EUR/SEK and USD/SEK. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Metals prices are likely to suffer in the short term on the back of weakening Chinese demand and fading inflationary pressures. Accordingly, in our most recent Global Asset Allocation (GAA) Quarterly Outlook, we downgraded the AUD to underweight against the greenback. Bond yields, globally, are bound to rise moderately over the course of the coming 12 months. Australian yields, however, are likely to rise slower than those in the US. The RBA has been explicit in communicating what it would take to adjust its policy stance and is likely to lag behind other central banks in DM. We therefore recommend investors favor Australian government bonds in a global bond portfolio. Australian equities, now dominated by Financials rather than the Materials sector, would benefit from a rise in bond yields. However, a weaker AUD and declining metal prices warrant no more than a benchmark exposure to Australian equities within a global equity portfolio. Introduction Recently, clients have often been asking about Australia. The reasons seem clear. With a potential commodities “super-cycle” driven by a shift to renewable energy and electric vehicles (EVs), both the Australian economy and equities should be in a position to benefit. The reality, however, has been much less positive. Particularly the divergence between the core driver of the Australian market, industrial metals, and the performance of both equities and the currency over the past few years has been a concern (Chart 1). Over the past year and a half, Australian equities have underperformed the MSCI ACWI by 12.4% (Chart 2, panel 1). This underperformance was mainly due to the outperformance of the US. However, even against global markets excluding the US, Australian equities did not match the rise in commodity prices – particularly industrial metals (Chart 2, panel 2). Chart 1Despite The Rise In Metals Prices... Despite The Rise In Metals Prices... Despite The Rise In Metals Prices... Chart 2...Australian Equities Have Not Outperformed ...Australian Equities Have Not Outperformed ...Australian Equities Have Not Outperformed   Chart 3Financials Dominate Australian Equities Financials Dominate Australian Equities Financials Dominate Australian Equities The structure of the Australian market has changed over the past few years. The commodities boom and subsequent global liquidity boom over the past two decades have fueled a housing bubble in Australia and an unsustainable rise in household debt. As a result, Australian equities are no longer dominated by metals and mining stocks, but rather by banks (Chart 3). We structured this Special Report in a Q&A format, answering questions we think are most relevant for investors to assess both the short- and long-term outlook for Australia. We aim to provide an overview of the economy and draw some conclusions on how investors should be positioned. Our conclusions are as follows: Over the past year and a half, the Australian economy has shown how complementary actions between fiscal and monetary policy, as well as social restriction measures, can mitigate both economic and human damage. The Reserve Bank of Australia (RBA) will be in no rush to adjust its policy stance until wage growth is back to its 3% target. However, RBA officials risk running the economy hot in the meantime given that measures of employment are back to their pre-pandemic levels. The RBA is not likely to change its policy stance before reaching its wage growth and inflation targets and will probably lag behind other global central banks in tightening. In that case, investors should favor Australian government bonds in a global bond portfolio. Australian banks remain well-funded and in good health. But their excessive exposure to the housing sector puts them at grave risk if home prices collapse. Despite this, there seems to be a feedback loop where a decline in mortgage rates fuels further demand for loans, pushing up home prices. A slowdown in Chinese credit growth and economic activity will hamper commodity demand, weighing down on Australian equities. The longer-term outlook remains compelling for Australian equities and metals as we enter into a new commodities “supercycle” fueled by a transition to renewable and alternative energy. The Australian economy stands to benefit given that the country has high levels of both production and reserves of the minerals needed for this transition.   Q: How Does The Economy Look In The Short-Term? A: Australia can be regarded as one of the few countries that successfully navigated the pandemic with a minimal amount of damage, both to its population and economy. With swift measures to limit travel and implement social restrictions, the spread of the outbreak was curtailed to slightly over 30,000 total cases, representing only 0.12% of its population (Chart 4). On the other hand, its vaccination campaign has been much slower (at 38 doses administered per 100 people) than in other DM economies such as the US, UK, France, or Germany with 100, 120, 90, and 102 doses per 100 people, respectively. In the short term, this might not seem particularly damaging to the economy. However, if vaccination rates do not pick up rapidly, Australia’s international travel restrictions (which cannot sustainably be kept in place) will hamper economic growth and become a major drag on the tourism and education sectors (Chart 5, panels 1 & 2). Chart 4Government Policies Contained The Pandemic Outbreak... Government Policies Contained The Pandemic Outbreak... Government Policies Contained The Pandemic Outbreak... Chart 5...At The Expense Of Tourism ...At The Expense Of Tourism ...At The Expense Of Tourism Ample fiscal support – in the form of wage subsidies and business support through the JobKeeper program – mitigated the shortfall in household incomes (Chart 6). This provided a boost to both consumers and businesses with Q1 GDP growth coming in at 1.8% quarter-on-quarter (7.4% annualized). GDP expectations for the remainder of this year and next show a resilient strong momentum for Australian growth and domestic demand (Chart 7). Chart 6Fiscal Stimulus Supported Employment... A Deeper Dive Into The Land Down Under A Deeper Dive Into The Land Down Under Chart 7...And Overall Growth ...And Overall Growth ...And Overall Growth Chart 8Labor Market Back To Pre-Pandemic Levels... Labor Market Back To Pre-Pandemic Levels... Labor Market Back To Pre-Pandemic Levels...   The labor market recovery has been an excellent example of how fiscal support and lockdown measures complement each other. Most employment indicators have almost recovered or surpassed their pre-pandemic levels: The unemployment rate stands at 4.90%, compared to 5.13%, the underemployment rate is at 7.44%, compared to 8.60%. The total number of those employed is now above its pre-pandemic level, albeit still below the 2018-2019 growth trend (Chart 8).   Q: When Will The RBA Shift Its Policy Stance? A: The RBA has been explicit in communicating that changes in its policy stance hinge on Australian wage growth rising sustainably towards 3% – a level last reached in Q1 2013. Even with economic activity mostly restored, wage growth remains low at 1.49% (Chart 9). Our belief is that until that occurs, the RBA will probably maintain its accommodative stance. Our global fixed-income strategists, in a recent report, highlighted their belief that the RBA is likely to be less hawkish than markets currently expect – on both tapering and hiking rates. We agree with that assessment. Comments by RBA Governor Lowe earlier last month back our dovish belief: He stated that “The Board is committed to maintaining highly supportive monetary conditions to support a return to full employment in Australia and inflation consistent with the target…This is unlikely to be until 2024 at the earliest”. Market expectations nevertheless remain much more hawkish – pointing to a first rate hike by mid 2022 and almost 70 basis points of hikes by 2024 (Chart 10). Chart 9...However Wage Growth Remains Muted ...However Wage Growth Remains Muted ...However Wage Growth Remains Muted Chart 10Market Expects A Hawkish RBA... Market Expects A Hawkish RBA Market Expects A Hawkish RBA   Chart 11...And Is Already Pricing That Down The Curve ...And Is Already Pricing That Down The Curve ...And Is Already Pricing That Down The Curve Chart 12Inflation Remains Well-Below The RBA's Target Inflation Remains Well-Below The RBA's Target Inflation Remains Well-Below The RBA's Target This means that the RBA will probably risk running the economy hot for a while. With total employment back to its pre-pandemic level and other employment indicators closely behind, inflationary pressures, sooner or later, will begin to mount. Higher growth prospects and inflation risks are being discounted further down the curve (Chart 11). The June CPI print is likely to reflect a transitory short-term base effect and the RBA is mostly going to see through that. In the meantime, we would watch other broad inflation indicators to gauge for price pressures. Broader measures such as the trimmed-mean inflation index or median inflation remain subdued at 1.1% and 1.3%, respectively. The 10-year breakeven rate currently stands at 2.1%, within the RBA’s range of 2%-3%, highlighting the market’s belief that long-term inflation remains well under control (Chart 12). Bottom Line: The RBA is likely to maintain its dovish stance for longer than the market expects. A return to sustainable levels of wage growth and inflation will remain the top objectives and it is unlikely that policy will be reversed before they are achieved. Our global fixed-income strategists laid out a checklist of what would make the RBA turn less dovish. So far, only 1 out of 5 items on their list (the recovery in private-sector demand) signals the need for a more hawkish stance. The remaining items signal no imminent pressure on the RBA to adjust policy (Table 1). The RBA is also wary of the currency appreciating if it took a more hawkish stance ahead of other central banks (e.g., the Fed) and is therefore likely to switch policy only after other central banks do so (Chart 13). Accordingly, investors should favor Australian government bonds within a global bond portfolio. Table 1RBA Checklist A Deeper Dive Into The Land Down Under A Deeper Dive Into The Land Down Under Chart 13The RBA Will Be Wary Of A Rising AUD The RBA Will Be Wary Of A Rising AUD The RBA Will Be Wary Of A Rising AUD   Q: Are There Signs Of Improvement In The Banking Sector? A: Headline indicators of the health of the Australian banking sector paint a picture of a well-capitalized, highly funded, and profitable industry. Return on equity (ROE) has averaged 12.1% over the past decade. Capital adequacy and Tier 1 capital ratios stand at 14.5% and 18.2%, respectively – much higher than at the start of the Global Financial Crisis (GFC). The ratio of non-performing loans remains low and Australian banks’ reliance on leverage has also decreased (Chart 14). Chart 14Banks Look Healthy... Banks Look Healthy... Banks Look Healthy... Chart 15...But Remain Exposed To The Housing Sector... ...But Remain Exposed To The Housing Sector ...But Remain Exposed To The Housing Sector However, these indicators mask a major underlying risk. Banks remain heavily exposed to the housing market, with housing loans as high as 62% of banks’ gross outstanding loans and 40% of total assets (Chart 15, panel 1). Over the past decade and a half, banks have lent an average of A$56 of housing-related loans for every A$100 in total loans (Chart 15, panel 2).   Chart 16...Which Is Showing No Signs Of Slowing Down ...Which Is Showing No Signs Of Slowing Down ...Which Is Showing No Signs Of Slowing Down Chart 17Households Remain Heavily Indebted Households Remain Heavily Indebted Households Remain Heavily Indebted With interest rates falling over the past few decades, construction activity has boomed. Consequently, the demand for loans for new homes has been rising, leading home prices higher (Chart 16). This also meant that household debt levels have climbed and currently standing at a staggering 130% of GDP and 180% of disposable income (Chart 17).   So what does this mean for banks’ stock prices? The short answer is that absent a bursting of the bubble in house prices, banks should continue to fare well. Interestingly, the long-standing relationship between bond yields and banks’ relative stock price returns – one that works in other financial-heavy markets such as the euro area – did not hold in Australia, at least until recently. In fact, we find that, historically, Australian banks outperformed the broad market when bond yields were falling. This relationship changed post-GFC, most likely when inflation expectations became unanchored and trended lower – reflecting lower commodity prices (Chart 18). Bottom Line: Rising rates, reflecting better growth prospects and higher long-term inflation, should be a tailwind for bank stocks in the short term. Accommodative monetary policy will spur activity in the property market, propping up bank profits. This, however, puts banks at even greater risk when profitability starts to decline, NPLs rise and regulations tighten further. The latter risk is one we would highlight following RBA deputy governor Guy Debelle’s statement that monetary policy will not be used as a tool to curtail housing prices and that there are other tools to address that issue. Chart 18Rising Yields Will Be A Tailwind For Australian Equities Rising Yields Will Be A Tailwind For Australian Equities Rising Yields Will Be A Tailwind For Australian Equities   Q: How Does Chinese Policy Impact Australian Growth? A: China's role in global supply chains, as both a producer and consumer, has increased dramatically since the early 2000s. China’s demand for commodities generally and industrial metals in particular has grown over the past two decades from an average of 10% of total global demand to 50% for most metals (Chart 19). Australia stood to benefit, redirecting more and more of its metals’ production away from the rest of the world and towards China. For example, during the same period, the share of Australian iron ore exports to China increased fourfold (Chart 20). Chart 19China Is A Major Consumer Of Metals... China Is A Major Consumer Of Metals... China Is A Major Consumer Of Metals... Chart 20...And This Has Benefited Australia Over The Past Two Decades ...And This Has Benefited Australia Over The Past Two Decades ...And This Has Benefited Australia Over The Past Two Decades     However, this dynamic leaves the Australian economy very exposed to the Chinese business cycle – one that is heavily reliant on policymakers’ decisions on how much liquidity to inject into the economy. After strong credit and fiscal support throughout 2020, the Chinese authorities – wary of excessive leverage in the economy – have begun paring back stimulus which is likely to lead to weaker growth in the second half of the year and put downward pressure on metal demand (Chart 21). Chart 21Weakening Chinese Demand Will Hurt Metals In The Short-Term Weakening Chinese Demand Will Hurt Metals In The Short-Term Weakening Chinese Demand Will Hurt Metals In The Short-Term Heightened political tensions between Australia and China have also played a role. China recently imposed restrictions, including additional tariffs and bans, on Australian imports such as beef, wine, coal, and other goods. Consequently, Australian exports to China slowed. However, the goods not imported by China were absorbed by other economies – Australian export growth did not fall that much. It is unlikely that a new commodity-heavy marginal buyer will emerge in the short-term to replace Chinese demand. The recent rise in commodity prices reflected a return to economic activity, as well as inflationary fears, and supply, shipping, and logistical backlogs. These will ease in the short term, weighing on both the AUD and Australian equities.   Q: Can The Shift To Renewable Energy Spur Future Australian Growth? A: The shift to renewable energy and electrification – particularly in the transport sector – will occur sooner rather than later. Some commodity-exporting countries stand to benefit, and Australia is likely to be one. We previously highlighted that modeling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency and recycling rates, and the rate of conversion to renewables. Chart 22The Shift To Renewables Will Require More Resources... A Deeper Dive Into The Land Down Under A Deeper Dive Into The Land Down Under The mechanics of the future demand/supply relationship hinge on the following: Demand will rise during this energy transition period – simply due to the fact that the new clean energy systems require more minerals (such as copper and zinc) than the current traditional hydrocarbon-fueled energy system (Chart 22, panel 1). Electric vehicles (EVs) require about four and a half times more of certain commodities – particularly copper, nickel, and graphite – than conventional vehicles do (Chart 22, panel 2). Supply limitations, on the other hand, are what might propel metal prices even higher and lead the world economy into a new commodities “supercycle”. A study by the Institute for Sustainable Futures has shown that, in the most positive energy transition scenarios, demand for some metals will exceed supply, in terms of both available resources and reserves (Table 2). Table 2...Which Are Likely To Be In Short Supply A Deeper Dive Into The Land Down Under A Deeper Dive Into The Land Down Under For some of those metals, Australia is either among the top producers, or has the largest reserves. For example, Australia produces almost 45% and 12% of the world’s lithium and zinc, and has 22% and 27% of the world’s reserves. Looking at other metals, supply disruptions – particularly in economies where political, social, and environmental influences are an issue – might be the driver of further price rises. For example, Chile has the largest shares of global lithium reserves (~44%), and copper reserves (~23%), while South Africa has the largest share of global manganese reserves (~40%). Bottom Line: The transition to renewable energy is already underway and is likely to intensify. Forecast demand should outstrip supply and Australia stands to benefit given its large share of current production and/or reserves. How much will depend on the pace of renewable energy integration but miners are likely to be long-term winners.   Q: What Is The Outlook For The AUD? A: The Global Asset Allocation (GAA) service, in its latest Quarterly Outlook, turned negative on the AUD. The currency has historically had a high positive correlation with commodity prices and industrial metals prices, which in turn are very sensitive to Chinese demand (Chart 23). Given our outlook for metals in the short term (falling demand driven by slowing Chinese activity), we expect some weakening in the AUD over the coming 9-to-12 months (Chart 24). Chart 23The AUD Is Highly Correlated To Metal Prices... The AUD Is Highly Correlated To Metal Prices... The AUD Is Highly Correlated To Metal Prices... Chart 24...Which In Turn Are Highly Correlated To Chinese Activity ...Which In Turn Are Highly Correlated To Chinese Activity ...Which In Turn Are Highly Correlated To Chinese Activity Additionally, short-term weakness in the economy, caused by further lockdowns as Delta-variant COVID cases rise, is a risk since it might reduce domestic demand. From a valuation perspective, the AUD is slightly below its fair value (Chart 25). However, this on its own does not compel us to remain positive on the currency. We also consider other indicators such as investor positioning – which has reached a decade high, according to Citibank’s FX Positioning Alert Indicator (PAIN) (Chart 26). This indicator suggests that active FX traders hold substantial long positions in the AUD against the USD. Historically, this indicator has provided contrarian signals, with extreme optimism (pessimism) providing useful short (long) signals. Chart 25The AUD Is Close To Fair Value The AUD Is Close To Fair Value The AUD Is Close To Fair Value Chart 26Investors Are Long The AUD Investors Are Long The AUD Investors Are Long The AUD Bottom Line: Short-term weakness in the economy and a reversal in metal prices warrant caution on the currency. While valuations do not signal overbought conditions, investor positioning (a contrarian indicator) does.   Q: How Should Equity Investors Be Positioned? A: Our recent Special Report on whether country or sector effects drive equity performance showed that sector composition was relatively important in Australia, given the large difference in sector weightings relative to the global benchmark. Our analysis showed that cumulative Australian sector performance over the past two decades detracted from overall returns (Chart 27). Given that framework, and the relationship between the Australian economy and industrial metals, we find that Australian equity performance relative to the US mirrors the performance of global metal and mining relative to global tech stocks (Chart 28). This underperformance makes sense: Commodity prices have been in a structural downtrend throughout the past decade. Chart 27Country Vs Sector Effect Country Vs Sector Effect Country Vs Sector Effect Chart 28Australia / US = Metals / Tech Australia / US = Metals / Tech Australia / US = Metals / Tech Therefore, given our view of the outlook for metals, we would not want to shun Australian equities. The Global Asset Allocation (GAA) service is currently neutral the Australian market within a global equity portfolio, and underweight the Materials sector over the next 12 months. We believe this positioning makes sense given the slowdown in the Chinese economy and the improbability that another country will emerge as the alternative marginal buyer of commodities. The longer-term outlook is more compelling however, as the shift to decarbonization, renewables, and alternative energy gets underway. Conclusions In the short term metals prices are likely to suffer on the back of weakening Chinese demand (with no immediate substitute as a marginal buyer) as well as fading inflationary fears and an easing of supply/logistical issues. Our analysis shows that sector composition is a larger driver of Australian equity relative performance than country composition. While Australian equities – dominated by Financials – would benefit from a moderate rise in global bond yields, yields will rise more slowly in Australia than in the US and the AUD is likely to weaken. Over the next 12 months, investors should remain neutral on Australian equities within a global equity portfolio. The RBA is likely to lag other central banks in tightening policy. Investors should therefore favor Australian government bonds over other developed economies such as the US and Canada.   Amr Hanafy, Senior Analyst Global Asset Allocation amrh@bcaresearch.com        

Highlights The ECB has changed its inflation target, but its credibility remains weak. Inflation will not allow the ECB to tighten policy anytime soon. Instead, the ECB will have to add to its asset purchase program next year and may even consider dual interest rates. EUR/USD should continue to appreciate because of the weakness in the USD, but EUR/GBP, EUR/NOK, and EUR/SEK will soften. The SNB will follow the ECB; buy Swiss stocks / sell Eurozone defensives as an uncorrelated trade. China matters more than COVID-19 for the cyclical/defensive ratio. Despite our pro-cyclical medium- to long-term portfolio bias, the reflation trade is pausing. Remain tactically long telecom / short consumer discretionary as a hedge. European momentum stocks are near critical levels relative to growth equities. Feature The European Central Bank has found a new way to shed its Bundesbank heritage further and to justify the continuation of its QE program well after other central banks around the world will have ended their asset purchases. The early results of the Strategy Review and the subsequent comments by President Christine Lagarde will make it near impossible for the ECB to taper its asset purchases anytime soon. Practically, this means that the European yield curve will steepen relative to that of the US. Additionally, this policy should not hurt EUR/USD, but it will hurt EUR/GBP, EUR/NOK, and EUR/SEK. In the equity space, Swiss stocks will outperform European defensive equities, creating an opportunity for an uncorrelated trade. A New Tougher Target The ECB has abandoned its long-standing target of “close but below” 2% inflation. Even more importantly, the ECB followed the Bank of Japan and the Fed in adopting an approach whereby both downside and upside deviations from the 2% inflation target are to be fought. The ECB’s credibility was already hurt by its inability to achieve its more modest previous inflation target. Since 2009, the Euro Area HICP only averaged 1.2% (Chart 1). To prevent losing further credibility under its new mandate, the ECB will have to increase its stockpile of assets. Moreover, the ECB is far from achieving its new mandate, which will add to the ECB’s need to expand stimulus to the system even once the impact of owner-equivalent rent is included in CPI. Chart 1Mission Impossible Mission Impossible Mission Impossible Chart 2Narrow Inflationary Pressures Narrow Inflationary Pressures Narrow Inflationary Pressures Today, the ECB’s measure of core inflation stands at 1%, while headline inflation is 1.9%. As the economy re-opens, a surge in inflation is likely, but this spike will be transitory, even more so than in the US. As we recently showed, our estimate of the Eurozone trimmed-mean CPI has plunged close to 0%, which highlights that inflation pressures remain narrow (Chart 2). The labor market is another hurdle that will prevent Eurozone inflation from durably reaching 2% anytime soon. Currently, the total hours worked in the Euro Area remains well below the equilibrium level implied by the working-age population (Chart 3), which historically constrains wages. Moreover, it generally takes many quarters after labor shortages become prevalent before inflation begins to inch higher (Chart 4). Chart 3No Wage Pressure Yet No Wage Pressure Yet No Wage Pressure Yet Chart 4No Inflation Labor Shortages For A While No Inflation Labor Shortages For A While No Inflation Labor Shortages For A While The euro is the last force that caps European inflation. Despite the recent depreciation in EUR/USD, the trade-weighted euro remains near all-time highs, which historically imparts strong deflationary pressures to the economy (Chart 5). Beyond the time it will take for realized inflation to reach the ECB’s new target, inflation expectations are still inconsistent with 2% inflation. As the top panel of Chart 6illustrates, market-based inflation expectations in the Eurozone remain well below both 2% and the levels that prevailed before the Great Financial Crisis, even though rising commodity prices are lifting global inflation expectations. Market participants are not alone in doubting the ECB; professional forecasters do not see inflation at 2% in the near-term or the long-term (Chart 6, bottom panel). Chart 5The Euro Is Deflationary The Euro Is Deflationary The Euro Is Deflationary Chart 6The ECB Lacks Credibility The ECB Lacks Credibility The ECB Lacks Credibility   In addition to the continued inability of the ECB to achieve its previous inflation target, let alone its present one, sovereign risk still hamstrings the central bank. The Italian economy remains fragile, because little structural reform has taken place. The Spanish economy cannot stand on its own two feet while the tourism industry continues to suffer due to COVID-19 related fears. And the exploding debt load of the French economy as well as its structural current account deficit raise the possibility that OATs will become unmoored. The ECB will ensure that spreads in those nations do not widen, or Eurozone inflation will never reach the new 2% target. Bottom Line: When it was time to achieve near—but below—2% inflation, the credibility of the ECB was already limited. The new target will be even harder to reach, but the symmetry around it gives the ECB more leeway to provide additional support to the Eurozone economy. Market Implications The ECB is now bound to maintain policy accommodation beyond the scheduled end of the PEPP program in March 2022, or the new policy target will be even less credible than the previous one. BCA Global Fixed Income Strategy team expects the ECB to maintain its asset purchase program beyond the stated end of the PEPP. Practically, this means that the ECB will fold the program into the pre-pandemic APP. The ECB cannot tighten policy while it remains so far from its target, especially now that missing the goalpost to the downside is as problematic as missing it to the upside. We expect the ECB to hint at this on Thursday. Chart 7The EONIA Curve Anticipated The Strategy Review The EONIA Curve Anticipated The Strategy Review The EONIA Curve Anticipated The Strategy Review The ECB will also not increase interest rates for the foreseeable future, which the EONIA curve already anticipates (Chart 7). Money markets only expect a first hike in late 2024, which is appropriate. Compared to a month ago, overnight rates 10-year forward fell by more than 10bps, from 0.75% to 0.61%. We are inclined to fade this move. More stimulus raises the outlook for long-term policy rates. Amid the correction in global bond yields, betting against the decline in the long-term EONIA rate is akin to catching a falling knife; however, because the ECB is easing relative to the Fed, a box trade of buying European steepeners at the same time as US flatteners remains appropriate. The ECB could also lower the rate on TLTRO operations, resulting in a dual interest rate regime in the Eurozone. As Megan Greene and Eric Lonergan have argued, this policy would provide a further lift to the Euro Area economy by boosting the attractiveness of borrowing; at the same time, it would limit the deleterious impact of ever-more negative deposit rates on the profitability of the banking sector, because banks would borrow at extremely negative rates to finance lending activities.  Chart 8JPY And YCC JPY And YCC JPY And YCC The effect of the policy on the euro is more complex. When Japan announced its Yield Curve Control strategy in September 2016, it defined price stability as achieving a 2% inflation rate over the span of the business cycle. In other words, the BoJ implemented a backdoor average inflation mandate. Following this announcement, USD/JPY strengthened (Chart 8), but this move reflected the dollar rally and the global bond selloff around the US election, not yen-specific factors. This suggests that the euro will continue to track the USD inversely. BCA’s FX Strategy team remains bearish on the greenback, as a result of the growing US current account deficit and the fact that the Fed continues to target an overshoot in inflation, which suggests that, even if US nominal interest rates rise, real rates will lag behind. The EUR is nonetheless set to underperform compared to other European currencies. In the UK, house price gains are accelerating, the jobless count is declining rapidly as the economy re-opens, and the cheapness of the pound is accentuating positive inflation surprises. This combination suggests that the BoE is likely to follow the path of the Bank of Canada or the Reserve Bank of New Zealand, by beginning to tighten policy by early next year. Norway also faces a similar set of circumstances and has already announced it will lift interest rates this year. As we argued two months ago, the Riksbank is likely to follow its western neighbor, because the Swedish housing market is roaring, and the economy will remain well supported by the upcoming global capex boom. Hence, EUR/GBP, EUR/NOK, and EUR/SEK will depreciate.  The Swiss National Bank should be the outlier that will follow the ECB. Swiss headline and core inflation linger at 0.6% and 0.4%, respectively. Wage growth is a meager 0.5%, because the Swiss output gap remains a massive 5.5% of GDP (Chart 9, top panel). Meanwhile, consumer confidence and retail sales are much weaker than those of Sweden, Norway, or the UK. Finally, Swiss private debt stands at 270% of GDP, which means that this economy still risks falling into a Fisherian debt-deflation trap. As a result, the SNB will continue to try to cap the upside in the CHF vis-à-vis the EUR, because the currency remains the main determinant of Swiss monetary conditions. Moreover, according to the central bank, the Swiss franc is still 10% overvalued relative to the euro, which is weighing on the country’s competitiveness (Chart 9, bottom panel). To fight the recent depreciation of EUR/CHF, the SNB will not raise rates for a long time and will intervene further in the FX market. The liquidity injections should prompt additional increases in the SNB’s domestic sight deposits, which since 2015 have resulted in a rise of Swiss bond yields relative to those of Germany (Chart 10). While counterintuitive, this relationship reflects the reflationary impact of the SNB’s asset purchases. It also means that the Swiss real estate market is set to become ever bubblier. Chart 9The SNB Will Follow The ECB The SNB Will Follow The ECB The SNB Will Follow The ECB Chart 10Swiss/German Spreads To Widen Swiss/German Spreads To Widen Swiss/German Spreads To Widen For Swiss shares, the picture is more complex. Swiss equities are extremely defensive, but, while they underperform Euro Area stocks when global yields rise, widening Swiss / German spreads often provide a lift to the SMI. A simple model, assuming US 10-year Treasury yields rise to 2.25% by the end of 2022 (BCA’s US Bond Strategy forecast) and that Swiss/German spreads widen to 20bps as the SNB domestic sight deposits swell, suggests that Swiss stocks will underperform that of the Euro Area over the coming 18 months (Chart 11). However, if we compare Swiss equities to European defensive sectors, then the widening in Swiss/German spreads should prompt an outperformance of Swiss equities, because their multiples benefit from ample liquidity conditions in Switzerland (Chart 12). Chart 11Swiss Stocks Are Too Defensive To Outperform Durably... Swiss Stocks Are Too Defensive To Outperform Durably... Swiss Stocks Are Too Defensive To Outperform Durably... Chart 12...But They Will Beat Euro Area Defensives ...But They Will Beat Euro Area Defensives ...But They Will Beat Euro Area Defensives Bottom Line: The results of the ECB Strategy Review will force this central bank to remain a laggard and continue to expand its balance sheet well after the expected end of the PEPP program. Eurozone interest rates will also fall behind that of other major economies. The ECB may even consider cutting the interest rate on TLTROs to boost lending. These policies will have a minimal impact on EUR/USD, which will continue to be dominated by the dollar’s fluctuations. However, EUR/GBP, EUR/SEK, and EUR/NOK will suffer. Finally, the SNB will follow the ECB and expand its balance sheet further, which will paradoxically lift Swiss/German spreads. As a result of their defensive nature, Swiss stocks will underperform Euro Area ones over the next 18 months, but they will outperform European defensive equities. Go long Swiss equities relative to European defensives, as a trade uncorrelated to the broad market. Follow China, Not Delta Chart 13 The ECB’s New Groove The ECB’s New Groove In recent days, doubts have grown about the European re-opening trade because of the resurgence of COVID-19 cases. The Delta variant (or any subsequent mutation for that matter) will cause hiccups along the way, but, ultimately, the re-opening will continue to proceed. As a result of the growing rate of vaccination, hospitalizations and deaths remain stable even if new cases are climbing rapidly in many countries (Chart 13). As long as the burden on the healthcare system remains limited, governments will find it difficult to justify further large-scale lockdowns. Instead, measures such as Macron’s Pass Sanitaire will provide increasing, widespread incentives for greater vaccination. Despite this sanguine take on the Delta variant, we remain concerned for the near-term outlook for cyclical equities because of the Chinese economy, even after the recent 50bps cut in the Reserve Requirement Ratio. BCA’s China Investment Strategy service believes that the RRR cut does not signal the beginning of a policy easing cycle.  More evidence would be needed, such as additional RRR cuts, rising excess reserves, or supportive policies for the infrastructure and real estate sectors. For now, we heed the message from PBoC official Sun Guofeng that “the RRR cut is a standard liquidity operation.” Chart 14Fade The RRR Cut Fade The RRR Cut Fade The RRR Cut The dominant force for the Chinese economy remains the previous deterioration in the credit impulse, which suggests that Q3 and Q4 growth will decelerate materially (Chart 14, top panel). Moreover, the softening impulse is consistent with weaker global economic activity, as approximated by our Global Nowcast (Chart 14, middle panel), especially since the lingering effect of the past RRR increases is still consistent with a global deceleration (Chart 14, bottom panel). In this context, we continue to hedge our long-term preference for cyclical stocks because of the near-term risks created by China and the excessively rapid move in the cyclical-to-defensives ratio (Chart 15). In response to this pause in the reflation trade, we continue to favor a long telecom/short consumer discretionary tactical position, which is supported by valuations and RoE differentials, as well as the still extended relative momentum (Chart 16). The period of risk to the global reflation trade should also allow the dollar to remain firm in the near-term, which means that for the coming months, the euro will not go beyond its trading range in place since the beginning of the year. Chart 15Cyclicals Remain Tactically Vulnerable Cyclicals Remain Tactically Vulnerable Cyclicals Remain Tactically Vulnerable Chart 16Stay Long Telecom / Short Consumer Discretionary Stay Long Telecom / Short Consumer Discretionary Stay Long Telecom / Short Consumer Discretionary Bottom Line: China’s RRR cut is not yet enough to bet against the temporary pause in the global reflation trade. Thus, investors should continue to hedge pro-cyclical long-term bets in their portfolios via a long telecom / short consumer discretionary position. An Exciting Chart A chart caught our eye this week: The underperformance of Eurozone momentum stocks relative to growth stocks is massively overdone (Chart 17). For now, we only want to highlight the phenomenon, but, in the coming weeks, we will delve deeper into the topic to gauge if these oversold conditions constitute an attractive opportunity. Chart 17Washed Out Moment Washed Out Moment Washed Out Moment   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com   Currency Performance The ECB’s New Groove The ECB’s New Groove Fixed Income Performance Government Bonds The ECB’s New Groove The ECB’s New Groove Corporate Bonds The ECB’s New Groove The ECB’s New Groove Equity Performance Major Stock Indices The ECB’s New Groove The ECB’s New Groove Geographic Performance The ECB’s New Groove The ECB’s New Groove Sector Performance The ECB’s New Groove The ECB’s New Groove