Economic Growth
Highlights Alternative energy is priced to deliver spectacular long-term earnings growth, but this will be a very tough ask. While alternative energy will take a greater share of the energy pie, the pie itself is shrinking, as is its price. At its current valuation, alternative energy does not meet the conditions to be in a long-term investment portfolio. As the Ethereum network becomes the ‘go to’ place to implement and execute smart contracts or decentralised finance, such services will have to be paid in ETH giving the token an economic value. ETH should certainly form a small part of a long-term investment portfolio. A near-term combination of valuation and technical constraints means that stocks will struggle to outperform ultra-long bonds. Fractal analysis: India versus China. Feature Chart of the WeekThe World Is Using Much Less Energy Per Unit Of Economic Output Alternative Energy Blues Alternative energy is the meme theme of the moment. Hardly a day passes without some exhortation to save the planet, by substituting fossil fuels with cleaner forms of energy. Yet this year, alternative energy stocks have performed dismally. Since January, the sector is down 30 percent in absolute terms, and almost 40 percent versus the broad market. Begging the question, how can one of the biggest themes of the moment be one of the worst investment performers? Last year, the forward earnings of the alternative energy sector rose by 35 percent, helped by post-pandemic stimulus measures that targeted the clean energy industry. But as investors fell in love with this meme theme, the bigger story was that the valuation paid for the sector skyrocketed from 13 times forward earnings to a nosebleed 42 times, an increase of 220 percent (Chart I-2 and Chart I-3). Chart I-2Alternative Energy Earnings Rose... Chart I-3...But The Valuation Skyrocketed To put the 42 into context, the peak multiple of the tech sector has reached ‘only’ 29 this cycle, meaning that alternative energy was trading at a near 50 percent premium even to the daddy of growth sectors! This year, as investors have pared back the nosebleed valuation, the alternative energy sector has underperformed. Nevertheless, it is still trading at a 25 percent premium to tech, meaning that its profits will have to deliver spectacular long-term growth to justify the sky-high valuation. Is this likely? We are not convinced. The world is using less energy per unit of economic output. A fundamental rule of long-term investment is that you shouldn’t own any sector whose sales are shrinking as a share of the economy. The problem for alternative energy is that it is, ultimately, energy (Chart I-4). And the world is using less energy per unit of economic output. Chart I-4Alternative Energy And Traditional Energy Show Similar Earnings Profiles In 1995, every $1000 of real GDP used 157 kilograms of oil equivalent energy. Today, that has plunged to 109 kilograms. Meaning that over the past 25 years, the world economy has reduced its energy intensity by 30 percent.1 And the downtrend persists (Chart I-1). Granted, over the past 25 years, the share of the energy pie taken by non-fossil fuels has increased from 13.4 to 16.9 percent, of which renewables have increased from 0.6 to 5.7 percent. But the marginal prices of wind, solar, and geothermal power generation are collapsing. As a recent report from the International Renewable Energy Agency (IRENA) points out: Generation costs for onshore wind and solar photovoltaics (PV) have fallen between 3 percent and 16 percent yearly since 2010 – far faster than anything in our shopping baskets or household budgets… (and) auction results show these favourable cost trends continuing through the 2020s.2 Given that the alternative energy market is competitive rather than monopolistic or oligopolistic, a large part of these massive cost savings will be passed on to end-users. Constituting a long-term boon to consumers rather than to alternative energy profits. To repeat, with the alternative energy sector still trading at a 25 percent premium to tech, it must deliver spectacular long-term earnings growth. But this will be a very tough ask. Energy sector profits tightly track the value of energy produced, meaning volume times price (Chart I-5). The risk is that while alternative energy will take a greater share of the energy pie, the pie itself is shrinking, as is its price. Chart I-5Energy Sector Profits Tightly Track The Value Of Energy Produced (Volume Times Price) We conclude that with an ambiguous outlook for long-term earnings growth, alternative energy does not meet the conditions to be in a long-term investment portfolio at its still nosebleed valuation multiple of 32 times forward earnings. Now let’s turn to an investment that you should have in a long-term investment portfolio. The London Hard Fork Is A Boon For The Ethereum Network The Ethereum network’s London hard fork – an event that passed under most radar screens – marks the shape of things to come for the blockchain and the cryptocurrency space. Crucially, it signals an ongoing sea-change that favours the Ethereum network’s users at the expense of its cryptocurrency miners. For those interested in the nerdy details, we direct you to Ethereum Improvement Protocol (EIP) 1559. But to cut to the chase, the fork has drastically reduced the profitability of Ethereum mining while “ensuring that only ETH can ever be used to pay for transactions on Ethereum, cementing the economic value of ETH within the Ethereum platform.” Only ETH can ever be used to pay for transactions on Ethereum, cementing the economic value of ETH within the Ethereum platform. The statements of intent address, and will ultimately alleviate, two of the biggest investment concerns about cryptocurrencies – first, that cryptocurrency mining is a prodigious user of energy, particularly dirty energy; and second, that as cryptocurrencies cannot be readily exchanged for goods and services, they have no value other than that from other investors believing they have value. Addressing the first concern, mining becomes irrelevant if the blockchain users employ the skin in the game ‘proof-of-stake’ protocol to validate transactions rather than the energy-intensive ‘proof-of-work’ protocol that relies on external miners. Which is where Ethereum is headed with the fully proof-of-stake Ethereum 2.0. Addressing the second concern, if the Ethereum network becomes the ‘go to’ place to implement and execute smart contracts or decentralised finance, then such services will have to be paid in ETH, giving the tokens an economic value. Hence, the key structural question is, which blockchain networks will become the go to places for decentralised intermediation? Ethereum is an excellent candidate. Note that the lending arm of the EU, the European Investment Bank, has effectively endorsed the Ethereum network by issuing a €100 million digital bond on it. And although the principal “is expected to be repaid in euros”, the intermediators get paid in ETH. Crucially, the token of a successful blockchain network will become the de-facto currency of the network, exchangeable for intermediation services on that network. With a value independent of speculative investments, investors can also justifiably own these tokens as a ‘digital gold.’ Clearly, cryptocurrencies experience a higher volatility than gold, but this can be adjusted through position sizing. To equalise drawdowns in digital gold versus gold, investors should own $1 of cryptocurrency for every $3 of gold (Chart I-6). On this relative risk basis, cryptocurrencies should constitute at least one quarter ($3.8 trillion) of the $15 trillion ‘anti-fiat’ market that gold currently dominates. Chart I-6Cryptocurrency Drawdowns Are Becoming Less Severe Therefore, if Ethereum became the dominant cryptocurrency based on its network size, it would command a market capitalisation of at least $1.9 trillion, a more than five-fold increase from today. ETH should certainly form a small part of a long-term investment portfolio. Stocks Versus Bonds Face A Double Constraint Since mid-March the world stock market (MSCI All Country World Index) has rallied by 10 percent, but the ultra-long bond (30-year T-bond) has done even better, rallying by 14 percent. Hence stocks to bonds have drifted gently lower, for which there are two reasons. First, the valuation of the most highly-rated parts of the stock market have reached the limit that has held in the post-GFC era. Specifically, tech’s earnings yield premium versus the 10-year T-bond has reached its 2.5 percent lower bound (Chart I-7). Chart I-7Tech Reached Its Post-GFC Valuation Limit Versus Bond Yields Second, the groupthink in overweighting stocks versus bonds reached an extreme. All investors up to 260-day investment horizons are already in the trade, and this level of extreme groupthink correctly signalled stocks versus bonds major-tops in 2010 and 2013 (as well as major-bottoms in 2008 and 2020) (Chart I-8). Chart I-8The Groupthink In Overweighting Stocks Versus Bonds Reached An Extreme This near-term combination of valuation and technical constraints means that stocks will struggle to outperform ultra-long bonds. In the near term, stocks will struggle to outperform ultra-long bonds. Nevertheless, if bonds rally, it will support stocks. But if bonds sell off, it will undermine stocks. The implication of the above is that a bond sell-off – should it even occur – will be self-limiting. As we explained last week in Stocks, Not The Economy, Will Set The Upper Limit To Bond Yields, the upper limit to the 10-year T-bond yield is 1.8 percent. India Trading At A Precarious Premium This week’s fractal analysis highlights that the spectacular outperformance of India versus China has reached the limit of fragility on its 260-day fractal structure that marked previous major-tops in 2014, 2016, and 2019 (as well as major bottoms in 2015, 2018, and 2020) (Chart I-9). Chart I-9The Outperformance Of India Versus China Is Fragile In effect, as China’s tech sector has recently corrected, tech stocks in India are now trading at a precarious 60 percent premium to those in China (Chart I-10). Chart I-10India Is Trading At A Precarious Premium To China The recommended trade is to short India versus China (MSCI indexes), setting the profit target and symmetrical stop-loss at 19 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Source: World Bank, and BP Statistical Review of World Energy 2021 2 Source: Renewable Power Generation Costs In 2019, International Renewable Energy Agency Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Since 2008, the 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. Based on the current technology earnings yield of 3.8 percent, and the 10-year T-bond yield at 1.3 percent, stock markets are on the edge of rationality. But at the limit, the elastic can briefly stretch by around 0.5 percent before it eventually snaps back. Hence, the 10-year T-bond yield could make a brief trip to 1.8 percent before reversing. The labour market participation rate for African Americans dropped sharply in July to 2.3 percent below its pre-pandemic benchmark level. The weakest performing demographic group could set the employment condition for the Fed’s lift-off, making it later than the market is pricing. The next shock will drive down the T-bond yield to its ultimate low, and the stock market’s valuation to its ultimate high. Fractal analysis: NOK/GBP, Hong Kong versus the world, and Netherlands versus New Zealand. Feature Chart of the WeekSince 2008, The 10-Year T-Bond Yield Has Struggled to Exceed the Earnings Yield On Tech (Minus A Constant Of 2.5 Percent) Since 2008, a remarkable financial relationship has held true. The 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. The 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. T-bond yield ≤ technology forward earnings yield – 2.5% (Chart I-1). The upshot is that whenever, as now, the yields on tech and other high-flying growth stocks have become depressed – which is to say highly valued – the upper limit to the bond yield has been established not by the economy, but by the financial markets. On the occasions that the bond yield has attempted to breach its stock market-set upper limit, it has unleashed a self-correcting sequence of events. It has pulled up the tech sector earnings yield, which is to say pulled down the tech sector’s valuation and price. Then, to contain and reverse this sharp sell-off, the bond yield has quickly unwound its short-lived spike. Stock Markets Are On The Edge Of Rationality Earlier this year in The Rational Bubble Is Turning Irrational we highlighted that the T-bond yield was at its stock market-set upper limit. And in the subsequent six months, the markets have behaved exactly as predicted. First, tech stocks declined sharply through February-March. Then, bond yields declined sharply through May-July, allowing tech stocks to claw back their declines and then reach new highs. Indeed, since mid-February, the T-bond yield and tech stocks have moved as a near-perfect mirror image (Chart I-2). Chart I-2The T-Bond Yield And Tech Stocks Have Moved As A Near-Perfect Mirror Image In the long run, a depressed earnings yield relative to the bond yield – which is to say a high valuation – can normalise as earnings go up. But in the short term, the adjustment must come from either the equity price declining or the bond yield declining. Or some combination of the two. With the tech earnings yield now at 3.8 percent – and assuming the post-GFC 2.5 percent minimum gap still holds true – it would set the upper limit of the 10-year T-bond yield at 1.3 percent, close to where it is trading today. Still, at the limit, the elastic can briefly stretch before it eventually snaps back. Over the last thirteen years, the maximum stretch has been around 0.5 percent. This means that, based on the current earnings yield of the tech sector, the 10-year T-bond yield could make a brief trip to 1.8 percent before reversing. For equity investors, a higher T-bond yield would support the value versus growth trade. But given that it would be a brief trip, the opportunity would not be cyclical (12-month) but merely tactical (3-month), as has been the case over the past ten years. Since 2012, cyclical opportunities to overweight value versus growth have been virtually non-existent, but there have been several good tactical opportunities (Chart I-3 and Chart I-4). Chart I-3Cyclical Opportunities To Overweight Value Versus Growth Have Been Virtually Non-Existent... Chart I-4...But There Have Been Several Good Tactical Opportunities We await a fractal signal that T-bonds are overbought to initiate this tactical trade. Stay tuned. The Truth About The Jobs Recovery At first glance, last week’s US employment report appeared strong. The unemployment rate continued its plunge from 14.8 percent in April 2020 to 5.4 percent in July 2021, constituting the fastest jobs recovery of all time. But the first glance doesn’t tell the true story. Unlike in previous recessions, the number of workers put on furlough or ‘temporary layoff’ surged and then plunged as the pandemic let rip and then was brought under control. Hence, to get the true story of the jobs recovery, we must strip out the furloughed workers and focus on the unemployment rate based on those ‘not on temporary layoff’ (Chart I-5). Chart I-5To Get The True Story Of The Jobs Recovery, Focus On Those 'Not On Temporary Layoff' Based on this truer measure of labour market slack, the pace of the current recovery in jobs looks remarkably like the recoveries that followed previous downturns in 1974/75, the early 1980s, the early 1990s, dot com bust, and the GFC. The true story is that the US is little more than a third of the way on the journey to full employment (Chart I-6). Chart I-6The Pace Of The Current Jobs Recovery Looks Remarkably Like Previous Recoveries This is significant, because unlike in previous recoveries, the Federal Reserve is now explicitly targeting full employment before it lifts the policy interest rate. Furthermore, the employment recovery must be broad and inclusive of minority demographic groups, which adds further conditionality for the Fed. While the market is focussing on the aggregate employment market, it is the weakest performing demographic group that could set the condition for the Fed’s lift-off. On this note, the labour market participation rate for African Americans dropped sharply in July to 2.3 percent below its pre-pandemic benchmark level (Chart I-7). This raises an interesting point. While the market is focussing on the aggregate employment market, it is the weakest performing demographic group that could set the condition for lift-off, if the Fed stays true to its promise of inclusivity. Which would push back lift-off to later than the market is pricing. Chart I-7The Labour Market Participation Rate For African Americans Dropped Sharply In July Shocks Do Not Have A Cycle According to the recovery in jobs then, we are still ‘early cycle.’ Some people argue that early cycle implies that a recession is a distant prospect, that stocks only underperform in a recession, and therefore that the bull market in stocks has further to run. The investment conclusion is right, but the reasoning is wrong, on two counts. First, nobody can predict the precise timing of recessions or shocks. Second, recessions or shocks do not have a ‘cycle.’ Shocks can come in quickfire succession such as the back-to-back GFC in 2008 and the euro debt crisis which started in 2010, or the back-to-back votes for Brexit and Trump in 2016 (Chart I-8). Chart I-8Shocks Do Not Have A Cycle Yet, while we cannot predict the precise timing of shocks, The Shock Theory Of Bond Yields tells us that we can predict their statistical distribution very accurately. The upshot is that in any 5-year period, the probability of (at least) one shock is an extremely high 81 percent, and in any 10-year period, it is a near-certain 96 percent. Given the tight feedback from bond yields to stocks and then back to bond yields, we can say with high conviction that the next shock will drive down the T-bond yield to its ultimate low. This will happen directly from a deflationary shock, or indirectly from an initially inflationary shock that drives up bond yields through the upper limit set by stock valuations. The resulting sharp correction in stocks will then cause bond yields to reverse to the ultimate low. The next shock will drive down the T-bond yield to its ultimate low, and the stock market’s valuation to its ultimate high. In turn, the ultimate low in the T-bond yield will mark the ultimate high in the stock market’s valuation, and the end of the structural bull market in stocks. Until then, long-term investors should own stocks. Fractal Analysis Update This week’s fractal analysis highlights three recent price moves that are at risk of reversal because of fragile fractal structures. First, the recent sell-off in NOK/GBP has become fragile on its 65-day fractal structure implying a likelihood of a countertrend move based on similar recent signals (Chart I-9). Chart I-9NOK/GBP Is Oversold Second, the sell-off following China’s aggressive crackdown on its technology and private education sectors has created fragility in Hong Kong’s relative performance on its composite 65-day/130-day fractal dimension. Assuming the worst of the policy crackdown is over, this would imply a countertrend reversal based on similar signals over the past decade. The recommended trade is long Hong Kong versus developed world (MSCI indexes), setting the profit target and symmetrical stop-loss at 4 percent (Chart I-10). Chart I-10Hong Kong Versus The World Is Oversold Finally, the massive outperformance of tech-heavy Netherlands versus healthcare and utility-heavy New Zealand has reached the limit of fragility on its 260-day fractal structure that signalled major turning points in 2011, 2015, 2016, and 2018 (Chart I-11). Hence the recommended trade is short Netherlands versus New Zealand, setting the profit target and symmetrical stop-loss at 13 percent. Chart I-11Netherlands Versus New Zealand Is Overbought Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Dear client, In addition to this abridged Strategy Report, we are sending a report written by Arthur Budaghyan, Chief Strategist of BCA’s Emerging Market Investment service. Arthur shares his thoughts on the future of Chinese TMT stocks, a subject we trust you will find insightful and beneficial. Jing Sima China Strategist Highlights Wealth and income inequality may be the most important contributors to rising populism in the past three decades. China has its share of increasing populism; reducing income inequality and improving social welfare are core principles of President Xi’s reform agenda. July’s economic data continues to indicate a softening in China’s economy. However, the magnitude of the slowdown is within policymakers’ pain threshold while the economy remains supported by strong external demand. For now, stay underweight in Chinese stocks within a global equity portfolio. Policy stance has yet to turn reflationary. Feature Populism Takes Root BCA's China Investment Strategy has argued that China is accelerating the pace of its structural reforms; addressing income inequality is at the core of the current administration’s reform agenda. Wealth and income inequality may be the most important structural cause of rising global populism and political polarization (Chart 1). The severity of income inequality in China is illustrated in Chart 2. It is noteworthy that China, whose political and economic ideology is based on creating a classless society, has found itself not far behind the US in terms of a widening wealth and income gap. Chart 1Populism Has Been On The Rise Globally For The Past 30 Years Chart 2The Great Gatsby Curve Paints A Not-So-Great Equality Picture Of China The relationship between inequality and intergenerational income mobility is captured in the "Great Gatsby Curve" – a concept based on a research paper by economist Miles Corak and later introduced by Alan Krueger, the late professor and Chairman of the Council Economic Advisers, during his speech at the Center for American Progress in 2012.1 The US has experienced a sharp rise in wealth and income inequality since the 1980s. On the eve of the Global Financial Crisis, income inequality in the US was as sharp as it had been since the time of "The Great Gatsby” novel set in the 1920s. After three decades of rapid industrialization and economic expansion, China also faces the challenge of escalating income inequality and discontent among middle-class households. Populism, defined as political stances that emphasize the idea of "the people", often benefits middle-class households, but not big business or corporate earnings (“the elite”). An increase in populist governments is usually positively correlated with rising number of antitrust investigations, since populist leaders tend to pander to popular outcries against big corporations by limiting or breaking up the corporations. In the US, the rise of Reaganism/neoliberalism in the 1980s led to a big drop in antitrust cases – a trend that was sustained for nearly three decades as the free-market Washington Consensus pushed against antitrust and other populist stances (Chart 3). However, the tide turned in 2016 when the US elected a populist president for first time, and antitrust threats started reemerging (Chart 4). Chart 3Antitrust Reinforcement In The US Has Been On A Secular Decline In The Past Two Decades… Chart 4...But Antitrust Noise Is Getting Louder In The US (And Lately In China) Both China and the US have transitioned towards larger government involvement in the economy. More restrictions on private enterprise and a greater redistribution of wealth will be forthcoming. In the US, there has been a shift towards a larger share of labor compensation versus capital in the country’s national income (Chart 5). In China, the “dual circulation” economic goal set by the 14th Five Year Plan, coupled with an economic divorce between the Middle Kingdom and the US, requires that China expands its domestic market. However, that expansion is constrained by its relatively low labor share (Chart 6). The external and internal challenges are fertile ground for rising and sustaining populism. Thus, reforms that promote the bargaining power of workers at the expense of corporate earnings will likely become a secular trend in China. Chart 5Labor Makes A Comeback Versus Capital In The US... Chart 6...And In China Too Checking In On The Data China’s economic data continues to soften as evidenced by a slew of new numbers published last weekend. On the growth front, the contraction in the volume of imports in the past two months reflects the sagging domestic economy, despite elevated commodity prices supporting the value of total imports (Chart 7). Global demand for Chinese goods, on the other hand, remains strong compared with the historical norm, and continues to offset weaknesses in China’s old economy sectors. Meanwhile, Chinese producers face persistent inflationary pressures stemming from elevated global commodity prices and a broken price transmission to pass on inflation to domestic consumers (Chart 8). Instead of stimulating demand in the near term, Chinese policymakers will likely address supply-side issues by releasing strategic reserves and curbing raw material exports, and relaxing domestic production restrictions. Chart 7Strong External Demand Continues To Offset Domestic Economic Weaknesses Chart 8Inflationary Pressures On Producers Remains Elevated We expect that Beijing will need greater economic pain before it decides to stimulate the economy more substantially. Monetary conditions have eased since earlier this year on the back of rising inflation, falling real interest rates and recently a breather in the RMB’s ascent (Chart 9). Nonetheless, as we noted in a previous report, a decisive rebound in the rate of credit expansion requires clear easing signals from China’s top leadership for local governments and corporates to ramp up leverage again. The July Politburo meeting pledged more fiscal support for the economy this year. Meanwhile, policymakers have intensified their tough regulatory stances on private-sector businesses and oversight on the public-sector’s balance sheet. Hence, the current policy backdrop does not suggest any imminent or meaningful reflationary measures. Chart 9A Meaningful Rebound In Credit Growth Requires More Than Monetary Easing Chart 10War Against Delta-Variant Remains A Risk The COVID-19 Delta-variant remains the biggest risk to our view. The mutated virus has spread to 14 provinces in China and triggered the strictest pandemic-control measures since Q1 last year. The drag on the service sector’s activities and employment will be substantial if measures are maintained for more than a month (Chart 10). In this case, the leadership may need to step in with policy supports to stabilize the economy and sentiment. For now, the pullback of stimulus and ongoing regulatory tightening since Q4 last year continue to dominate China’s financial assets. Thus, investors should maintain an underweight allocation to Chinese equities within a global equity portfolio. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1Krueger, Alan (12 January 2012). "The Rise and Consequences of Inequality in the United States" (PDF). Market/Sector Recommendations Cyclical Investment Stance
Highlights Investors have grown enamored with online retailers (AMZN), payment processing companies (V, MA, PYPL, SQ), and social media companies (FB, SNAP). All three sectors are likely to experience headwinds over the next 12 months as life returns to normal following the pandemic. Looking further out, market saturation, increased competition, and heightened regulation all pose risks to these sectors. Internet companies in general, and social media firms in particular, will face increased scrutiny not just for their monopolistic practices, but for the mental harm they are causing young people. Just like cigarettes are heavily regulated due to their addictive qualities, the same could happen to social media. We think there is a 50/50 chance that governments will start restricting social media usage only to adults over the age of 18 by the end of the decade, a move that could decimate the sector. Global Growth Will Remain Above Trend Investors are worried about growth again. Globally, the number of Covid cases is on the rise due to the proliferation of the Delta variant (Chart 1). The ISM manufacturing index dropped to 59.5 in July, down from a high of 64.7 in March. Both of China’s manufacturing PMIs have fallen, with the new orders component of the Caixin index dipping below the 50 line. The European PMIs have also come off their highs (Chart 2). Chart 1Number Of Covid Cases On The Rise Globally Due To The Delta Variant Chart 2Manufacturing PMIs Are Off Their Highs Growth concerns have registered in financial markets (Chart 3). After climbing to 1.74% in March, the US 10-year Treasury yield has fallen back to 1.22%. Cyclical equity sectors have underperformed defensives. Growth-sensitive currencies such as the Swedish krona and the Australian dollar have weakened. We are more upbeat about global growth prospects than the consensus. As the experience of the UK demonstrates, there is little will to impose lockdowns in countries with ample access to vaccines. Strict social distancing restrictions remain a fact of life in countries lacking adequate vaccine supplies. However, the situation should improve later this year as vaccine production increases (Chart 4). Chart 3Financial Markets Trim Growth Expectations Chart 4Over 10 Billion Vaccine Doses Will Be Produced This Year Households in developed economies are sitting on US$5 trillion in excess savings, half of which reside in the United States (Chart 5). Inventories are at record low levels, which should support production over the coming quarters (Chart 6). Chart 5Households Flush With Excess Savings Chart 6Record Low Inventories Will Provide A Boost To Production Chinese policy should turn more stimulative, as the recent cut to bank reserve requirements foreshadows. With credit growth back down to 2018 lows, policymakers can afford to give the economy some juice. The 6-month credit impulse has already turned up (Chart 7). From Goods To Services While global growth should remain well above trend for the next 12 months, the composition of that growth will shift in ways that could meaningfully affect equities. As Chart 8 illustrates, aggregate US consumption has returned to its pre-pandemic trend. However, spending on goods is 11% above trend while spending on services is still 6% below trend. Chart 7Chinese Policy Is Turning More Stimulative Chart 8The Divergence Between Goods And Services Spending Households typically cut spending on durable goods during recessions, while services serve as the ballast for the economy. The opposite happened during the pandemic. As the global economy recovers, goods spending will slow while services spending will stay robust. This is critical for online retailers such as Amazon, which derive the bulk of their e-commerce revenue from selling goods. Even after its disappointing Q2 earnings report, analysts still expect Amazon to grow e-commerce sales by 17% in 2022 (Chart 9). Such a goal may be difficult to achieve, given that core US retail sales currently stand 13% above their trendline (Chart 10). Chart 9AAnalysts’ Great Expectations May Be Dashed (I) Chart 9BAnalysts’ Great Expectations May Be Dashed (II) Chart 10AUS Retail Spending Is Well Above Trend (I) Chart 10BUS Retail Spending Is Well Above Trend (II) Chart 11Screen Time Is Moderating If e-commerce spending slows, shares of payment processing companies could disappoint. Likewise, social media companies could suffer as people start going out more often. After spiking during the height of the pandemic, growth in data usage has returned to normal (Chart 11). Long-Term Risks Looking beyond the post-pandemic recovery, all three equity sectors face structural challenges that are not being fully discounted by investors. The first is market saturation. Close to three-quarters of US households have Amazon Prime accounts. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, Google and Facebook generate about 60% of all online advertising revenue. Competition is another challenge. Companies such as Amazon, Facebook, and Google dominate their respective markets. As they look for further growth, they will invariably invade each other’s turf. The result might benefit consumers, but it is unlikely to help the bottom line if it means more competitive pressures. Moreover, it is not just competition from within the tech industry that may disrupt incumbent firms. Consider payment processors. Like most other central banks, the Fed is planning to launch its own digital currency. Widely available, free-to-use Central Bank Digital Currencies (CBDCs) could thwart the ability of Visa and MasterCard to skim 2%-to-3% off of every transaction. Regulatory Pressures In recent years, tech companies have faced increased scrutiny over their alleged monopolistic practices. In contrast to Chinese tech firms, which have fallen under the thumb of the authorities, US companies have been able to evade harsh measures. Just last month, a US federal court judge dismissed a case filed by more than 40 state attorneys general arguing that Facebook’s acquisitions of Instagram and WhatsApp had harmed competition. In the past, evidence that companies were setting prices well above marginal costs could be used to build a case for anti-trust enforcement. Such cases are more difficult to argue today because so many online services are given away for free. Nevertheless, governments are likely to become more adept in pursuing regulatory actions. Rather than focusing simply on pricing policies, regulators are increasingly looking at the ways big tech companies use vendor data in the case of Amazon and user data in the case of Facebook and Google to maintain market dominance. Public contempt for tech companies is fueling a political backlash. According to a Gallup poll conducted earlier this year, only 34% of Americans held a favorable view of tech companies such as Amazon, Facebook, and Google, down from 46% in 2019; 45% had an unfavorable opinion, up from 33% in 2019. The shift in public sentiment over the past two years has been entirely driven by Independent and Republican voters, many of whom feel that tech companies are unfairly censoring their opinions (Table 1). The same poll revealed that the majority of Americans – including the majority of Republicans – now favor increased regulation of tech companies. Table 1American Views On Big Tech A Drug Worse Than Nicotine? Social media companies are among the most loathed within the tech sector. A Pew Research Center study conducted last year revealed that more than six times as many Americans had a negative opinion of social media as a positive one (Chart 12). The public’s disdain for social media is increasingly going beyond traditional concerns over privacy. As psychologists Jonathan Haidt and Jean Twenge recently argued in the New York Times, there is growing evidence that the pervasive use of social media is harming the mental health of the nation’s youth. The share of students reporting high levels of loneliness has more than doubled in both the US and abroad over the past decade (Chart 13). Chart 12Social Media Increasingly Vilified Chart 13Alone In The Crowd In 2019, the last year for which comprehensive data is available, nearly a quarter of girls between the ages of 12 and 17 reported experiencing a major depressive episode over the prior year, up from 12% in 2011 (Chart 14). Academic studies have shown that adolescents who use Facebook and Instagram frequently feel greater anxiety and unease than those who do not. Just like cigarettes are heavily regulated due to their addictive qualities, the same could happen to social media. Facebook and most other social media companies already restrict access to those under the age of 13, although enforcement is generally spotty. We assign a 50/50 chance that governments start restricting social media usage only to adults over the age of 18 by the end of the decade, a move that could decimate the sector. Priced For Perfection The seven companies in the three high-flying sectors mentioned in this report trade at 91-times forward earnings compared to the S&P 500’s aggregate multiple of 22. They also trade at an average price-to-sales ratio of 16 compared to 3.2 for the broader market (Chart 15). Chart 14The Rise In Depression Rates Coincided With Increased Social Media Usage Chart 15Trading At A High Multiple To Sales Such valuations can be justified only if these companies grow earnings-per-share by nearly 30% per year over the next five years, as analysts currently expect (Chart 16). However, as noted above, that may be too high a hurdle to clear. Higher bond yields represent another threat to valuations. Growth stocks are much more sensitive to changes in discount rates than value stocks. Chart 17show that tech stocks have generally outperformed the S&P 500 over the past four years whenever bond yields were falling. We expect bond yields to rebound over the coming months, with the 10-year yield rising to 1.8% by early next year. Tech is likely to lag the market in that environment. Chart 16Long-Term Growth Estimates May Be Too Optimistic For These High-Fliers Chart 17Higher Bond Yields Could Hurt Tech Stocks Trade Update Our long EM equity trade got stopped out last Tuesday before recouping some of its losses in subsequent days. We continue to expect EM stocks to bounce back later this year. That said, in keeping with this report, we see more upside for “traditional” EM sectors such as banks, industrials, energy, and materials than for EM tech (especially Chinese tech). Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Highlights China’s July Politburo meeting signaled that policy is unlikely to be overtightened. The Biden administration is likely to pass a bipartisan infrastructure deal – as well as a large spending bill by Christmas. Geopolitical risk in the Middle East will rise as Iran’s new hawkish president stakes out an aggressive position. US-Iran talks just got longer and more complicated. Europe’s relatively low political risk is still a boon for regional assets. However, Russia could still deal negative surprises given its restive domestic politics. Japan will see a rise in political turmoil after the Olympic games but national policy is firmly set on the path that Shinzo Abe blazed. Stay long yen as a tactical hedge. Feature Chart 1Rising Hospitalizations Cause Near-Term Jitters, But UK Rolling Over? Our key view of 2021, that China would verge on overtightening policy but would retreat from such a mistake to preserve its economic recovery, looks to be confirmed after the Politburo’s July meeting opened the way for easier policy in the coming months. Meanwhile the Biden administration is likely to secure a bipartisan infrastructure package and push through a large expansion of the social safety net, further securing the American recovery. Growth and stimulus have peaked in both the US and China but these government actions should keep growth supported at a reasonable level and dispel disinflationary fears. This backdrop should support our pro-cyclical, reflationary trade recommendations in the second half of the year. Jitters continue over COVID-19 variants but new cases have tentatively peaked in the UK, US vaccinations are picking up, and death rates are a lot lower now than they were last year, that is, prior to widescale vaccination (Chart 1). This week we are taking a pause to address some of the very good client questions we have received in recent weeks, ranging from our key views of the year to our outstanding investment recommendations. We hope you find the answers insightful. Will Biden’s Infrastructure Bill Disappoint? Ten Republicans are now slated to join 50 Democrats in the Senate to pass a $1 trillion infrastructure bill that consists of $550 billion in new spending over a ten-year period (Table 1). The deal is not certain to pass and it is ostensibly smaller than Biden’s proposal. But Democrats still have the ability to pass a mammoth spending bill this fall. So the bipartisan bill should not be seen as a disappointment with regard to US fiscal policy or projections. The Republicans appear to have the votes for this bipartisan deal. Traditional infrastructure – including broadband internet – has large popular support, especially when not coupled with tax hikes, as is the case here. Both Biden and Trump ran on a ticket of big infra spending. However, political polarization is still at historic peaks so it is possible the deal could collapse despite the strong signs in the media that it will pass. Going forward, the sense of crisis will dissipate and Republicans will take a more oppositional stance. The Democratic Congress will pass President Joe Biden’s signature reconciliation bill this fall, another dollop of massive spending, without a single Republican vote (Chart 2). After that, fiscal policy will probably be frozen in place through at least 2025. Campaigning will begin for the 2022 midterm elections, which makes major new legislation unlikely in 2022, and congressional gridlock is the likely result of the midterm. Republicans will revert to belt tightening until they gain full control of government or a new global crisis erupts. Table 1Bipartisan Infrastructure Bill Likely To Pass Chart 2Reconciliation Bill Also Likely To Pass Chart 3Biden Cannot Spare A Single Vote In Senate Hence the legislative battle over the reconciliation bill this fall will be the biggest domestic battle of the Biden presidency. The 2021 budget reconciliation bill, based on a $3.5 trillion budget resolution agreed by Democrats in July, will incorporate parts of the American Jobs Plan that did not pass via bipartisan vote (such as $436 billion in green energy subsidies), plus a large expansion of social welfare, the American Families Plan. This bill will likely pass by Christmas but Democrats have only a one-seat margin in the Senate, which means our conviction level must be medium, or subjectively about 65%. The process will be rocky and uncertain (Chart 3). Moderate Democratic senators will ultimately vote with their party because if they do not they will effectively sink the Biden presidency and fan the flames of populist rebellion. US budget deficit projections in Chart 4 show the current status quo, plus scenarios in which we add the bipartisan infra deal, the reconciliation bill, and the reconciliation bill sans tax hikes. The only significant surprise would be if the reconciliation bill passed shorn of tax hikes, which would reduce the fiscal drag by 1% of GDP next year and in coming years. Chart 4APassing Both A Bipartisan Infrastructure Bill And A Reconciliation Bill Cannot Avoid Fiscal Cliff In 2022 … Chart 4B… The Only Major Fiscal Surprise Would Come If Tax Hikes Were Excluded From This Fall’s Reconciliation Bill Chart 5Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing There are two implications. First, government support for the economy has taken a significant step up as a result of the pandemic and election in 2020. There is no fiscal austerity, unlike in 2011-16. Second, a fiscal cliff looms in 2022 regardless of whether Biden’s reconciliation bill passes, although the private economy should continue to recover on the back of vaccines and strong consumer sentiment. This is a temporary problem given the first point. Monetary policy has a better chance of normalizing at some point if fiscal policy delivers as expected. But the Federal Reserve will still be exceedingly careful about resuming rate hikes. President Biden could well announce that he will replace Chairman Powell in the coming months, delivering a marginally dovish surprise (otherwise Biden runs the risk that Powell will be too hawkish in 2022-23). Inflation will abate in the short run but remain a risk over the long run. Essentially the outlook for US equities is still positive for H2 but clouds are forming on the horizon due to peak fiscal stimulus, tax hikes in the reconciliation bill, eventual Fed rate hikes (conceivably 2022, likely 2023), and the fact that US and Chinese growth has peaked while global growth is soon to peak as well. All of these factors point toward a transition phase in global financial markets until economies find stable growth in the post-pandemic, post-stimulus era. Investors will buy the rumor and sell the news of Biden’s multi-trillion reconciliation bill in H2. The bill is largely priced out at the moment due to China’s policy tightening (Chart 5). The next section of this report suggests that China’s policy will ease on the margin over the coming 12 months. Bottom Line: US fiscal policy is delivering, not disappointing. Congress is likely to pass a large reconciliation bill by Christmas, despite no buffer in the Senate, because Democratic Senators know that the Biden presidency hangs in the balance. China’s Khodorkovsky Moment? Many clients have asked whether China’s crackdown on private business, from tech to education, is the country’s “Khodorkovsky moment,” i.e. the point at which Beijing converts into a full, autocratic regime where private enterprise is permanently impaired because it is subject to arbitrary seizure and control of the state. The answer is yes, with caveats. Yes, China’s government is taking a more aggressive, nationalist, and illiberal stance that will permanently impair private business and investor sentiment. But no, this process did not begin overnight and will not proceed in a straight line. There is a cyclical aspect that different investors will have to approach differently. First a reminder of the original Khodorkovsky moment. After the Soviet Union’s collapse, extremely wealthy oligarchs emerged who benefited from the privatization of state assets. When President Putin began to reassert the primacy of the state, he arbitrarily imprisoned Khodorkovsky and dismantled his corporate energy empire, Yukos, giving the spoils to state-owned companies. Russia is a petro state so Putin’s control of the energy sector would be critical for government revenues and strategic resurgence, especially at the dawn of a commodity boom. Both the RUB-USD and Russian equity relative performance performed mostly in line with global crude oil prices, as befits Russia’s economy, even though there was a powerful (geo)political risk premium injected during these two decades due to Russia’s centralization of power and clash with the West (Chart 6). Investors could tactically play the rallies after Khodorkovsky but the general trend depended on the commodity cycle and the secular rise of geopolitical risk. Chart 6Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer President Xi Jinping is a strongman and hardliner, like Putin, but his mission is to prevent Communist China from collapsing like the Soviet Union, rather than to revive it from its ashes. To that end he must reassert the state while trying to sustain the country’s current high level of economic competitiveness. Since China is a complex economy, not a petro state, this requires the state-backed pursuit of science, technology, competitiveness, and productivity to avoid collapse. Therefore Beijing wants to control but not smother the tech companies. Hence there is a cyclical factor to China’s regulatory crackdown. A crackdown on President Xi Jinping’s potential rivals or powerful figures was always very likely to occur ahead of the Communist Party’s five-year personnel reshuffle in 2022, as we argued prior to tech exec Jack Ma’s disappearance. Sackings of high-level figures have happened around every five-year leadership rotation. Similarly a crackdown on the media was expected. True, the pre-party congress crackdowns are different this time around as they are targeted at the private sector, innovative businesses, tech, and social media. Nevertheless, as in the past, a policy easing phase will follow the tightening phase so as to preserve the economy and the mobilization of private capital for strategic purposes. The critical cyclical factor for global investors is China’s monetary and credit impulse. For example, the crackdown on the financial sector ahead of the national party congress in 2017 caused a global manufacturing slowdown because it tightened credit for the entire Chinese economy, reducing imports from abroad. One reason Chinese markets sold off so heavily this spring and summer, was that macroeconomic indicators began decelerating, leaving nothing for investors to sink their teeth into except communism. The latest Politburo meeting suggests that monetary, fiscal, and regulatory policy is likely to get easier, or at least stay just as easy, going forward (Table 2). Once again, the month of July has proved an inflection point in central economic policy. Financial markets can now look forward to a cyclical easing in regulation combined with easing in monetary and fiscal policy over the next 12-24 months. Table 2China’s Politburo Prepares To Ease Policy, Secure Recovery Despite all of the above, for global investors with a lengthy time horizon, the government’s crackdown points to a secular rise of Communist and Big Government interventionism into the economy, with negative ramifications for China’s private sector, economic freedoms, and attractiveness as a destination for foreign investment. The arbitrary and absolutist nature of its advances will be anathema to long-term global capital. Also, social media, unlike other tech firms, pose potential sociopolitical risks and may not boost productivity much, whereas the government wants to promote new manufacturing, materials, energy, electric vehicles, medicine, and other tradable goods. So while Beijing cannot afford to crush the tech sector, it can afford to crush some social media firms. Chart 7China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China’s equity market profile looks conspicuously like Russia’s at the time of Khodorkovsky’s arrest (Chart 7). Chinese renminbi has underperformed the dollar on a multi-year basis since Xi Jinping’s rise to power, in line with falling export prices and slowing economic growth, as a result of economic structural change and the administration’s rolling back Deng Xiaoping’s liberal reform era. We expect a cyclical rebound to occur but we do not recommend playing it. Instead we recommend other cyclical plays as China eases policy, particularly in European equities and US-linked emerging markets like Mexico. Bottom Line: The twentieth national party congress in 2022 is a critical political event that is motivating a cyclical crackdown on potential rivals to Communist Party power. Chinese equities will temporarily bounce back, especially with a better prospect for monetary and fiscal easing. But over the long run global investors should stay focused on the secular decline of China’s economic freedoms and hence productivity. What Happened To The US-Iran Deal? Our second key view for 2021 was the US strategic rotation from the Middle East and South Asia to Asia Pacific. This rotation is visible in the Biden administration’s attempt to withdraw from Iraq and Afghanistan while rejoining the 2015 nuclear deal with Iran. However, Biden here faces challenges that will become very high profile in the coming months. The Biden administration failed to rejoin the 2015 deal under the outgoing leadership of the reformist President Hassan Rouhani. This means a new and much more difficult negotiation process will now begin that could last through Biden’s term or beyond. On August 5, President Ebrahim Raisi will take office with an aggressive flourish. The US is already blaming Iran for an act of sabotage in the Persian Gulf that killed one Romanian and one Briton. Raisi will need to establish that he is not a toady, will not cower before the West. The new Israeli government of Prime Minister Naftali Bennett also needs to demonstrate that despite the fall of his hawkish predecessor Benjamin Netanyahu, Jerusalem is willing and able to uphold Israel’s red lines against Iranian nuclear weaponization and regional terrorism. Hence both Iran and its regional rivals, including Saudi Arabia, will rattle sabers and underscore their red lines. The Persian Gulf and Strait of Hormuz will be subject to threats and attacks in the coming months that could escalate dramatically, posing a risk of oil supply disruptions. Given that the Iranians ultimately do want a deal with the Americans, the pressure should be low-to-medium level and persistent, hence inflationary, as opposed to say a lengthy shutdown of the Strait of Hormuz that would cause a giant spike in prices that ultimately kills global demand. Short term, the US attempt to reduce its commitments in Iraq and Afghanistan will invite US enemies to harass or embarrass the Biden administration. The Taliban is likely to retake control of Afghanistan. The US exit will resemble Saigon in 1975. This will be a black eye for the Biden administration. But public opinion and US grand strategy will urge Biden to be rid of the war. So any delays, or a decision to retain low-key sustained troop presence, will not change the big picture of US withdrawal. Long term, Biden needs to pivot to Asia, while President Raisi is ultimately subject to the Supreme Leader Ali Khamenei, who wants to secure Iran’s domestic stability and his own eventual leadership succession. Rejoining the 2015 nuclear deal leads to sanctions relief, without requiring total abandonment of a nuclear program that could someday be weaponized, so Iran will ultimately agree. The problem will then become the regional rise of Iranian power and the balancing act that the US will have to maintain with its allies to keep Iran contained. Bottom Line: The risk to oil prices lies to the upside until a US-Iran deal comes together. The US and Iran still have a shared interest in rejoining the 2015 deal but the time frame is now delayed for months if not years. We still expect a US-Iran deal eventually but previously we had anticipated a rapid deal that would put downward pressure on oil prices in the second half of the year. What Comes After Biden’s White Flag On Nord Stream II? Our third key view for 2021 highlighted Europe’s positive geopolitical and macro backdrop. This view is correct so far, especially given that China’s policymakers are now more likely to ease policy going forward. But Russia could still upset the view. Italy has been the weak link in European integration over the past decade (excluding the UK). So the national unity coalition that has taken shape under Prime Minister Mario Draghi exemplifies the way in which political risks were overrated. Italy is now the government that has benefited the most from the overall COVID crisis in public opinion (Chart 8). The same chart shows that the German government also improved its public standing, although mostly because outgoing Chancellor Angela Merkel is exiting on a high note. Her Christian Democrat-led coalition has not seen a comparable increase in support. The Greens should outperform their opinion polling in the federal election on September 26. But the same polling suggests that the Greens will be constrained within a ruling coalition (Chart 9). The result will be larger spending without the ability to raise taxes substantially. Markets will cheer a fiscally dovish and pro-European ruling coalition. Chart 8European Political Risk Limited, But Rising, Post-COVID The chief risk to this view of low EU political risk comes from Russia. Russia is a state in long-term decline due to the remorseless fall in fertility and productivity. The result has been foreign policy aggression as President Putin attempts to fortify the country’s strategic position and frontiers ahead of an even bleaker future. Chart 9German Election Polls Point To Gridlock? Now domestic political unrest has grown after a decade of policy austerity and the COVID-19 pandemic. Elections for the Duma will be held on September 19 and will serve as the proximate cause for Russia’s next round of unrest and police repression. Foreign aggressiveness may be used to distract the population from the pandemic and poor economy. We have argued that there would not be a diplomatic reset for the US and Russia on par with the reset of 2009-11. We stand by this view but so far it is facing challenges. Putin did not re-invade Ukraine this spring and Biden did not impose tough sanctions canceling the construction of the Nord Stream II gas pipeline to Germany. Russia is tentatively cooperating on the US’s talks with Iran and withdrawal from Afghanistan. The US gave Germany and Russia a free point by condoning the NordStream II. Now the US will expect Germany to take a tough diplomatic line on Russian and Chinese aggression, while expecting Russia to give the US some goodwill in return. They may not deliver. The makeup of the new German coalition will have some impact on its foreign policy trajectory in the coming years. But the last thing that any German government wants is to be thrust into a new cold war that divides the country down the middle. Exports make up 36% of German output, and exports to the Russian and Chinese spheres account for a substantial share of total exports (Chart 10). The US administration prioritizes multilateralism above transactional benefits so the Germans will not suffer any blowback from the Americans for remaining engaged with Russia and China, at least not anytime soon. Russia, on the other hand, may feel a need to seize the moment and make strategic gains in its region, despite Biden’s diplomatic overtures. If the US wraps up its forever wars, Russia’s window of opportunity closes. So Russia may be forced to act sooner rather than later, whether in suppressing domestic dissent, intimidating or attacking its neighbors, or hacking into US digital networks. In the aftermath of the German and Russian elections, we will reassess the risk from Russia. But our strong conviction is that neither Russian nor American strategy have changed and therefore new conflicts are looming. Therefore we prefer developed market European equities and we do not recommend investors take part in the Russian equity rally. Chart 10Germany Opposes New Cold War With Russia Or China Bottom Line: German and European equities should benefit from global vaccination, Biden’s fiscal and foreign policies, and China’s marginal policy easing (Chart 11). Eastern European emerging markets and Russian assets are riskier than they appear because of latent geopolitical tensions that could explode around the time of important elections in September. Chart 11Geopolitical Tailwinds To European Equities What Comes After The Olympics In Japan? Japan is returning to an era of “revolving door” prime ministers. Prime Minister Yoshihide Suga’s sole purpose was to tie up the loose ends of the Shinzo Abe administration, namely by overseeing the Olympics. After the games end, he will struggle to retain leadership of the Liberal Democratic Party. He will be blamed for spread of Delta variant even if the Olympics were not a major factor. If he somehow retains the party’s helm, the October general election will still be an underwhelming performance by the Liberal Democrats, which will sow the seeds of his downfall within a short time (Chart 12). Suga will need to launch a new fiscal spending package, possibly as an election gimmick, and his party has the strength in the Diet to push it through quickly, which will be favorable for the economy. For the elections the problem is not the Liberal Democrats’ popularity, which is still leagues above the nearest competitor, but rather low enthusiasm and backlash over COVID. Abe’s retirement, and the eventual fall of Abe’s hand-picked deputy, does not entail the loss of Abenomics. The Bank of Japan will retain its ultra-dovish cast at least until Haruhiko Kuroda steps down in 2023. The changes that occurred in Japan from 2008-12 exemplified Japan’s existence as an “earthquake society” that undergoes drastic national changes suddenly and rapidly. The paradigm shift will not be reversed. The drivers were the Great Recession, the LDP’s brief stint in the political wilderness, the Tohoku earthquake and Fukushima nuclear crisis, and the rise of China. The BoJ became ultra-dovish and unorthodox, the LDP became more proactive both at home and abroad. The deflationary economic backdrop and Chinese nationalism are still a powerful impetus for these trends to continue – as highlighted by increasingly alarming rhetoric by Japanese officials, including now Shinzo Abe himself, regarding the Chinese military threat to Taiwan. In other words, Suga’s lack of leadership will not stand even if he somehow stays prime minister into 2022. The Liberal Democrats have several potential leaders waiting in the wings and one of these will emerge, whether Yuriko Koike, Shigeru Ishiba, or Shinjiro Koizumi, or someone else. The popular and geopolitical pressures will force the Liberal Democrats and various institutions to continue providing accommodation to the economy and bulking up the nation’s defenses. This will require the BoJ to stay easier for longer and possibly to roll out new unorthodox policies, as with yield curve control in the 2010s. Japan has some of the highest real rates in the G10 as a result of very low inflation expectations and a deeply negative output gap (Chart 13). Abenomics was bearing fruit, prior to COVID-19, so it will be justified to stay the course given that deflation has reemerged as a threat once again. Chart 12Japan: Back To Revolving Door Of Prime Ministers Chart 13Japan To Keep Fighting Deflation Post-Abe Bottom Line: The political and geopolitical backdrop for Japan is clear. The government and BoJ will have to do whatever it takes to stay the course on Abenomics even in the wake of Abe and Suga. Prime ministers will come and go in rapid succession, like in past eras of political turmoil, but the trajectory of national policy is set. We would favor JGBs relative to more high-beta government bonds like American and Canadian. Given deflation, looming Japanese political turmoil, and the secular rise in geopolitical risk, we continue to recommend holding the yen. These views conform with those of BCA’s fixed income and forex strategists. Investment Takeaways China’s policymakers are backing away from the risk of overtightening policy this year. Policy should ease on the margin going forward. Our number one key forecast for 2021 is tentatively confirmed. Base metals are still overextended but global reflation trades should be able to grind higher. The US fiscal spending orgy will continue through the end of the year via Biden’s reconciliation bill, which we expect to pass. Proactive DM fiscal policy will continue to dispel disinflationary fears. Sparks will fly in the Middle East. The US-Iran negotiations will now be long and drawn out with occasional shows of force that highlight the tail risk of war. We expect geopolitics to add a risk premium to oil prices at least until the two countries can rejoin the 2015 nuclear deal. Germany’s Green Party will surprise to the upside in elections, highlighting Europe’s low level of geopolitical risk. China policy easing is positive for European assets. Russia’s outward aggressiveness is the key risk. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com
Highlights Advances in tennis, swimming and the high jump came from challenging the ‘best practices’, and finding better ways of doing these things. The pandemic has challenged the best practices on how we should work, do business, and shop, catalysing better ways of doing these things. The productivity boom could be a super-boom because the current disruption is not in just one sector but across the entire economy. A productivity super-boom means that the economy will take longer to reabsorb the unemployed, and that structural inflation will stay depressed. This means that interest rate hikes will be much later and much shallower than the market is pricing. For equity investors, a productivity super-boom plus the market’s overestimation of Fed rate hikes structurally favours growth sectors versus value sectors. Thereby, it also structurally favours the S&P500 versus the Eurostoxx50. Fractal analysis: stocks versus bonds remains fragile, and the rally in tin is very fragile. Feature Chart of the WeekThe Pandemic Has Catalysed A Productivity Boom “I believe that the (Fosbury) flop was a natural style and I was just the first to find it” – Dick Fosbury, on how he revolutionised the high jump Watching the Tokyo Olympics, the flurry of new world records reassures us that human athletic productivity continues to advance. It does so in three ways: better biology, better technology, and better ways of doing the same thing. Better biology comes from advances in nutrition and healthcare – at least, for those that embrace the advances. Better technology means better equipment. For example, more ergonomic bikes, sharkskin-like swimwear that minimises water resistance, and running shoes that re-channel energy back into the legs. Albeit this raises the contentious issue that technological advances are giving some athletes an unfair and unnatural advantage. Case in point, World Athletics (and the Tokyo Olympics) have banned prototype versions of Nike’s Vaporfly running shoe that was used by Eliud Kipchoge to run the first sub-two hour marathon. The banned prototype shoe, containing triple carbon plates inside thick ultra-compressed foam, is claimed to improve running economy by up to four percent. But if technological advances are giving some athletes an advantage, it follows that they must also be giving some firms and economies an advantage. While this is unfair in sporting competition, it is fair in economic competition. An important implication is that firms and economies that embrace disruptive technologies and innovations – such as working from home – are likely to generate superior long-term productivity growth than firms and economies that do not. Productivity Growth Comes From Finding Better Ways Of Doing The Same Thing Yet, looking at the longer-term ‘productivity growth’ in sport, many of the greatest advances have come not from better biology or better technology, but just from finding better ways of doing the same thing. Tennis, swimming, and athletics provide three excellent examples of such innovation. A tennis ball weighs just 50 grams, so anybody can hit a tennis ball hard. The difficult part is hitting the ball hard and landing it within the 78 foot court. In the 1970s, Bjorn Borg revolutionised tennis by hitting with aggressive topspin on both the forehand and backhand as well as the serve. Meaning that rather than having to approach the net as was the ‘best practice’, Borg could win matches from the baseline. All it required was a different way of holding the racket and using his arms (Figure I-1). Figure I-1Challenging The Best Practice In Tennis Boosted Its Productivity Borg’s revolution has a fascinating backstory. Borg’s father, a table tennis champion, won a tennis racket in a table tennis tournament and gave it to the 9-year old Bjorn. Familiar with table tennis and now armed with a tennis racket, the young Borg’s revolution was to play tennis as if it were table tennis – with its trademark topspin on both wings as well as the serve – albeit on a much bigger ‘table.’ And with a racket that was far too heavy for him that he held with both hands. (He eventually switched to a one-handed forehand but kept his two-handed backhand.) Go back a hundred years, and swimming experienced a similar revolution. Until the 1870s, the best practice for European swimmers was the highly inefficient breaststroke. But in 1873, John Arthur Trudgen emulated the technique used by Native Americans whereby the arms moved in a crawl. Later, the Australian Fred Cavill also emulated the Natives’ flutter kick, and thus made mainstream the front crawl, which has significantly increased swimming speed, or swimming ‘productivity.’ All it required was a different way of moving our arms and legs. But probably the greatest example of athletic innovation came in the 1968 Mexico Olympics, when Dick Fosbury turned the standard high jumping technique on its head – or, more precisely, on its back – to win the gold medal and smash the world record. Prior to the 1968 Games, the best practice high jump technique had been the ‘straddle’ which involved jumping forward, twisting the body to navigate the bar, and then landing on your feet. Fosbury changed all that forever. He jumped backwards off the wrong foot, arched his back over the bar, and landed on his back (Figure I-2). Figure I-2Challenging The Best Practice In The High Jump Boosted Its Productivity Just like the tennis topspin and swimming’s front crawl, high jump’s ‘Fosbury flop’ has become the mainstream technique in the sport, taking performance and ‘productivity’ literally to new highs. And just like the tennis topspin and swimming’s front crawl, all it required was a different way of using our existing resources – in this case, jumping backwards rather than forwards. Yet in the case of the innovative Fosbury flop, something else also played an important role – a new environment. Until the 1960s, high jumpers cleared the bar and landed on sawdust, sand, or thin mats. Hence, any innovation in high jump techniques was constrained by having to land on your feet. This changed when Fosbury’s high school became one of the first to install deep foam matting for high jump landing. The Fosbury flop could not have been innovated before the introduction of deep foam matting, because jumping backwards and landing on your back depended on the existence of a soft foam mat for a safe landing. The crucial lesson is that a new environment gives us a chance to challenge beliefs on ‘how things should be done’, a chance to discover new ways of doing the same thing differently, and better. To challenge beliefs on how things should be done, what bigger change in the environment can there be than a global pandemic? The Pandemic Has Catalysed Better Ways Of Doing The Same Thing Just like athletic productivity growth, economic productivity growth comes from better biology (which improves both our physical and intellectual capacity), better technology, and finding better ways of doing the same thing. Of these three drivers, the first two are continuous processes but the third, finding better ways of doing the same thing, gets a massive boost from disruptive changes in the environment such as recessions (Chart of the Week and Chart I-2). Chart I-2Productivity Surges After Recessions In this regard, any technology that is required already generally exists, but the recession is the necessary catalyst for its wholesale adoption. For example, the mass manufacturing of autos already existed well before the Great Depression, but the Depression was the catalyst for its wholesale adoption. Likewise, word processors existed well before the dot com bust, but the 2000 recession was what finally killed the office typing pool. In the same way, the technology for online shopping and remote meetings has been around for years, but it is the pandemic that has catalysed its wholesale adoption (Chart I-3). Chart I-3The Pandemic Has Accelerated The Shift To Online As Fosbury said, he was just the first to find a more natural style of high jumping, yet it required a change of environment to challenge the best practice. Similarly, it has taken a global pandemic for us to challenge the best practice on how we should work, do business, shop, and interact (Chart I-4). Chart I-4The Pandemic Has Accelerated The Shift To Online It is sub-optimal to work in the office or to shop in-person all the time. It is also sub-optimal to do these things remotely all the time. The optimal way is some hybrid of in-person and remote interactions, which will clearly differ for each person. But the pandemic has given us the opportunity to find this more natural and better way, and thereby to give our productivity a massive boost (Chart I-5). Chart I-5The Pandemic Has Challenged The Best Practice On How To Work The productivity boom could be a super-boom because the current disruption has forced us all to find better ways of doing things. This differentiates the current episode from previous post-recession periods where transformations were focussed in one sector. For example, the 80s recession reshaped manufacturing, the dot com bust changed the technology sector, and the 2008 recession transformed the financial sector. By comparison, the current transformation is penetrating the entire economy. The Investment Conclusion A productivity super-boom carries two important implications for policymakers. It will take longer for the economy to reabsorb the unemployed, and it will keep structural inflation depressed. This means that interest rate hikes will be much later and much shallower than the market is pricing (Chart I-6 and Chart I-7). Chart I-6Rate Hikes Will Be Later Than The Market Is Pricing Chart I-7Rate Hikes Will Be Shallower Than The Market Is Pricing The investment conclusion is to buy any of the US interest rate futures that expire from December 2022 out to June 2024. The earlier contracts have the higher probabilities of expiring in profit while the later contracts have the greater potential upside. An alternative expression is to buy the 30-year T-bond, or to go long the 30-year T-bond versus the 30-year German bund. For equity investors, a productivity super-boom plus the market’s overestimation of Fed rate hikes structurally favours growth sectors versus value sectors. Thereby, it also structurally favours the S&P500 versus the Eurostoxx50. Fractal Analysis Update Global stocks versus bonds (MSCI All Country World versus 30-year T-bond) continue to exhibit the fragility on the 260-day fractal structure that started in mid-March. Since then, and consistent with this fragility, global stocks have underperformed bonds by 6 percent (Chart I-8). Chart I-8Stocks Versus Bonds Remains Fractally Fragile But fragility on a 260-day fractal structure implies elevated risk of a reversal through at least the following six months. On this basis, our recommendation is to remain, at most, neutral to global stocks versus bonds through the summer. Among recent trades, short corn versus wheat, and short marine transportation versus market achieved their profit targets of 12 percent and 16.5 percent respectively, but short Austria versus Chile, and short lead versus platinum hit their stop-losses of 7 percent and 6.4 percent respectively. The 6-month win ratio stands at a very pleasing 71 percent. This week’s recommended trade is to reinitiate the stopped-out metals pair-trade in a modified expression – short tin versus platinum – given the very fragile 130-day and 260-day fractal structure (Chart I-9). Set the profit target and symmetrical stop-loss at 16.5 percent. Chart I-9Tin Is Fractally Fragile Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Globalization is recovering to its pre-pandemic trajectory. But it will fail to live up to potential, as the “hyper-globalization” trends of the 1990s are long gone. China was the biggest winner of hyper-globalization. It now faces unprecedented risks in the context of hypo-globalization. Global investors woke up to China’s domestic political risks this year, which include arbitrary regulatory crackdowns on tech and private business. While Chinese officials will ease policy to soothe markets, the cyclical and structural outlook is still negative for this economy. Growth and stimulus have peaked. Political risk will stay high through the national party congress in fall 2022. US-China relations have not stabilized. India, the clearest EM alternative for global investors, is high-priced relative to China and faces troubles of its own. It is too soon to call a bottom for EM relative to DM. Feature Global investors woke up to China’s domestic political risk over the past week, as Beijing extended its regulatory crackdown to private education companies. Our GeoRisk Indicator shows Chinese political risk reaching late 2017 levels while the broad Chinese stock market continued this year’s slide against emerging market peers (Chart 1). Chart 1China: Domestic Political Risk Takes Investors By Surprise A technical bounce in Chinese tech stocks will very likely occur but we would not recommend playing it. The first of our three key views for 2021 is the confluence of internal and external headwinds for China. True, today’s regulatory blitz will pass over like previous ones and the fast money will snap up Chinese tech firms on the cheap. The Communist Party is making a show of force, not destroying its crown jewels in the tech sector. However, the negative factors weighing on China are both cyclical and structural. Until Chinese President Xi Jinping adjusts his strategy and US-China relations stabilize, investors do not have a solid foundation for putting more capital at risk in China. Globalization is in retreat and this is negative for China, the big winner of the past 40 years. Hypo-Globalization Globalization in the truest sense has expanded over millenia. It will only reverse amid civilizational disasters. But the post-Cold War era of “hyper-globalization” is long gone.1 The 2010s saw the emergence of de-globalization. In the wake of COVID-19, global trade is recovering to its post-2008 trend but it is nowhere near recovering the post-1990 trend (Chart 2). Trade exposure has even fallen within the major free trade blocs, like the EU and USMCA (Chart 3). Chart 2Hypo-Globalization Chart 3Trade Intensity Slows Even Within Trade Blocs Of course, with vaccines and stimulus, global trade will recover in the coming decade. We coined the term “hypo-globalization” to capture this predicament, in which globalization is set to rebound but not to its previous trajectory.2 We now inhabit a world that is under-globalized and under-globalizing, i.e. not as open and free as it could be. A major factor is the US-China economic divorce, which is proceeding apace. China’s latest state actions – in diplomacy, finance, and business – underscore its ongoing disengagement from the US-led global architecture. The US, for its part, is now on its third presidency with protectionist leanings. American and European fiscal stimulus are increasingly protectionist in nature, including rising climate protectionism. Bottom Line: The stimulus-fueled recovery from the global pandemic is not leading to re-globalization so much as hypo-globalization. A cyclical reboot of cross-border trade and investment is occurring but will fall short of global potential due to a darkening geopolitical backdrop. Still No Stabilization In US-China Relations Chart 4Do Nations Prefer Growth? Or Security? A giant window of opportunity is closing for China and Russia – they will look back fondly on the days when the US was bogged down in the Middle East. The US current withdrawal from “forever wars” incentivizes Beijing and Moscow to act aggressively now, whether at home or abroad. Investors tend to overrate the Chinese people’s desire for economic prosperity relative to their fear of insecurity and domination by foreign powers. China today is more desirous of strong national defense than faster economic growth (Chart 4). The rise of Chinese nationalism is pronounced since the Great Recession. President Xi Jinping confirmed this trend in his speech for the Communist Party’s first centenary on July 1, 2021. Xi was notably more concerned with foreign threats than his predecessors in 2001 and 2011 (Chart 5).3 China has arrived as a Great Power on the global stage and will resist being foisted into a subsidiary role by western nations. Chart 5Xi Jinping’s Centenary Speech Signaled Nationalist Turn Meanwhile US-China relations have not stabilized. The latest negotiations did not produce agreed upon terms for managing tensions in the relationship. A bilateral summit between Presidents Biden and Xi Jinping has not been agreed to or scheduled, though it could still come together by the end of October. Foreign Minister Wang Yi produced a set of three major demands: that the US not subvert “socialism with Chinese characteristics,” obstruct China’s development, or infringe on China’s sovereignty and territorial integrity (Table 1). The US’s opposition to China’s state-backed economic model, export controls on advanced technology, and attempts to negotiate a trade deal with the province of Taiwan all violate these demands.4 Table 1China’s Three Demands From The United States (July 2021) The removal of US support for China’s economic, development – recently confirmed by the Biden administration – will take a substantial toll on sentiment within China and among global investors. US President Joe Biden and four executive departments have explicitly warned investors not to invest in Hong Kong or in companies with ties to China’s military-industrial complex and human rights abuses. The US now formally accuses China of genocide in the Xinjiang region.5 Bottom Line: There is no stabilization in US-China relations yet. This will keep the risk premium in Chinese currency and equities elevated. The Sino-American divorce is a major driver of hypo-globalization. China’s Regulatory Crackdown President Xi Jinping’s strategy is consistent. He does not want last year’s stimulus splurge to create destabilizing asset bubbles and he wants to continue converting American antagonism into domestic power consolidation, particularly over the private economy. Now China’s sweeping “anti-trust” regulatory crackdown on tech, education, and other sectors is driving a major rethink among investors, ranging from Ark-founder Cathie Wood to perma-bulls like Stephen Roach. The driver of the latest regulatory crackdown is the administration’s reassertion of central party control. The Chinese economy’s potential growth is slowing, putting pressure on the legitimacy of single-party rule. The Communist Party is responding by trying to improve quality of life while promoting nationalism and “socialism with Chinese characteristics,” i.e. strong central government control and guidance over a market economy. Beijing is also using state power and industrial policy to attempt a great leap forward in science and technology in a bid to secure a place in the sun. Fintech, social media, and other innovative platforms have the potential to create networks of information, wealth, and power beyond the party’s control. Their rise can generate social upheaval at home and increase vulnerability to capital markets abroad. They may even divert resources from core technologies that would do more to increase China’s military-industrial capabilities. Beijing’s goal is to guide economic development, break up the concentration of power outside of the party, prevent systemic risks, and increase popular support in an era of falling income growth. Sociopolitical Risks: Social media has demonstrably exacerbated factionalism and social unrest in the United States, while silencing a sitting president. This extent of corporate power is intolerable for China. Economic And Financial Risks: Innovative fintech companies like Ant Group, via platforms like Alipay, were threatening to disrupt one of the Communist Party’s most important levers of power: the banking and financial system. The People’s Bank of China and other regulators insisted that Ant be treated more like a bank if it were to dabble in lending and wealth management. Hence the PBoC imposed capital adequacy and credit reporting requirements.6 Data Security Risks: Didi Chuxing, the ride-sharing company partly owned by Uber, whose business model it copied and elaborated on, defied authorities by attempting to conduct its initial public offering in the United States in June. The Communist Party cracked down on the company after the IPO to show who was in charge. Even more, Beijing wanted to protect its national data and prevent the US from gaining insights into its future technologies such as electric and autonomous vehicles. Foreign Policy Risks: Beijing is also preempting the American financial authorities, who will likely take action to kick Chinese companies that do not conform to common accounting and transparency standards off US stock exchanges. Better to inflict the first blow (and drive Chinese companies to Hong Kong and Shanghai for IPOs) than to allow free-wheeling capitalism to continue, giving Americans both data and leverage. Thus Beijing is continuing the “self-sufficiency” drive, divorcing itself from the US economy and capital markets, while curbing high-flying tech entrepreneurs and companies. The party’s muscle-flexing will culminate in Xi Jinping’s consolidation of power over the Politburo and Central Committee at the twentieth national party congress in fall 2022, where he is expected to take the title of “Chairman” that only Mao Zedong has held before him. The implication is that the regulatory crackdown can easily last for another six-to-12 more months. True, investors will become desensitized to the tech crackdown. But health care and medical technology are said to be in the Chinese government’s sights. So are various mergers and acquisitions. Both regulatory and political risk premia in different sectors can persist. The current administration has waged several sweeping regulatory campaigns against monopolies, corruption, pollution, overcapacity, leverage, and non-governmental organizations. The time between the initial launch of one of these campaigns and their peak intensity ranges from two to five years (Chart 6). Often, but not always, central policy campaigns have an express, three-year plan associated with them. Chart 6ABeijing Cracked Down On Monopolies, Corruption, Pollution... Chart 6B...NGOs, Overcapacity, And Leverage Chart 7China Tech: Buyer Beware The first and second year mark the peak impact. The negative profile of Chinese tech stocks relative to their global peers suggests that the current crackdown is stretched, although there is little sign of bottom formation yet (Chart 7). The crackdown began with Alibaba founder Jack Ma, and Alibaba stocks have yet to arrest their fall either in absolute terms or relative to the Hang Seng tech index. Bottom Line: A technical bounce is highly likely for Chinese stocks, especially tech, but we would not recommend playing it because of the negative structural factors. For instance, we fully expect the US to delist Chinese companies that do not meet accounting standards. The Chinese Government’s Pain Threshold? The government is not all-powerful – it faces financial and economic constraints, even if political checks and balances are missing. Beijing does not have an interest in destroying its most innovative companies and sectors. Its goal is to maintain the regime’s survival and power. China’s crackdown on private companies goes against its strategic interest of promoting innovation and therefore it cannot continue indefinitely. The hurried meeting of the China Securities Regulatory Commission with top bankers on July 28 suggests policymakers are already feeling the heat.7 In the case of Ant Group, the company ultimately paid a roughly $3 billion fine (which is 18% of its annual revenues) and was forced to restructure. Ant learned that if it wants to behave more like a bank athen it will be regulated more like a bank. Yet investors will still have to wrestle with the long-term implications of China’s arbitrary use of state power to crack down on various companies and IPOs. This is negative for entrepreneurship and innovation, regardless of the government’s intentions. Chart 8China's Pain Threshold = Property Sector Ultimately the property sector is the critical bellwether: it is a prime target of the government’s measures against speculative asset bubbles. It is also an area where authorities hope to ease the cost of living for Chinese households, whose birth rates and fertility rates are collapsing. While there is no risk of China’s entire economy crumbling because of a crackdown on ride-hailing apps or tutoring services, there is a risk of the economy crumbling if over-zealous regulators crush animal spirits in the $52 trillion property sector, as estimated by Goldman Sachs in 2019. Property is the primary store of wealth for Chinese households and businesses and falling property prices could well lead to an unsustainable rise in debt burdens, a nationwide debt-deflation spiral, and a Japanese-style liquidity trap. Judging by residential floor space started, China is rapidly approaching its overall economic pain threshold, meaning that property sector restrictions should ease, while monetary and credit policy should get easier as necessary to preserve the economic recovery (Chart 8). The economy should improve just in time for the party congress in late 2022. Bottom Line: China will be forced to maintain relatively easy monetary and fiscal policy and avoid pricking the property bubble, which should lend some support to the global recovery and emerging markets economies over the cyclical (12-month) time frame. China’s Regulation And Demographic Pressures Is the Chinese government not acting in the public interest by tamping down financial excesses, discouraging anti-competitive corporate practices, and combating social ills? Yes, there is truth to this. But arbitrary administrative controls will not increase the birth rate, corporate productivity, or potential GDP growth. First, it is true that Chinese households cite high prices for education, housing, and medicine as reasons not to have children (Chart 9). However, price caps do not attack the root causes of these problems. The lack of financial security and investment options has long fueled high house prices. The rabid desire to get ahead in life and the exam-oriented education system have long fueled high education prices. Monetary and fiscal authorities are forced to maintain an accommodative environment to maintain minimum levels of economic growth amid high indebtedness – and yet easy money policies fuel asset price inflation. In Japan, fertility rates began falling with economic development, the entrance of women in the work force, and the rise of consumer society. The fertility rate kept falling even when the country slipped into deflation. It perked up when prices started rising again! But it relapsed after the Great Recession and Fukushima nuclear crisis (Chart 10, top panel). Chart 9China: Concerns About Having Children China’s fertility rate bottomed in the 1990s and has gradually recovered despite the historic surge in property prices (Chart 10, second panel), though it is still well below the replacement rate needed to reverse China’s demographic decline in the absence of immigration. A lower cost of living and a higher quality of life will be positive for fertility but will require deeper reforms.8 Chart 10Fertility Fell In Japan Despite Falling Prices At the same time, arbitrary regulatory crackdowns that punish entrepreneurs are not likely to boost productivity. Anti-trust actions could increase competition, which would be positive for productivity, but China’s anti-trust actions are not conducted according to rule of law, or due process, so they increase uncertainty rather than providing a more stable investment environment. China’s tech crackdown is also aimed at limiting vulnerability to foreign (American) authorities. Yet disengagement with the global economy will reduce competition, innovation, and productivity in China. Bottom Line: China’s demographic decline will require larger structural changes. It will not be reversed by an arbitrary game of whack-a-mole against the prices of housing, education, and health. India And South Asia Chart 11China Will Ease Policy... Or India Will Break Out Global investors have turned to Indian equities over the course of the year and they are now reaching a major technical top relative to Chinese stocks (Chart 11). Assuming that China pulls back on its policy tightening, this relationship should revert to mean. India faces tactical geopolitical and macroeconomic headwinds that will hit her sails and slow her down. In other words, there is no great option for emerging markets at the moment. Over the long run, India benefits if China falters. Following the peak of the second COVID-19 wave in May 2021, some high frequency indicators have showed an improvement in India’s economy. However, activity levels appear weaker than of other emerging markets (Chart 12). Given the stringency levels of India’s first lockdown last spring, year-on-year growth will look faster than it really is. As the base effect wanes, underlying weak demand will become evident. Moreover India is still vulnerable to COVID-19. Only 25% of the population has received one or more vaccine shots which is lower than the global level of 28%. The result will be a larger than expected budget deficit. India refrained from administering a large dose of government spending in 2020 (Chart 13). With key state elections due from early 2022 onwards, the government could opt for larger stimulus. This could assume the form of excise duty cuts on petroleum products or an increase in revenue expenditure. These kinds of measures will not enhance India’s productivity but will add to its fiscal deficit. Chart 12Weak Post-COVID Rebound In India – And Losing Steam Chart 13India Likely To Expand Fiscal Spending Soon Such an unexpected increase in India’s fiscal deficit could be viewed adversely by markets. India’s fiscal discipline tends to be poorer than that of peers (see Chart 13 above). Meanwhile India’s north views Pakistan unfavorably and key state elections are due in this region. Consequently, Indian policy makers may be forced to adopt a far more aggressive foreign policy response to any terrorist strikes from Pakistan or territorial incursions by China over August 2021. The US withdrawal from Afghanistan poses risks for India as it has revived the Taliban’s influence. India has a long history of being targeted by Afghani terrorist groups. And its diplomatic footprint in Afghanistan has been diminishing. Earlier in July, India decided temporarily to close its consulate in Kandahar and evacuated about 50 diplomats and security personnel. As August marks the last month of formal US presence in Afghanistan, negative surprises emanating from Afghanistan should be expected. Bottom Line: Pare exposure to Indian assets on a tactical basis. Our Emerging Markets Strategy takes a more optimistic view but geopolitical changes could act as a negative catalyst in the short term. We urge clients to stay short Indian banks. Investment Takeaways US stimulus contrasts with China’s turmoil. The US Biden administration and congressional negotiators of both parties have tentatively agreed on a $1 trillion infrastructure deal over eight years. Even if this bipartisan deal falls through, Democrats alone can and will pass another $1.3-$2.5 trillion in net deficit spending by the end of the year. Stay short the renminbi. Prefer a balance of investments in the dollar and the euro, given the cross-currents of global recovery yet mounting risks to the reflation trade. A technical bounce in Chinese stocks and tech stocks is nigh. China’s policymakers are starting to respond to immediate financial pressures. However, growth has peaked and structural factors are still negative. The geopolitical outlook is still gloomy and China’s domestic political clock is a headwind for at least 12 more months. Prefer developed market equities over emerging markets (Chart 14). Emerging markets failed to outperform in the first half of the year, contrary to our expectation that the global reflation trade would lift them. China/EM will benefit when Beijing eases policy and growth rebounds. Chart 14Emerging Markets: Not Out Of The Woods Yet Stay short Indian banks and strongman EM currencies, including the Turkish lira, the Brazilian real, and the Philippine peso. The biggest driver of EM underperformance this year is the divergence between the US and China. But until China’s policy corrects, the rest of EM faces downside risks. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Dani Rodrik, The Globalization Paradox: Democracy and the Future of the World Economy (New York: Norton, 2011). 2 See my "Nationalism And Globalization After COVID-19," Investments & Wealth Monitor (Jan/Feb 2021), pp13-21, investmentsandwealth.org. 3 Our study of Xi’s speech is not limited to this quantitative, word-count analysis. A fuller comparison of his speech with that of his predecessors on the same occasion reveals that Xi was fundamentally more favorable toward Marx, less favorable toward Deng Xiaoping and the pro-market Third Plenum, utterly silent on notions of political reform or liberal reform, more harsh in his rhetoric toward the outside world, and hawkish about the mission of reunifying with Taiwan. 4 The Chinese side also insisted that the US stop revoking visas, punishing companies and institutes, treating the press as foreign agents, and detaining executives. It warned that cooperation – which the US seeks on the environment, Iran, North Korea, and other areas – cannot be achieved while the US imposes punitive measures. 5 See US Department of State, "Xinjiang Supply Chain Business Advisory," July 13, 2021, and "Risks and Considerations for Businesses Operating in Hong Kong," July 16, 2021, state.gov. 6 Top business executives are also subject to these displays of state power. For example, Alibaba founder Jack Ma caricatured China’s traditional banks as “pawn shops” and criticized regulators for stifling innovation. He is now lying low and has taken to painting! 7 See Emily Tan and Evelyn Cheng, "China will still allow IPOs in the United States, securities regulator tells brokerages," CNBC, July 28, 2021, cnbc.com. Officials are sensitive to the market blowback but the fact remains that IPOs in the US have been discouraged and arbitrary regulatory crackdowns are possible at any time. 8 Increasing social spending also requires local governments to raise more revenue but the central government had been cracking down on the major source of revenues for local government: land sales and local government financing vehicles. With the threat of punishment for local excesses and lack of revenue source, local governments have no choice but to cut social services, pushing affluent residents towards private services, while leaving the less fortunate with fewer services. As with financial regulations, the central government may backpedal from too tough regulation of local governments, but more economic and financial pain will be required to make it happen. The Geopolitics Of The Olympics The 2020 Summer Olympics are currently underway in Tokyo, even though it is 2021. The arenas are mostly empty given the global pandemic and economic slowdown. Every four years the Summer Olympics create a golden opportunity for the host nation to showcase its achievements, infrastructure, culture, and beauty. But the Olympics also have a long history of geopolitical significance: terrorist acts, war protests, social demonstrations, and boycotts. In 1906 an Irish athlete climbed a flag pole to wave the Irish flag in protest of his selection to the British team instead of the Irish one. In 1968 two African American athletes raised their fists as an act of protest against racial discrimination in the US after the assassination of Martin Luther King Jr. In 1972, the Palestinian terrorist group Black September massacred eleven Israeli Olympians in Munich, Germany. In 1980 the US led the western bloc to boycott the Moscow Olympics while the Soviet Union and its allies retaliated by boycotting the 1984 Los Angeles Olympics. In 2008, Russia used the Olympics as a convenient distraction from its invasion of Georgia, a major step in its geopolitical resurgence. So far, thankfully, the Tokyo Olympics have gone without incident. However, looking forward, geopolitics is already looming over the upcoming 2022 Winter Olympics in Beijing. How the world has changed. The 2008 Summer Olympics marked China’s global coming-of-age celebration. The breathtaking opening ceremony featured 15,000 performers and cost $100 million. The $350 million Bird’s Nest Stadium showcased to the world China’s long history, economic prowess, and various other triumphs. All of this took place while the western democratic capitalist economies grappled with what would become the worst financial and economic crisis since the Great Depression. In 2008, global elites spoke of China as a “responsible stakeholder” that was conducting a “peaceful rise” in international affairs. The world welcomed its roughly $600 billion stimulus. Now elites speak of China as primarily a threat and a competitor, a “revisionist” state challenging the liberal world order. China is blamed for a lack of transparency (if not virological malfeasance) in handling the COVID-19 pandemic. It is blamed for breaking governance promises and violating human rights in Hong Kong, for alleged genocide in Xinjiang, and for a list of other wrongdoings, including tough “Wolf Warrior” diplomacy, cyber-crime and cyber-sabotage, and revanchist maritime-territorial claims. Even aside from these accusations it is clear that China is suffering greater financial volatility as a result of its conflicting economic goals. Talk of a diplomatic or even full boycott of Beijing’s winter games is already brewing. Sponsors are also second-guessing their involvement. More than half of Canadians support boycotting the winter games. Germany is another bellwether to watch. In 2014, Germany’s president (not chancellor) boycotted the Sochi Olympics; in 2021, the EU and China are witnessing a major deterioration of relations. Parliamentarians in the UK, Italy, Sweden, Switzerland, and Norway have asked their governments to outline their official stance on the winter games. In the age of “woke capitalism,” a sponsorship boycott of the games is a possibility. This is especially true given the recent Chinese backlash against European multinational corporations for violating China’s own rules of political correctness. A boycott which includes any members of the US, Norway, Canada, Sweden, Germany, or the Netherlands would be substantial as these are the top performers in the Winter Olympics. Even if there is no boycott, there is bound to be some political protests and social demonstrations, and China will not be able to censor anything said by Western broadcasters televising the events. Athletes usually suffer backlash at home if they make critical statements about their country, but they run very little risk of a backlash for criticizing China. If anything, protests against China’s handling of human rights will be tacitly encouraged. Beijing, for its part, will likely overreact, as these days it not only controls the message at home but also attempts more actively to export censorship. This is precisely what the western governments are now trying to counteract, for their own political purposes. The bottom line is that the 2008 Beijing Olympics reflected China’s strengths in stark contrast with the failures of democratic capitalism, while the 2022 Olympics are likely to highlight the opposite: China’s weaknesses, even as the liberal democracies attempt a revival of their global leadership. Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Section II: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia Section III: Geopolitical Calendar
Dear Client, I will be on vacation next week. In lieu of our regular report, we will be sending you a Special Report written by my colleague Arthur Budaghyan, BCA Research’s Chief Emerging Markets Strategist. Arthur’s report will discuss the long-term outlook for industrial companies. He argues that the US is entering an industrial boom prompted by infrastructure stimulus and onshoring. This will benefit US industrial equities, or ones selling into the US on a multi-year horizon. I trust you will find it insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Investors keep asking whether the recent increase in US inflation is transitory. However, this is the wrong question to ask. Annualized core CPI inflation reached 10.6% in the second quarter. There is little doubt that inflation will fall from such elevated levels. The key question that investors should be asking is whether inflation will decline more or less than what the market is discounting. The widely watched 5-year/5-year forward TIPS inflation breakeven rate has sunk to 2.11%, below the Fed’s “comfort zone” of 2.3%-to-2.5%. Thus, the market already expects a substantial decline in inflation. Our sense is that US inflation will come down fast enough to allow the Fed to maintain a highly dovish policy stance, but not as fast as market expectations currently imply. As inflation surprises on the upside, long-term bond yields will rise. This should revive bank shares and other reflationary plays. The combination of a weaker US dollar, faster sequential Chinese growth, increased vaccine supplies, and favorable valuations should all help EM stocks later this year. Go long the Vanguard FTSE Emerging Markets ETF (VWO) versus the Vanguard S&P 500 ETF (VOO). The Right Question About Inflation Chart 1After A Spike In Q2, US Inflation Will Decelerate Investors remain focused on whether the recent bout of US inflation is transitory. However, this is not the correct question to be asking at the present juncture. The US core CPI rose by 10.6% at an annualized pace in Q2 relative to the first quarter (Chart 1). It is almost inevitable that inflation will come down from such high levels. The key question investors should be asking is whether inflation will decline more or less than what is already baked into market expectations. As Chart 2 shows, investors expect US inflation to come down rapidly over the next two years. The 5-year/5-year forward TIPS breakeven inflation rate – a good proxy for where investors expect inflation to be over the long haul – has sunk to 2.11% (Chart 3). This is below the Fed’s comfort zone of 2.3%-to-2.5%.1 Globally, long-term inflation expectations remain subdued (Chart 4). Chart 2Inflation Is Expected To Moderate Over The Coming Years Chart 3Inflation Expectations Have Fallen Back Below The Fed's Target Zone Chart 4Long-Term Inflation Expectations Remain Subdued Inflation Will Fall, But… Our sense is that US inflation will come down fast enough to allow the Fed to maintain a highly dovish policy stance, but not as fast as market expectations currently imply. Broad-based inflationary pressures would make the Fed nervous. However, that is not what we are seeing. Wages have accelerated markedly in only a few relatively low-skilled sectors such as retail trade and leisure and hospitality (Chart 5). For the economy as a whole, wage growth is broadly stable (Chart 6). The expiration of extended unemployment benefits, the reopening of schools, and increased immigration should also boost labor supply in the fall. Chart 5Faster Wage Growth Has Been Confined To A Few Low-Wage Sectors Chart 6No Sign Of A Wage-Price Spiral... For Now On the price front, more than two-thirds of the increase in the core CPI in June stemmed from pandemic-afflicted sectors (Chart 7). The price of the median item within the CPI index rose by just 2.2% year-over-year in June, somewhat below the pre-pandemic pace of inflation (Chart 8). Chart 7Most Of The Recent Increase In Inflation Is Pandemic-Related Chart 8The Median Price In The CPI Basket Is Up Only 2.2% … Not As Fast As The Market Expects While inflation will fall as pandemic effects recede, investors are overestimating how fast this will happen. US growth has undoubtedly peaked, but at a very high level. Economists surveyed by Bloomberg estimate that US GDP rose by 9.0% in Q2. Growth is expected to slow to 7.1% in Q3 and 5.1% in Q4, while averaging 4.2% in 2022 (Table 1). By any standard, these are very strong, above-trend growth rates. Table 1Growth Is Peaking, But At A Very High Level Chart 9Nearly 90% Of US Seniors Have Had At Least One Shot The current Delta-variant wave is unlikely to slow US growth by very much. Although vaccination rates among younger people are at middling levels, they are quite high for the elderly who are most at risk of serious illness. Close to 89% of Americans above the age of 65 have received at least one shot, and nearly 80% are fully vaccinated (Chart 9). The 65+ age group accounts for four-fifths of all Covid deaths in the United States. Widespread vaccination coverage for older Americans will take pressure off the hospital system, allowing the economy to remain open. Fiscal Support In The US And Abroad As we noted last week, Senate Democrats are likely to use the reconciliation process to both raise the debt ceiling and pass President Biden’s $3.5 trillion American Jobs and Families Plan. They are also likely to move forward on Biden’s proposed $600 billion in infrastructure spending, with or without Republican support. Meanwhile, much of the fiscal stimulus that has already been undertaken has yet to make its way through to the economy. US households are sitting on about $2.5 trillion in excess savings, about half of which stems from increased government transfers (Chart 10). Chart 10A Lot Of Excess Savings Chart 11Inventories Are At Low Levels Satiating that demand has not been easy for many companies. Retail sector inventories are at record lows (Chart 11). The number of homes that have been authorized for construction but where building has yet to begin has increased by 62% since the start of the pandemic (Chart 12). By limiting production, supply-chain bottlenecks will push some spending towards the future. This will keep growth from decelerating more than it otherwise would. Outside the US, fiscal policy will remain supportive. All 27 EU countries ratified the €750 billion Next Generation fund on May 28th. The allocations from the fund for southern European countries are relatively large (Chart 13). Most of the money will be spent on public investment projects with high fiscal multipliers. Chart 12Growing Backlog Of New Home Construction Projects Chart 13EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large Chart 14Economic Growth In China Was Slow In H1 The Japanese government is contemplating sending stimulus checks to low-income citizens in advance of the general election due by October 22nd. It is an understandable move. Covid cases are rising again. As a result, the authorities have declared a state of emergency in Tokyo and barred spectators from attending the Olympic games in and around the city. Fortunately, the Japanese vaccination campaign has accelerated after a slow start. A third of the population has now received at least one shot. The government intends to vaccinate all eligible people by November. Looking at quarter-over-quarter growth rates, Chinese growth averaged just 3.8% on an annualized basis in the first half of 2021 (Chart 14). Growth should pick up in the second half of the year thanks in part to increased fiscal spending. As of June, local governments had used only 28% of their annual bond issuance quotas, compared with 61% over the same period last year and 65% in 2019. Most of the proceeds from local government bond sales will likely flow into infrastructure projects. Resumption Of The Dollar Bear Market Will Keep Inflation From Falling Too Far As a countercyclical currency, the US dollar usually weakens when global growth is strong (Chart 15). Short-term real interest rate differentials have moved sharply against the dollar, a trend that is unlikely to change anytime soon given the Fed’s dovish bias (Chart 16). While inflation in the US is not as sensitive to currency fluctuations as in most other countries, a weaker dollar will still lift tradeable goods prices (Chart 17). Chart 15The Dollar Is A Countercyclical Currency Chart 16Rate Differentials Are A Headwind For The Dollar Chart 17The Dollar And Inflation Structural Forces Turning More Inflationary Not only are cyclical forces likely to turn out to be less disinflationary than investors believe, but many of the structural factors that have suppressed inflation over the past 40 years are reversing direction: Chart 18Globalization Plateaued More Than A Decade Ago Globalization is in retreat: The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 18). Looking out, the ratio could even decline as more companies shift production back home in order to gain greater control over supply chains of essential goods. Baby boomers are leaving the labor force en masse. As a group, baby boomers hold more than half of US household wealth (Chart 19). They will continue to run down their wealth once they retire. However, since they will no longer be working, they will no longer contribute to national output. Continued spending against a backdrop of diminished production could be inflationary. Despite a pandemic-induced bounce, underlying productivity growth remains anemic (Chart 20). Slow productivity growth could cause aggregate supply to fall short of aggregate demand. Social stability is in peril, as exemplified by the recent dramatic increase in the US homicide rate. In the past, social instability and higher inflation have gone hand in hand (Chart 21). Perhaps most importantly, policymakers are deliberately aiming to run the economy hot. A tight labor market will eventually lift wage growth to a greater degree than what we have seen so far (Chart 22). Not only could higher wage growth push up inflation through the usual “cost-push” channel, but by boosting labor’s share of income, a tight labor market could spur aggregate demand. Chart 19Baby Boomers Have Accumulated A Lot Of Wealth Chart 20Trend Productivity Growth Has Been Disappointing Chart 21Historically, Social Unrest And Higher Inflation Move In Lock-Step Chart 22A Tight Labor Market Eventually Bolsters Wages Investment Implications Chart 23Positive Earnings Revisions Are At High Levels The path to higher rates is lined with lower rates. The longer central banks keep interest rates below their neutral level, the more economies will overheat, and the more rates will eventually need to rise to bring inflation back down. For now, we are still in the warm-up phase to higher inflation. With long-term inflation expectations below target, central banks will be able to maintain accommodative monetary policies. This is good news for stocks, at least in the short-to-medium term. The recent wobble in equity markets has occurred despite a strong second quarter earnings season. According to the latest available data from I/B/E/S, 90% of S&P 500 companies have reported earnings above analyst expectations. Earnings have surprised on the upside by an average of 19.2%, compared to a historical average of 3.9%. Positive earnings revisions are at record high levels (Chart 23). Full year 2021 S&P 500 EPS estimates have risen 16% since the start of the year. Analysts have also raised their estimates for 2022 and 2023 (Chart 24). We continue to recommend that asset allocators favor stocks over bonds over a 12-month horizon. Chart 24Analysts Have Been Revising Up Earnings Estimates This Year Chart 25The Gains Of Recent Winners Have Not Been Fully Mirrored In Relative Earnings Growth Chart 26Bank Shares Thrive In A Rising Yield Environment Tech stocks have outperformed the broader market over the past seven weeks. However, unlike during the pandemic, 12-month forward EPS estimates for tech have not risen in relation to other sectors (Chart 25). As long-term bond yields move back up, tech shares will underperform. In contrast, banks will benefit from higher yields (Chart 26). Along the same lines, US stocks have outpaced other stock markets by more than one would have expected based on relative EPS trends. Notably, EM earnings have moved sideways versus the US since mid-2019. Yet, US stocks have outperformed EM by 17% over this period. Today, the forward P/E ratio for EM stands at 13.8, compared to 22.1 for the US (Chart 27). The combination of a weaker US dollar, faster sequential Chinese growth, increased vaccine supplies, and favorable valuations should all help EM stocks later this year. Go long the Vanguard FTSE Emerging Markets ETF (VWO) versus the Vanguard S&P 500 ETF (VOO). Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Chart 27Wide Valuation Gap Between US And Non-US Markets Footnotes 1 The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Dear Client, We will be presenting our quarterly webcast next week, and, as a result, will not be publishing on 29 July 2021. We will cover our major calls for the quarter and provide a look-ahead. I look forward to the Q+A, and am hopeful you will tune in. Bob Ryan Chief Commodity & Energy Strategist Highlights Chart Of The WeekOPEC 2.0's Hand Strengthened By Production Agreement The deal crafted by OPEC 2.0 over the weekend to add 400k b/d of oil every month from August preserves the coalition, and sends a credible signal of its ability to raise output after its 5.8mm b/d of spare capacity is returned to market next year.1 KSA and Russia will remain primi inter pares, but the position of OPEC 2.0's core producers – not just the UAE, which negotiated an immediate baseline increase – was enhanced for future negotiations. This deal explicitly recognizes they are the only ones capable of increasing output over an extended period. We assume the revised production baselines for core OPEC 2.0 effective May 2022 reflect the coalition's demand expectations from 2H22 onward. Our modeling indicates core OPEC 2.0's output will almost converge on the revised baseline production of 34.3mm b/d by 2H23, when we expect these producers to be at ~ 33.4mm b/d. Holding our demand estimates constant from last week, our revised supply expectations prompt us to move our forecast closer to our June forecast. We expect Brent to average $70/bbl in 2H21, with 2022 and 2023 averaging $74 and $80/bbl (Chart of the Week). Feature The deal concluded by OPEC 2.0 over the weekend will do more than add 400k b/d of spare capacity to the market every month beginning next month. It also does more than preserve the producer coalition's successful production-management strategy. The big take-away from the deal is the clear message being sent by the coalition's core members – KSA, Russia, Iraq, UAE and Kuwait – that they are able to significantly increase output after their 5.8mm b/d of spare capacity has been returned to the market over the next year or so. It does so by raising the baselines of the core producers starting in May 2022, clearly indicating the capacity and willingness to raise output and keep it there (Table 1). Table 1Baseline Increases For Core OPEC 2.0 What OPEC 2.0's Deal Signals Internally, the deal is meant to recognize the investment made by the UAE in particular, which was not being accounted for in its current baseline. Externally – i.e., to competitors outside the coalition – the deal signals OPEC 2.0's successful production management strategy will continue, by raising the likelihood the coalition will remain intact. This has kept the level of supply below demand over the course of the COVID-19 pandemic (Chart 2), and is responsible for the global decline in inventories (Chart 3). Chart 2OPEC 2.0 Durability Increases Chart 3Inventories Will Remain Under Control Specifically, the massive spare capacity still to be returned to the market between now and 2H22 can be accomplished with minimal risk of a market-share war breaking out among the core OPEC 2.0 members seeking to monetize their off-the-market production before the other members of the coalition. Most importantly, the revised benchmark production levels that becomes effective May 2022 signal the coalition members with the capacity to increase production can do so. Longer-Term Forward Guidance We assume the revised production baselines for core OPEC 2.0 effective May 2022 reflect the coalition's demand expectations from 2H22 onward. Our modeling indicates core OPEC 2.0's output will approach the revised baseline reference levels of 34.3mm b/d, hitting 33.4mm b/d for crude and liquids output by 2H23 (Table 2). Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 This implies the core group expects to be able to cover production declines within the coalition and to meet demand increases going forward. The estimates are far enough into the future to prepare ahead of time to increase production. Our estimates for core OPEC 2.0 production reflects our assumption the revised baseline levels do reflect demand expectations of the coalition. In estimating the coalition's production, we rely on historical data from the US EIA, which allows us to estimate future production using regressors we consider reliable (e.g., GDP estimates from the IMF and World Bank). Non-OPEC 2.0 Production We use EIA historical data for non-OPEC 2.0 production as well. In last week’s balances, we substituted the EIA's estimates for non-OPEC 2.0 producers ex-US for our estimates, which resulted in lower supply numbers throughout our forecast sample. This threw off our balances estimates in particular, as we did not balance the decrease in supply from this group using the new data set with an increase from another group. We corrected this oversight this week: We will continue to use EIA estimates for non-OPEC 2.0 ex-US countries, but will balance the decrease in oil production from this cohort with increased supply from other countries. Chart 4US Shales Are The Marginal Barrel For US oil production, we will continue to estimate it as a function of WTI price levels, the forward curve and financial variables – chiefly high-yield rates, which serve as a good proxy for borrowing costs for the marginal US shale producer, which we view as the quintessential marginal producer in the global price-taking cohort (Chart 4). Our research indicates US shale producers – like all producers, for that matter – are prioritizing shareholder interests first and foremost. This means they will focus on profitability and margins. While we have observed this tendency for some time, it appears it is gaining speed, as oil and gas producers are now considering whether they want to retain their existing exposure to their hydrocarbon assets.2 There appears to be a reluctance among resource producers generally – this is true in copper, as we have noted – to substantially increase capex. This could be the result of covid uncertainty, demand uncertainty, monetary-policy uncertainty or a real attempt to provide competitive returns. We think it is a combination of all of these, but the picture is clouded by the difficulty in separating all of these uncertainties. Income Drives Oil Demand Chart 5Income Drives Oil Demand Our demand estimates will continue to be driven by estimates of GDP from the IMF and the World Bank. We have found the level of oil consumption is highly correlated with GDP, particularly for EM states (Chart 5). Holding our demand estimates constant from last week, our revised supply expectations prompt us to move our forecast closer to our June forecast. This week, we also will adjust our inventory calculations, which will rely less on EIA estimates of OECD stocks. In the recent past, these estimates played a sizeable role in our forecasts. From this month on, they will play a smaller part. This is why, even though our supply estimates have risen from last week, there is not a significant change to our inventory levels. Investment Implications Holding our demand estimates constant from last week, our revised supply expectations prompt us to move our forecast closer to our June forecast. We expect Brent to average $70/bbl in 2H21, with 2022 and 2023 averaging $74 and $80/bbl. We remain bullish commodities in general, given the continued tightness in these markets. We expect this to persist, as capex remains elusive in oil, gas and metals markets. This underpins our long S&P GSCI and COMT ETF commodity recommendations, and our long MSCI Global Metals & Mining Producers ETF (PICK) recommendation. 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 US natural gas exports via pipeline to Mexico averaged just under 7 bcf/d in June, according to the EIA. Exports hit a record high of 7.4 bcf/d on 24 June 2021. The record high for the month was 7.4 Bcf/d on June 24. The EIA attributes the higher exports to increases in industrial and power demand, and high temperatures, which are driving air-conditioning demand south of the US border. Close to 5 bcf/d of the imported gas is used to generate power, according to the EIA. This was up close to 20% y/y. Increases in gas-pipeline infrastructure are allowing more gas to flow to Mexico from the US. Base Metals: Bullish China reportedly will be selling additional copper from its strategic stockpiles later this month, in an effort to cool the market. According to reuters.com, market participants expect China to auction 20k MT of Copper on 29 July 2021. This will bring total sales via auction to 50k MT, as the government earlier this month sold 30k MT at $10,500/MT (~ $4.76/lb). Prior to and since that first auction, copper has been trading on either side of $4.30/lb (Chart 6). Market participants expected a higher volume than the numbers being discussed as we went to press. In addition to auctioning copper, the government reportedly will auction other base metals. Precious Metals: Bullish Interest rates on 10-year inflation-linked bonds remain below -1%, as U.S. CPI inflation rises. US 10-year treasury yields have rebounded since sinking to a five-month low at the beginning of this week. The positive effect of negative real interest rates on gold is being balanced by a rising USD (Chart 7). Safe-haven demand for the greenback is being supported by uncertainty caused by COVID-19’s Delta variant. Gold prices are still volatile after the Fed’s ‘dot shock’ in mid-June.3 This volatility is reducing safe-haven demand for the yellow metal despite rising economic and policy uncertainty. Ags/Softs: Neutral Hot, dry weather is expected over most of the grain-growing regions of the US for the balance of July, which will continue to support prices, according to Farm Futures. Chart 6Copper Prices Going Down Chart 7Weaker USD Supports Gold Footnotes 1Please see 19th "OPEC and non-OPEC Ministerial Meeting concludes" published by OPEC 18 July 2021. 2Please see "BHP said to seek an exit from its petroleum business" published by worldoil.com July 20, 2021. 3Please refer to ‘“Dot Shock” Continues To Roil Gold; Oil…Not So Much’, which we published on July 1, 2021 for additional discussion. It is available at ces.bcaresearch.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2021 Summary of Trades Closed