Economic Growth

Highlights Tactically downgrade cyclical equities from overweight in Europe. The shift in global growth drivers, the beginning of the global liquidity withdrawal, and lingering COVID worries create headwinds for the cyclicals-to-defensives ratio this summer. Weaker global inflation expectations, commodity prices, and a dollar rebound will accompany this period of turbulence. The relative technical and valuation backdrop will also contribute to this period. Short consumer discretionary / long telecommunication is a high-octane version of the trade. Short technology / long healthcare is its lower-risk / lower-reward cousin. This temporary portfolio shift is a risk management move to capitalize on our positive 18- to 24- month view on cyclicals. Feature Last week, we recommended investors adopt a more defensive tactical posture.  They should raise cash and shift into defensive quality names in order to weather a summer replete with potential downside risk. This will place investors in a good position to shift back into a more aggressive stance this fall, when cyclical sectors should resume their outperformance. This week, we explore this idea in more detail. The combination of a Chinese credit slowdown, a potential transition in the driver of growth away from goods into services, and a shift in tone from global central banks will feed the expected market volatility this summer. European defensive stocks are set to outperform during this period. Buying telecommunication equities / selling consumer discretionary stocks is a high octane bet on this trend, while going long healthcare / short technology shares is its low-risk incarnation. Summer Storms This summer, three forces will feed some downside risk in the market and, more specifically, an underperformance of cyclical sectors relative to defensive ones: a transition in global growth, preliminary signs that global central banks will begin to take away the punch bowl, and disappointments caused by COVID variants. Growth Transition The global economy is set to cool down as we transition away from the first stage of the post-pandemic recovery. As we showed last week, China’s deteriorating credit impulse is consistent with global industrial activity receding from its extremely robust pace of expansion (Chart 1). The continued decline in China’s banking system excess reserve ratio suggests that total social financing flows will slow further. Consequently, China’s intake of raw materials and industrial goods will decelerate, which will impact global industrial activity negatively. Already, the New Orders component of China’s Manufacturing PMI has rolled over. The disappointment of Chinese retail sales last week further indicates that China will act as a drag on global growth in the coming quarters. We have also highlighted that the combined effect of higher yields and oil prices has become strong enough to alter negatively the path of global industrial activity going forward. Our Global Growth Tax indicator, which includes both variables, shows that the US ISM Manufacturing survey and the global manufacturing PMI have reached their apex and will moderate this summer (Chart 2). Chart 1The China Drag Chart 2Rising Costs Bite The problem for global growth is one of changing leadership. Global economic activity is not about to collapse, but the extraordinary surge in goods consumption that started in 2020 will make room for a catch-up in the service sector. As an example, US retail sales stand 15% above their pre-pandemic trends; however, services spending still lies 7% below its pre-pandemic tendency (Chart 3). Thus, as summer progresses, the recent deceleration in consumer spending on goods will continue and services will progressively pick up the slack. The change in growth leadership will cause some temporary trepidation in global economic activity, because it is happening when the effect of both the Chinese credit slowdown and the previous increase in yields and oil will be most potent. As a result, we expect the G-10 Economic Surprises Index to follow that of China and experience an air pocket this summer (Chart 4). Chart 3From Goods To Services Chart 4Where China Goes, So Will The G-10   The Chaperone Is On The Way More than 65 years ago, former Fed Chair William McChesney Martin noted that the job of central bankers was to be “the chaperone who has ordered the punch bowl removed just as the party was really warming up.” Chart 5The Chaperone Is Waking Up Today, the party is a rager, and central bankers are indicating that they will remove the punch bowl soon. Real estate speculation is worrying the Bank of Canada, and its balance sheet has already shrunk by C$99 billion, to C$476 billion. The Norges Bank has indicted that it will lift interest rates twice this year. The Reserve Bank of New Zealand is set to lift the Official Cash Rate soon. The Bank of England has begun to adjust its asset purchases and could begin a full-fledge tapering this year. The 800-pound gorilla is the Fed, which telegraphed more clearly last week its intention to raise rates twice in 2023, and therefore moved closer to the pricing of the OIS curve (Chart 5). Implied in this forecast, the Fed will start tapering its asset purchase in early 2022 at the latest. This change in tone by global central banks is not a major problem for the business cycle – global rates are still far below any reasonable estimates of the neutral rate of interest, but periods of transition in monetary policy are often associated with transitory market turbulences. This time will not be an exception, especially because it is happening when global growth is downshifting. Delta, Gamma, Epsilon, etc? Chart 6Depressed Macro Volatility With the rapid progress of vaccination, the worst of the COVID tragedy is behind us. Nonetheless, the pandemic is not yet fully in the rear-view mirror, not even in the Western nations that lead the global inoculation campaign. SARS-CoV-2 continues to evolve and will therefore produce new variants over time, some of which will be problematic. The UK illustrates this phenomenon. The government has postponed the so-called Freedom Day, when life returns to normal, by five weeks despite the country’s high vaccination rate. The Delta variant is significantly increasing among the unvaccinated and not fully inoculated Britons. Many countries will also face this problem. These delays will be minor and will not threaten national recoveries. However, they will feed market tensions in a context where global macro volatility is low (Chart 6), global growth is already peaking, and monetary accommodation is receding. Global Market Implications… The confluence of the change in global economic growth leadership, the upcoming liquidity removal, and the potential for short-lived delays to the global economic re-opening point toward a decline in global inflation expectations, a rebound in the US dollar, weaker commodity prices, and an underperformance of global cyclical relative to defensive equities. Over the coming months, inflation breakeven rates are likely to soften, while real yields will rise modestly. In May, US inflation breakeven rates peaked near 2.6%, their highest level in ten years. A weaker global growth impulse in combination with a Fed that is more willing to remove some monetary accommodation will cool inflationary fears among investors and cause inflation expectations to decline further. However, the specter of tighter policy will also support TIPS yields. Bond yields are likely to correct somewhat more over the summer. Bond prices have not yet fully purged their oversold conditions (Chart 7); thus, a decrease in inflation expectations will temporarily support Treasury prices, even if real yields do not fall. Recent market action is moving in this direction. Last week, by Thursday evening, 10-year Treasury yields had already lost their 9 bps rise that followed Wednesday’s FOMC meeting. 30-year Treasury yields have plunged to a four-month low. Bund yields are unable to hang on to their gains either. The dollar has more upside this summer. Higher real US yields offer a potent backing for a DXY that still refuses to drop below 89. Moreover, the greenback is a highly counter-cyclical currency and is particularly sensitive to the gyrations in the global industrial cycle. Thus, the deceleration in the global manufacturing cycle will create a temporary tailwind for the greenback. Over the past three years, the gap between US TIPS yields and the Chinese Economic Surprise index explained the fluctuation of the DXY; it currently points toward a continued rebound in the USD (Chart 8). Even if this move is ephemeral, it will have implications for investors this summer. Chart 7Technical Backdrop For Bonds Chart 8Near-Term Upside For The DXY Commodities will also suffer. Natural resource prices have rallied in a parabolic fashion and our Composite Technical Indicator is massively overbought (Chart 9). Meanwhile, Chinese authorities are verbally jawboning industrial metal prices and have begun to release copper, zinc, aluminum, and nickel from their stockpiles. In this context, the Chinese credit slowdown and the imminent removal of monetary accommodation in various corners of the globe will catalyze a correction in commodities, even if a new supercycle has begun. The recent travails of lumber prices, which have collapsed 47% since May 7 (while they still remain in technical bull market!), may constitute a canary in the coalmine for the wider commodity complex. Global cyclical equities have greater downside against their defensive counterparts. US markets are global trendsetters; while the S&P cyclicals have lost some altitude compared to defensives, they have yet to purge their oversold state and remain very expensive (Chart 10). This backdrop makes them vulnerable to slowing Chinese import growth, a stronger dollar, and weaker commodity prices. Chart 9Will The GSCI Follow Lumber? Chart 10Vulnerable Global Cyclicals   … And European Investment Implications Chart 11European Cyclicals Are Also At Risk The European cyclicals-to-defensives ratio is vulnerable, like it is in the US. Hence, a more defensive portfolio bias makes sense for the summer, which should allow investors to regain maximum cyclical exposure later this year. Short consumer discretionary / long telecommunications and short technology / long healthcare are pair trades with particularly attractive risk profiles. The cyclicals-to-defensives ratio is technically unattractive. The relative share prices stand toward the top of their 16-year trading range (Chart 11). Moreover, their 52-week momentum measure is rolling over at a highly elevated level, while the 13-week rate of change is deteriorating. Meanwhile, the Combined Mechanical Valuation Indicator1 (CMVI) of the cyclicals towers far above that of the defensives and is consistent with a corrective episode (Chart 11, bottom panel). The drivers of the performance of Eurozone cyclical relative to defensive sectors confirm that cyclicals could suffer a turbulent summer. For instance: The potential for further declines in global yields does not bode well for the European cyclicals-to-defensives ratio (Chart 12). Weaknesses in market-based inflation expectations would prove particularly threatening (Chart 12, bottom panel). The deceleration in China’s total social financing flows anticipates an underperformance of European cyclicals (Chart 13). As China’s credit decelerates, so will the earnings revisions of cyclical equities. Moreover, a weaker Chinese TSF is consistent with falling Treasury yields. Chart 12Lower Inflation Expectations Equals Underperforming Cyclicals Chart 13Cyclicals Listen To China The potential for weaker commodity prices is another problem for European cyclical equities (Chart 14). Commodities capture the ebb and flow of global growth sentiment, which is also a driver of the earnings revisions of cyclicals relative to defensives. Moreover, commodity prices greatly affect the earnings of cyclical equities. Unsurprisingly, the momentum of the European cyclicals-to-defensives ratio correlates closely with the BCA Commodity Composite Technical Indicator (Chart 14, bottom panel). Cyclicals perform poorly when the dollar appreciates. The Eurozone’s cyclicals-to-defensives ratio moves in lock-step with the euro and high-beta cyclical currencies (Chart 15). These relationships reflect the counter-cyclicality of the dollar, as well as the negative effect on global financial conditions of its rallies, and thus, on the earnings outlook for cyclicals. Chart 14Beware The Impact Of Weaker Commodities Chart 15A Strong Dollar Hurts European Cyclicals Chart 16Short Consumer Discretionary And Long Telecommunication Based on these observations, we are tactically downgrading cyclicals from our overweight stance for the summer, despite our conviction that cyclicals have upside on an 18- to 24-month basis. We look at this move as risk management. For investors looking to bet on a potential underperformance of cyclical equities in Europe, we recommend two positions: a high-octane pair trade and a lower-risk one. The high-octane version is to sell consumer discretionary stocks and buy telecommunications ones (Chart 16). This pair trade is exposed to lower yields, lower inflation expectations, and the shift in growth drivers from China and goods consumption to services expenditures. Additionally, the relative 52-week momentum measure is overextended, while the 13-week rate of change is already sagging. The CMVI of the consumer discretionary sector is extremely elevated, while that of telecommunication stocks is the most depressed of any Eurozone sector. Consequently, the gap between the two sectors’ CMVI stands at nearly three-sigma, which is concerning because the RoE of consumer discretionary shares lies 7% below that of the telecoms industry (Chart 16, third and fourth panel). Because higher RoEs should justify higher valuations, consumer discretionary and telecommunication stand out as the greatest outliers among European sectors (Chart 17). As an added benefit, this trade enjoys a positive dividend carry of more than 2.5%. Chart 17Spot The Outliers Chart 18Short Technology And Long Healthcare The low octane pair trade is to sell technology stocks and buy healthcare names instead. This position offers lower expected returns but also a lower risk, because both sectors are growth stocks and they will benefit from falling yields and inflation expectations. However, based on their respective CMVI, tech equities are much more expensive than healthcare ones (Chart 18), while they are also extremely overbought. Thus, healthcare should benefit more from falling yields and inflation expectations than tech. Moreover, technology is a more cyclical sector than healthcare; it will therefore be more sensitive to the evolution of global growth. Bottom Line: We remain positive on the outlook for cyclical equities on an 18- to 24-month horizon, but the changing global growth leadership, the imminent removal of global monetary accommodation, and the demanding valuation and technical backdrop of the European cyclicals-to-defensives ratio suggest that a period of turbulence will materialize this summer. Thus, we are tactically downgrading cyclicals. Investors should consider going long telecommunications / short consumer discretionary as a high-octane tactical bet on this portfolio stance. Buying healthcare / selling technology would constitute a lower risk / lower return play. Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Footnotes 1 For a detailed explanation of the Combined Mechanical Valuation Indicator, see Special Report, “Valuation – A Mechanical Approach,” dated May 31, 2021. Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance

Feature This week, we present the BCA Central Bank Monitor Chartbook, detailing our set of proprietary indicators measuring the cyclical forces influencing future monetary policy decisions in developed market countries. The surging Monitors are all sending a similar message: tighter global monetary policy is necessary because of above-trend economic growth, intensifying inflation pressur­­es and booming financial markets (Charts 1A & 1B). Chart 1ATightening Pressures … Chart 1B… Everywhere The Monitors are pointing to a continuation of the cyclical rise in global bond yields seen since mid-2020, justifying our recommended below-benchmark stance on overall duration exposure in global bond portfolios. The driver of the next leg upward in yields, however, is shifting from growth and inflation expectations to monetary policy expectations. The Fed is starting to slowly prepare markets for the next US tightening cycle, which is already putting flattening pressure on the US Treasury curve and creating more two-way risk for the US dollar over the next 6-12 months. The timing and pace of rate hikes discounted by markets varies across countries, however, creating interesting opportunities for currency pairs, via changing interest rate differentials, away from the US dollar crosses. An Overview Of The BCA Research Central Bank Monitors The BCA Research Central Bank Monitors are composite indicators that include data which have historically been correlated to changes in monetary policy. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure similar things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, financial conditions). The data series are standardized and combined to form the Monitors. We have constructed Monitors for ten developed market countries: the US, the euro area, the UK, Japan, Canada, Australia, New Zealand, Sweden, Switzerland and Norway. A rising trend for each Monitor indicates growing pressures for central banks to tighten policy, and vice versa. Within each country, we have aggregated the various data series within the Monitors into sub-groupings covering economic, inflation and financial conditions indicators (equity prices, corporate credit spreads, etc). The latter is critical as policymakers have increasingly realized the importance of financial conditions as a key transmission mechanism of monetary policy to the real economy. The weightings of each bucket vary by country, based on the strength of historical correlations of the Monitors to actual changes in policy interest rates. Disaggregating the Monitors this way offers an additional layer of analysis by helping describe central bank reaction functions (i.e. some central banks respond more strongly to economic growth, others to inflation or financial conditions). Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the major developed markets (Charts 2A & 2B). The Monitors do also exhibit steady correlations to currencies, although not in the same consistent fashion as with bond yields. For example, the Fed Monitor is typically negatively correlated to the US dollar, while the Reserve Bank of Australia (RBA) Monitor is positively correlated to the Australian dollar. We present charts showing the links between the Monitors and bond yields (and foreign exchange rates) in the individual country sections of this Chartbook. Chart 2AThe Surging CB Monitors …. Chart 2B… Suggest More Upside For Bond Yields In each edition of the Central Bank Monitor Chartbook, we include a “non-standard” chart that shows an interesting correlation between the Monitors and a financial market variable. In this latest report, we show how the relationship between the Monitors and our 24-Month Discounters, which measure that amount of rate hikes/cuts discounted in overnight index swap (OIS) forward curves over the next two years. We have also added a new Appendix Table that shows the so-called “liftoff dates” (the date when a first full rate hike is discounted in OIS curves), the cumulative amount of rate hikes expected to the end of 2024, and the valuation of each country’s currency on a purchasing power parity (PPP) basis. We’ve ranked the countries in the table by liftoff dates, thus providing a handy reference to see how markets are judging the order with which central banks will begin the next monetary policy tightening cycle. Fed Monitor: A Clear Signal Our Fed Monitor has been climbing steadily, uninterrupted, for 13 consecutive months, driven by the combination of strong US growth, sharply higher inflation and booming financial markets (Chart 3A). The message from the highly elevated level of the indicator is clear – the Fed should begin the process of unwinding the massive monetary policy accomodation put in place because of the COVID-19 pandemic. At this week’s FOMC meeting, the Fed delivered a mildly hawkish surprise by pulling forward the projected timing of “liftoff” (the first fed funds rate hike) from 2024 to 2023. The timing and pace of future Fed tapering of asset purchases and rate hikes will be determined by how rapidly the US economy approaches the Fed’s definition of “maximum employment”. We see that happening by the end of 2022, which is a bit ahead of the Fed’s own projections for the unemployment rate. The US OIS curve now discounts liftoff near the end of 2022 (see Appendix Table 1), which is now more in line with our own view that the Fed will begin tapering next January and begin rate hikes in December 20221. US economic growth momentum has likely peaked in Q2, but will remain solid in the latter half of 2021. Most of the nation has lifted the remaining pandemic restrictions on activity after a succesful vaccination program, and fiscal policy is still providing a boost to growth. The Fed’s updated economic projections call for real GDP growth to reach 7% this year, 3.4% in 2022 and 2.4% in 2023. The Fed’s assumption is trend GDP growth is still only 1.8%, thus the central bank now expects three consecutive years of above-trend growth. Unsurprisingly, the Fed is forecasting headline PCE inflation to stay above the Fed’s 2% target for all three years (Chart 3B). Chart 3AUS: Fed Monitor Chart 3BIs This Really 'Transitory' Inflation? The recovery in the Fed Monitor has been led primarily by the growth component, although the inflation and financial components have also risen significantly (Chart 3C). The Fed Monitor has typically been negatively correlated to the momentum of the US dollar, which has always been more of a counter-cyclical currency that weakens in good economic times. A more hawkish path for US interest rates could eventually give a sustainable lift to the greenback, but for now, the currency will be caught in a tug of war between shifting Fed expectations and robust global growth over the next 6-12 months. Chart 3CBooming Growth Supporting USD Weakness We continue to recommend an underweight strategic allocation to US Treasuries within global government bond portfolios, with markets still pricing in a pace of Fed tightening that appears too conservative (Chart 3D). Chart 3DNot Enough Fed Rate Hikes Priced The Fed’s mildly hawkish surprise this week generated a signficant flattening of the US Treasury curve, with the spread between 5-year and 30-year US yields narrowing by a whopping 20bps. We are closing our two recommeded yield curve trades in the BCA Research Global Fixed Income Strategy tactical trade portfolio, which were positioned more to earn near-term carry in a stable curve environment that has now changed with the Fed injecting volatility back into the bond market. BoE Monitor: More Hawkish Surprises Coming Our Bank of England (BoE) Monitor has spiked higher, fueled by a rapid recovery of UK growth alongside a pickup in inflation pressures (Chart 4A). The BoE has already responded by slowing the pace of its asset purchases in May, and we expect more tapering announcements over the next 6-12 months. The most recent set of BoE economic forecasts calls for headline UK CPI inflation to rise to 2.3% in 2022 before settling down to 2% in 2023 and 1.9% in 2024 (Chart 4B). This would be a mild inflation outcome by recent UK standards during what will certainly be a period of strong post-pandemic growth over the next 12-18 months. Longer-term inflation expectations, both survey-based and extracted from CPI swaps and inflation-linked Gilts, are priced for a bigger inflation upturn above 3%. Chart 4AUK: BoE Monitor Chart 4BUpside UK Inflation Surprises Ahead? The recent decision by the UK government to delay “Freedom Day”, when all remaining COVID-19 restrictions would be lifted, into July because of the spread of the Delta virus variant represents a potential near-term setback to UK growth momentum. The bigger picture, however, still points to an economy benefitting far more from the earlier success of the vaccination program. Consumer confidence remains resilient, while business confidence – and investment intentions – has taken a notable turn higher as well. The housing market has also started to heat up, with house price inflation accelerating. The backdrop still remains one of above-potential UK growth over the next 12-24 months. Within the BoE Monitor sub-components, the economic and financial elements stand out as having the biggest moves over the past year (Chart 4C). Momentum in the British pound is positively correlated to our BoE Monitor. As the central bank moves incrementally moves towards more tapering and eventual rate hikes, the currency, which remains moderately undervalued on a PPP basis (see Appendix Table 1), should be well supported. Chart 4CAll BoE Monitor Components Are Rising The UK OIS curve currently discounts BoE liftoff in May 2023, with 57bps of cumulative rate hikes expected by the end of 2024. We see risks of the central bank moving sooner than the market on liftoff, with a rate hike in the 3rd or 4th quarter of 2022 more likely. The Gilt market is vulnerable to any hawkish shift by the BoE with so few rate hikes discounted (Chart 4D). For now, we are maintaining a neutral stance on UK Gilts, given the BoE’s history of talking hawkishly but failing to deliver, but we do have them on “downgrade watch.” Chart 4DBoE Monitor Suggests Continued Downward Pressure On Gilt Yields ECB Monitor: Growth? Yes. Inflation? No. Our European Central Bank (ECB) Monitor has moved sharply higher as more of the euro area has emerged from pandemic restrictions (Chart 5A). Yet the central bank is not sending any of the kinds of moderately hawkish signals coming from the Fed and other central banks. The ECB is still a long way from such a move. While growth has clearly recovered strongly, the overall euro area unemployment rate remains high at 8% and wage growth remains anemic in most countries. There is the potential for upside growth surprises coming from fiscal policy, with the Next Generation EU (NGEU) funds set to be disributed by the EU later this year. Yet even with this fiscal boost, most of the euro area is likely to remain far enough away from full employment allowing the ECB to stay dovish for longer. While headine euro area inflation reached the ECB’s 2% target in May, core inflaton remained subdued at a mere 0.9% (Chart 5B). Market based measures of inflation expectations are also well below the ECB target, with the 5-year/5-year forward CPI swap rate only at 1.6%. Such “boring” inflation readings – even after a surge in commodity price fueled inflation in many other countries – proves that there remains ample spare capacity in the euro area economy and labor markets. The ECB is under no pressure to turn less dovish anytime soon. Chart 5AEuro Area: ECB Monitor Chart 5BStill Lots Of Spare Capacity In Europe The lack of an immediate inflation threat can also be seen in the sub-components of our ECB Monitor, where the inflation elements have clearly lagged the growth upturn (Chart 5C). From a currency perspective, a growth fueled surge in the ECB Monitor is usually enough to provide a boost to the euro. Yet, without an inflation trigger, the likelihood of the ECB dialing back bond purchases, let alone raising interest rates, is low. This suggests any rally in the euro from current levels will be a slow adjustment towards fair value. Chart 5CInflation Components Lagging Currently, the European OIS curve is discounting an initial ECB rate hike in October 2023, with only 27bps of rate hikes expected by the end of 2024 - one of the most dovish pricings in the G10 (see Appendix Table 1). Even though our ECB Monitor suggests that European bond markets should be pricing in more rate hikes (Chart 5D), that is unlikely to happen with the ECB messaging a dovish stance and with the central bank set to release a review of its inflation strategy later this year. We continue to recommend an overweight stance on European government bonds within global fixed income portfolios. Chart 5DMarkets Hear The ECB's Dovish Message BoJ Monitor: Deflation Is Still A Threat Our Bank of Japan (BoJ) Monitor has recovered from deeply depressed pandemic lows to just above the zero line (Chart 6A). This is welcome news for the BoJ, that kept interest rates and asset purchases unchanged at yesterday's meeting, but recognized the need for additional stimulus via "green" loans.The reading from the central bank monitor is also consistent with a Japanese economy that requires more accommodative monetary policy vis-à-vis the rest of the G10. The Japanese economy remains under siege from the pandemic. The number of new COVID-19 cases remains at the highest level per capita in developed Asia. Meanwhile, the manufacturing PMI is the lowest in the developed world and a third wave of infections has also crippled the services sector. This pins the Japanese recovery well behind that of other G10 countries. The IMF expects the output gap in Japan to close sometime in 2023, but it is worth noting that there are few signs of inflationary pressures that would signal such an outcome. Both core and headline Japanese prices are deflating in a world where the risks are tilted towards an inflation overshoot (Chart 6B). The unemployment rate has rolled over, but still remains a ways from pre-pandemic lows. Savings in Japan are also surging, short-circuiting the sort of positive feedback loop that will generate genuine inflation. Chart 6AThe BoJ Monitor Chart 6BDeflation Is Still A Threat In Japan The individual elements of the BoJ Monitor suggest that the growth component has seen steady improvement over the last few months, while the financial component has rolled over (Chart 6C). The latter reflects the underperformance of Japanese equities in recent months, after a spectacular rally late last year. However, weakness in the yen has also allowed financial conditions to remain relatively easy. The yen is a safe-haven currency, making the relationship with the central bank monitor less intuitive. When the central bank monitor is improving (both in Japan and globally), traders tend to use the yen to fund carry trades elsewhere, which weakens the currency. When risk aversion sets in, these trades are unwound, and the yen rallies. This year, the yen has weakened in sympathy with improving global growth, suggesting this playbook remains very much relevant. Chart 6CModest Improvement In The Growth And Inflation Components The strength of our BoJ Monitor indicates that Japanese Government Bond (JGB) yields should rise towards the upper bound of the -25bps to +25bps band. However, the BoJ will stand firm in maintaining easy monetary policy, as expected by market participants (Chart 6D). This policy-induced stability makes JGBs a defensive bond market when US Treasury yields are rising, a key reason for our overweight stance on JGBs. Chart 6DNo Change In Policy Expected BoC Monitor: Strong Growth = Early Tightening Our Bank of Canada (BoC) Monitor has shown an impressive rebound and currently displays the highest figure among our Central Bank Monitors (Chart 7A). With a growing number of central banks contemplating a less dovish turn, Canada will be in the group of developed countries that hikes policy rates first. The Canadian economy started the year gaining significant positive momentum, with Q1 GDP growing by +5.6% (annualized quarter-on-quarter rate of change). The Q2 picture is a bit more mixed because of another wave of COVID-19 lockdowns. However, thanks to the rapid improvement in the pace of vaccinations after a botched initial rollout, Canadian household consumption and confidence have notably accelerated. Business confidence and investment intentions have also picked up solidly according the BoC’s most recent Business Outlook Survey. The job market also gained significant momentum, and as the lockdown measures gradually ease, workers who have been laid off during the pandemic will return to work. Therefore, the improvement in labor market will continue. A rapidly closing output gap means that the current surge in inflation may endure after the base effect comparisons to 2020 fade (Chart 7B). Chart 7ACanada: BoC Monitor Chart 7BCanadian Inflation Pressures Intensifying Looking at the components of our BoC Monitor, all three factors have clearly rebounded but the growth factor has shown the most impressive move (Chart 7C). Amid the broad economic factors that have improved, booming house prices – a primary cause for the BoC’s decision to taper its asset purchases back in April - have caused the growth factor to rebound quickly. Chart 7CA Positive Story For The CAD The Canadian OIS curve is pricing in BoC liftoff in August 2022 (Appendix Table 1), with a sooner liftoff only expected in Norway and New Zealand. We see risks that the BoC moves much sooner than that next year. A quicker liftoff which will put additional upward pressure on the Canadian dollar, both against the US dollar and on a trade-weighted basis, particularly if Canadian export demand remains solid and oil prices continue to climb, as our commodity strategists expect. Our PPP model suggests that the Loonie is close to fair value, so valuation is not yet an impediment to additional strength in the Canadian dollar. Looking at the longer-term horizon, the OIS curve is discounting four BoC rate hikes within the next 24 months, and it is not clear that will be enough to cool off the red-hot Canadian housing market – currently the biggest threat to inflation stability in Canada (Chart 7D). Given that relatively hawkish view, the more optimistic growth outlook, and the high-beta status of Canadian government bonds, we continue to recommend an underweight position on Canadian government bonds within a global fixed income portfolio. Chart 7DCanadian Rate Expectations Look Fairly Priced RBA Monitor: Waiting For Inflation Our Reserve Bank of Australia (RBA) Monitor has continued its strong rebound since the trough in 2020 and is now at all-time highs, suggesting heightened pressure on the RBA to tighten policy (Chart 8A). This rebound comes amid dovish messaging from an RBA that is waiting on signs of an inflation turnaround. The RBA’s patience makes sense when you consider measures of slack in the economy, such as output and unemployment gaps (Chart 8B). While the IMF does expect the output gap to tighten up significantly in 2021, it does not expect it to be closed even by 2022. Looking to capacity in the labor market, the unemployment rate has just returned to pre-COVID levels. However, the labor market will need to run “hot” for a sustained period of time to push up wage inflation, which remains deep in the doldrums according to the RBA’s wage price index. Chart 8AAustralia: RBA Monitor Chart 8BMuted Inflationary Pressures Down Under A look at the components of our RBA Monitor explains the RBA’s dovishness in the face of the tightening pressure indicated by the “headline” figure (Chart 8C). The rebound in the Monitor can be attributed almost entirely to the growth and financial components, which are driven in turn by improving confidence and an expanding RBA balance sheet. However, the inflation component, which has barely budged off its 2020 low, best captures the metrics that the RBA is watching. Importantly, the RBA will need to see sustainable domestically-generated inflation before it can begin to tolerate a stronger AUD which would otherwise imperil tradable goods inflation. With the AUD only slightly expensive on our PPP models, the RBA does not have much of a “valuation cushion” to play with in terms of delivering a hawkish surprise (Appendix Table 1). ​​​​​​ Chart 8CGrowth Factors Are Driving the RBA Monitor Chart 8D shows that market pricing for hikes over the next two years has remained mostly flat in 2021 in the face of persistently dovish messaging from the RBA. Our view, as expressed in a recent update of our “RBA checklist”2, is that fundamental factors will force the RBA to remain dovish, making Australian government debt an attractive overweight within global government bond portfolios. Chart 8DMarkets Are (Rightly) Looking Through Tightening Pressures In Australia RBNZ Monitor: Heating Up Our Reserve Bank of New Zealand (RBNZ) Monitor has rebounded to levels last seen in 2017, largely on the back of improving growth (Chart 9A). Success at containing the virus has allowed the New Zealand economy to beat growth expectations for Q1/2021, effectively pulling forward future policy tightening. Measures of capacity utilization in New Zealand will likely respond accordingly to improved growth prospects, with the output gap likely to close even faster than projected by the IMF (Chart 9B). Measures of core and headline inflation remain within the RBNZ’s 1-3% target range, with the Bank expecting headline inflation to shoot up to 2.6% in Q2/2021 before settling around the midpoint of the range. Chart 9ANew Zealand: RBNZ Monitor Chart 9BThe New Zealand Economy Is Quickly Working Off Slack Looking at the individual components of our RBNZ Monitor, the rebound in the overall indicator is clearly a growth story (Chart 9C). This component of our Monitor also captures the effect of accelerating house prices, which have become a direct concern for RBNZ policy. According to the bank’s own projections, house prices will post a whopping 29% growth rate in the second quarter. With issues of housing affordability at the forefront, and political pressure mounting, the RBNZ will likely be forced to turn less dovish soon, even if it comes with unwanted strength in the NZD. However, the currency is among the most expensive on our PPP models (Appendix Table 1), which means that a reversion to fair value could counteract upward pressure from a hawkish RBNZ. Chart 9CThe RBNZ Will Do Whatever It Takes To Stabilize House Prices Historically, our RBNZ Monitor has correlated well with market pricing embedded in the OIS curve (Chart 9D). In 2021, however, market expectations have far outstripped the signal from our central bank monitor, meaning that markets believe the RBNZ is more focused on growth factors rather than the overall picture, a view that we largely agree with. Chart 9DMarkets Expect A Hawkish RBNZ Even after the Fed’s hawkish surprise at this week’s meeting, we still believe that the RBNZ will be among the first to taper its balance sheet and move towards normalizing policy. Stay underweight New Zealand sovereign debt. Riksbank Monitor: Watch For An Upside Surprise Our Riksbank Monitor has posted a strong rebound, reaching all-time highs (Chart 10A). This rebound has come on the back of a robust economic recovery. Meanwhile, monetary policy has been accommodative with the Riksbank holding the repo rate at 0% while expanding the size of its balance sheet. Capacity utilization, which in Sweden did not fall nearly as much as in other developed economies, is looking set to recover in the coming years (Chart 10B). Although headline CPI shot past the 2% target, driven by fuel and food prices, underlying core inflation remains stable. The Riksbank expects inflation to fall due to less favorable year-over-year base effects, and only sustainably climb to the 2% level by mid-2024. Chart 10ASweden: Riksbank Monitor Chart 10BThe Rise In Swedish Inflation Is 'Transitory'... Breaking down the rise in the Riksbank Monitor, we can see that it is driven overwhelmingly by the growth component (Chart 10C). This, in turn, has been driven by surging PMIs and soaring business and consumer confidence. Our colleagues at BCA Research European Investment Strategy have pointed out that the small export-sensitive economy will be poised to benefit from an upturn in the global industrial cycle3. While Sweden did arguably botch its COVID-19 response last year, it is catching up, with 42% of Swedes having already received their first dose of the vaccine. The case for the SEK is strong, given that the currency is a high-beta play on global growth and is also quite undervalued according to our PPP models (Appendix Table 1). Market expectations are that the Riksbank will lag others in normalizing policy, putting off a hike until September 2023. The Riksbank baseline is a flat repo rate out to Q2/2024 but an earlier rate hike is well within the “uncertainty bands” of the Riksbank’s forecast. Such a scenario may manifest if growth and inflation surprise to the upside. Chart 10C...But The Riksbank Cannot Ignore Explosive Growth Given the positive economic backdrop and the financial stability risks posed by rising house prices and household indebtedness, we believe market pricing is too dovish relative to the actual pressure on the Riksbank to tighten policy (Chart 10D). This makes Swedish sovereign debt an attractive underweight candidate in global government bond portfolios. Chart 10DThe OIS Curve Is Pricing In Too Much Dovishness From The Riksbank Norges Bank Monitor: The First To Hike Our Norges Bank Monitor has risen sharply from the pandemic lows and now signals that emergency monetary settings are no longer appropriate for the Norwegian economy (Chart 11A). Consistent with this message, Norges Bank governor, Øystein Olsen, suggested this week that a rate hike will occur in September, with possibly another hike by December of this year. Norway has handled the pandemic successfully. Since the onset of the COVID-19 crisis, it has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was also prompt and finely tailored to the sectors most in need of emergency funds. Moreover, monetary policy was highly accommodative, with the Norges Bank cutting interest rates to zero for the first time since its founding in 1816. Fiscal stimulus will remain relatively accommodative, as Norway will register one of the smallest fiscal drags in the G10 for the remainder of 2021 and 2022. Rapid improvement in the labor market also continues. After peaking at 9.5% in March 2020, the headline unemployment rate has fallen to 3.3%. On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024. These developments have set the Norwegian economy on a sustainable recovery path. This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3% (Chart 11B). Meanwhile, while core inflation at 2% is decelerating, the slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mindset has not taken root in Norway. Chart 11AThe Norges Bank Monitor Chart 11BInflation Is Well Anchored In Norway The biggest improvement in our Norges Bank Monitor comes from its growth and inflation components, the former surging to its highest level in two decades. This improvement surpasses those that followed the global financial crisis and the bursting of the dot-com bubble (Chart 11C). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. The Monitor shows a very tight correlation with the trade-weighted currency, suggesting the exchange rate is an important valve for adjusting financial conditions. As an oil-producing economy, the drop in the NOK cushioned the crash in oil prices last year. This year, a recovery has benefitted the krone. The Norwegian krone also remains undervalued according to our PPP models. Chart 11CThe Norges Bank Should Hike Rates A positive correlation also exists between the Monitor and expected rate hikes by the Norges bank (Chart 11D). This suggest yields in Norway should either coincide or lead the improvement in global bond yields. From a portfolio perspective, our default stance is neutral, as the market is thinly traded. Chart 11DThe Norges Bank Should Hike Rates SNB Monitor: Green Shoots Our Swiss National Bank (SNB) Monitor has recovered smartly, and is at the highest level in over a decade (Chart 12A). This is a marked turnaround for a country that has had negative interest rates since 2015. It also raises the prospect that Switzerland may be finally able to escape its liquidity trap, allowing the SNB to modestly adjust monetary policy upward. The Swiss economy has recovered swiftly. As of May, the manufacturing PMI was at 69.9, the highest reading since the start of the series. If past manufacturing sentiment is prologue, the Swiss economy is about to experience its biggest rebound in decades. This will quell any deflationary fears about domestic conditions in Switzerland and begin to re-anchor inflation expectations upwards. This will also be a very welcome development for the SNB. Inflation dynamics in Switzerland will be particularly beholden to improvements in private sector demand. The unemployment rate in Switzerland has rolled over, which should begin to provide an anchor to wage growth. Both core and headline inflation are also recovering, albeit at a slow pace (Chart 12B). Import prices in Switzerland will also rise, driven by the relative weakness of the currency. This is important because for a small, open economy like Switzerland, the exchange rate often dictates the trend in domestic inflation. Chart 12AThe SNB Monitor Chart 12BSwiss Inflation Not Out Of The Woods Looking at the components of our SNB Monitor, the growth component has been in the driver’s seat (Chart 12C). But encouragingly, both the inflation and financial component have also been grinding higher. This improvement suggests that the weakness in the franc, especially amidst global dollar weakness, has been a welcome jolt to the economy. Like the yen, the CHF is a safe-haven currency, making the relationship with the central bank monitor less intuitive. Most of the time, the relationship with the monitor is inverse, corresponding to investors using the Swiss franc for carry trades when global conditions improve. Similar to the yen this year, the CHF has also weakened in sympathy with improving global growth. Should global growth see a setback in the near term, the franc will benefit. Chart 12CGrowth Indicators Are Surging In Switzerland The SNB Monitor is more accurate at capturing expected policy changes by the SNB. This means that yields in Switzerland could see more meaningful upside (Chart 12D). That said, our default stance on Swiss bonds is neutral in a global portfolio, given low liquidity. Chart 12DCould The SNB Finally Lift Rates? Appendix Table 1 Table 1Appendix Table 1 Footnotes 1 See BCA Research US Bond Strategy/Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021, available at gfis.bcaresearch.com 2 Please see BCA Research Global Fixed Income Strategy Report, "A Summer Nap For Global Bond Yields", dated June 9, 2021, available at gfis.bcaresearch.com. 3 Please see BCA Research European Investment Strategy Report, "Take A Chance On Sweden", dated May 3, 2021, available at eis.bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Feature This week, we present the BCA Central Bank Monitor Chartbook, detailing our set of proprietary indicators measuring the cyclical forces influencing future monetary policy decisions in developed market countries. The surging Monitors are all sending a similar message: tighter global monetary policy is necessary because of above-trend economic growth, intensifying inflation pressur­­es and booming financial markets (Charts 1A & 1B). Chart 1ATightening Pressures … Chart 1B… Everywhere The Monitors are pointing to a continuation of the cyclical rise in global bond yields seen since mid-2020, justifying our recommended below-benchmark stance on overall duration exposure in global bond portfolios. The driver of the next leg upward in yields, however, is shifting from growth and inflation expectations to monetary policy expectations. The Fed is starting to slowly prepare markets for the next US tightening cycle, which is already putting flattening pressure on the US Treasury curve and creating more two-way risk for the US dollar over the next 6-12 months. The timing and pace of rate hikes discounted by markets varies across countries, however, creating interesting opportunities for currency pairs, via changing interest rate differentials, away from the US dollar crosses. An Overview Of The BCA Research Central Bank Monitors The BCA Research Central Bank Monitors are composite indicators that include data which have historically been correlated to changes in monetary policy. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure similar things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, financial conditions). The data series are standardized and combined to form the Monitors. We have constructed Monitors for ten developed market countries: the US, the euro area, the UK, Japan, Canada, Australia, New Zealand, Sweden, Switzerland and Norway. A rising trend for each Monitor indicates growing pressures for central banks to tighten policy, and vice versa. Within each country, we have aggregated the various data series within the Monitors into sub-groupings covering economic, inflation and financial conditions indicators (equity prices, corporate credit spreads, etc). The latter is critical as policymakers have increasingly realized the importance of financial conditions as a key transmission mechanism of monetary policy to the real economy. The weightings of each bucket vary by country, based on the strength of historical correlations of the Monitors to actual changes in policy interest rates. Disaggregating the Monitors this way offers an additional layer of analysis by helping describe central bank reaction functions (i.e. some central banks respond more strongly to economic growth, others to inflation or financial conditions). Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the major developed markets (Charts 2A & 2B). The Monitors do also exhibit steady correlations to currencies, although not in the same consistent fashion as with bond yields. For example, the Fed Monitor is typically negatively correlated to the US dollar, while the Reserve Bank of Australia (RBA) Monitor is positively correlated to the Australian dollar. We present charts showing the links between the Monitors and bond yields (and foreign exchange rates) in the individual country sections of this Chartbook. Chart 2AThe Surging CB Monitors …. Chart 2B… Suggest More Upside For Bond Yields In each edition of the Central Bank Monitor Chartbook, we include a “non-standard” chart that shows an interesting correlation between the Monitors and a financial market variable. In this latest report, we show how the relationship between the Monitors and our 24-Month Discounters, which measure that amount of rate hikes/cuts discounted in overnight index swap (OIS) forward curves over the next two years. We have also added a new Appendix Table that shows the so-called “liftoff dates” (the date when a first full rate hike is discounted in OIS curves), the cumulative amount of rate hikes expected to the end of 2024, and the valuation of each country’s currency on a purchasing power parity (PPP) basis. We’ve ranked the countries in the table by liftoff dates, thus providing a handy reference to see how markets are judging the order with which central banks will begin the next monetary policy tightening cycle. Fed Monitor: A Clear Signal Our Fed Monitor has been climbing steadily, uninterrupted, for 13 consecutive months, driven by the combination of strong US growth, sharply higher inflation and booming financial markets (Chart 3A). The message from the highly elevated level of the indicator is clear – the Fed should begin the process of unwinding the massive monetary policy accomodation put in place because of the COVID-19 pandemic. At this week’s FOMC meeting, the Fed delivered a mildly hawkish surprise by pulling forward the projected timing of “liftoff” (the first fed funds rate hike) from 2024 to 2023. The timing and pace of future Fed tapering of asset purchases and rate hikes will be determined by how rapidly the US economy approaches the Fed’s definition of “maximum employment”. We see that happening by the end of 2022, which is a bit ahead of the Fed’s own projections for the unemployment rate. The US OIS curve now discounts liftoff near the end of 2022 (see Appendix Table 1), which is now more in line with our own view that the Fed will begin tapering next January and begin rate hikes in December 20221. US economic growth momentum has likely peaked in Q2, but will remain solid in the latter half of 2021. Most of the nation has lifted the remaining pandemic restrictions on activity after a succesful vaccination program, and fiscal policy is still providing a boost to growth. The Fed’s updated economic projections call for real GDP growth to reach 7% this year, 3.4% in 2022 and 2.4% in 2023. The Fed’s assumption is trend GDP growth is still only 1.8%, thus the central bank now expects three consecutive years of above-trend growth. Unsurprisingly, the Fed is forecasting headline PCE inflation to stay above the Fed’s 2% target for all three years (Chart 3B). Chart 3AUS: Fed Monitor Chart 3BIs This Really 'Transitory' Inflation? The recovery in the Fed Monitor has been led primarily by the growth component, although the inflation and financial components have also risen significantly (Chart 3C). The Fed Monitor has typically been negatively correlated to the momentum of the US dollar, which has always been more of a counter-cyclical currency that weakens in good economic times. A more hawkish path for US interest rates could eventually give a sustainable lift to the greenback, but for now, the currency will be caught in a tug of war between shifting Fed expectations and robust global growth over the next 6-12 months. Chart 3CBooming Growth Supporting USD Weakness We continue to recommend an underweight strategic allocation to US Treasuries within global government bond portfolios, with markets still pricing in a pace of Fed tightening that appears too conservative (Chart 3D). Chart 3DNot Enough Fed Rate Hikes Priced The Fed’s mildly hawkish surprise this week generated a signficant flattening of the US Treasury curve, with the spread between 5-year and 30-year US yields narrowing by a whopping 20bps. We are closing our two recommeded yield curve trades in the BCA Research Global Fixed Income Strategy tactical trade portfolio, which were positioned more to earn near-term carry in a stable curve environment that has now changed with the Fed injecting volatility back into the bond market. BoE Monitor: More Hawkish Surprises Coming Our Bank of England (BoE) Monitor has spiked higher, fueled by a rapid recovery of UK growth alongside a pickup in inflation pressures (Chart 4A). The BoE has already responded by slowing the pace of its asset purchases in May, and we expect more tapering announcements over the next 6-12 months. The most recent set of BoE economic forecasts calls for headline UK CPI inflation to rise to 2.3% in 2022 before settling down to 2% in 2023 and 1.9% in 2024 (Chart 4B). This would be a mild inflation outcome by recent UK standards during what will certainly be a period of strong post-pandemic growth over the next 12-18 months. Longer-term inflation expectations, both survey-based and extracted from CPI swaps and inflation-linked Gilts, are priced for a bigger inflation upturn above 3%. Chart 4AUK: BoE Monitor Chart 4BUpside UK Inflation Surprises Ahead? The recent decision by the UK government to delay “Freedom Day”, when all remaining COVID-19 restrictions would be lifted, into July because of the spread of the Delta virus variant represents a potential near-term setback to UK growth momentum. The bigger picture, however, still points to an economy benefitting far more from the earlier success of the vaccination program. Consumer confidence remains resilient, while business confidence – and investment intentions – has taken a notable turn higher as well. The housing market has also started to heat up, with house price inflation accelerating. The backdrop still remains one of above-potential UK growth over the next 12-24 months. Within the BoE Monitor sub-components, the economic and financial elements stand out as having the biggest moves over the past year (Chart 4C). Momentum in the British pound is positively correlated to our BoE Monitor. As the central bank moves incrementally moves towards more tapering and eventual rate hikes, the currency, which remains moderately undervalued on a PPP basis (see Appendix Table 1), should be well supported. Chart 4CAll BoE Monitor Components Are Rising The UK OIS curve currently discounts BoE liftoff in May 2023, with 57bps of cumulative rate hikes expected by the end of 2024. We see risks of the central bank moving sooner than the market on liftoff, with a rate hike in the 3rd or 4th quarter of 2022 more likely. The Gilt market is vulnerable to any hawkish shift by the BoE with so few rate hikes discounted (Chart 4D). For now, we are maintaining a neutral stance on UK Gilts, given the BoE’s history of talking hawkishly but failing to deliver, but we do have them on “downgrade watch.” Chart 4DBoE Monitor Suggests Continued Downward Pressure On Gilt Yields ECB Monitor: Growth? Yes. Inflation? No. Our European Central Bank (ECB) Monitor has moved sharply higher as more of the euro area has emerged from pandemic restrictions (Chart 5A). Yet the central bank is not sending any of the kinds of moderately hawkish signals coming from the Fed and other central banks. The ECB is still a long way from such a move. While growth has clearly recovered strongly, the overall euro area unemployment rate remains high at 8% and wage growth remains anemic in most countries. There is the potential for upside growth surprises coming from fiscal policy, with the Next Generation EU (NGEU) funds set to be disributed by the EU later this year. Yet even with this fiscal boost, most of the euro area is likely to remain far enough away from full employment allowing the ECB to stay dovish for longer. While headine euro area inflation reached the ECB’s 2% target in May, core inflaton remained subdued at a mere 0.9% (Chart 5B). Market based measures of inflation expectations are also well below the ECB target, with the 5-year/5-year forward CPI swap rate only at 1.6%. Such “boring” inflation readings – even after a surge in commodity price fueled inflation in many other countries – proves that there remains ample spare capacity in the euro area economy and labor markets. The ECB is under no pressure to turn less dovish anytime soon. Chart 5AEuro Area: ECB Monitor Chart 5BStill Lots Of Spare Capacity In Europe The lack of an immediate inflation threat can also be seen in the sub-components of our ECB Monitor, where the inflation elements have clearly lagged the growth upturn (Chart 5C). From a currency perspective, a growth fueled surge in the ECB Monitor is usually enough to provide a boost to the euro. Yet, without an inflation trigger, the likelihood of the ECB dialing back bond purchases, let alone raising interest rates, is low. This suggests any rally in the euro from current levels will be a slow adjustment towards fair value. Chart 5CInflation Components Lagging Currently, the European OIS curve is discounting an initial ECB rate hike in October 2023, with only 27bps of rate hikes expected by the end of 2024 - one of the most dovish pricings in the G10 (see Appendix Table 1). Even though our ECB Monitor suggests that European bond markets should be pricing in more rate hikes (Chart 5D), that is unlikely to happen with the ECB messaging a dovish stance and with the central bank set to release a review of its inflation strategy later this year. We continue to recommend an overweight stance on European government bonds within global fixed income portfolios. Chart 5DMarkets Hear The ECB's Dovish Message   BoJ Monitor: Deflation Is Still A Threat Our Bank of Japan (BoJ) Monitor has recovered from deeply depressed pandemic lows to just above the zero line (Chart 6A). This is welcome news for the BoJ, that kept interest rates and asset purchases unchanged at yesterday's meeting, but recognized the need for additional stimulus via "green" loans.The reading from the central bank monitor is also consistent with a Japanese economy that requires more accommodative monetary policy vis-à-vis the rest of the G10. The Japanese economy remains under siege from the pandemic. The number of new COVID-19 cases remains at the highest level per capita in developed Asia. Meanwhile, the manufacturing PMI is the lowest in the developed world and a third wave of infections has also crippled the services sector. This pins the Japanese recovery well behind that of other G10 countries. The IMF expects the output gap in Japan to close sometime in 2023, but it is worth noting that there are few signs of inflationary pressures that would signal such an outcome. Both core and headline Japanese prices are deflating in a world where the risks are tilted towards an inflation overshoot (Chart 6B). The unemployment rate has rolled over, but still remains a ways from pre-pandemic lows. Savings in Japan are also surging, short-circuiting the sort of positive feedback loop that will generate genuine inflation. Chart 6AThe BoJ Monitor Chart 6BDeflation Is Still A Threat In Japan The individual elements of the BoJ Monitor suggest that the growth component has seen steady improvement over the last few months, while the financial component has rolled over (Chart 6C). The latter reflects the underperformance of Japanese equities in recent months, after a spectacular rally late last year. However, weakness in the yen has also allowed financial conditions to remain relatively easy. The yen is a safe-haven currency, making the relationship with the central bank monitor less intuitive. When the central bank monitor is improving (both in Japan and globally), traders tend to use the yen to fund carry trades elsewhere, which weakens the currency. When risk aversion sets in, these trades are unwound, and the yen rallies. This year, the yen has weakened in sympathy with improving global growth, suggesting this playbook remains very much relevant. Chart 6CModest Improvement In The Growth And Inflation Components The strength of our BoJ Monitor indicates that Japanese Government Bond (JGB) yields should rise towards the upper bound of the -25bps to +25bps band. However, the BoJ will stand firm in maintaining easy monetary policy, as expected by market participants (Chart 6D). This policy-induced stability makes JGBs a defensive bond market when US Treasury yields are rising, a key reason for our overweight stance on JGBs. Chart 6DNo Change In Policy Expected BoC Monitor: Strong Growth = Early Tightening Our Bank of Canada (BoC) Monitor has shown an impressive rebound and currently displays the highest figure among our Central Bank Monitors (Chart 7A). With a growing number of central banks contemplating a less dovish turn, Canada will be in the group of developed countries that hikes policy rates first. The Canadian economy started the year gaining significant positive momentum, with Q1 GDP growing by +5.6% (annualized quarter-on-quarter rate of change). The Q2 picture is a bit more mixed because of another wave of COVID-19 lockdowns. However, thanks to the rapid improvement in the pace of vaccinations after a botched initial rollout, Canadian household consumption and confidence have notably accelerated. Business confidence and investment intentions have also picked up solidly according the BoC’s most recent Business Outlook Survey. The job market also gained significant momentum, and as the lockdown measures gradually ease, workers who have been laid off during the pandemic will return to work. Therefore, the improvement in labor market will continue. A rapidly closing output gap means that the current surge in inflation may endure after the base effect comparisons to 2020 fade (Chart 7B). Chart 7ACanada: BoC Monitor Chart 7BCanadian Inflation Pressures Intensifying Looking at the components of our BoC Monitor, all three factors have clearly rebounded but the growth factor has shown the most impressive move (Chart 7C). Amid the broad economic factors that have improved, booming house prices – a primary cause for the BoC’s decision to taper its asset purchases back in April - have caused the growth factor to rebound quickly. Chart 7CA Positive Story For The CAD The Canadian OIS curve is pricing in BoC liftoff in August 2022 (Appendix Table 1), with a sooner liftoff only expected in Norway and New Zealand. We see risks that the BoC moves much sooner than that next year. A quicker liftoff which will put additional upward pressure on the Canadian dollar, both against the US dollar and on a trade-weighted basis, particularly if Canadian export demand remains solid and oil prices continue to climb, as our commodity strategists expect. Our PPP model suggests that the Loonie is close to fair value, so valuation is not yet an impediment to additional strength in the Canadian dollar. Looking at the longer-term horizon, the OIS curve is discounting four BoC rate hikes within the next 24 months, and it is not clear that will be enough to cool off the red-hot Canadian housing market – currently the biggest threat to inflation stability in Canada (Chart 7D). Given that relatively hawkish view, the more optimistic growth outlook, and the high-beta status of Canadian government bonds, we continue to recommend an underweight position on Canadian government bonds within a global fixed income portfolio. Chart 7DCanadian Rate Expectations Look Fairly Priced RBA Monitor: Waiting For Inflation Our Reserve Bank of Australia (RBA) Monitor has continued its strong rebound since the trough in 2020 and is now at all-time highs, suggesting heightened pressure on the RBA to tighten policy (Chart 8A). This rebound comes amid dovish messaging from an RBA that is waiting on signs of an inflation turnaround. The RBA’s patience makes sense when you consider measures of slack in the economy, such as output and unemployment gaps (Chart 8B). While the IMF does expect the output gap to tighten up significantly in 2021, it does not expect it to be closed even by 2022. Looking to capacity in the labor market, the unemployment rate has just returned to pre-COVID levels. However, the labor market will need to run “hot” for a sustained period of time to push up wage inflation, which remains deep in the doldrums according to the RBA’s wage price index. Chart 8AAustralia: RBA Monitor Chart 8BMuted Inflationary Pressures Down Under A look at the components of our RBA Monitor explains the RBA’s dovishness in the face of the tightening pressure indicated by the “headline” figure (Chart 8C). The rebound in the Monitor can be attributed almost entirely to the growth and financial components, which are driven in turn by improving confidence and an expanding RBA balance sheet. However, the inflation component, which has barely budged off its 2020 low, best captures the metrics that the RBA is watching. Importantly, the RBA will need to see sustainable domestically-generated inflation before it can begin to tolerate a stronger AUD which would otherwise imperil tradable goods inflation. With the AUD only slightly expensive on our PPP models, the RBA does not have much of a “valuation cushion” to play with in terms of delivering a hawkish surprise (Appendix Table 1). ​​​​​​ Chart 8CGrowth Factors Are Driving the RBA Monitor Chart 8D shows that market pricing for hikes over the next two years has remained mostly flat in 2021 in the face of persistently dovish messaging from the RBA. Our view, as expressed in a recent update of our “RBA checklist”2, is that fundamental factors will force the RBA to remain dovish, making Australian government debt an attractive overweight within global government bond portfolios. Chart 8DMarkets Are (Rightly) Looking Through Tightening Pressures In Australia RBNZ Monitor: Heating Up Our Reserve Bank of New Zealand (RBNZ) Monitor has rebounded to levels last seen in 2017, largely on the back of improving growth (Chart 9A). Success at containing the virus has allowed the New Zealand economy to beat growth expectations for Q1/2021, effectively pulling forward future policy tightening. Measures of capacity utilization in New Zealand will likely respond accordingly to improved growth prospects, with the output gap likely to close even faster than projected by the IMF (Chart 9B). Measures of core and headline inflation remain within the RBNZ’s 1-3% target range, with the Bank expecting headline inflation to shoot up to 2.6% in Q2/2021 before settling around the midpoint of the range. Chart 9ANew Zealand: RBNZ Monitor Chart 9BThe New Zealand Economy Is Quickly Working Off Slack Looking at the individual components of our RBNZ Monitor, the rebound in the overall indicator is clearly a growth story (Chart 9C). This component of our Monitor also captures the effect of accelerating house prices, which have become a direct concern for RBNZ policy. According to the bank’s own projections, house prices will post a whopping 29% growth rate in the second quarter. With issues of housing affordability at the forefront, and political pressure mounting, the RBNZ will likely be forced to turn less dovish soon, even if it comes with unwanted strength in the NZD. However, the currency is among the most expensive on our PPP models (Appendix Table 1), which means that a reversion to fair value could counteract upward pressure from a hawkish RBNZ. Chart 9CThe RBNZ Will Do Whatever It Takes To Stabilize House Prices Historically, our RBNZ Monitor has correlated well with market pricing embedded in the OIS curve (Chart 9D). In 2021, however, market expectations have far outstripped the signal from our central bank monitor, meaning that markets believe the RBNZ is more focused on growth factors rather than the overall picture, a view that we largely agree with. Chart 9DMarkets Expect A Hawkish RBNZ Even after the Fed’s hawkish surprise at this week’s meeting, we still believe that the RBNZ will be among the first to taper its balance sheet and move towards normalizing policy. Stay underweight New Zealand sovereign debt. Riksbank Monitor: Watch For An Upside Surprise Our Riksbank Monitor has posted a strong rebound, reaching all-time highs (Chart 10A). This rebound has come on the back of a robust economic recovery. Meanwhile, monetary policy has been accommodative with the Riksbank holding the repo rate at 0% while expanding the size of its balance sheet. Capacity utilization, which in Sweden did not fall nearly as much as in other developed economies, is looking set to recover in the coming years (Chart 10B). Although headline CPI shot past the 2% target, driven by fuel and food prices, underlying core inflation remains stable. The Riksbank expects inflation to fall due to less favorable year-over-year base effects, and only sustainably climb to the 2% level by mid-2024. Chart 10ASweden: Riksbank Monitor Chart 10BThe Rise In Swedish Inflation Is 'Transitory'... Breaking down the rise in the Riksbank Monitor, we can see that it is driven overwhelmingly by the growth component (Chart 10C). This, in turn, has been driven by surging PMIs and soaring business and consumer confidence. Our colleagues at BCA Research European Investment Strategy have pointed out that the small export-sensitive economy will be poised to benefit from an upturn in the global industrial cycle3. While Sweden did arguably botch its COVID-19 response last year, it is catching up, with 42% of Swedes having already received their first dose of the vaccine. The case for the SEK is strong, given that the currency is a high-beta play on global growth and is also quite undervalued according to our PPP models (Appendix Table 1). Market expectations are that the Riksbank will lag others in normalizing policy, putting off a hike until September 2023. The Riksbank baseline is a flat repo rate out to Q2/2024 but an earlier rate hike is well within the “uncertainty bands” of the Riksbank’s forecast. Such a scenario may manifest if growth and inflation surprise to the upside. Chart 10C...But The Riksbank Cannot Ignore Explosive Growth Given the positive economic backdrop and the financial stability risks posed by rising house prices and household indebtedness, we believe market pricing is too dovish relative to the actual pressure on the Riksbank to tighten policy (Chart 10D). This makes Swedish sovereign debt an attractive underweight candidate in global government bond portfolios. Chart 10DThe OIS Curve Is Pricing In Too Much Dovishness From The Riksbank Norges Bank Monitor: The First To Hike Our Norges Bank Monitor has risen sharply from the pandemic lows and now signals that emergency monetary settings are no longer appropriate for the Norwegian economy (Chart 11A). Consistent with this message, Norges Bank governor, Øystein Olsen, suggested this week that a rate hike will occur in September, with possibly another hike by December of this year. Norway has handled the pandemic successfully. Since the onset of the COVID-19 crisis, it has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was also prompt and finely tailored to the sectors most in need of emergency funds. Moreover, monetary policy was highly accommodative, with the Norges Bank cutting interest rates to zero for the first time since its founding in 1816. Fiscal stimulus will remain relatively accommodative, as Norway will register one of the smallest fiscal drags in the G10 for the remainder of 2021 and 2022. Rapid improvement in the labor market also continues. After peaking at 9.5% in March 2020, the headline unemployment rate has fallen to 3.3%. On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024. These developments have set the Norwegian economy on a sustainable recovery path. This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3% (Chart 11B). Meanwhile, while core inflation at 2% is decelerating, the slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mindset has not taken root in Norway. Chart 11AThe Norges Bank Monitor Chart 11BInflation Is Well Anchored In Norway The biggest improvement in our Norges Bank Monitor comes from its growth and inflation components, the former surging to its highest level in two decades. This improvement surpasses those that followed the global financial crisis and the bursting of the dot-com bubble (Chart 11C). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. The Monitor shows a very tight correlation with the trade-weighted currency, suggesting the exchange rate is an important valve for adjusting financial conditions. As an oil-producing economy, the drop in the NOK cushioned the crash in oil prices last year. This year, a recovery has benefitted the krone. The Norwegian krone also remains undervalued according to our PPP models. Chart 11CThe Norges Bank Should Hike Rates A positive correlation also exists between the Monitor and expected rate hikes by the Norges bank (Chart 11D). This suggest yields in Norway should either coincide or lead the improvement in global bond yields. From a portfolio perspective, our default stance is neutral, as the market is thinly traded. Chart 11DThe Norges Bank Should Hike Rates SNB Monitor: Green Shoots Our Swiss National Bank (SNB) Monitor has recovered smartly, and is at the highest level in over a decade (Chart 12A). This is a marked turnaround for a country that has had negative interest rates since 2015. It also raises the prospect that Switzerland may be finally able to escape its liquidity trap, allowing the SNB to modestly adjust monetary policy upward. The Swiss economy has recovered swiftly. As of May, the manufacturing PMI was at 69.9, the highest reading since the start of the series. If past manufacturing sentiment is prologue, the Swiss economy is about to experience its biggest rebound in decades. This will quell any deflationary fears about domestic conditions in Switzerland and begin to re-anchor inflation expectations upwards. This will also be a very welcome development for the SNB. Inflation dynamics in Switzerland will be particularly beholden to improvements in private sector demand. The unemployment rate in Switzerland has rolled over, which should begin to provide an anchor to wage growth. Both core and headline inflation are also recovering, albeit at a slow pace (Chart 12B). Import prices in Switzerland will also rise, driven by the relative weakness of the currency. This is important because for a small, open economy like Switzerland, the exchange rate often dictates the trend in domestic inflation. Chart 12AThe SNB Monitor Chart 12BSwiss Inflation Not Out Of The Woods Looking at the components of our SNB Monitor, the growth component has been in the driver’s seat (Chart 12C). But encouragingly, both the inflation and financial component have also been grinding higher. This improvement suggests that the weakness in the franc, especially amidst global dollar weakness, has been a welcome jolt to the economy. Like the yen, the CHF is a safe-haven currency, making the relationship with the central bank monitor less intuitive. Most of the time, the relationship with the monitor is inverse, corresponding to investors using the Swiss franc for carry trades when global conditions improve. Similar to the yen this year, the CHF has also weakened in sympathy with improving global growth. Should global growth see a setback in the near term, the franc will benefit. Chart 12CGrowth Indicators Are Surging In Switzerland The SNB Monitor is more accurate at capturing expected policy changes by the SNB. This means that yields in Switzerland could see more meaningful upside (Chart 12D). That said, our default stance on Swiss bonds is neutral in a global portfolio, given low liquidity. Chart 12DCould The SNB Finally Lift Rates? Appendix Table 1 Table 1Appendix Table 1 Footnotes 1 See BCA Research US Bond Strategy/Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021, available at gfis.bcaresearch.com 2 Please see BCA Research Global Fixed Income Strategy Report, "A Summer Nap For Global Bond Yields", dated June 9, 2021, available at gfis.bcaresearch.com. 3 Please see BCA Research European Investment Strategy Report, "Take A Chance On Sweden", dated May 3, 2021, available at eis.bcaresearch.com.

Highlights China’s Communist Party has overcome a range of challenges over the past 100 years, performed especially well over the past 42 years, but the macro and geopolitical outlook is darkening. The “East Asian miracle” phase of Chinese growth has ended. Potential GDP growth is slowing and it will be harder for Beijing to maintain financial and sociopolitical stability. The Communist Party has shifted the basis of its legitimacy from rapid growth to quality of life and nationalist foreign policy. The latter, however, will undermine the former by stirring up foreign protectionism. In the near term, global investors should favor developed market equities over China/EM equities. But they should favor China and Hong Kong stocks over Taiwanese stocks given significant geopolitical risk over the Taiwan Strait. Structurally, favor the US dollar and euro over the renminbi. Feature Ten years ago, in the lead up to the Communist Party’s 90th anniversary, I wrote a report called “China and the End of the Deng Dynasty,” referring to Deng Xiaoping, the Chinese Communist Party’s great pro-market reformer.1 The argument rested on three points: the end of the export-manufacturing economic model, an increasingly assertive foreign policy, and the revival of Maoist nationalism. After ten years the report holds up reasonably well but it did not venture to forecast what precisely would come next. In reality it is the rule of the Communist Party, and not the leader of any one man, that fits into China’s history of dynastic cycles. As the party celebrates a hundred years since its founding on July 23, 1921, it is necessary to pause and reflect on what the party has achieved over the past century and what the current Xi Jinping era implies for the country’s next 100 years. Single-Party Rule Can Bring Economic Success. Communism Cannot. Regime type does not preclude wealth. Countries can prosper regardless of whether they are ruled by one person, one party, or many parties. The richest countries in the world grew rich over centuries in which their governments evolved from monarchy to democracy and sometimes back again. Even today several of the world’s wealthy democracies are better described as republics or oligarchies. Chart 1China Outperformed Communism But Not Liberal Democracy The rule of one person, or autocracy, is not necessarily bad for economic growth. For every Kim Il Sung of North Korea there is a Lee Kuan Yew of Singapore. But authority based on a single person often expires with that person and rarely survives his grandchild. In China, Chairman Mao Zedong’s death occasioned a power struggle. Deng Xiaoping’s attempts to step down led to popular unrest that threatened the Communist Party’s rule on two separate occasions in the 1980s. The rule of a single party is thought to be more sustainable. Japan and Singapore are effectively single-party states and the wealthiest countries in Asia. They are democracies with leadership rotation and a popular voice in national affairs. And yet South Korea’s boom times occurred under single-party military rule. The same goes for the renegade province of Taiwan. Only around the time these two reached about $11,000-$14,000 GDP per capita did they evolve into multi-party democracies – though their wealth grew rapidly in the wake of that transition. China and soon Vietnam will test whether non-democratic, single-party rule can persist beyond the middle-income economic status that brought about democratic transition in Taiwan (Chart 1). Vietnam and Taiwan are the closest communist and non-communist governing systems, respectively, to mainland China. Insofar as China and Vietnam succeed at catching up with Taiwan it will be for reasons other than Marxist-Leninist ideology. Most communist systems have failed. At the height of international communism in the twentieth century there were 44 states ruled by communist parties; today there are five. China and Vietnam are the rare examples of communist states that not only survived the Soviet Union’s fall but also unleashed market forces and prospered (Chart 2). North Korea survived in squalor; Cuba’s experience is mixed. States that close off their economies do not have a good record of generating wealth. Closed economies lack competition and investment, struggle with stagflation, and often succumb to corruption and political strife. Openness seems to be a more diagnostic variable than government type or ideology, given the prosperity of democratic Japan and non-democratic China. Has the CPC performed better than other communist regimes? Arguably. It performs better than Vietnam but worse than Cuba on critical measures like infant mortality rates and life expectancy. Has it performed better than comparable non-communist regimes? Not really, though it is fast approaching Taiwan in all of these measures (Chart 3). Chart 2Communist States Get Rich By Compromising Their Communism Chart 3China Catching Up To Cuba On Basic Wellbeing What can be said for certain is that, since China’s 1979 reform and opening up, the CPC has avoided many errors and catastrophes. It survived the 1980s, 1990s, and 2000s without succumbing to international isolation, internal divisions, or economic crisis. It has drastically increased its share of global power (Table 1). Contrast this global ascent with the litany of mistakes and crises in the US since the year 2000. The CPC also managed the past decade relatively well despite the Chinese financial turmoil of 2015-16, the US trade war of 2018-19, and the COVID-19 pandemic. However, these events hint at greater challenges to come. China’s transition to a consumer-oriented economy has hardly begun. The struggle to manage systemic financial risk is intensifying today at risk to growth and stability (Chart 4). The trade war is simmering despite the Phase One trade deal and the change of party in the White House. And it is too soon to draw conclusions about the impact of the global pandemic, though China suppressed the virus more rapidly than other countries and led the world into recovery. Table 1China’s Global Rise After ‘Reform And Opening Up’ Chart 4China To Keep Struggling With Financial Instability Judging by the points above, there are two significant risks on the horizon. First, the CPC’s revival of neo-Maoist ideology, particularly the new economic mantra of self-reliance and “dual circulation” (import substitution), poses the risk of closing the economy and undermining productivity.2 Second, China’s sliding back into the rule of a single person – after the “consensus rule” that prevailed after Deng Xiaoping – increases the risk of unpredictable decision-making and a succession crisis whenever General Secretary Xi Jinping steps down. The party’s internal logic holds that China’s economic and geopolitical challenges are so enormous as to require a strongman leader at the helm of a single-party and centralized state. But because of the traditional problems with one-man rule, there is no guarantee that the country will remain as stable as it has been over the past 42 years. Slowing Growth Drives Clash With Foreign Powers Every major East Asian economy has enjoyed a “miracle” phase of growth – and every one of them has seen this phase come to an end. Now it is China’s turn. The country’s potential GDP growth is slowing as the population peaks, the labor force shrinks, wages rise, and companies outsource production to cheaper neighbors (Charts 5A & 5B). The Communist Party is attempting to reverse the collapse in the fertility rate by shifting from its historic “one Child policy,” which sharply reduced births. It shifted to a two-child policy in 2016 and a three-child policy in 2021 but the results have not been encouraging over the past five years. Chart 5AChina’s Demographic Decline Accelerating Chart 5BChina’s Demographic Decline Accelerating In the best case China’s growth will follow the trajectory of Taiwan and South Korea, which implies at most a 6% yearly growth rate over the next decade (Chart 6). This is not too slow but it will induce financial instability as well as hardship for overly indebted households, firms, and local governments. Chart 6China's Growth Rates Will Converge With Taiwan, South Korea The Communist Party’s legitimacy was not originally based on rapid economic growth but it came to be seen that way over the roaring decades of the 1980s through the 2000s. Thus when the Great Recession struck the party had to shift the party’s base of legitimacy. The new focus became quality of life, as marked by the Xi administration’s ongoing initiatives to cut back on corruption, pollution, poverty, credit excesses, and industrial overcapacity while increasing spending on health, education, and society (Chart 7). Chart 7China’s Fiscal Burdens Will Rise On Social Welfare Needs The party’s efforts to improve standards of living and consumer safety also coincided with an increase in propaganda, censorship, and repression to foreclose political dissent. The country falls far short in global governance indicators (Chart 8). Chart 8China Lags In Governance, Rule Of Law A second major new source of party legitimacy is nationalist foreign policy. China adopted a “more assertive” foreign and trade policy in the mid-2000s as its import dependencies ballooned. It helped that the US was distracted with wars of choice and financial crises. After the Great Recession the CPC’s foreign policy nationalism became a tool of generating domestic popular support amid slower economic growth. This was apparent in the clashes with Japan and other countries in the East and South China Seas in the early 2010s, in territorial disputes with India throughout the past decade, in political spats with Norway and most recently Australia, and in military showdowns over the Korean peninsula (2015-16) and today the Taiwan Strait (Chart 9). Chart 9Proxy Wars A Real Risk In China’s Periphery If China were primarily focused on foreign policy and global strategy then it would not provoke multiple neighbors on opposite sides of its territory at the same time. This is a good way to motivate the formation of a global balance-of-power coalition that can constrain China in the coming years. But China’s outward assertiveness is not driven primarily by foreign policy considerations. It is driven by the secular economic slowdown at home and the need to use nationalism to drum up domestic support. This is why China seems indifferent to offending multiple countries at once (like India and Australia) as well as more distant trade partners whom it “should be” courting rather than offending (like Europe). Such assertive foreign policy threatens to undermine quality of life, namely by provoking international protectionism and sanctions on trade and investment. The US is galvanizing a coalition of democracies to put pressure on China over its trade practices and human rights. The Asian allies are mostly in step with the US because they fear China’s growing clout. The European states do not have as much to fear from China’s military but they do fear China’s state-backed industry and technological rise. Europe’s elites also worry about anti-establishment political movements just like American elites and therefore are trying to win back the hearts and minds of the working class through a more proactive use of fiscal and industrial policy. This entails a more assertive trade policy. China has so far not adapted to the potential for a unified front among the democracies, other than through rhetoric. Thus the international horizon is darkening even as China’s growth rates shift downward. China’s Geopolitical Outlook Is Dimming China’s government has overcome a range of challenges and crises. The country takes an ever larger role in global trade despite its falling share of global population because of its productivity and competitiveness. The drop in China’s outward direct investment is tied to the global pandemic and may not mark a top, given that the country will still run substantial current account surpluses for the foreseeable future and will need to recycle these into natural resources and foreign production (Chart 10). However, the limited adoption of the renminbi as a reserve currency in the face of this formidable commercial power reveals the world’s reservations about Beijing’s ability to maintain macroeconomic stability, good governance, and peaceful foreign relations. Chart 10China's Rise Continues Chart 11China's Policy Uncertainty: A Structural Uptrend China is not in a position to alter the course of national policy dramatically prior to the Communist Party’s twentieth national congress in 2022. The Xi administration is focused on normalizing monetary and fiscal policy and heading off any sociopolitical disturbances prior to that critical event, in which General Secretary Xi Jinping, who was originally slated to step down at this time according to the old rules, may be anointed the overarching “chairman” position that Mao Zedong once held. The seventh generation of Chinese leaders will be promoted at this five-year rotation of the Central Committee and will further consolidate the Xi administration’s grip. It will also cement the party’s rotation back to leaders who have ideological educations, as opposed to the norm in the 1990s and early 2000s of promoting leaders with technocratic skills and scientific educations.3 This does not mean that President Xi will refuse to hold a summit with US President Biden in the coming months nor does it mean that US-China strategic and economic dialogue will remain defunct. But it does mean that Beijing is unlikely to make any major course correction until after the 2022 reshuffle – and even then a course correction is unlikely. China has taken its current path because the Communist Party fears the sociopolitical consequences of relinquishing economic control just as potential growth slows. The new ruling philosophy holds that the Soviet Union fell because of Mikhail Gorbachev’s glasnost and perestroika, not because openness and restructuring came too late. Moreover it is far from clear that the US, Europe, and other democratic allies will apply such significant and sustained pressure as to force China to change its overall strategy. America is still internally divided and its foreign policy incoherent; the EU remains reactive and risk-averse. China has a well-established set of strategic goals for 2035 and 2049, the 100th anniversary of the People’s Republic, and the broad outlines will not be abandoned. The implication is that tensions with the US and China’s Asian neighbors will persist. Rising policy uncertainty is a secular trend that will pick back up sooner rather than later (Chart 11), to the detriment of a stable and predictable investment environment. Chart 12Chinese Government’s Net Worth High But Hidden Liabilities Pose Risks Monetary and fiscal dovishness and a continued debt buildup are the obvious and necessary solutions to China’s combination of falling growth potential, rising social liabilities, the need to maintain the rapid military buildup in the face of geopolitical challenges. Sovereign countries can amass vast debts if they own their own debt and keep nominal growth above average bond yields. China’s government has a very favorable balance sheet when national assets are taken into consideration as well as liabilities, according to the IMF (Chart 12). On the other hand, China’s government is having to assume a lot of hidden liabilities from inefficient state-owned companies and local governments. In the short run there are major systemic financial risks even though in the long run Beijing will be able to increase its borrowing and bail out failing entities in order to maintain stability, just like Japan, the US, and Europe have had to do. The question for China is whether the social and political system will be able to handle major crises as well as the US and Europe have done, which is not that well. Investment Takeaways The rule of a single party is not a bar to economic success – but the rule of a single person is a liability due to the problem of succession. Marxism-Leninism is terrible for productivity unless it is compromised to allow for markets to operate, as in China and Vietnam. States that close their economies to the outside world usually atrophy. There is no compelling evidence that China’s Communist Party has performed better than a non-communist alternative would have done, given the province of Taiwan’s superior performance on most economic indicators. Since 1979, the Communist Party has avoided catastrophic errors. It has capitalized on domestic economic potential and a favorable international environment. Now, in the 2020s, both of these factors are changing for the worse. China’s “miracle” phase of growth has expired, as it did for other East Asian states before it. The maturation of the economy and slowdown of potential GDP have forced the Communist Party to shift the base of its political legitimacy to something other than rapid income growth: namely, quality of life and nationalist foreign policy. An aggressive foreign policy works against quality of life by provoking protectionism from foreign powers, particularly the United States, which is capable of leading a coalition of states to pressure China. The Communist Party’s policy trajectory is unlikely to change much through the twentieth national party congress in 2022. After that, a major course correction to improve relations with the West is conceivable, though we would not bet on it. Between 2021 and China’s 2035 and 2049 milestones, the Communist Party must navigate between rising socioeconomic pressures at home and rising geopolitical pressures abroad. An economic or political breakdown at home, or a total breakdown in relations with the US, could lead to proxy wars in China’s periphery, including but not limited to the Taiwan Strait. For now, global investors should favor the euro and US dollar over the renminbi (Chart 13). Chart 13Prefer The Dollar And Euro To The Renminbi Mainland investors should favor government bonds relative to stocks. Chinese stocks hit a major peak earlier this year and the government’s seizure of control over the tech sector is taking a toll. Investors should prefer developed market equities relative to Chinese equities until China’s current phase of policy tightening ends and there is at least a temporary improvement in relations with the United States. But investors should also prefer Chinese and Hong Kong stocks relative to Taiwanese due to the high risk of a diplomatic crisis and the tail risk of a war. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 The report concluded, “the emerging trends suggest a likely break from Deng's position toward heavier state intervention in the economy, more contentious relationships with neighbors, and a Party that rules primarily through ideology and social control.” Co-written with Jennifer Richmond, "China and the End of the Deng Dynasty," Stratfor, April 19, 2011, worldview.stratfor.com. 2 The Xi administration’s new concept of “dual circulation” entails that state policy will encourage the domestic economy whereas the international economy will play a secondary role. This is a reversal of the outward and trade-oriented economic model under Deng Xiaoping. See “Xi: China’s economy has potential to maintain long-term stable development,” November 4, 2020, news.cgtn.com. 3 See Willy Wo-Lap Lam, "China’s Seventh-Generation Leadership Emerges onto the Stage," Jamestown Foundation, China Brief 19:7, April 9, 2019, Jamestown.org.

Dear Client, Next week, in lieu of our regular weekly report, I will be hosting two webcasts where I will discuss the outlook for China’s economy and financial markets, a year into policy normalization. The webcasts will be held on Tuesday, June 22 at 10:00 am EDT (English), and Thursday, June 24 at 9:00 am HKT (Mandarin). We will return to our regular publishing schedule on Wednesday, June 30. Best regards, Jing Sima, China Strategist   Feature China’s onshore stocks rebounded in the past two months on the back of a rapidly appreciating RMB versus the US dollar and accelerating foreign capital inflows (Chart 1). However, in our view, China’s domestic policy backdrop and economic fundamentals do not support a sustained rally in Chinese stocks in the next six months. The RMB’s rise vis-à-vis the US dollar will likely falter in the second half of the year as China’s growth weakens. A narrowing in real yields later this year between China’s government bonds and US Treasuries will also discourage foreign flows into Chinese assets. Performance of Chinese cyclical stocks versus defensives failed to decisively breakout in both the onshore and offshore equity markets. An underperformance in cyclical stocks relative to defensives has historically pointed to waning market sentiment towards the Chinese economy (Chart 2). Chart 1Rapid Appreciation In The RMB Buoyed A Recent Rebound In A-Shares Chart 2Cyclical Stocks Continued To Underperform Defensives The number of onshore stocks with prices rising versus falling remains low, even though there has been a slight improvement this year from Q4 2020. The narrow breath in the equity market implies that recent rebound in A-share stocks has been largely driven by a handful of companies (Chart 3). Such narrow breadth suggests that the rebound in Chinese stock prices will not sustain (Chart 4). Chart 3A Narrow-Based Market Rally in A-Shares Chart 4Narrowing Market Breadth Has Historically Led To Price Pullbacks A tightened monetary and credit environment has created obstacles for Chinese equities since early this year. Credit numbers released last week show that credit growth deceleration has gathered speed in May, raising the risk of policy overtightening, i.e. credit growth undershooting the government’s 2021 targets. We could see some moderation in the credit growth deceleration into 2H21. A delay in the rollout of local government (LG) bonds and LG special purpose bonds (SPBs) in the first five months of the year means the pace of LG bond issuance between June and October will escalate, which will help to stabilize credit growth. However, weak corporate bond net financing and contracting shadow banking will cap the upside in credit expansion. Chart 5The Economy Could Surprise The Market To The Downside In Q3 Additionally, if more LG bonds come onto the market in Q3, then we could see tighter interbank liquidity conditions and higher bond yields. This, in turn, would partially offset the positive effects on the economy and equity market from a slower pace in credit growth deceleration. For the next six months, we continue to hold an underweight position in Chinese onshore and investable stocks, in both absolute terms and within a global equity portfolio. Policy tightening has not reversed course and there is an escalating risk that economic data will surprise the market to the downside in Q3 (Chart 5). Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com     Macro Policy Conditions Are Still Unfavorable For Risk Assets A further deterioration in the credit impulse in May reflects Chinese authorities’ efforts to reduce local government leverage and shadow banking activities. Net corporate bond financing contracted for the first time since early 2018, driven by shrinking local government financing vehicle (LGFV) bonds (Chart 6). Meanwhile, the pace of contraction in shadow-bank loans climbed. At this rate of deceleration, credit growth will undershoot the government’s 2021 target, which is expected to be in line with this year’s nominal GDP growth. The pace in credit expansion on a year-over-year basis has dropped to its previous cycle’s trough (Chart 7). Moreover, the speed of the deceleration in credit growth has outpaced the 2017/18 tightening cycle. It has been seven months since Chinese credit growth peaked (October 2020), which is significantly less than the 13 months it took for credit to decline from top to bottom in 2017/18. Chart 6Contraction In Net Corporate Bond Financing And Shadow Banking Dragged Down Credit Growth In May Chart 7Credit Growth Has Decelerated To Its Trough Reached In 2017/18 Tightening Cycle Chart 8Most Of LG Bonds Issued In The First Five Months Are Refinancing Bonds So far this year, LG bond issuance is also behind schedule. About 63% of LG bonds issued in the first five months are refinancing bonds (Chart 8). The new LG bonds and LG SPBs issued to date account for only 21% and 16.5%, respectively, of their 2021 quotas. A delay in LG bond issuance in the first five months means that much more bonds will be on the market between June and October, which may help to stabilize credit growth in Q3. However, weak corporate bond financing and an acceleration in contracting shadow banking activities will cap the upside on broad credit. We do not expect a reversal in policy tightening. Instead, credit growth will likely hover near current levels for the rest of the year. In the past, Chinese policymakers eased when the global manufacturing backdrop faltered. Given that global growth is robust, Chinese policymakers will not feel any urgency to reverse policy setting and will likely use the strong external environment as an opportunity for domestic deleveraging. Chinese Exports Will Face Challenges In The Second Half Of The Year Chart 9A Broad-Based Moderation In China's Exports to DMs Export growth slowed in May with a broad-based moderation in the country’s exports to developed markets (DMs), albeit from a very elevated level (Chart 9). The easing in exports reflects an ongoing demand shift in the DMs away from goods to services as economic activity normalizes (Chart 10). China’s robust exports, which have been driven by strong and partly pandemic-induced global demand for goods, will likely gradually lose strength in the second half of the year. China’s weakening new export orders component in the May manufacturing PMI reflects this trend (Chart 11). Chart 10Global Consumption Recovery In Services Will Likely Outpace Goods Chart 11China's Softening New Export Orders Signal Further Export-Sector Weakness An appreciating RMB versus the US dollar is also a headwind for Chinese exports. The USD/CNY historically has led Chinese new export orders by around six months, with the exception of the pandemic-hit outlier in 2020 (Chart 12).  The recent sharp RMB appreciation is starting to weight on Chinese exports. Moreover, BCA’s Geopolitical strategists do not expect that China will principally benefit from US President Biden’s $2.4 trillion infrastructure and green energy plan . US explicitly aims to diminish China’s role as a supplier of US goods and materials. The widening divergence between US’s trade deficit with China and the rest of world already shows evidence (Chart 13). Chart 12The RMB's Rapid Rise Creates Headwinds For Chinese Exports Chart 13China's Exports May Not Benefit From Biden's Infrastructure Plan Still No Inflation Pass-Through Chart 14Chinese Producers Are Unable To Pass Rising Input Costs On To Consumers Chinese surging producer prices overstate domestic inflationary pressures. Inflation in the Producer Price Index (PPI) surged by 9.0% year-over-year in May, jumping to its highest level since 2009. High PPI inflation reflects rising commodity prices and a low base effect. Meanwhile, inflationary pressures are much more muted for consumer goods and services. The gap between producer and consumer prices widened to the highest level since 1990, highlighting the absence of price inflation pass-through from producers to consumers (Chart 14). We expect soaring PPI inflation to be transitory; it will ease when low-base factors from last year and global supply constraints are removed later this year. CPI inflation will remain tame through the year. As such, Chinese authorities are unlikely to tighten monetary policy in response to high PPI readings. Instead, Beijing will continue to use regulatory measures to curb speculation in the commodity market and window-guide industries to readjust material inventories to help ease the pace of rising commodity prices. Historically, PPI inflation’s impact on consumer prices has been weak when prices on producer goods were pushed up by supply shocks rather than mounting domestic demand. The sharp uptick in the PPI during the 2017/18 cycle was mostly due to China’s supply-side reforms and a rapid consolidation in the upstream industries. Global supply constraints linked to the pandemic have also resulted in a sharp upturn in the Chinese PPI since mid-2020. Moreover, Chart 15 shows that the pass-through from PPI inflation to consumers is closely correlated to household income growth. The pass-through has weakened significantly since 2011 when household income growth subdued along with a declining Chinese working population (Chart 16). Chart 15Subdued Household Income Growth Since 2011 Has Suppressed CPI Inflation Chart 16Income Growth Decelerated After China's Working Population Peaked Chart 17Profits Diverged Between Upstream And Mid & Downstream Industries Lacking inflation pass-through from producers to consumers has led to a bifurcated profit recovery between upstream and mid & downstream industries. Since late last year, the share of upstream industries in total profits increased sharply at the expense of mid and downstream businesses (Chart 17). A deterioration in the profits of mid and downstream industries will weigh on the outlook for their capex, which in turn, will reduce the demand for upstream goods.     Domestic Demand Remains China’s Weakest Link Investments and household demand remain the weakest links in China’s economy. Sluggish household consumption reflects a fragile post-pandemic recovery in manufacturing and services employment, and a rising propensity for precautionary savings (Chart 18). A PBoC survey shows that households’ preference for more saving deposits soared in 2020 (Chart 19). Although it has slightly diminished since late 2020, the reading is still much higher than its pre-pandemic level and will likely persist to year-end on the back of a subdued outlook for employment and income. Chart 18Weak Employment In Both Manufacturing And Service Industries Chart 19Propensity For Precautionary Savings Is Still Elevated Manufacturing investment continued its rebound in April, but the growth has not rallied to its pre-pandemic state and the recovery was more than offset by falling old-economy infrastructure and real estate investment growth (Chart 20). Although a pickup in LG SPB issuance in Q3 will provide some support to infrastructure expenditures, the effect on aggregate infrastructure investment probably will be muted. China’s Ministry of Finance has raised the requirements for approvals of new investment projects, which have decreased notably since early this year (Chart 21). Hence, growth in infrastructure investment may not significantly improve in 2H21 without a harmonized policy impetus for more bank loans and loosened regulations on local government spending. Chart 20Recovery In Manufacturing Investment Was More Than Offset By Falling Infrastructure And Real Estate Investment Growth Chart 21Falling New Projects Approval Real Estate Sector: Mounting Deleverage Pressure Property developers face challenges from heightened government scrutiny on bank loans and limits on the sector’s leverage ratio, along with curtailed off-balance sheet funding due to Asset Management Regulation (AMR) . Bank loans to real estate developers and household mortgages have tumbled to historical lows and will likely slow further in the next few months (Chart 22, top panel). The tightened financing policies have started to cool demand in the real estate market (Chart 22, bottom panel). Softer housing demand will start to drag down property developers’ capital spending and real estate construction activities (Chart 23). Chart 22Deteriorating Financing Starting To Cool The Property Market Chart 23Real Estate Investments And Construction Activities May Slow Further   Table 1China Macro Data Summary Table 2China Financial Market Performance Summary   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Highlights Geopolitical risk is trickling back into financial markets. China’s fiscal-and-credit impulse collapsed again. The Global Economic Policy Uncertainty Index is ticking back up after the sharp drop from 2020. All of our proprietary GeoRisk Indicators are elevated or rising. Geopolitical risk often rises during bull markets – the Geopolitical Risk Index can even spike without triggering a bear market or recession. Nevertheless a rise in geopolitical risk is positive for the US dollar, which happens to stand at a critical technical point. The macroeconomic backdrop for the dollar is becoming less bearish given China’s impending slowdown. President Biden’s trip to Europe and summit with Russian President Vladimir Putin will underscore a foreign policy of forming a democratic alliance to confront Russia and China, confirming the secular trend of rising geopolitical risk. Shift to a defensive tactical position. Feature Back in March 2017 we wrote a report, “Donald Trump Is Who We Thought He Was,” in which we reaffirmed our 2016 view that President Trump would succeed in steering the US in the direction of fiscal largesse and trade protectionism. Now it is time for us to do the same with President Biden. Our forecast for Biden rested on the same points: the US would pursue fiscal profligacy and mercantilist trade policy. The recognition of a consistent national policy despite extreme partisan divisions is a testament to the usefulness of macro analysis and the geopolitical method. Trump stole the Democrats’ thunder with his anti-austerity and anti-free trade message. Biden stole it back. It was the median voter in the Rust Belt who was calling the shots all along (after all, Biden would still have won the election without Arizona and Georgia). We did make some qualifications, of course. Biden would maintain a hawkish line on China and Russia but he would reject Trump’s aggressive foreign and trade policy when it came to US allies.1 Biden would restore President Obama’s policy on Iran and immigration but not Russia, where there would be no “diplomatic reset.” And Biden’s fiscal profligacy, unlike Trump’s, would come with tax hikes on corporations and the wealthy … even though they would fall far short of offsetting the new spending. This is what brings us to this week’s report: New developments are confirming this view of the Biden administration. Geopolitical Risk And Bull Markets Chart 1Global Geopolitical Risk And The Dollar In recent weeks Biden has adopted a hawkish policy on China, lowered tensions with Europe, and sought to restore President Obama’s policy of détente with Iran. The jury is still out on relations with Russia – Biden will meet with Putin on June 16 – but we do not expect a 2009-style “reset” that increases engagement. Still, it is too soon to declare a “Biden doctrine” of foreign policy because Biden has not yet faced a major foreign crisis. A major test is coming soon. Biden’s decision to double down on hawkish policy toward China will bring ramifications. His possible deal with Iran faces a range of enemies, including within Iran. His reduction in tensions with Russia is not settled yet. While the specific source and timing of his first major foreign policy crisis is impossible predict, structural tensions are rebuilding. An aggregate of our 13 market-based GeoRisk indicators suggests that global political risk is skyrocketing once again. A sharp spike in the indicator, which is happening now, usually correlates with a dollar rally (Chart 1). This indicator is mean-reverting since it measures the deviation of emerging market currencies, or developed market equity markets, from underlying macroeconomic fundamentals. The implication is positive for the dollar, although the correlation is not always positive. Looking at both the DXY’s level and its rate of change shows periods when the global risk indicator fell yet the dollar stayed strong – and vice versa. The big increase in the indicator over the past week stems mostly from Germany, South Korea, Brazil, and Australia, though all 13 of the indicators are now either elevated or rising, including the China/Taiwan indicators. Some of the increase is due to base effects. As global exports recover, currencies and equities that we monitor are staying weaker than one would expect. This causes the relevant BCA GeoRisk indicator to rise. Base effects from the weak economy in June 2020 will fall out in coming weeks. But the aggregate shows that all of the indicators are either high or rising and, on a country by country level, they are now in established uptrends even aside from base effects. Chart 2Global Policy Uncertainty Revives Meanwhile the global Economic Policy Uncertainty Index is recovering across the world after the drop in uncertainty following the COVID-19 crisis (Chart 2). Policy uncertainty is also linked to the dollar and this indicator shows that it is rising on a secular basis. The Geopolitical Risk Index, maintained by Matteo Iacoviello and a group of academics affiliated with the Policy Uncertainty Index, is also in a secular uptrend, although cyclically it has not recovered from the post-COVID drop-off. It is sensitive to traditional, war-linked geopolitical risk as reported in newspapers. By contrast our proprietary indicators are sensitive to market perceptions of any kind of risk, not just political, both domestic and international. A comparison of the Geopolitical Risk Index with the S&P 500 over the past century shows that a geopolitical crisis may occur at the beginning of a business cycle but it may not be linked with a recession or bear market. Risk can rise, even extravagantly, during economic expansions without causing major pullbacks. But a crisis event certainly can trigger a recession or bear market, particularly if it is tied to the global oil supply, as in the early 1970s, 1980s, and 1990s (Chart 3). Chart 3Secular Rise In Geopolitical Risk Soon To Reassert Itself While geopolitical risk is normally positive for the dollar, the macroeconomic backdrop is negative. The dollar’s attempt to recover earlier this year faltered. This underlying cyclical bearish dollar trend is due to global economic recovery – which will continue – and extravagant American monetary expansion and budget deficits. This is why we have preferred gold – it is a hedge against both geopolitical risk and inflation expectations. Tactically this year we have refrained from betting against the dollar except when building up some safe-haven positions like Japanese yen. Over the medium and long term we expect geopolitical risk to put a floor under the greenback. The bottom line is that the US dollar is at a critical technical crossroads where it could break out or break down. Macro factors suggest a breakdown but the recovery of global policy uncertainty and geopolitical risk suggests the opposite. We remain neutral. A final quantitative indicator of the recovery of geopolitical risk is the performance of global aerospace and defense stocks (Chart 4). Defense shares are rising in absolute and relative terms. Chart 4Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Can The WWII Peace Be Prolonged? Qualitative assessments of geopolitical risk are necessary to explain why risk is on a secular upswing – why drops in the quantitative indicators are temporary and the troughs keep getting higher. Great nations are returning to aggressive competition after a period of relative peace and prosperity. Over the past two decades Russia and China took advantage of America’s preoccupations with the Middle East, the financial crisis, and domestic partisanship in order to build up their global influence. The result is a world in which authority is contested. The current crisis is not merely about the end of the post-Cold War international order. It is much scarier than that. It is about the decay of the post-WWII international order and the return of the centuries-long struggle for global supremacy among Great Powers. The US and European political establishments fear the collapse of the WWII settlement in the face of eroding legitimacy at home and rising challenges from abroad. The 1945 peace settlement gave rise to both a Cold War and a diplomatic system, including the United Nations Security Council, for resolving differences among the great powers. It also gave rise to European integration and various institutions of American “liberal hegemony.” It is this system of managing great power struggle, and not the post-Cold War system of American domination, that lies in danger of unraveling. This is evident from the following points: American preeminence only lasted fifteen years, or at best until the 2008 Georgia war and global financial crisis. The US has been an incoherent wild card for at least 13 years now, almost as long as it was said to be the global empire. Russian antagonism with the West never really ended. In retrospect the 1990s were a hiatus rather than a conclusion of this conflict. China’s geopolitical rise has thawed the frozen conflicts in Asia from the 1940s-50s – i.e. the Chinese civil war, the Hong Kong and Taiwan Strait predicaments, the Korean conflict, Japanese pacifism, and regional battles for political influence and territory. Europe’s inward focus and difficulty projecting power have been a constant, as has its tendency to act as a constraint on America. Only now is Europe getting closer to full independence (which helped trigger Brexit). Geopolitical pressures will remain historically elevated for the foreseeable future because the underlying problem is whether great power struggle can be contained and major wars can be prevented. Specifically the question is whether the US can accommodate China’s rise – and whether China can continue to channel its domestic ambitions into productive uses (i.e. not attempts to create a Greater Chinese and then East Asian empire). The Great Recession killed off the “East Asia miracle” phase of China’s growth. Potential GDP is declining, which undermines social stability and threatens the Communist Party’s legitimacy. The renminbi is on a downtrend that began with the Xi Jinping era. The sharp rally during the COVID crisis is over, as both domestic and international pressures are rising again (Chart 5). Chart 5Biden Administration Review Of China Policy: More China Bashing While the data for China’s domestic labor protests is limited in extent, we can use it as a proxy for domestic instability in lieu of official statistics that were tellingly discontinued back in 2005. The slowdown in credit growth and the cyclical sectors of the economy suggest that domestic political risk is underrated in the lead up to the 2022 leadership rotation (Chart 6). Chart 6China's Domestic Political Risk Will Rise Chart 7Steer Clear Of Taiwan Strait The increasing focus on China’s access to key industrial and technological inputs, the tensions over the Taiwan Strait, and the formation of a Russo-Chinese bloc that is excluded from the West all suggest that the risk to global stability is grave and historic. It is reminiscent of the global power struggles of the seventeenth through early twentieth centuries. The outperformance of Taiwanese equities from 2019-20 reflects strong global demand for advanced semiconductors but the global response to this geopolitical bottleneck is to boost production at home and replace Taiwan. Therefore Taiwan’s comparative advantage will erode even as geopolitical risk rises (Chart 7). The drop in geopolitical tensions during COVID-19 is over, as highlighted above. With the US, EU, and other countries launching probes into whether the virus emerged from a laboratory leak in China – contrary to what their publics were told last year – it is likely that a period of national recriminations has begun. There is a substantial risk of nationalism, xenophobia, and jingoism emerging along with new sources of instability. An Alliance Of Democracies The Biden administration’s attempt to restore liberal hegemony across the world requires a period of alliance refurbishment with the Europeans. That is the purpose of his current trip to the UK, Belgium, and Switzerland. But diplomacy only goes so far. The structural factor that has changed is the willingness of the West to utilize government in the economic sphere, i.e. fiscal proactivity. Infrastructure spending and industrial policy, at the service of national security as well as demand-side stimulus, are the order of the day. This revolution in economic policy – a return to Big Government in the West – poses a threat to the authoritarian powers, which have benefited in recent decades by using central strategic planning to take advantage of the West’s democratic and laissez-faire governance. If the West restores a degree of central government – and central coordination via NATO and other institutions – then Beijing and Moscow will face greater pressure on their economies and fewer strategic options. About 16 American allies fall short of the 2% of GDP target for annual defense spending – ranging from Italy to Canada to Germany to Japan. However, recent trends show that defense spending did indeed increase during the Trump administration (Chart 8). Chart 8NATO Boosts Defense Spending The European Union as a whole has added $50 billion to the annual total over the past five years. A discernible rise in defense spending is taking place even in Germany (Chart 9). The same point could be made for Japan, which is significantly boosting defense spending (as a share of output) after decades of saying it would do so without following through. A major reason for the American political establishment’s rejection of President Trump was the risk he posed to the trans-Atlantic alliance. A decline in NATO and US-EU ties would dramatically undermine European security and ultimately American security. Hence Biden is adopting the Trump administration’s hawkish approach to trade with China but winding down the trade war with Europe (Chart 10). Chart 9Europe Spending More On Guns Chart 10US Ends Trade War With Europe? A multilateral deal aimed at setting a floor in global corporate taxes rates is intended to prevent the US and Europe from undercutting each other – and to ensure governments have sufficient funding to maintain social spending and reduce income inequality (Chart 11). Inequality is seen as having vitiated sociopolitical stability and trust in government in the democracies. Chart 11‘Global’ Corporate Tax Deal Shows Return Of Big Government, Attempt To Reduce Inequality In The West Risks To Biden’s Diplomacy It is possible that Biden’s attempt to restore US alliances will go nowhere over the course of his four-year term in office. The Europeans may well remain risk averse despite their initial signals of willingness to work with Biden to tackle China’s and Russia’s challenges to the western system. The Germans flatly rejected both Biden and Trump on the Nord Stream II natural gas pipeline linkage with Russia, which is virtually complete and which strengthens the foundation of Russo-German engagement (more on this below). The US’s lack of international reliability – given the potential of another partisan reversal in four years – makes it very hard for countries to make any sacrifices on behalf of US initiatives. The US’s profound domestic divisions have only slightly abated since the crises of 2020 and could easily flare up again. A major outbreak of domestic instability could distract Biden from the foreign policy game.2 However, American incapacity is a risk, not our base case, over the coming years. We expect the US economic stimulus to stabilize the country enough that the internal political crisis will be contained and the US will continue to play a global role. The “Civil War Lite” has mostly concluded, excepting one or two aftershocks, and the US is entering into a “Reconstruction Lite” era. The implication is negative for China and Russia, as they will now have to confront an America that, if not wholly unified, is at least recovering. Congress’s impending passage of the Innovation and Competition Act – notably through regular legislative order and bipartisan compromise – is case in point. The Senate has already passed this approximately $250 billion smorgasbord of industrial policy, supply chain resilience, and alliance refurbishment. It will allot around $50 billion to the domestic semiconductor industry almost immediately as well as $17 billion to DARPA, $81 billion for federal research and development through the National Science Foundation, which includes $29 billion for education in science, technology, engineering, and mathematics, and other initiatives (Table 1). Table 1Peak Polarization: US Congress Passes Bipartisan ‘Innovation And Competition Act’ To Counter China With the combination of foreign competition, the political establishment’s need to distract from domestic divisions, and the benefit of debt monetization courtesy of the Federal Reserve, the US is likely to achieve some notable successes in pushing back against China and Russia. On the diplomatic front, the US will meet with some success because the European and Asian allies do not wish to see the US embrace nationalism and isolationism. They have their own interests in deterring Russia and China. Lack Of Engagement With Russia Russian leadership has dealt with the country’s structural weaknesses by adopting aggressive foreign policy. At some point either the weaknesses or the foreign policy will create a crisis that will undermine the current regime – after all, Russia has greatly lagged the West in economic development and quality of life (Chart 12). But President Putin has been successful at improving the country’s wealth and status from its miserably low base in the 1990s and this has preserved sociopolitical stability so far. Chart 12Russia's Domestic Political Risk It is debatable whether US policy toward Russia ever really changed under President Trump, but there has certainly not been a change in strategy from Russia. Thus investors should expect US-Russia antagonism to continue after Biden’s summit with Putin even if there is an ostensible improvement. The fundamental purpose of Putin’s strategy has been to salvage the Russian empire after the Soviet collapse, ensure that all world powers recognize Russia’s veto power over major global policies and initiatives, and establish a strong strategic position for the coming decades as Russia’s demographic decline takes its toll. A key component of the strategy has been to increase economic self-sufficiency and reduce exposure to US sanctions. Since the invasion of Ukraine in 2014, Putin has rapidly increased Russia’s foreign exchange reserves so as to buffer against shocks (Chart 13). Chart 13Russia Fortified Against US Sanctions Putin has also reduced Russia’s reliance on the US dollar to about 22% (Chart 14), primarily by substituting the euro and gold. Russia will not be willing or able to purge US dollars from its system entirely but it has been able to limit America’s ability to hurt Russia by constricting access to dollars and the dollar-based global financial architecture. Russian Finance Minister Anton Siluanov highlighted this process ahead of the Biden-Putin summit by declaring that the National Wealth Fund will divest of its remaining $40 billion of its US dollar holdings. Chart 14Russia Diversifies From USD In general this year, Russia is highlighting its various advantages: its resilience against US sanctions, its ability to re-invade Ukraine, its ability to escalate its military presence in Belarus and the Black Sea, and its ability to conduct or condone cyberattacks on vital American food and fuel supplies (Chart 15). Meanwhile the US is suffering from deep political divisions at home and strategic incoherence abroad and these are only starting to be mended by domestic economic stimulus and alliance refurbishment. Chart 15Cyber Security Stocks Recover Europe’s risk-aversion when it comes to strategic confrontation with Russia, and the lack of stability in US-Russia relations, means that investors should not chase Russian currency or financial assets amid the cyclical commodity rally. Investors should also expect risk premiums to remain high in developing European economies relative to their developed counterparts. This is true despite the fact that developed market Europe’s outperformance relative to emerging Europe recently peaked and rolled over. From a technical perspective this outperformance looks to subside but geopolitical tensions can easily escalate in the near term, particularly in advance of the Russian and German elections in September (Chart 16). Chart 16Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Europe trades in line with EUR-RUB and these pair trades all correspond closely to geopolitical tensions with Russia (Chart 17). A notable exception is the UK, whose stock market looks attractive relative to eastern Europe and is much more secure from any geopolitical crisis in this region (Chart 17, bottom panel). The pound is particularly attractive against the Czech koruna, as Russo-Czech tensions have heated up in advance of October’s legislative election there (Chart 18). Chart 17Long UK Versus Eastern Europe Chart 18Long GBP Versus CZK Meanwhile Russia and China have grown closer together out of strategic necessity. Germany’s Election And Stance Toward Russia Germany’s position on Russia is now critical. The decision to complete the Nord Stream II pipeline against American wishes either means that the Biden administration can be safely ignored – since it prizes multilateralism and alliances above all things and is therefore toothless when opposed – or it means that German will aim to compensate the Americans in some other area of strategic concern. Washington is clearly attempting to rally the Germans to its side with regard to putting pressure on China over its trade practices and human rights. This could be the avenue for the US and Germany to tighten their bond despite the new milestone in German-Russia relations. The US may call on Germany to stand up for eastern Europe against Russian aggression but on that front Berlin will continue to disappoint. It has no desire to be drawn into a new Cold War given that the last one resulted in the partition of Germany. The implication is negative for China on one hand and eastern Europe on the other. Germany’s federal election on September 26 will be important because it will determine who will succeed Chancellor Angela Merkel, both in Germany and on the European and global stage. The ruling Christian Democratic Union (CDU) is hoping to ride Merkel’s coattails to another term in charge of the government. But they are likely to rule alongside the Greens, who have surged in opinion polls in recent years. The state election in Saxony-Anhalt over the weekend saw the CDU win 37% of the popular vote, better than any recent result, while Germany’s second major party, the Social Democrats, continued their decline (Table 2). The far-right Alternative for Germany won 21% of the vote, a downshift from 2016, while the Greens won 6% of the vote, a slight improvement from 2016. All parties underperformed opinion polling except the CDU (Chart 19). Table 2Saxony-Anhalt Election Results Chart 19Germany: Conservatives Outperform In Final State Election Before Federal Vote, But Face Challenges Chart 20Germany: Greens Will Outperform in 2021 Vote The implication is still not excellent for the CDU. Saxony-Anhalt is a middling German state, a CDU stronghold, and a state with a popular CDU leader. So it is not representative of the national campaign ahead of September. The latest nationwide opinion polling puts the CDU at around 25% support. They are neck-and-neck with the Greens. The country’s left- and right-leaning ideological blocs are also evenly balanced in opinion polls (Chart 20). A potential concern for the CDU is that the Free Democratic Party is ticking up in national polls, which gives them the potential to steal conservative votes. Betting markets are manifestly underrating the chance that Annalena Baerbock and the Greens take over the chancellorship (Charts 21A and 21B). We still give a subjective 35% chance that the Greens will lead the next German government without the CDU, a 30% that the Greens will lead with the CDU, and a 25% chance that the CDU retains power but forms a coalition with the Greens. A coalition government would moderate the Greens’ ambitious agenda of raising taxes on carbon emissions, wealth, the financial sector, and Big Tech. The CDU has already shifted in a pro-environmental, fiscally proactive direction. Chart 21AGerman Greens Will Recover Chart 21BGerman Greens Still Underrated No matter what the German election will support fiscal spending and European solidarity, which is positive for the euro and regional equities over the next 12 to 24 months. However, the Greens would pursue a more confrontational stance toward Russia, a petro-state whose special relations with the German establishment have impeded the transition to carbon neutrality. Latin America’s Troubles A final aspect of Biden’s agenda deserves some attention: immigration and the Mexican border. Obviously this one of the areas where Biden starkly differs from Trump, unlike on Europe and China, as mentioned above. Vice President Kamala Harris recently came back from a trip to Guatemala and Mexico that received negative media attention. Harris has been put in charge of managing the border crisis, the surge in immigrant arrivals over 2020-21, both to give her some foreign policy experience and to manage the public outcry. Despite telling immigrants explicitly “Do not come,” Harris has no power to deter the influx at a time when the US economy is fired up on historic economic stimulus and the Democratic Party has cut back on all manner of border and immigration enforcement. From a macro perspective the real story is the collapse of political and geopolitical risk in Mexico. From 2016-20 Mexico faced a protectionist onslaught from the Trump administration and then a left-wing supermajority in Congress. But these structural risks have dissipated with the USMCA trade deal and the inability of President Andrés Manuel López Obrador to follow through with anti-market reforms, as we highlighted in reports in October and April. The midterm election deprived the ruling MORENA party of its single-party majority in the Chamber of Deputies, the lower house of the legislature (Chart 22). AMLO is now politically constrained – he will not be able to revive state control over the energy and power sectors. Chart 22Mexican Midterm Election Constrained Left-Wing Populism, Political Risk Chart 23Buy Mexico (And Canada) On US Stimulus American monetary and fiscal stimulus, and the supply-chain shift away from China, also provide tailwinds for Mexico. In short, the Mexican election adds the final piece to one of our key themes stemming from the Biden administration, US populism, and US-China tensions: favor Mexico and Canada (Chart 23). A further implication is that Mexico should outperform Brazil in the equity space. Brazil is closely linked to China’s credit cycle and metals prices, which are slated to turn down as a result of Chinese policy tightening. Mexico is linked to the US economy and oil prices (Chart 24). While our trade stopped out at -5% last week we still favor the underlying view. Brazilian political risk and unsustainable debt dynamics will continue to weigh on the currency and equities until political change is cemented in the 2022 election and the new government is then forced by financial market riots into undertaking structural reforms. Chart 24Brazil's Troubles Not Truly Over - Mexico Will Outperform Elsewhere in Latin America, the rise of a militant left-wing populist to the presidency in a contested election in Peru, and the ongoing social unrest in Colombia and Chile, are less significant than the abrupt slowdown in China’s credit growth (Charts 25A and 25B). According to our COVID-19 Social Stability Index, investors should favor Mexico. Turkey, the Philippines, South Africa, Colombia, and Brazil are the most likely to see substantial social instability according to this ranking system (Table 3). Chart 25AMexico To Outperform Latin America Chart 25BChina’s Slowdown Will Hit South America Table 3Post-COVID Emerging Market Social Unrest Only Just Beginning Investment Takeaways Close long emerging markets relative to developed markets for a loss of 6.8% – this is a strategic trade that we will revisit but it faces challenges in the near term due to China’s slowdown (Chart 26). Go long Mexican equities relative to emerging markets on a strategic time frame. Our long Mexico / short Brazil trade hit the stop loss at 5% but the technical profile and investment thesis are still sound over the short and medium term. Chart 26China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets Chart 27Relative Uncertainty And Safe Havens China’s sharp fiscal-and-credit slowdown suggests that investors should reduce risk exposure, take a defensive tactical positioning, and wait for China’s policy tightening to be priced before buying risky assets. Our geopolitical method suggests the dollar will rise, while macro fundamentals are becoming less dollar-bearish due to China. We are neutral for now and will reassess for our third quarter forecast later this month. If US policy uncertainty falls relative to global uncertainty then the EUR-USD will also fall and safe-haven assets like Swiss bonds will gain a bid (Chart 27). Gold is an excellent haven amid medium-term geopolitical and inflation risks but we recommend closing our long silver trade for a gain of 4.5%. Disfavor emerging Europe relative to developed Europe, where heavy discounts can persist due to geopolitical risk premiums. We will reassess after the Russian Duma election in September. Go long GBP-CZK. Close the Euro “laggards” trade. Go long an equal-weighted basket of euros and US dollars relative to the Chinese renminbi. Short the TWD-USD on a strategic basis. Prefer South Korea to Taiwan – while the semiconductor splurge favors Taiwan, investors should diversify away from the island that lies at the epicenter of global geopolitical risk. Close long defense relative to cyber stocks for a gain of 9.8%. This was a geopolitical “back to work” trade but the cyber rebound is now significant enough to warrant closing this trade.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Trump’s policy toward Russia is an excellent example of geopolitical constraints. Despite any personal preferences in favor of closer ties with Russia, Trump and his administration ultimately reaffirmed Article 5 of NATO, authorized the sale of lethal weapons to Ukraine, and deployed US troops to Poland and the Czech Republic. 2 As just one example, given the controversial and contested US election of 2020, it is possible that a major terrorist attack could occur. Neither wing of America’s ideological fringes has a monopoly on fanaticism and violence. Meanwhile foreign powers stand to benefit from US civil strife. A truly disruptive sequence of events in the US in the coming years could lead to greater political instability in the US and a period in which global powers would be able to do what they want without having to deal with Biden’s attempt to regroup with Europe and restore some semblance of a global police force. The US would fall behind in foreign affairs, leaving power vacuums in various regions that would see new sources of political and geopolitical risk crop up. Then the US would struggle to catch up, with another set of destabilizing consequences.

Highlights US labor-market disappointments notwithstanding, the global recovery being propelled by real GDP growth in the world's major economies is on track to be the strongest in 80 years. This growth will fuel commodity demand, which increasingly confronts tighter supply.  Higher commodity prices will ensue, and feed through to realized and expected inflation.  Manufacturers will continue to see higher input and output prices. Our modeling suggests the USD will weaken to end-2023; however, most of the move already has occurred.  Real US rates will remain subdued, as the Fed looks through PCE inflation rates above its 2% target and continues to focus on its full-employment mandate (Chart of the Week). Given these supportive inflation fundamentals, we remain long gold with a price target of $2,000/oz for this year.  We are upgrading silver to a strategic position, expecting a $30/oz price by year-end.  We remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to steepen backwardations in forward curves, and long the Global Metals & Mining Producers ETF (PICK). Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. Feature The recovery of the global economy catalyzed by massive monetary accommodation and fiscal stimulus is on track to be the strongest in the past 80 years, according to the World Bank.1 The Bank revised its growth expectation for real GDP this year sharply higher – to 5.6% from its January estimate of 4.1%. For 2022, the rate of global real GDP growth is expected to slow to 4.3%, which is still significantly higher than the average 3% growth of 2018-19. DM economies are expected to grow at a 4% rate this year – double the average 2018-19 rate – while EM growth is expected to come in at 6% this year vs a 4.2% average for 2018-19. The big drivers of growth this year will be China, where the Bank expects an unleashing of pent-up demand to push real GDP up by 8.5%, and the US, where massive fiscal and monetary support will lift real GDP 6.8%. The Bank expects other DM economies will contribute to this growth, as well. Growth in EM economies will be supported by stronger demand and higher commodity prices, in the Bank's forecast. Commodity demand is recovering faster than commodity supply in the wake of this big-economy GDP recovery. As a result, manufacturers globally are seeing significant increases in input and output prices (Chart 2). Chart of the WeekUS Real Rates Continue To Languish Chart 2Global Manufacturers' Prices Moving Higher These price increases at the manufacturing level reflect the higher-price environment in global commodity markets, particularly in industrial commodities – i.e., bulks like iron ore and steel; base metals like copper and aluminum; and oil prices, which touch most processes involved in getting materials out of the ground and into factories before they make their way to consumers, who then drive to stores to pick up goods or have them delivered. Chart 3Commodity Price Increases Reflected in CPI Inflation Expectations These price pressures are being picked up in 5y5y CPI swaps markets, which are cointegrated with commodity prices (Chart 3). This also is showing up in shorter-tenor inflation gauges – monthly CPI and 2y CPI swaps. Oil prices, in particular, will be critical to the evolution of 5-year/5-year (5y5y) CPI swap rates, which are closely followed by fixed-income markets (Chart 4). Chart 4Oil Prices Are Key To 5Y5Y CPI Swap Rates Higher Gold Prices Expected CPI inflation expectations drive 5-year and 10-year real rates, which are important explanatory variables for gold prices (Chart 5).2 In addition, the massive monetary and fiscal policy out of the US also is driving expectations for a lower USD: Currency debasement fears are higher than they otherwise would be, given all the liquidity and stimulus sloshing around global markets, which also is bullish for gold (Chart 6). Chart 5Weaker Real Rates Bullish For Gold Chart 6Weaker USD Supports Gold All of these effects, particularly the inflationary impacts, are summarized in our fair-value gold model (Chart 7). At the beginning of 2021, our fair-value gold model indicated price would be closer to $2,005/oz, which was well above the actual gold price in January. Gold prices have remained below the fair value model since the beginning of 2021. The model explains gold prices using real rates, TWIB, US CPI and global economic policy uncertainty. Based on our modeling, we expect these variables to continue to be supportive of gold, bolstering our view the yellow metal will reach $2000/ oz this year. Unlike industrial commodities, gold prices are sensitive to speculative positioning and technical indicators. Our gold composite indicator shows that gold prices may be reflecting bullish sentiment. This sentiment likely reflects increasing inflation expectations, which we use as an explanatory variable for gold prices. The fact that gold is moving higher on sentiment is corroborated by the latest data point from Marketvane’s gold bullish consensus, which reported 72% of the traders expect prices to rise further (Chart 8). Chart 7BCAs Gold Fair-Value Model Supports 00/oz View Chart 8Sentiment Supports Oil Prices Investment Implications The massive monetary and fiscal stimulus that saw the global economy through the worst of the economic devastation of the COVID-19 pandemic is now bubbling through the real economy, and will, if the World Bank's assessment proves out, result in the strongest real GDP growth in 80 years. Liquidity remains abundant and interest rates – real and nominal – remain low. In its latest Global Economic Prospects, the Bank notes, " The literature generally suggests that monetary easing, both conventional and unconventional, typically boosts aggregate demand and inflation with a lag of 1-3 years …" The evidence for this is stronger for DM economies than EM; however, as the experience in China shows, scale matters. If the Bank's assessment is correct, the inflationary impulse from this stimulus should be apparent now – and it is – and will endure for another year or two. This stimulus has catalyzed organic growth and will continue to do so for years, particularly in economies pouring massive resources into renewable-energy generation and the infrastructure required to support it, a topic we have been writing about for some time.3 We remain long gold with a price target of $2,000/oz for this year. We are long silver on a tactical basis, but given our growth expectations, are upgrading this to a strategic position, expecting a $30/oz price by year-end. As we have noted in the past, silver is sensitive to all of the financial factors we consider when assessing gold markets, and it has a strong industrial component that accounts for more than half of its demand.4 Supportive fundamentals remain in place, with total supply (mine output and recycling) falling, demand rising and balances tightening (Chart 9). Worth noting is silver's supply is constrained because of underinvestment in copper production at the mine level, where silver is a by-product. On the demand side, continued recovery of industrial and consumer demand will keep silver prices well supported. In terms of broad commodity exposure, we remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to continue to draw down inventories – particularly in energy and metals markets – which will lead to steeper backwardations in forward curves. Backwardation is the source of roll-yields for long commodity index investments. Investors initially have a long exposure in deferred commodity futures contracts, which are then liquidated and re-established when these contracts become more prompt (i.e., closer to delivery). If the futures' forward curves are backwardated, investors essentially are buying the deferred contracts at a lower price than the price at which the position likely is liquidated. We also remain long the Global Metals & Mining Producers ETF (PICK), an equity vehicle that spans miners and traders; the longer discounting horizon of equity markets suits our view on metals. Chart 9Upgrading Silver To Strategic Position Chart 10Wider Vaccine Distribution Will Support Gold Demand Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. We expect the wider distribution of vaccines will become increasingly apparent during 2H21 and in 2022. This will be bullish for physical gold demand – particularly in China and India – which will add support for our gold position (Chart 10).       Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The US EIA expects Brent crude oil prices to fall to $60/bbl next year, given its call higher production from OPEC 2.0 and the US shales will outpace demand growth. The EIA expects global oil demand will average just under 98mm this year, or 5.4mm b/d above 2020 levels. For next year, the EIA is forecasting demand will grow 3.6mm b/d, averaging 101.3mm b/d. This is slightly less than the demand growth we expect next year – 101.65mm b/d. We are expecting 2022 Brent prices to average $73/bbl, and $78/bbl in 2023. We will be updating our oil balances and price forecasts in next week's publication. Base Metals: Bullish Pedro Castillo, the socialist candidate in Peru's presidential election, held on to a razor-thin lead in balloting as we went to press. Markets have been focused on the outcome of this election, as Castillo has campaigned on increasing taxes and royalties for mining companies operating in Peru, which accounts for ~10% of global copper production. The election results are likely to be contested by opposition candidate rival Keiko Fujimori, who has made unsubstantiated claims of fraud, according to reuters.com. Copper prices traded on either side of $4.50/lb on the CME/COMEX market as the election drama was unfolding (Chart 11). Precious Metals: Bullish As economies around the world reopen and growth rebounds, car manufacturing will revive. Stricter emissions regulations mean the demand for autocatalysts – hence platinum and palladium – will rise with the recovery in automobile production. Platinum is also used in the production of green hydrogen, making it an important metal for the shift to renewable energy. On the supply side, most platinum shafts in South Africa are back to pre-COVID-19 levels, according to Johnson Matthey, the metals refiner. As a result, supply from the world’s largest platinum producer will rebound by 40%, resulting in a surplus. South Africa accounts for ~ 70% of global platinum supply. The fact that an overwhelming majority of platinum comes from a nation which has had periodic electricity outages – the most recent one occurring a little more than a week ago – could pose a supply-side risk to this metal. This could introduce upside volatility to prices (Chart 12). Ags/Softs: Neutral As of 6 June, 90% of the US corn crop had emerged vs a five-year average of 82%; 72% of the crop was reported to be in good to excellent condition vs 75% at this time last year. Chart 11 Chart 12 Footnotes 1     Please see World Bank's Global Economic Prospects update, published June 8, 2021. 2     In fact, US Treasury Inflation-Indexed securities include the CPI-U as a factor in yield determination.  3    For our latest installment of this epic evolution, please see A Perfect Energy Storm On The Way, which we published last week.  It is available at ces.bcareserch.com. 4    Please see Higher Inflation Expectations Battle Lower Risk Premia In Gold Markets, which we published February 4, 2021. It is available at ces.bcareserch.com.     Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Bond Market Performance: Government bonds in the developed economies are currently trapped in ranges, consolidating the sharp upward moves seen in the first quarter of 2021. This is only a pause in the broader cyclical uptrend, however, with central banks under increasing pressure to turn less dovish amid surging inflation and tightening labor markets. Oversold USTs: Technical indicators of yield/price momentum and investor sentiment/positioning suggest that US Treasuries are oversold. Working off this condition can take another 2-3 months, based on an analysis of past oversold episodes. Beyond that, higher yields loom with the Fed starting to prepare the markets for a taper in 2022. Stay underweight Treasuries in global bond portfolios on a cyclical basis. RBA Checklist: Only one of the five components of our “RBA Checklist” – designed to measure the pressures that would force the Reserve Bank of Australia to turn less dovish – is flashing such a signal. We are upgrading our recommended allocation for Australian government bonds to overweight on a tactical (0-6 months) investment horizon. Feature Dear Client, Next week, in lieu of our regularly weekly report, I will be hosting a webcast on Tuesday, June 15 where I will discuss the outlook for global fixed income markets in the second half of 2021. Following that, we will be jointly publishing our bi-annual Global Central Bank Monitor Chartbook with our colleagues at BCA Research Foreign Exchange Strategy on Friday, June 18th. We will return to our regular publishing schedule on Tuesday, June 29th. Best Regards, Rob Robis Chart of the WeekA Tale Of Two Quarters The performance of government bond markets in the developed world so far in 2021 has been a tale of two quarters. In Q1, yields were rising steadily on the back of upside surprises in global growth and emerging signs of the biggest inflation upturn seen in nearly a generation. The Bloomberg Barclays Global Treasury index delivered a total return of -2.7% (hedged into US dollars) during the quarter, with no country escaping losses (Chart of the Week). The biggest declines were seen in the UK (-7.5%) the US (-4.3%), with the smallest losses occurring in Japan (-0.3%) and Italy (-0.7%). Chart 2Lower Vol Means High Yielders Outperform Low Yielders Q2 has been a different story, however. Yields have retreated somewhat from the year-to-date peaks seen at the end of Q1, leading to positive returns so far in Q2 in the UK (+0.8), the US (+1.2%) and Australia (+1.1%). The laggards are the low yielding euro area markets, most notably Italy (-0.7%) and France (-0.9%), that have seen yields move higher on the back of accelerating European growth. The Q2 returns look very much like a carry-driven market, with higher-yielding markets outperforming lower-yielding ones. That trend can persist if the current backdrop of low market volatility persists (Chart 2), although this calm will eventually be broken by a shift towards less dovish monetary policies. Some countries will make that shift at a faster pace than others, leading to relative value opportunities for bond investors in the latter half of 2021. This week, we discuss one such opportunity – Australia versus the US. US Treasuries: Oversold & Trendless – For Now After reaching a 2021 intraday high of 1.77% back on March 30, the benchmark 10-year US Treasury yield has traded in a narrow 15bp range between 1.55% and 1.70%. From a fundamental perspective, US yields are lacking direction because inflation expectations have already made a major upward adjustment to the more inflationary backdrop, but real yields have remained depressed by the continued dovish messaging from the Fed – for now - with regards to the timing of tapering or future rate hikes. From a technical perspective, however, the sideways pattern for US Treasury yields is also consistent for a market that trying to work off an oversold condition. Most of the technical indicators for the US Treasury market that we monitor regularly were at or close to the most bearish/oversold extremes seen since 2000 (Chart 3): Chart 3US Treasuries Are Working Off An Oversold Condition The 10-year Treasury yield is 39bps above its 200-day moving average, but that gap was as high as 84bps on March 19; The 26-week total return of the 10-year Treasury is -4.7%, after reaching a low of -8.8% on March 19; The JP Morgan client survey of bond managers and traders shows some of the largest underweight duration positioning in the 19-year history of the series; The Market Vane index of sentiment for Treasuries is in the bottom half of the range that has prevailed since 2000; The CFTC data on positioning in 10-year Treasury futures is the only one of our indicators that is not signaling an oversold market, with a small net long position of +3% (scaled by open interest). The overall message of these indicators suggests that price momentum and positioning reached such a bearish extreme by mid-March that some pullback in Treasury yields was inevitable. However, a look back at past periods when Treasuries became heavily oversold since the turn of the century shows that the duration and magnitude of such a pullback is highly variable – anywhere from two months to ten months. The main determining factors are the trends in economic growth and inflation in the US, and the Fed’s expected policy response to both. To show this, we conducted a simple study, updating work we first presented in a 2018 report.1 We looked at “oversold episodes” since 2000, which began when the 10-year Treasury yield was trading at least 50bps above its 200-day moving average. We then defined the end of the oversold episode as simply the point when the 10-year Treasury yield subsequently converged back to its 200-day moving average. We then looked at the length of the episode (in days), and the change in bond yields, for each oversold episode. There were nine such episodes since the year 2000, not counting the current one which has not yet ended. In Table 1, we rank the episodes by the number of days it took to complete each one, based on our simple moving average rule. We also show the change in both the 10-year Treasury yield and its 200-day moving average during each episode, to show how the convergence between the two unfolds. Table 1A Look At Prior Episodes Of An Oversold Treasury Market To describe the US economic backdrop during each episode, we looked at the change in the ISM manufacturing index and core PCE inflation during those oversold periods. We also show changes in two important determinants of the level of Treasury yields: inflation expectations using 10-year TIPS breakeven rates, and Fed rate hike expectations using our 12-month Fed discounter which measures the expected change in interest rates - one year ahead - priced into the US overnight index swap (OIS) curve. At the bottom of the table, we show the average for all nine oversold episodes, as well as the averages for the episodes were the ISM was rising and where core PCE inflation was rising. Chart 4US Treasury Market Oversold Episodes: 2003-2007 There are a few messages gleaned from the results in Table 1: The longest correction of an oversold Treasury market since 2000 took place between February 2018 and December 2018, when 305 days passed before the 10-year yield fell back to its 200-day moving average; The shortest correction was between June 2007 and August 2007, where only 52 days elapsed; Treasury yields typically decline during oversold periods, with two notable exceptions: 2018 and 2013/14, which were also the two longest episodes; During all of the oversold periods, markets reduced the amount of expected Fed tightening by an average of 26bps. However, that was entirely concentrated in four of the nine episodes - including three of the four shortest episodes – and is typically associated with a decline in inflation expectations. Growth momentum appears to be a bigger factor than inflation momentum in determining the length of an oversold episode, with longer episodes typically occurring alongside a rising ISM index, and vice versa. The notable exception was the longest episode in 2018, where the ISM declined by six points, although the bulk of that decline occurred in a single month at the end of the period (November 2018). For the more visually oriented, we present the time series for all the data in Table 1, shaded for the oversold periods, in Chart 4 (for the 2003-2007 period), Chart 5 (2008-2012), Chart 6 (2013-2017) and Chart 7 (2018 to today). We’ve added one additional variable – our Fed Monitor, designed to signal the need for tighter or looser US monetary policy – in the bottom panel of each of those charts. Chart 5US Treasury Market Oversold Episodes: 2008-2012 Chart 6US Treasury Market Oversold Episodes: 2013-2017 Chart 7US Treasury Market Oversold Episodes: 2018 To Today What does this look back tell us about looking ahead? The current episode, at only 105 days old, is still 62 days “younger” than the average oversold period, and 76 days “younger” than the average period where core inflation was rising. This would put the end of the current episode sometime in August. The ISM is essentially unchanged over the current episode so far, making it difficult to draw conclusions based on growth momentum – although the longest episode in 2018 shows that yields can trade sideways for a long time, even in the absence of a big slowing of growth, if the Fed is in a rate hiking cycle. However, the current episode differs dramatically from others in this analysis on two critical fronts. Core inflation has surged 1.6 percentage points since the oversold period began in February, far more than any other episode, while the gap between a rapidly increasing Fed Monitor and a flat 12-month Fed Discounter is also unique among post-2000 oversold periods. In other words, the Treasury market is still vulnerable to a repricing of Fed tightening expectations, especially with positioning and sentiment measures like the Market Vane survey and net futures positioning not yet at fully bearish extremes. Bottom Line: The current oversold condition in the US Treasury market can take another 2-3 months to unwind, based on an analysis of past oversold episodes. Beyond that, higher yields loom with the Fed starting to prepare the markets for a taper in 2022. Stay underweight Treasuries in global bond portfolios on a cyclical basis. RBA Checklist Update: No Case For A Hawkish Turn Yet Australia has been one of the top performing government bond markets within the developed economies, as discussed earlier. This performance has occurred even with strong acceleration of both Australian economic momentum and market-based inflation expectations (Chart 8). Despite our RBA Monitor flashing pressure on the RBA to tighten, and the Australian OIS curve already discounting 48bps of rate hikes over the next two years, Australian bond yields have remained very well behaved during the “calm” second quarter for global fixed income. Chart 8RBA Policies Limiting Rise In Bond Yields Chart 9RBA Stimulus Takes Many Forms The continued dovish messaging from the Reserve Bank of Australia (RBA) is the main reason for the solid Australia bond performance. The central bank is signaling no imminent shift in its combination of 0.1% nominal policy rates, deeply negative real rates, yield curve control on 3-year bonds and quantitative easing on longer-maturity bonds (Chart 9). Other central banks are starting to inch towards reining in the massive monetary accommodation of the past year. Could the RBA be next? In a Special Report published back in January of this year, we outlined a list of variables to watch to determine when the Reserve Bank of Australia (RBA) could be expected to turn less dovish.2 This checklist would also inform our country allocation view on Australian government bonds, which has remained neutral. A quick update on the latest readings from the RBA Checklist shows little pressure on the RBA to begin preparing markets for tighter monetary policy. 1. The vaccination process goes quickly and smoothly We are NOT placing a checkmark next to this part of our RBA Checklist. Australia has weathered COVID-19 far better than most other Western countries in terms of actual cases and deaths, but the vaccine rollout Down Under has been underwhelming. Only 16% of the population has received at least one vaccine jab, while a mere 2% is fully vaccinated. These are numbers that are more comparable to pandemic-ravaged emerging market countries like India and Brazil where access to vaccines is an issue (Chart 10). Chart 10A Slow Vaccine Rollout Down Under The slow vaccine rollout is less worrisome in light of the Australian government having secured enough vaccine doses to inoculate the entire population, and with the domestic economy facing limited remaining COVID-19 restrictions. The issue has been distribution and that is now occurring at a quickening pace. Until a much greater share of the population is vaccinated, however, Australia will continue to maintain aggressive COVID-related international travel restrictions – the government just announced that borders will remain shut until mid-2022 - that will be a major drag on the economically-important tourism sector. 2. Private sector demand accelerates alongside fiscal stimulus (✔) We ARE placing a checkmark next to this part of our RBA Checklist. Australia’s fiscal stimulus in response to the pandemic was one of the largest in the developed world. The stimulus was heavily focused on wage subsidies and income support measures like the JobSeeker program, which expired back in March. As the expensive stimulus programs are unwound, it is critical that the domestic economy can stand on its own without support. On that front, the news is good. Australia’s economy grew by 1.8% during Q1/2021, lifting the level of real GDP above the pre-pandemic peak (Chart 11). Both consumer spending and business investment posted solid growth during the quarter, fueled by surging confidence with the NAB business outlook measure hitting a record high in May (bottom panel). As a sign that the domestic economy is benefitting from a return to pre-pandemic habits, Q1 saw a 15% increase in spending in hotels, cafes and restaurants. That strength looked to extend into the Q2, with retail sales rising 1.1% in April, suggesting that Australian domestic demand is enjoying strong upward momentum. Chart 11A Confidence-Led Recovery In Domestic Demand Chart 12China Is A Drag On Australian Exports 3. China reins in policy stimulus by less than expected We are NOT placing a checkmark next to this part of our RBA Checklist. China is by far Australia’s largest trading partner, so Chinese demand is always an important contributor to Australian economic growth. This is why we included a China element in our RBA Checklist. Specifically, we deemed the outcome that would potentially turn the RBA more hawkish would be Chinese policymakers pulling back monetary and fiscal stimulus by less than expected in 2021 after the big policy support in 2020. The combined fiscal and credit impulse for China has already slowed by 9% of GDP since December 2020, signaling a meaningful cooling of Chinese growth in the latter half of 2021 that should weigh on demand for imports from Australia (Chart 12). However, Chinese import demand has already been severely impacted because of worsening China-Australia political tensions, which has led Beijing to impose restrictions on Australian imports for a variety of products, include coal, wine, beef, barley and cotton. The result is that there has been no growth in Australian total exports to China over the past year – an outcome that was flattered by the surge in iron ore prices - which has weighed on overall Australian export growth. Given this weak starting point for Chinese demand for Australian goods, the sharp reduction in the China stimulus is, on the margin, a factor that will not force the RBA to turn less dovish sooner than expected. 4. Inflation, both realized and expected, returns to the RBA’s 2-3% target We are NOT placing a checkmark next to this part of our RBA Checklist. Australian inflation remains well below the RBA’s 2-3% target range, with the headline CPI and the less volatile trimmed mean CPI both expanding at only a 1.1% annual rate in Q1/2021 (Chart 13). The RBA is forecasting a brief boost to both measures in Q2, before settling back below 2% to the end of 2022. Chart 13No Bond-Bearish RBA Policy Shift Without More Inflation Chart 14Diminishing Financial Stability Risks From Housing The RBA’s message on the inflation outlook has been very consistent. A sustainable move of realized inflation back to the 2-3% target range – that would prompt a normalization of monetary policy – cannot occur without a significant tightening of labor markets that drives wage growth back to 3% from the Q1/2021 reading of 1.5%. The RBA currently does not expect that outcome to occur before 2024. The RBA believes that the full employment NAIRU is between 4-4.5%, well below the OECD’s latest estimate of 5.4%. Given the sharp drop in Australian unemployment already seen over the past few quarters, there is the potential for an upside surprise in the wage data that could lead the RBA to change its policy bias. The central bank would need to see a few quarters of such wage surprises, however, before altering its forward guidance on the timing of future rate hikes. 5. House price inflation begins to accelerate We are NOT placing a checkmark next to this part of our RBA Checklist. Given Australia’s past history with periods of surging home values, signs that housing markets were overheating could prompt the RBA to consider tighten monetary policy. The annual growth of median house prices has dipped from +8% in Q1 2020 to +4% in Q4 2020, despite robust housing demand as evidenced by the 40% growth in building approvals. At the same time, housing valuations have become less stretched with the ratio of median home prices to median household incomes falling -9% from the 2017 peak according to data from the OECD (Chart 14). The RBA remains sensitive to the potential financial stability risks from overvalued housing. The latest trends in the house price data, however, suggest that the central bank does not yet to have the use the blunt tool of tighter monetary policy to cool off an overheated housing market. Chart 15Upgrade Australia To Overweight (Vs. USTs) In sum, the majority of items in our RBA Checklist are signaling no immediate pressure on the central bank to tighten policy. The first 25bp rate hike is not discounted in the Australian OIS curve until April 2023, a little ahead of RBA guidance but still consistent with a very dovish policy bias. The inflation data, in our view, will be the critical factor that could prompt the markets to pull forward expected monetary tightening, leading to a surge in Australian bond yields. With the RBA already expecting a surge in inflation in the Q2/2020 data, the central bank would likely want to see at least a couple of more quarterly inflation prints – both for the CPI and wage price index - before signaling a more hawkish policy shift. Thus, the RBA will likely stay dovish over the latter half of 2021 Therefore, we are moving to an overweight recommended stance on Australian government bonds on a tactical (0-6 months) basis. In our model bond portfolio on pages 16-17, we are “funding” that shift to an above-benchmark weighting in Australia out of US Treasury exposure. Given our view that the Fed will soon begin to signal a 2022 taper of its asset purchases, relative policy dovishness should lead Australian government bonds to outperform US Treasuries in the latter half of this year. In addition, Australian bonds have a lower yield beta to changes in US Treasury yields, relative to the high beta to changes in non-US developed market yields (Chart 15), making allocations out of the US into Australia attractive from a risk management perspective in a global bond portfolio. Bottom Line: Only one of the five components of our “RBA Checklist” – designed to measure the pressures that would force the Reserve Bank of Australia to turn less dovish – is flashing such a signal. We are upgrading our recommended allocation to Australian government bonds to overweight on a tactical investment horizon.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 See BCA Research Global Fixed Income Strategy Report, "Bond Markets Are Suffering Withdrawal Symptoms", dated March 20, 2018. 2 See BCA Research Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Australia: Regime Change For Bond Yields & The Currency?", dated January 20, 2021. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Economy – Following a recession like no other, American households are flush with cash: Since COVID-19 broke out last March, real disposable income has grown at its fastest 14-month rate ever, the S&P 500 is 24% above its pre-pandemic peak and home prices are up 14%. With social distancing measures hindering consumption as income rose, savings have exploded. Markets – If the cash is spent in line with economists’ expectations, corporate profits should have little trouble topping undemanding targets: The bottom-up consensus forecast for nominal earnings contraction over the rest of the year is incompatible with real GDP growth forecasts of nearly 7%. Strategy – Stick with equities unless the Fed changes its tune: Multiple contraction looms as the main threat to equities over the next twelve months, and a shift in Fed policy is the most likely de-rating catalyst. As long as Powell and company stay the course, we will too. Feature BCA researchers’ mission is simple. We analyze the world’s major economies for insight into where financial markets are headed. On the US Investment Strategy team, we primarily use the US economy to anticipate the future direction of US equity and bond markets. Our market take drives our investment strategy views and asset allocation recommendations. With this Strategy Report, we are tweaking the format of our written output to align more clearly with our mission. We will highlight the most relevant economic takeaways and link them to expected market outcomes, with our strategy recommendations following from the forecasted outcomes. To provide more detail than US Investment Strategy’s legacy overweight/equal weight/underweight asset allocation recommendations, we will add a multi-asset ETF portfolio linking our cyclical views to specific ticker symbols. We are at work on our cyclical portfolio and will unveil it sometime over the next month. One Fantastic Recession If a visitor from space had touched down at the beginning of 2020 and spent the subsequent seventeen months boarding in an American household, he/she/they might ask why recessions have gotten such a bad rap. Savings piled up as fiscal transfers swelled household income while social distancing measures curtailed spending. Wealth got an additional boost from surging stock and bond markets and a potent rally in home prices. Put it all together, and households are on much firmer footing today than they were when the pandemic began to assert itself last March. As a first-time visitor, the space traveler may not appreciate that the pandemic recession was sui generis thanks to the unprecedented policy measures undertaken to limit its damage. For the first time in 51 years (seven recessions ago), the rate of nominal disposable income growth accelerated during a recession (Chart 1). In real terms, the pandemic period has been the best fourteen-month stretch for disposable income growth in the 70-year history of the series, reaching a level three standard deviations above the mean (Chart 2). Lavish fiscal transfers in the form of direct payments to over three-quarters of all households (Chart 3, top panel) and supplemental benefits to the unemployed (Chart 3, middle panel) cushioned the blow that would typically result from economic contraction and soaring unemployment. Chart 1Uncharacteristic Growth In Nominal Income ... Chart 2... And Unprecedented Growth In Real Income Chart 3No Adult Left Behind So far, the consequence of the policy measures has been to limit the decline in output (real 4Q20 GDP was 2.4% below its 4Q19 level, or about 4.4% below trend) and stave off a self-reinforcing wave of defaults that would have limited credit availability and hampered future growth. Going forward, the potential for households to spend some of the $2.3 trillion mountain of excess savings they’ve accumulated since March 2020 (Table 1) should turbo-charge growth across the rest of the year and keep it well above trend in 2022. Excess pandemic savings will be the primary spending driver, but equity gains (Chart 4, top panel) and home price appreciation (Chart 4, bottom panel) will help at the margin. All in all, savings and increases in financial asset and real property prices have driven an unprecedentedly rapid increase in household net worth as a share of GDP (Chart 5), feeding a remarkable buildup of dry powder to support a surge in consumption. Table 1A Great Recession For Household Savings ... Chart 4The Recession That Was Good For Asset Prices Chart 5The Pandemic Recession Did Wonders For Households' Relative Standing What Does GDP Growth Have To Do With Equity Returns? There’s a good reason why Treasury investors pay much more attention to GDP releases than equity analysts and PMs: S&P 500 returns have no near-term relationship with GDP moves. Corporate revenue growth ought to converge with the economy’s nominal growth rate over time, however, so future GDP moves could inform the future direction of S&P 500 earnings. With all the fuel households have stored up for consumption once the economy fully reopens, consensus forecasts are calling for blockbuster growth over the final three quarters of the year and solidly above-trend growth in 2022 (Table 2). Though BCA does not make economic point forecasts, we concur with the direction and magnitude of the consensus view. The top-down forecast of red-hot economic growth is seemingly incompatible with bottom-up analysts’ consensus forecast of a decline in the run rate of S&P 500 earnings. With 495 constituents having reported, calendar first quarter S&P 500 earnings are projected to come in at $49 per share. Absent seasonal adjustments, $49 equates to an annualized run rate of $196 per share. Analysts are calling for a nearly 10% sequential decline in earnings in the second quarter, to $44.49, third quarter earnings that fall about 4% shy of their first quarter level, and meager 1% and 2% increases over 1Q21 in 4Q21 and 1Q22, respectively (Table 3). Table 2Economists Predict Explosive GDP Growth ... Table 3... But Analysts Foresee Declining Earnings ...   The key takeaway is that analysts expect the sum of the next four quarters of S&P 500 earnings to fall short of the first quarter’s annualized run rate. That is an unusual development in a series that has averaged double-digit expected forward growth over its 42-year life and had previously only called for earnings to shrink on three instances during the Carter Administration (Chart 6). We are in accord with widely held expectations that the economy’s sequential growth rate will peak in the second quarter and fully expect that sequential earnings growth will decelerate from the last three quarters’ torrid pace. Outright contraction, however, strikes us as highly unlikely when the economy is growing at the fastest sustained rate we expect to see over the rest of our lifetime. Chart 6... For The First Time In Four Decades Investment Strategy We view equity prices as the product of expected earnings and the multiple investors will pay for those earnings. Holding the index price-earnings (P/E) multiple constant, the S&P 500 will rise if earnings beat expectations and that beat feeds into upward revisions in future estimates or fall if they disappoint, leading to downward revisions. We expect that the S&P’s constituents will beat current expectations over the next four quarters, which simply require them to run in place. Earnings growth should not be too hard to come by when the economy is expected to expand at a 7% pace – three-and-a-half times its trend rate of growth – over the rest of 2021. That leaves the multiple investors are willing to pay for those future earnings as the swing factor. If earnings are the stolid fundamental component of equity investing, P/E multiples are the animal-spirits wild card. The current 22 multiple is expensive relative to history and potential de-rating is the biggest risk confronting equity investors (Chart 7). Chart 7Equity Multiples Are Elevated The key question is what will trigger a de-rating and when. We expect that monetary policy tightening will be the most likely catalyst and are therefore keeping a close eye on the Fed as we formulate our strategy. Our US Bond Strategy colleagues have stressed that the Fed will not hike rates until all three of its criteria (Table 4) are met. With the economy seemingly much closer to checking the inflation boxes, “maximum employment” is poised to be the final hurdle standing in the way of rate hikes. Table 4A Checklist For Liftoff We did not view the May employment situation report, released before Friday’s open, as materially changing the timeframe for attaining maximum employment. Though bond, currency and equity markets saw the approximate 100,000 March-May payrolls miss as a cue to reprice their Fed assumptions, the report fit the broad contours that we expect to remain in place over the next year: the labor market will revive as the services sector fully reopens and the restoration of child care and elder care services free those sidelined by family obligations to return to work. There are still more than 7.5 million fewer people working than there were before the pandemic (Chart 8). If payrolls expand at an average monthly clip of 500 to 750 thousand, employment progress will support tapering in the winter of 2021-22 and an initial rate hike before the end of 2022. Chart 8Still 7.6 Million People To Re-employ We do not see the sure-to-be-well-telegraphed tapering of the Fed’s asset purchases as posing a threat to equity multiples. Our first-hike-in-2022 timetable is ahead of the market’s but we do not expect meaningful de-rating over the next twelve months while investors of every stripe are stuffed with cash. If the rate-hike timetable accelerates because of unexpectedly strong growth, S&P 500 earnings estimates will have to rise to reflect it. We would expect that “numerator effect” to fully offset increases in the discount rate denominator used to the calculate the present value of expected future cash flows, as periods of rising real rates have typically been associated with better equity performance than periods of falling real rates.1 Equities would be in trouble if rates were to take off because of runaway inflation expectations rather than rising real growth. In that scenario, the future-cash-flows numerator would not be able to keep up with the rising-discount-rate denominator and it could even fall outright as profit margins were squeezed. We are continuously monitoring our inflation checklist and are vigilant for signs of enduring inflation pressures. The bottom line is that the potential emergence of inflation pressures, and the Fed’s reaction to them, are the biggest imminent threat to forward earnings multiples and equity performance. As long as the inflation coast is clear and the Fed is able to stand pat, abiding by last summer’s revised statement of long-run policy goals, we will stick with our equity overweight. Postcard From The High Street The Harry Potter store filling 20,000 square feet of retail space between Broadway and Fifth Avenue just below 22nd Street had its grand opening on Thursday. The Peta children’s attempt to visit the store on its first day came to no avail, however, as they encountered late-afternoon switchback lines around the building. Scattered showers were not enough to dampen would-be shoppers’ enthusiasm, some of whom claimed to have been waiting for six hours.2 The event highlighted two themes from last week’s Special Report: brick-and-mortar retail has not yet given up the ghost and the post-COVID period in the United States, marked by a desire to congregate, celebrate and spend, appears to have arrived. The near-term growth implications are favorable. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see US Investment Strategy Special Report "When Will Higher Rates Hurt Stocks?" dated September 24, 2018, available at usis.bcaresearch.com 2 Harry Potter fans wait hours in the rain for NYC store opening (nypost.com)

Dear Client, In this special report we are pleased to introduce Ritika Mankar, the newest Strategist to join BCA Research and Geopolitical Strategy. Ritika hails from Mumbai where she has led a distinguished career as a director at Ambit, an institutional equity brokerage, leading one of the top macro research franchises in India. She is also a director on the board of CFA Society India. Going forward Ritika will oversee Geopolitical Strategy’s India and South Asia analysis. In this report Ritika argues that owing to both under-investment and under-employment, India’s growth engine is set to misfire in FY22. Investors should pare their exposure to Indian assets for now. I trust you will find the report insightful and will look forward to Ritika’s regular contributions, which will deepen our global coverage of market-relevant geopolitical trends and themes. Sincerely, Matt Gertken Geopolitical Strategist   Highlights Indian equities have outperformed emerging market equities decisively since March 2020. But a festering jobs problem in the informal sector and weak consumer confidence, will mean that both consumption and investment growth could disappoint in FY22. We recommend closing the Long Indian / Short Chinese Equities trade and the Long Indian Local Currency Bond / Short EM Bonds trade. We launch two new trades: Short India Banks and Long India Consumer Discretionary. Feature India has been the blue-eyed boy of the emerging market space since the dawn of the twenty-first century. Narratives about India have had a marked bullish tilt. To be fair, this optimism is justified most of the time for three very good reasons. Firstly, India’s geopolitical backdrop has improved. At home, the aftermath of the Great Recession saw the emergence of a new policy consensus consisting of nationalism and economic development. Indian policymakers recognize that if they undertake reforms to boost productivity then India has a chance of achieving a stronger strategic position in South Asia than military might alone can give it. Abroad, India is being courted by foreign powers and foreign investors. The United States has broken up the special relationship it maintained with China since the early 1970s. India stands to benefit from the West’s need now to counter-balance China. Secondly, India’s growth engine relies primarily on consumption as compared to more volatile components like net exports. Consumption makes up 56% of GDP. A consumption-powered economy that is young and not yet saturated with consumer goods, from washing machines to cars, deserves a premium. Growth in such an economy is likely to be far more predictable as compared to an export-driven economy that must contend with commodity price cycles, foreign business cycles, and de-globalization. Thirdly, India scores over other emerging markets as it offers political stability in a well-entrenched democratic framework. Despite having a low per capita income, India has a political system that is comparable to that of high-income developed countries. India’s head of state has been democratically elected since 1951 and the government at the centre has completed its full five-year term every time since 1999. More importantly, India’s institutions by design are “inclusive.”1 Institutions that provide checks and balances also deliver most of the time. So, unlike say in the case of China, Russia, Brazil, or even Turkey, India rarely gives an emerging market fund manager sleepless nights on account of politics or policy unpredictability. Whilst India deserves the premium it attracts most of the time, in this note we highlight that the market seems to be underpricing certain material risks that are building up in India. Distinct from the challenges created by COVID-19 (more on this later), India’s growth engine appears to be sputtering as two key faults develop: Under-investment: India has underinvested in capital creation for over a decade now. With government finances stretched, and with middling capacity utilization rates, investment growth in the short run is likely to stay compromised. Under-employment: India’s high GDP growth rate over the last few years has not been accompanied by an expansion in employment. Even before the pandemic, the Indian economy’s growth process had been asymmetric (or K-shaped) with the majority’s employment prospects worsening while a limited minority’s economic prospects were improving. This trend has become even more entrenched post-pandemic. Till India’s fast-compounding unemployment problem is solved, consumption growth in India will disappoint. And until then, only a select few upwardly mobile consumers of the service economy and business class will be supporting consumption growth in India. Both these dynamics will hurt India’s ability to grow its economy in the short term. These faults could force policymakers to take imprudent fiscal decisions to boost growth in the medium term too. Against this backdrop and with MSCI India trading at a 79% premium to EMs versus a two-year average of 57%, we reckon that the time is right for investors to scale down their exposure to segments of the Indian market where valuations look stretched. This report is divided into three segments: Segment 1: India’s GDP in FY22: Brace for disappointments Segment 2: COVID-19 in India: The road to normalcy will be long Segment 3: Investment conclusions India GDP In FY22: Brace For Disappointments Both the under-investment and the under-employment problem predate the COVID-19 crisis. Even as a degree of reflation kicks in as the second wave of COVID-19 infections abates, both these problems will act as a drag on India’s GDP growth in FY22. Investment Growth In India To Stay Constrained In FY22 The importance of investment in India is often underrated. Not only does gross fixed capital formation make up a third of India’s GDP each year, it also plays a critical role in driving consumption growth over the subsequent period (Chart 1). Occasional upcycles in investment are required to ensure that income growth remains robust, which in turn powers consumption growth. What is worrying is that India’s investment-to-GDP ratio had been trending downwards even before the onset of COVID-19 (Chart 2). This ratio in fact has been inching lower since the global financial crisis (GFC) from a peak of 36% to 29% in FY20. Unsurprisingly, investments have fallen further following the pandemic. The investment-to-GDP ratio fell to 27% in FY21 which is the lowest reading for this metric since the bursting of the dot-com bubble in 2001. Chart 1Consumption Growth Today, Is A Function Of Investments Made In The Past Chart 2India’s Investment To Gdp Ratio Has Been Trending Lower Since The GFC In addition, India’s investment-to-GDP ratio appears likely to stay constrained in FY22 as well. This is because the government sector and the private corporate sector (which together account for 62% of India’s investments) are unlikely to have the ability or incentive to expand capacity. Government “big push” is missing: The stock of capital in any country is created by the household sector, the private corporate sector, and the government sector. In India’s case, the government accounts for about 25% of capital formation on a cross-cycle basis. India’s government has consistently underinvested in growing its capital stock. For instance, the central government’s allocation towards capital expenditure has stayed range-bound between 1.5%-2.5% of GDP for over a decade now (see Chart 2). Hence India has not had the benefit of a big push from the government to create capital assets, such as the Four Asian Tigers undertook in the 1970-80s and China undertook in the 1990s. To be fair, the Union Budget for FY22 envisages an increase in capital expenditure to 2.5% of GDP from 2.2% of GDP last year. However, this increase is small, and we worry that the actual government spending on capital investments could well surprise to the downside. Moreover government revenues could get crimped owing to the second wave of COVID-19 in India. History suggests that government capital expenditure priorities are often set aside when India confronts a crisis. Following the GFC, the Indian central government expanded its fiscal deficit from 2.6% of GDP in FY08 to 6.1% of GDP in FY09. However, a breakdown of expenditure-side data suggests that this increase was mainly driven by higher revenue spends. Capital expenditure in fact was cut back from 2.4% of GDP in FY08 to 1.6% of GDP in FY09.   Private sector faces low demand: The private sector accounts for about 37% of capital formation on a cross-cycle basis. The private corporate sector is unlikely to want to fire up investments in FY22 as the demand scenario looks weak and capacity utilization rates in the economy are middling. Whilst specific sectors and companies are growing, consumer confidence in India on an economy-wide level remains low thereby pointing to a lackluster demand environment. The post-2020 revival in consumer confidence in India, surveys suggest, has been weaker than that experienced by developed and developing country peers (Chart 3). History suggests that upturns in the investment cycle are triggered when capacity utilization rates hover at 74% or more (Chart 4). Reserve Bank of India’s latest capacity utilization survey suggests that utilization rates were recorded at only 67% in 4Q 2020. So, with consumer confidence levels low and with capacity utilization rates not being high enough, an economy-wide upsurge in investment growth in India at this stage appears unlikely. Chart 3Consumer Confidence In India Is Yet To Return To Pre-2020 Levels Chart 4Capacity Utilization Rates In India Are Low And Hovering At Less Than 70% Levels ​​​​​​​Finally, the household sector accounts for about 38% of capital formation and is the only source of hope. Whilst the upper-income segment of India’s household sector may have the financial firepower to support investment growth, the lower income segment is unlikely to be able to drive investments in an environment of poor jobs growth. Large-Scale Unemployment Likely In India’s Unreported Underbelly Unlike most developing and developed countries, data on India’s monthly employment situation is not collected. But piecing together jobs data from a range of sources makes it clear that India’s job market is undergoing a meaningful squeeze. These job losses in India’s mid- and low-income groups will restrain consumption growth in India in FY22. GDP growth not translating into employment growth: The last pan-India employment survey was conducted in 2019. An analysis of these historical surveys suggests that India’s high GDP growth rate has not been translating into high employment growth in India for a while. The formal employment data could be understating the extent of unemployment in India and even the official unemployment rate has not fallen despite high GDP growth (Chart 5). Chart 5Even When Gdp Growth Is High, Unemployment Rates In India Remain Elevated Chart 6For Most Of India’s Population, Business Relevance Of Education And Digital Preparedness Is Poor Unless India’s manufacturing sector grows rapidly, the widening rift between India’s GDP growth rate and jobs growth rate could become a structural phenomenon. Whilst labor supply in India is large, only part of this can be absorbed into India’s fast-growing service sector, as the business relevance of education as well as the digital preparedness of India’s labor force is low (Chart 6).​​​​​​​   Job losses in the informal sector: According to the Centre for Monitoring Indian Economy (CMIE), a private firm, India’s unemployment rate was recorded at 11.9% as at June 1, 2021. Even before the second COVID-19 wave and related lockdowns began, this metric was recorded at an elevated level of 7.5% over Dec 2020 to Feb 2021. Most of the job losses that have occurred are likely to be concentrated in the informal or unorganized sector, which employs 80% of India’s workforce. Rural wage inflation collapse points to excess supply: The supply of labor in the informal sector has increased at a faster pace than demand as evinced by the slowdown in rural wage inflation in India from an average of 12% over 2008-19 to 5% over 2019. This dynamic has worsened amid the pandemic as rural wage inflation fell to 2% in 2021YTD. This is after a challenging 2020 when unorganized sector wages could have contracted by 22%, according to a study conducted by the International Labor Organization (ILO). Informal sector’s market share loss suggests demand may stay weak: The Indian economy over the last five years has been undergoing a rapid pace of formalization. This was triggered by government action including the “de-monetization” move in 2016 (which outlawed high denomination notes that were in circulation) and then the introduction of the goods and services tax regime in 2017 (which discourages businesses from working with informal, non-tax paying businesses). The trend of formalization was then cemented in the pre-pandemic years by the fact that the economic health of the informal sector’s consumer was worsening. The formal sector on the other hand caters to a relatively high-income consumer whose incomes/jobs grew at a steady clip. The pandemic expedited this trend of formal sector businesses gaining market share as access to finance from unorganized sources either dried up or became prohibitively expensive, thereby leading to another wave of causalities in the informal sector. Also, it is worth noting that formal sector businesses tend to be more efficient and need fewer hands to generate each unit of profit so even as this sector grows it needs fewer workers. This trend of formalization has been particularly true for the retail, financial, building materials and real estate sectors in India, where the informal sector has shrunk and left behind a trail of job losses. Bottom Line: India’s growth prospects in FY22 could disappoint. With government finances strained and private demand weak, investment growth in FY22 is likely to decelerate. Additionally, employment growth is likely to stay low, especially for informal workers, as the economy rapidly formalizes. Given that wage growth has not slowed down for the top income strata as much as for the bottom, it is this top income group’s consumption growth which is likely to support consumption in FY22. However, the bulk of household consumption will falter. The interplay of these forces will mean that the two prime drivers of India’s growth engine, consumption and investment, will stay constrained in the short run. In view of these factors, we highlight the risk of India’s GDP growth rate in FY22 undershooting the Indian central bank’s forecast of 10.5% by 200-350bps. Now it is tempting to think that even a 7.5% real GDP growth rate appears decent compared to peers. But it is critical to note that India’s headline GDP growth data in FY22 has an unusual padding built into it. Strong low base effect: Whilst emerging markets’ GDP growth contracted by 2.2% in 2020 as per IMF, India’s GDP contracted by 7.3%. So, the contraction experienced by India in 2021 was 3x times more than that experienced by peer countries. FY22 GDP comparison with FY21 makes growth appear high, when it is not: If India’s GDP growth rate in FY22 were to be recorded at 8%, then this would in fact imply no growth over the real GDP recorded in FY20. COVID-19 Effect: The Road To Economic Normalcy Will Be Long Whilst the second wave of the pandemic has peaked in India, the time required for this peak to turn into a trough could take longer than was the case last year. Furthermore, India’s slow vaccine roll-out (particularly in India’s large states) adds to the probability of a potential third wave. The Second Wave In India Was 3.6 Times Stronger Than First Chart 7Second COVID-19 Wave Was 3.6x Stronger The virus in the second wave has been far more virulent and necessitated another wave of lockdowns. In specific, the peak COVID-19 deaths during the second wave were recorded at 4,188 deaths per day (on a 7-day moving average basis), which is 3.6 times greater than the peak hit last year (Chart 7). Also, a range of sources2 suggest that actual daily deaths in India could be 1.5-2x the stated numbers. Given that this wave has been stronger, the journey to the trough too is likely to be longer and thus may need localized lockdowns to stay in place. Headline Vaccination Rates Hide Vast Regional Disparities Only 15% of India’s population has received at least one dose. Headline vaccination rates conceal the slow pace of vaccination underway in some of India’s largest states (Chart 8). For instance, less than 8% of the population has been given its first dose in India’s most populous state (i.e. Uttar Pradesh). Given that state borders are porous, persistently low vaccination rates in large states can allow the virus to spread and mutate. Chart 8India’s Largest States Are Lagging On Vaccinations Even today only 3% of India’s population has received both doses of vaccines. Even as the government plans to vaccinate all of India’s adult population by December 2021, this goalpost could have to be shifted to early 2022. A Loaded State Election Calendar Cometh In 2022 Looking into 2022, the state election calendar will get busier than it was this year. This could be a problem if vaccination rates are slow because elections involve large-scale rallies and gatherings. It is worth noting that: Five state elections that account for about 20% of India’s population were held in 2021. Elections will be due in seven states that account for about 25% of India’s population in 2022. To provide context, the population involved in state elections in India in 2021 was almost equivalent to that of a national election in Brazil. The states in India undergoing elections in 2022 have a population comparable to the United States. Besides involving a larger population, state elections due in 2022 will also have higher political stakes. This is mainly because in five of the seven states, the ruling Bharatiya Janata Party (BJP) is the incumbent party and will want to defend its status. This contrasts with the 2021 elections when the BJP was the incumbent in only one of the five states. In specific, India’s most populous state, Uttar Pradesh, is scheduled to undergo elections in February 2022. This is easily the most important state election in India and will be a high stakes four-cornered contest. Vaccine rates in this state are currently lagging the national average. Bottom Line: During the first wave, it took about five months for the trough to form after the peak in September 2020. The current wave has been significantly stronger (causing 4x more deaths) with vaccine rates too being low. Therefore, this wave may take longer than 5-6 months to subside. The long road to the trough in turn implies that the road to economic normalcy too may be slower than anticipated. Investment Takeaways Chart 9India's Outperformance Since March 2020 - Driven More By P/E Expansion, Less By Earnings The Indian stock market has outperformed relative to emerging markets (Chart 9). Given that we are increasingly worried about India’s growth capabilities, we will close our Long Indian / Short Chinese Equities trade for a gain of 11.7%. Tactically, excessive policy tightening remains a genuine risk for the Chinese economy. Incidentally, we also expect that the looming US-Iran diplomatic détente will weigh on bullish fundamentals for oil in the second half of the year, which would be good for Indian stocks. However, the pair trade is challenged from a technical perspective and so we will book gains and move to the sidelines for now. Moreover to mitigate the effects of the coming growth slowdown in India on client portfolios, we recommend initiating two sectoral trades, namely Short India Banks and Long India Consumer Discretionary.  Our Emerging Markets Strategy has shown that Indian private banks have higher efficiency and better balance sheets vis-à-vis EM banks. Our concern is that markets have already priced this dynamic. Specifically, Indian banks’ return on equity has seen a sharp drop from pre-pandemic levels and yet valuations remain high (Chart 10). As GDP growth in India slows, credit growth will stay low. This along with rising domestic interest rates could mean that banks’ net interest margins disappoint. As India’s broader consumption story disappoints and a K-shaped recovery takes shape, we expect a limited set of high-income services and business sector professionals to drive demand for high end-consumer discretionary products. So these two sectoral trades tap into the differential growth rates that two different segments of the economy are set to experience. Finally, we recommend closing the Long Indian Local Currency Bond / Short EM Bonds trade which is currently in the money. This is for two sets of reasons. Firstly, history points to a tight correlation between the US 10-year bond yield and Indian local currency denominated 10-year bond yields. As the US 10-year yield moves upwards, we expect Indian yields also to inch higher. Secondly, we worry that India’s fiscal response to the pandemic has been relatively small thus far and so India could opt for an unexpected expansion in its fiscal deficit over the next 12 months (Chart 11). Chart 10Indian Banks Appear To Be Factoring In All Positives Chart 11India’s Fiscal Response To The Pandemic Has Been Relatively Small So Far ​​​​​​​ Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com     Footnotes 1Daron Acemoglu and James Robinson, Why Nations Fail: The Origins of Power, Prosperity, and Poverty (New York: Crown, 2012) 2Please see Jeffrey Gettleman, Sameer Yasir, Hari Kumar, and Suhasini Raj, “As Covid-19 Devastates India, Deaths Go Undercounted,” New York Times, April 24, 2021, nytimes.com and Murad Banaji, “The Importance of Knowing How Many Have Died of COVID-19 in India,” The Wire, May 9, 2021, science.thewire.in.