Economy

Special Report

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

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

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