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Highlights The greatest legislative battle of the Biden presidency will unfold between now and the end of the year.   Biden’s bipartisan infrastructure deal is likely to pass the Senate soon but will have to cross several hurdles before passage in the House of Representatives. We maintain our 80% subjective odds that it will pass one way or another. Assuming the infrastructure bill does not fall apart, we will upgrade the odds that Biden’s budget reconciliation bill will pass this fall from 50% to 65%. The latter comprises a nominal $3.5 trillion in social spending and tax hikes that will be watered down and revised heavily by the time it passes, which may take until Christmas. Uncertainty about passage will cause volatility to rise in financial markets. Democrats left the debt ceiling out of their fiscal 2022 budget resolution, which ostensibly means they cannot raise the debt limit via a simple majority but will need 10 Republican senators to join. A bruising standoff will ensue that will add to volatility. Ultimately Republicans will comply as they cannot afford to be held responsible for a default on the national debt. The party is currently unpopular and tarred with accusations of insurrection. If Biden succeeds in passing both bills, US fiscal policy will be frozen in place through at least 2025, though endogenous disinflationary fears will largely be dispelled. Feature The biggest domestic political battle of the Joe Biden presidency is likely to occur between now and Christmas. With a one-seat de facto majority in the Senate, and a four-seat majority in the House, Biden is barely capable of passing his two outstanding legislative proposals. The first of these is the $550 billion bipartisan infrastructure deal, which we have given an 80% subjective chance of passing and which passed the Senate on a 69-30 vote margin as we went to press. The second is the $3.5 trillion partisan reconciliation package, based on the remainder of Biden’s American Jobs and Families Plan, which we have given a 50% chance of passage. We will upgrade these odds to 65% if bipartisan infrastructure does not fall through in the House. Next year will be consumed by campaigning for the 2022 midterms so it will be hard to pass any major legislation with such thin majorities (though bipartisan anti-trust legislation could pass and poses a risk to the equity market). The midterms are likely – though not guaranteed – to result in Republicans taking at least the House. The result will be gridlock in which only the rare bipartisan bill can pass. In other words, after Christmas, Biden’s domestic legislative capability and hence US fiscal policy will likely be frozen in place through 2025. In this report we provide a road map for the budget battle that will define the Biden presidency. Buy The Dip … Unless New Variants Change The Game First, a brief word regarding the COVID-19 pandemic. The Delta variant is ramping up, particularly in states where vaccination rates have lagged and social restrictions are minimal (Chart 1). The new lambda variant is also causing concerns that vaccines may be inadequate. Equity markets could easily suffer more downside in the near term but US-dedicated investors should consider the following: Scientists have created one vaccine for COVID-19 and can create others. There has been a concrete reduction in uncertainty since November 2020. Vaccination rates will never be perfect – many people smoke cigarettes and refuse to wear seat belts! – but greater infection rates and hospitalizations are leading to improvements in vaccination coverage. While new lockdowns are not impossible, the public will only support them as a last resort. Not only is the White House still officially opposed to new lockdowns but also the authority to impose lockdowns rests with governors. If hospital systems are crashing then even Republican governors will endorse new social restrictions. Otherwise, restrictions will not be draconian unless a much more virulent variant emerges (one that is more deadly or that has a worse impact on children). Monetary and fiscal stimulus will ramp up if a new variant is more deadly or the economy otherwise starts to slide back. In the US, additional fiscal stimulus will come faster than in other countries because new short-term measures can easily be tacked onto major bills that are already coming down the pike. Chart 1Stay Constructive Amid Delta Jitters Might the White House leverage a renewed sense of crisis to get its main fiscal bills passed? We can see that. The last thing Biden needs is a sluggish recovery to translate into congressional gridlock in the 2022 midterms – the bane of the Obama administration. Rather, the goal is to harness the sense of crisis to pass stimulus. Biden’s approval rating is falling, as is the norm with modern presidents. However, it is still “above water” (net positive) and still sufficient to get his legislative initiatives across the line. Biden’s forthcoming bills will reinforce economic recovery and sentiment (Chart 2) Chart 2Biden’s Approval Comes Down To Earth What if a variant evades vaccination? Especially if it is more deadly and/or more harmful to children? That would be a game changer and would cause at least a market correction. Still, investors would want to buy the dip given what they know today relative to what they knew in early 2020 (and given that they bought the dip in March 2020 even not knowing what they know today). Bipartisan Structural Reform Our second key view for 2021 – “bipartisan structural reform” – is coming to fruition with the Senate’s 69-30 vote passage of the American Infrastructure and Jobs Act as we go to press. Major bipartisan deals are rare in highly polarized America but we have given an 80% subjective chance of passage to this bill. Passage in the Senate reinforces that view, though the odds of final passage remain the same as there will be hurdles in the House. We include infrastructure as a “structural reform” because of its ability to increase the productivity of an economy. The bill contains funding for traditional infrastructure, like roads, bridges, and ports, as well as non-traditional infrastructure such as subsidies for electric vehicles and high-speed internet (Table 1). Table 1What’s In The Bipartisan Infrastructure Deal? Table 2 shows the 19 Republican senators who voted in favor of this bipartisan deal, along with their ideological ranking and state support rates. This tally provides a nine-seat buffer in case the House version of the bill requires another Senate vote. It also provides a measure of the support that might be brought to bear for bipartisan causes later, such as funding the government, suspending the debt ceiling, or passing bills on popular issues (such as regulating Big Tech) in 2022-24. All Democrats voted in unison for the bill. Table 2Republican Senators Who Voted For Biden’s Bipartisan Infrastructure Bill Our high confidence on infrastructure spending stems both from its popular support (Chart 3) and from the fact that even if bipartisanship fails, there remains a partisan option: budget reconciliation. This is still true today. The bipartisan infrastructure bill could still die in the House, given Speaker Nancy Pelosi’s determination to make its passage contingent on the success of the larger reconciliation bill, which is anathema to Republicans. But if it dies, Democrats would take up the key provisions in the reconciliation bill – and the odds of that bill passing would go up, not down, since Democrats would need to close ranks to clinch a legislative victory ahead of the midterms. Chart 3Popular Support For Bipartisan Infrastructure Deal Thus the real risk is not that infrastructure spending will fail but that its success will reduce the political capital needed to pass the more controversial reconciliation bill, which we discuss below. Over the short and medium term, this bipartisan infrastructure deal emblematizes the sea change in US fiscal policy – the shift against austerity – and thus serves to dispel fears of disinflation. At the same time, the deal epitomizes America’s long-term fiscal predicament. Democrats only want to increase spending while Republicans only want to decrease taxes. The former will not make budget cuts while the latter will not hike taxes. The result, inevitably, is higher budget deficits. This is precisely what occurred with the latest agreement: tax measures to pay for new infrastructure spending are mostly chimerical – the Congressional Budget Office (CBO) estimates that only $200 billion of the new spending will be offset with new revenue. The other $350 billion will add directly to deficits and debt. The difference is small but the political signal is notable. Chart 4 highlights the increase in the deficit likely to occur, with the CBO’s more realistic assessment delineated from the nominal bill. From a macro point of view, the takeaway is that the US economy faces a stark withdrawal of government support in 2022 but this bill slightly cushions the blow. Continued recovery will depend on consumers and businesses (which look to be in good shape). Beginning in 2025 deficits will start to rise again and hence the overall picture is one in which US government support for the economy has taken a step up for the decade. Chart 4Bipartisan Deal Not Paid For = Fiscal Stimulus Side note: Chart 4 is worrisome for President Biden if his reconciliation bill fails, as it points to fiscal drag through 2024, the election year. Bottom Line: We still see an 80% chance that Biden’s infrastructure proposals will pass, as the Democrats have a backup plan if the bipartisan deal somehow collapses in the House. Biden’s Greatest Legislative Battle Up till now we have assigned 50% odds of passage to the subsequent part of the Biden agenda, the American Families Plan, which covers social spending and tax hikes (corporate and individual). If bipartisan infrastructure passes promptly, we would upgrade the reconciliation bill’s odds of passing to 65%. The reason is twofold: first, reconciliation only requires a simple majority consisting of all 50 Senate Democrats plus the vice president; second, hesitant moderate senators ultimately will be forced to recognize that sinking the bill would render the Biden presidency defunct and fan the flames of populist rebellion on both sides of the political spectrum. And yet, since Biden cannot spare a single vote, conviction levels cannot be high. Therefore 65% seems appropriate. On August 9 Senate Democrats presented a $3.5 trillion budget resolution that will form the basis of the reconciliation bill this fall. The bill contains a wish list of spending priorities, as outlined in Table 3. Most of these are familiar from last month when the Senate Budget Committee first put forward its framework. The hang-up stems from House Speaker Pelosi. Knowing that infrastructure’s passage will suck away political capital from social spending, Pelosi is attempting to link the two bills. If the Senate fails to pass the reconciliation bill, the House will not pass the infrastructure bill. This gambit will create a big increase in uncertainty this fall as the legislative battle heats up. Republicans cannot support the infrastructure bill if it is directly tied to the Democrats’ “Nanny State” debt blowout, which will be the basis for their campaign against Democrats in future. They need plausible deniability. If Pelosi insists on linking the two bills, Republican support will evaporate. True, Democrats would then proceed to partisan reconciliation – but they would need to sacrifice other agenda items, such as subsidies for green tech, college, health care, and manufacturing (see Table 3 above). Table 3Senate Democratic FY22 Budget Resolution (July 2021) Biden and the Senate are now united on the infrastructure bill. Biden and Democrats in marginal seats need a legislative victory ahead of the midterms – and a bipartisan victory on a popular policy like infrastructure is critical. A bird in the hand is worth two in the bush. Therefore, Pelosi will probably have to concede, after gaining assurances from moderate Senate Democrats that they will not sink reconciliation. Moderate Democrats, in turn, will need to see the reconciliation bill watered down, both on spending and taxes. Table 4 shows both bills together, as Biden’s “Build Back Better” agenda, with a baseline net deficit impact. Budget deficit scenarios are then updated in Chart 5. Once again what stands out is the large fiscal drag in 2022, the fiscal thrust for the remainder of the decade, and (in this case) minimal fiscal drag for 2024. Table 4Face Value Impact Of Biden’s Spending Proposals Before Congress (Baseline) Chart 5Deficit Scenarios For Bipartisan Infrastructure Deal And Reconciliation Bill This is true even if tax hikes fail to make it into the final reconciliation bill. We still maintain that the corporate tax rate will rise above Senator Joe Manchin’s ideal 25% rate (if not all the way to Biden’s 28%) while individual tax rates will return to pre-Trump levels. It is not clear if capital gains tax hikes will make the final cut. Most likely some tax hikes will occur but they will fall short of Biden’s plan, producing, at most, a one percentage point increase in the budget deficit relative to the Congressional Budget Office’s baseline estimate (Chart 6). Chart 6What Happens If Tax Hikes Fail To Pass Congress? In Table 5 we update our various legislative scenarios, each consisting of different mixes of spending and tax hikes. We assume that the size of the bipartisan infrastructure deal will not be reduced in the House; that the revenue offsets of that deal will be $200 billion maximum; that moderate Senate Democrats will have greater success in watering down tax hikes than spending programs; and that the government overestimates its ability to collect revenue through tougher tax enforcement. Finally we assume that Senate Democrats’ spending proposals will not be cut – an extremely generous assumption that will not hold up in practice. Table 5Legislative Scenarios For Bipartisan Infrastructure Deal And FY22 Reconciliation Bill Each legislative scenario’s impact on the deficit is shown in Table 6. The result is a wide range of deficit impacts, from the baseline of $588 billion to Scenario 6, with $2.59 trillion (zero tax offsets). The more realistic range is from $1 trillion to $2.3 trillion (i.e. all scenarios except the baseline and Scenario 5). Within this range the result depends on the moderate senators’ negotiation skills. Conservatively, the impact will range from $1-$1.5 trillion (Scenarios 1, 2, 4), with moderate senators preventing a $2 trillion price tag as politically impracticable (e.g. Scenario 3). Table 6Scoring Of Legislative Scenarios For Bipartisan Infrastructure Deal And FY22 Reconciliation Bill There are two other aspects of Biden’s massive legislative battle this fall: regular government budget appropriations and the debt ceiling. Government appropriations are supposed to be passed by the end of the fiscal year, September 30, but often run over and likely will this time. Republicans will not support regular spending increases given that Democrats will ram through a partisan spending blowout. Therefore Congress will have to settle for a continuing resolution (a stop-gap measure) that keeps spending levels the same. Otherwise a government shutdown will occur. A shutdown is possible but would weigh heavily on Republicans’ public image, which is already at a low point in recent memory following the scandals of the Trump presidency. That is not all – there is also the debt ceiling (limit on national debt). Democrats made a major gambit by not including a suspension or increase of the debt ceiling in their fiscal 2022 budget resolution. If they had included it, then they could have raised the debt ceiling on their own with a simple majority when they passed their reconciliation bill. Instead they are attempting to make Republicans share the blame. Republicans, however, will mount an aggressive resistance, as they do not want to be seen as authorizing the debt increase necessary to accommodate the Democrats’ “socialist” spending spree. The “X date,” when the Treasury Department runs out of the ability to use extraordinary measures to make payments due on US debt, is expected sometime in October or November, though Treasury Secretary Janet Yellen warns it could come sooner and will try to pressure lawmakers. After this date the US would technically default on national debt obligations, triggering financial turmoil and potentially a global crisis. A debt ceiling showdown is virtually inevitable and volatility will rise – but ultimately a default will be averted, as we outlined in a recent report. First, Democrats still have the ability to revise the budget resolution so as to include a debt ceiling suspension in their final reconciliation bill. While Republicans could arguably block this attempt via a filibuster in the Budget Committee, they would have no interest in doing so (they could abstain and thus keep their hands clean of any debt ceiling increase). Second, Republicans can be forced to agree to a suspension of the debt ceiling when they fund the government, since it is necessary to do so anyway to fund their own infrastructure deal. Suspending the debt ceiling is not the same as raising it. New battles would be set up for later, in 2022 and beyond. But Republicans do not have the political ability to force a default on the public debt of the United States in the same year that Democrats accuse them of raising an insurrection against its Congress. Bottom Line: This fall will see the great legislative battle of the Biden presidency. Infrastructure spending has an 80% chance of passing. Pelosi will not be able to withstand Biden and the Senate in passing this deal separately from the more partisan reconciliation bill. If it passes, then Biden’s reconciliation bill will rise from 50% to 65% odds of passage. The latter will be watered down to a net deficit impact of $1-$1.5 trillion to secure the votes of moderate Senate Democrats, who ultimately will not betray their party to neuter Biden’s presidency. Thin margins in the House and Senate do not permit higher odds of passage or a high level of confidence. Investment Takeaways Political polarization has fallen sharply (Chart 7). This is connected to our view that the Republican Party is split, while Biden’s key initiative (infrastructure) has bipartisan support. However, Biden’s bipartisanship has resulted in a larger loss of Democratic support than a gain of Republican support (Chart 7, bottom panel). And the upcoming reconciliation bill will reignite Republican opposition. Moreover, polarization will remain at historically elevated levels, even to the point of generating domestic terrorist attacks, as we have argued. Biden’s approval rating has fallen but not enough to sink his legislative proposals. The overall economy is strong judging by both consumer confidence (Chart 8) and capital spending (Chart 9). Any soft patch in the economy in the near term will assist Biden in his legislative battles. Passage of either or both major bills will boost his approval rating, potentially ameliorating the Democrats’ challenging situation in the 2022 midterms. Chart 7Bipartisan Biden Lowers Polarization As Dems Waver Chart 8US Consumer Confidence Soars Chart 9US Capital Spending At Peak Levels Still, we expect investors to “buy the rumor and sell the news” of Biden’s upcoming stimulus bills. After the Senate passes the reconciliation measure, investors will have to look forward to the combined impact of tax hikes, the Fed’s tapering of asset purchases and eventual rate hikes, and the various troubles with global growth and geopolitical risk. Until that time, investors must weigh the risks of the COVID-19 variants against actions by both American and Chinese policymakers to dispel deflationary tail risks. Thus for now we are sticking with our key trades of the year: value stocks, materials, and infrastructure plays (Chart 10). After Biden wins his big legislative battles, we will reassess.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Chart 10Buy Rumor, Sell News On Biden Plan   Appendix Table A1USPS Trade Table Table A2Political Risk Matrix Chart A1Presidential Election Model Chart A2Senate Election Model Table A3Political Capital Index Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets Footnotes    

In this Sector Insight report, we come back to the issue of “how much inflation is too much” for equities. The short answer is – equities don’t mind inflation as long as the Fed does not mind it either. Chart 1 shows historical analysis of forward SPX returns (both real and nominal) using different inflation ranges as a starting point.  Empirically, CPI prints of below 3% do not weigh on market performance.  However, once inflation rises above the 3-4% range, it causes a notable slowdown in returns, and above the 4% mark, it results into negative expected forward returns. Chart 2 is a scatterplot of trailing PE multiples vs core CPI prints.  This chart confirms our initial conclusion that an inflation sweet spot for the equity market is around 2-3% core CPI range: this is the range where equity multiples expand the most. It is also clear from the chart that any higher core CPI values become a headwind for equities. The implication is that the negative forward expected return that we showed on Chart 1 comes from the multiple contraction. Chart 1Moderate Inflation Does Not Have An Adverse Effect On The Performance Of Equities Chart 2High Levels Of Inflation Are Associated With Multiple Contraction Equities are a real asset, and rising inflation does not have a negative effect on the earnings, as most companies are able to pass cost increases to their customers, and strong earnings growth translates into robust equity returns. Inflation is a concern for equity investors only from one angle: higher inflation may provoke the Fed to raise rates, and higher rates do have an adverse effect on the performance of equities. Bottom Line: Our view remains that inflation surge was transitory, but we do believe that the inflation will stay elevated for a while. Yet, if it does not exceed the 3% mark, there will be no negative repercussions for equities if the Fed stays patient.

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

Special Report

Highlights Chinese authorities’ regulatory crackdown on new economy companies reflects new socio-political and economic shifts in China. Hence, this regulatory crackdown is not transitory. Investors in Chinese TMT/new economy stocks are facing uncertainty on multiple fronts which warrants lower valuation multiples. These companies will experience weaker profit growth and lower profitability relative to the past due to disruptions to their business models. Elsewhere, widening credit spreads among Chinese property developers reflects the property market’s poor outlook. In turn, shrinking Chinese construction heralds weaker demand for commodities and manufacturing goods. This poses a material risk to raw material prices and, consequently, EM in general. Feature Chart 1Chinese Growth/TMT Share Prices And P/E Ratio The Chinese MSCI Investable Growth stock index is down by 35% from its February peak (Chart 1, top panel). Such a drawdown in the previous market leaders has produced a temptation to buy. The enticement is especially strong given that US FAANGM stocks are hitting new all-time highs. Is the latest crash in Chinese new economy/growth/TMT stocks a bad dream that will soon end, or does it mark a new reality for these companies? In our opinion, Chinese authorities’ regulatory crackdown on new economy companies reflects new socio-political and economic shifts in China. Hence, this regulatory crackdown is not transitory but is a part of China’s ongoing transformation. In brief, these companies are facing a new reality. What’s more, their outlook is very uncertain and equity valuations are not low enough to offset potential risks related to owning these stocks. Overall, investors should not start bottom fishing in Chinese stocks in general and Chinese TMT stocks in particular. Uncertainty = Lower Equity Multiples Immense uncertainty surrounds the outlook for Chinese TMT share prices. Even though China’s growth stocks have been de-rated, their trailing P/E ratio remains at 36.5 (Chart 1, bottom panel). Table 1A Snapshot Of Drawdown And Valuations Table 1 shows the drawdowns and trailing P/E ratios for TMT/new economy/growth indexes as well as their largest constituencies: Alibaba, Tencent and Meituan. These equity multiples are still high given the uncertainty these companies are facing. By extension, investors in Chinese TMT/new economy stocks are also facing uncertainty on multiple fronts: Regulatory crackdowns mean that the business models of many of these companies will have to undergo substantial changes. Corporations may need to overhaul their product lines or abandon existing products/markets and find new niches and introduce new offerings. It is impossible to know what the long-term revenue and profit growth rates of these companies will be so that they can be properly valued. Such heightened uncertainty about the long-term outlook warrants a higher equity risk premium and, hence, lower equity multiples. President Xi Jinping’s long-term objective is to reduce income equality and achieve more equal wealth distribution. There will therefore be little tolerance for excessive profitability of individual companies. Chart 2 illustrates the large income gap between the top 10% and bottom 50% of the population. In turn, the mean-to-median wealth ratio points to a large and rising wealth gap – a higher ratio reflects greater wealth concentration among rich households (Chart 3). Chart 2China: Income Disparity Has Not Been Narrowing Chart 3Wealth Concentration Remains High In China   President Xi’s goal is to appease the broader population, not shareholders or businesses. Top authorities have been using phrases such as “disorderly expansion of capital” since last fall. This language marked a major shift in government policies regarding market power and dominance of private companies. Investors should take note that they are now dealing with a new investment regime in China. For some time, we have argued that China’s regulatory tightening on private platform companies would aim to limit their monopolistic or oligopolistic power and ration their profitability. As a result, we alleged that these new economy companies would end up being regulated like utilities or become quasi-government entities. Consequently, their profitability would decline to close to that of utilities or SOEs. Yet, utility stocks or SOEs in China command much lower equity multiples than those at which platform companies’ stocks have been trading. Even as of today, the trailing P/E ratio on the China MSCI Growth Investable index is 36.5. Meanwhile, global utility stocks command a trailing P/E ratio of 19. It is hard to know where the P/E ratios of these Chinese TMT stocks will settle, but our hunch is that their multiple compression is not over yet. Regulatory clampdowns will not only curtail their revenues and pricing power but also increase their costs. These companies will need to spend money to comply with the new regulatory regime. They will, for instance, be expected to take on more in the way of social responsibilities, as SOEs in China have been doing. This and other measures will eat into their profit margins and will lower the return on capital. Finally, many Chinese TMT companies that have their ADRs listed in the US have been caught in the crossfire of the “big data war” between the US and China. On the one hand, US authorities want to oblige these Chinese issuers to comply with US regulations in terms of information and risks disclosure. On the other hand, Chinese authorities are reluctant to allow more data/information disclosure by their dominant platform companies to foreign investors. Given that the US-China confrontation is likely to escalate on many fronts going forward, odds are low that there will be a lasting solution to this conflict around US-traded Chinese equities. Authorities in the Middle Kingdom are not very sensitive to the fact that foreign shareholders are losing money in Chinese offshore trading stocks. Unless the crash in offshore stocks spills into the domestic financial markets and the economy, their willingness to compromise will be limited. In turn, the US will not “encourage” American investors to invest more in Chinese stocks where its regulatory authority and influence is weak. Overall, such high uncertainty regarding offshore Chinese stocks in general and the ones trading in the US in particular warrants a higher equity risk premium and lower equity multiples. Despite these negatives, there is a silver lining: China’s new economy segments have been and will continue expanding at a rapid pace. Chinese authorities are genuinely interested in supporting new economy sectors which could help boost productivity and be growth engines as the growth contribution from construction/infrastructure/manufacturing diminishes. The challenge for investors is to find companies that benefit from the continued expansion of new economy sectors, and acquire their stocks at reasonable multiples to secure limited drawdowns during market selloffs. Bottom Line: Chinese growth stocks/TMT share prices – on the index level – remain at risk of further de-rating/multiple compression. These companies also face potentially weaker profit growth and lower profitability compared to the past due to disruptions to their business models and/or higher costs of doing business. A Breakdown In Chinese Property Stocks And Bonds Is Flying Under The Radar Chart 4Property Stocks And Bond Prices Have Crashed While Chinese TMT stocks are at the center of the global investment community’s interest, there has been a breakdown in mainland real estate share prices and a spike in property companies’ offshore credit spreads (Chart 4). The rising cost of capital imply that real estate developers will curtail their new property launches and construction. In addition, authorities will not ease regulatory tightening in the property market in general and property companies in particular. The objective is to halt the rise in property prices so that the continuous increase in personal income brings down the household income-to-property price ratio. The latter is extremely high in China making housing unaffordable for average Chinese. Authorities are very sensitive to the issue of housing unaffordability. Not only are property developers under pressure from tightening but also authorities are curbing demand for housing. In particular, two weeks ago the PBoC ordered banks in Shanghai to raise the rate of mortgage loans for first-time homebuyers to 5% from 4.65% and for people who are buying second homes to 5.7% from 5.25%. This measure might be extended to other tier-1 cities if house prices do not stop rising. As a result of the clampdown on property developers and move to restrain investment/speculative demand for housing, construction activity will shrink. The top panel of Chart 5 illustrates that the level of aggregate building construction starts has turned down. Residential property sales are decelerating and starts are contracting (Chart 5, bottom panel). Bottom Line: Property construction in China will start shrinking in the coming months. This will spill into other industrial/manufacturing sectors that supply construction and produce durable consumer goods. Chinese industrial output is set to decelerate materially as is predicted by a relapse in the nation’s manufacturing PMI’s new and backlog orders (Chart 6). This poses a material risk to raw material prices and, consequently, to EM in general. Chart 5Chinese Property Construction Is Set To Contract Chart 6China's Manufacturing To Decelerate   Investment Conclusions From a short-term perspective, Chinese growth stocks are oversold, however this is not true from a long-term perspective. As shown in the top panel of Chart 1 above, the Chinese MSCI Investable Growth Stock Index is only back to its June 2020 levels. In fact, the parabolic rise in Chinese TMT stocks in late 2020 and early 2021 reflected investor euphoria that typically occurs at the end of a major bull market. Hence, the February peak in these equities could mark a major top. If so, these stocks are unlikely to embark on a sustainable bull market any time soon. For now, investors should fade rebounds in Chinese TMT stocks. We have been overweight Chinese stocks within an EM equity portfolio but this has been a bad call. However, among Chinese stocks we have recommended the following strategy since March 4th of this year: long A shares/short Investable stocks. The basis has been that we foresaw more downside risks in TMT stocks than onshore equities indexes (Chart 7). This recommendation is up by 15.5% since then and investors should maintain this strategy. Chart 7Stay Long Chinese A-Shares / Short Offshore Trading Stocks Chinese equities are oversold relative to the EM index, and we are reluctant to downgrade them now. We are also waiting for our view of the continued US dollar rebound and lower commodities prices to play out before we downgrade Chinese equities. Other EM bourses typically underperform when the US dollar rallies and commodities sell off markedly. As we argued in last week’s report, the weakness in EM equities has not been limited to Chinese TMT stocks. EM ex-TMT share prices have also rolled over, which is consistent with rising EM corporate bond yields (Chart 8). Chart 8Rising EM Corporate Bond Yields Herald Lower EM ex-TMT Share Prices Although most of the rise in EM corporate bond yields/spreads can be attributed to Chinese property companies, their widening credit spreads reflect the mainland property market’s poor outlook. In turn, shrinking Chinese construction heralds weaker demand for commodities and manufacturing goods. Notably, Chart 9 reveals that there has been a widening gap between a declining Chinese manufacturing PMI and resilient industrial metals prices. Odds are that commodity prices will recouple with China’s manufacturing PMI to the downside. Chart 9An Unsustainable Divergence: Beware Of Risks To Commodity Prices We continue to recommend underweighting EM versus DM for global equity and credit portfolios, a strategy we initiated on March 25, 2021. We also recommend shorting a basket of EM currencies versus the US dollar and maintaining a cautious stance on commodity prices. The full list of our country recommendations for equity, fixed-income and currency investors is available at the end of this report. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com  

Foreword Today we are publishing a charts-only report focused on the S&P 500 and its sectors. Many of the charts are self-explanatory; to some we have added a short commentary.  As with the styles Chart Pack, published a month ago, the sector charts cover macro, valuations, fundamentals, technicals, and the uses of cash.  Our goal is to equip you with all the data you need to underpin sector allocation decisions.  We also include performance, valuations, and earnings growth expectations tables for all the styles, sectors, industry groups, and industries (GICS 1, 2 and 3). We hope you will find this publication useful. We plan to update it monthly, alternating sector and style coverage. Overarching Investment Themes Macro Economic surprise index is flagging while Q2-21 earnings surprises are unprecedented.  Much of the good economic news has been priced in and the Citigroup Economic Surprise Index is hovering around zero (Chart 1A).  Most of the economic indicators have turned, confirming that the surge in growth has run its course and the macroeconomic environment is normalizing. Covid-19 fears are resurfacing:  The spread of the Delta variant is unlikely to trigger another lockdown, but consumers may curtail their activities out of fear of infection, adversely affecting demand for goods and services.  However, for now, we are sanguine about this risk. Investors expect inflation to roll over: Investors’ inflation fears are dissipating, attested by the falling 5Y/5Y inflation breakevens (Chart 1B).  Indeed, it appears that the debate on the persistence of inflation has been won by the “inflation is transitory” camp.  Yet, we won’t be surprised if inflation surprises on the upside (no pun intended).  Chart 1AGood Economic News Has Been Priced In Chart 1BMost Investors Are Now Convinced That Inflation Will Be Transitory Labor shortages are starting to dissipate: On the labor front, companies are still struggling to fill job openings.  However, there are signs that the labor market is healing, with more and more workers interested in returning to the labor force  (Chart 2). Inventories will be replenished, spurring investment: Post-pandemic economic recovery is still plagued by the mismatch between supply and demand. Supply-chain disruptions and shortages fail to meet pent-up demand of consumers eager to spend “helicopter drop cash” and accumulated savings.  As a result, inventories have been drawn down, chipping away 1.1% from GDP growth. In fact, they are at all-time lows: Non-farm inventories to final sales have dropped lower than they were during the GFC (Chart 3).  Low inventories will have to be replenished, resulting in further gains in investment and providing a boost to industrial activity going forward. Chart 2More Workers Are Interested In Returning To The Labor Force Demand for services will continue to exceed demand for goods: Last, but not least, consumers have money to spend but are shifting away from goods and toward services and experiences.  Consumer expenditure on goods is above trend and has recently turned down, while spending on services is still below pre-pandemic levels, and rebound is still running its course (Chart 4). Chart 3Inventories Are At All Time Low Chart 4Real Spending On Services Is At PrePandemic Levels: Room For Further Rebound Valuations And Profitability The US stock market remains expensive: The S&P 500 is trading more than two standard deviations above the long-term average.  However, there are pockets of reasonably priced, albeit unloved, stocks within the S&P 500: Telecom (11x forward earnings), Health Care (17x), Energy (14x), and Financials (14x).  Earnings continue to crush expectations: While equities are expensive, they are redeemed by the strong showing of earnings and sales growth reported for Q2-2021.  The scale of earnings beats relative to analyst expectations is spectacular: Running at nearly 20%, or more than two standard deviations above the historical average (Chart 5). Chart 5Earnings Surprises Are Unprecedented Earnings growth is normalizing: Earnings have increased 90% over the lackluster Q2, 2020.  Compared to Q2-2019 as a baseline quarter, earnings are up 22%, pointing to normalization going forward.  Earnings growth will become a tailwind for the outperformance of equities into the balance of the year and will help the S&P 500 to grow into its big valuation “shoes”. Margins are expanding despite inflation:  Many sectors are able to grow earnings and recover margins despite increases in costs of raw materials and labor, thanks to their strong pricing power, i.e., ability to pass on higher input costs to their customers (Chart 6A).  Sectors with the highest pricing power are: Communications Services, Consumer Discretionary, Industrials, Energy and Materials.  They are the best inflation hedges. Chart 6ACompanies' Profitability Is Improving To Pre-Pandemic Levels Uses Of Cash Cash to be disbursed to shareholders: Share buybacks and other shareholder-friendly activities are on the rise again and are expected to gain steam this year and next.  This is supported both by strong earnings growth, healthy balance sheets, and regulatory headwinds to any potential M&A activity due to the anti-trust stance of the current administration Capex is about to make a comeback: Capex is still lagging across most sectors.  A pickup in capex will signal that the post-pandemic recovery is firmly on track, and companies are comfortable investing in future growth.  However, there are early signs that that is about to change.  Philly Fed survey shows that over 40% of respondents are planning to increase their capex expenditure  (Chart 6B). Chart 6BCapex Increases Are On The Way Investment Implications Overweight sectors and industry groups exposed to consumer services spending (airlines, hotels, leisure) and be selective about consumer goods and retailing industry groups: Real PCE for goods has turned down toward the trend line.  Exceptions are areas of the market with well-publicized shortages such as Autos and Parts. Overweight Industrials – US manufacturing has limited capacity, onshoring is a new trend, inventories need to be replenished, and capex intentions are on the rise. Overweight Health Care – growth slowdown favors this defensive sector, which also benefits from a backlog of demand for medical procedures and services. Reflation trade is out of the picture, now that inflation fears have abated and the Delta variant preoccupies investors.  For that, we still favor Growth over Value.  Yet, we watch this allocation closely, to time rotation once Covid-19 fears dissipate, rates pick up and inflation surprises on the upside. With valuations high, and forward returns expectations lackluster, we favor sectors likely to delivery healthy cash yield: Financials, Health Care, Energy, and Technology.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   S&P 500 Chart 7Macroeconomic Backdrop And Earnings Surprise Chart 8Profitability Chart 9Valuations And Technicals Chart 10Uses Of Cash Communication Services Chart 11Macroeconomic Backdrop Chart 12Profitability Chart 13Valuations And Technicals Chart 14Uses Of Cash Consumer Discretionary Chart 15Macroeconomic Backdrop Chart 16Profitability Chart 17Valuations And Technicals Chart 18Uses Of Cash Consumer Staples Chart 19Macroeconomic Backdrop Chart 20Profitability Chart 21Valuations And Technicals Chart 22Uses Of Cash Energy Chart 23Macroeconomic Backdrop Chart 24Profitability Chart 25Valuations And Technicals Chart 26Uses Of Cash Financials Chart 27Macroeconomic Backdrop Chart 28Profitability Chart 29Valuations And Technicals Chart 30Uses Of Cash Health Care Chart 31Health Care: Sector vs Industry Groups Chart 32Profitability Chart 33Valuations And Technicals Chart 34Uses Of Cash Industrials Chart 35Macroeconomic Backdrop Chart 36Profitability Chart 37Valuations And Technicals Chart 38Uses Of Cash Information Technology Chart 39Macroeconomic Backdrop Chart 40Profitability Chart 41Valuations And Technicals Chart 42Uses Of Cash Materials Chart 43Macroeconomic Backdrop Chart 44Profitability Chart 45Valuations And Technicals Chart 46Uses Of Cash Real Estate Chart 47Macroeconomic Backdrop Chart 48Profitability Chart 49Valuations And Technicals Chart 50Uses Of Cash Utilities Chart 51Macroeconomic Backdrop Chart 52Profitability Chart 53Valuations And Technicals Chart 54Uses Of Cash  Table 1Performance Table 2Valuations And Forward Earnings Growth Recommended Allocation   Footnotes  

Highlights Economy – A range of economic and fundamental indicators are at such high levels that deceleration is inevitable: US growth will peak any day if it hasn’t done so already. Markets – Financial markets typically pay closer heed to direction than level: All else equal, we prefer direction to level as well, but levels are likely to remain elevated for a while even as deceleration takes hold, and investors should take that into account when assessing the outlook. Strategy – Remain overweight equities and credit in multi-asset portfolios: Risk assets are likely to continue to generate positive excess returns over Treasuries and cash despite moderating growth. Feature COVID-19’s arrival ushered in a wave of extremes in monetary and fiscal policy measures, economic data and financial markets. Everywhere investors look, data series are at unusually outlying levels. Inflation pressures are more intense than they have been in decades, as measured by consumer price indexes and a range of business surveys. Household net worth has advanced at its fastest-ever five-quarter pace despite the record setback that began the pandemic, S&P 500 earnings growth has demolished analyst expectations over the last five quarters, the federal government has injected a head-spinning amount of fiscal stimulus into the economy and the Fed has done all it seemingly could to cushion the pandemic’s economic blow. Much of the growth has resulted from Herculean stimulus measures that cannot be maintained on a rate-of-change basis. The slowdown in fiscal and monetary thrust implies that economic growth, along with several other series that are viewed as significant financial market drivers, will soon peak if they haven’t already. The looming deceleration has kindled a recurring debate among BCA researchers: What matters most for financial markets, level or direction? The answer to the most challenging questions in markets and economics is often “it depends,” and that’s the way we view the level-versus-direction debate. We’d position a portfolio based on direction if key series were just breaking above or below trend levels with robust momentum, but it’s a more nuanced decision when they are slowing from exceedingly high levels and a modestly decelerating pace should have them still sitting well above trend this time next year. Our view, then, is that the interaction between level and direction will drive markets going forward. Given that we have cited a range of levels in support of our bullish stance, however, it is prudent to ask how good might be too good for reliably mean-reverting series. We therefore examine the empirical record of how S&P 500 returns have interacted with the level and direction of the unemployment rate, earnings-per-share growth, and interest rates. We conclude that the humble level matters as well as the more celebrated rate of change and that deceleration will not spell the end of the equity bull market. The Unemployment Rate We used the unemployment rate as a proxy for the impact of macroeconomic changes on S&P 500 returns. While the unemployment rate is quite variable from month to month, it tends to follow a clear pattern over longer periods of time, rising very rapidly to cyclical peaks before meandering its way to cyclical troughs. Over the series’ 73-year history, there have been eleven complete rising phases and it is currently in its eleventh declining phase (Chart 1). Owing to unemployment’s established pattern – it takes the elevator up and the stairs down, flipping equity indexes’ pattern on its head – the eleven rising phases have spanned 30% of the nearly 900 months while the falling phases currently total 70% of them. Chart 1Unemployment Takes The Elevator Up And The Stairs Down A simple compilation of one-month forward S&P 500 returns based on the level of the unemployment rate has a clear theme – stocks do well when the rate is at least one standard deviation above the mean (about 7.4% or higher) and poorly when it is one or more standard deviations below it (about 4.2% or lower) (Chart 2, left side). A compilation based on the month-to-month direction of the unemployment rate – up, down or unchanged – also favors rising unemployment, though it is unclear what investors should conclude from the fact that rising and falling both outperform unchanged (Chart 2, right side). Chart 2The S&P 500 Is Sensitive To Anticipated Turns In Unemployment We think the analysis is much improved if the unemployment rate is combined with its direction as indicated by the cycle phase. The interaction of level and phase provides more information than the simple message that high unemployment is good for equities and low unemployment is bad. Applying the rising or falling unemployment rate phase to the ranges shown in Chart 2, we find that direction matters quite a lot within four of the five ranges, where the annualized return differs by thirteen to sixteen percentage points based on the underlying trend (Table 1). Table 1Level And Direction Tell The Most Compelling Story Equities are just coming off their bottom, on balance, when the unemployment rate exceeds a standard deviation above its mean and is still rising. Direction is everything when the rate is below its mean (5.8%). When it’s falling, there’s plenty of money to be made in an expanding economy before the Fed has designs on removing the punch bowl, though once the rate is a standard deviation below the mean (4.2% or lower), the equity top is near. Once the unemployment rate rises off the bottom, even though it’s still at an unusually low level, the equity tide has already begun to go out. Losses are in store until the rate gets back above the mean, signaling future improvement. Chart 3Up, Up And Away It is important to recognize that we can only demarcate the unemployment rate’s phases in retrospect. There is no telling with certainty in real time how far a nascent trend will go. We do expect, however, in line with every FOMC voter, that the unemployment rate is likely to approach the vicinity of last cycle’s lows before the current phase ends. If that expectation is realized, there is a stretch of downward movement ahead (a good chunk of the 1.7% standard deviation, though July claimed 50 basis points of it) that has empirically been quite favorable for the S&P 500. The speed with which it covers the ground from here to 4% or below is unknown. Given the tremendous pent-up demand for labor, as evidenced by a record high job openings rate (Chart 3), the unemployment rate may come down much faster than it normally does. The level-and-direction analysis makes it clear that 5.9% and falling has provided an auspicious backdrop for equity investors, and the Fed’s more relaxed reaction function may allow the economy to run a little hotter than it normally would once unemployment falls below its natural rate. All in all, the empirical record of the relationship between the unemployment rate and equities suggests that stocks have room to run while the labor market improves. Earnings The unemployment rate may not be too low for equities to continue to rally, but is earnings growth too good for stocks’ own good? It doesn’t appear to be, given the historical interaction between forward one-quarter S&P 500 performance and the speed and acceleration of growth in trailing four-quarter earnings. We use trailing earnings because they exhibit extended trends that highly variable sequential changes in single-quarter data do not. Since 1948, trailing four-quarter operating earnings have experienced eleven complete double-digit declines from cycle peaks and eleven complete earnings growth phases, while beginning a new growth phase in the first quarter (Chart 4). Chart 4Steady Growth With Occasional Hiccups The chart shows that four-quarter earnings have grown in a pattern that features extended growth phases punctuated by concentrated declines that are occasionally severe. This pattern is the mirror image of the unemployment rate’s and S&P 500 earnings have been in a growth phase three out of every four quarters on the way to an annualized growth rate of 6.4%. Since P/E multiples are a mean-reverting series, stocks need to grow earnings to rise over time, but there is little difference in lagged S&P 500 returns when earnings are in growth or contraction mode (Chart 5). The disparity widens within each broad phase when we considered the growth rates – deceleration has been better for stock prices than acceleration within expansion phases, while a slowing rate of decline has been a tremendous catalyst when earnings are in a contraction phase. Chart 5More Money Is Made From Terrible To Bad Than From Good To Great To explore S&P 500 index performance during acceleration and deceleration phases within growth ranges, we repeated the unemployment rate analysis. The return disparities for different earnings ranges were not nearly as clear cut as they were for different unemployment ranges, but acceleration was good for near-term equity returns in the middle of the earnings growth distribution, while deceleration trumped acceleration at growth rates plus or minus three quarters of a standard deviation from the mean (Table 2). Table 2Headed Out Of The Earnings Sweet Spot The muddled empirical record does not point to a clear path for S&P 500 returns over the next few quarters. We assign a very low probability to a recession over the next year, virtually ensuring that the growth phase that began last quarter will continue. If actual earnings turn out to be somewhat close to the current consensus expectation, however, all subsequent quarters in this growth phase will be decelerating, and deceleration within growth phases (Table 2, circled three outcomes) has previously yielded below-average price returns. Trailing four-quarter earnings growth appears sustainable over the next year, however, and history is hardly sounding an alarm. Interest Rates We have already examined the relationship between moves in real 10-year Treasury yields and equity performance in a dedicated Special Report.1 The executive summary is that the level of real rates has exerted a greater influence on S&P 500 returns than their direction. The empirical evidence suggests that stocks generally outperform when real rates are rising, though they hit a wall once the real 10-yield exceeds estimated potential real GDP growth. They also underperform at the other extreme, as extremely negative real rates tend to be associated with dire economic conditions, but potentially frightening weakness is not a feature of today’s negative real-rate backdrop. Per the potential-GDP-rule-of-thumb, the nominal 10-year Treasury yield that would begin to crimp economic activity is around 4.5-5%, assuming potential GDP growth of 1.75-2% and annual inflation with a central tendency near 3%. It is very difficult to see the 10-year yield exceeding one-half of that threshold level in the next twelve months. Though a yield backup to 2% or above over the next year would likely have significant implications for relative returns within the S&P 500, we do not think it would spell the end of the equity rally. The bottom line, then, is that we do not believe that interest rates are at a level that makes equities especially vulnerable. Price-earnings multiples may well contract if real rates rise in line with our expectations, but we expect that earnings and earnings estimates would rise enough to offset the de-rating pressure. Investment Implications Mean reversion is a bedrock investment concept, and it helps explain why the level of variables that impact equity returns can be deceiving. When key variables reach extremes, the potential of an abrupt reversal increases. Financial markets are additionally forward discounting mechanisms and the rate of change – a variable’s “second derivative” – may offer more insight into its future path than its existing position. It is easy to see why investors typically favor direction over level when looking ahead. Level does not always take a back seat to direction, however, and we think a consideration of how level and direction interact is important when assessing the current landscape. Economic growth will surely slow from double or triple its long-run trend level, earnings will surely stop beating estimates by three or four times the maximum magnitude of the previous 32 quarters, nonfarm payrolls won’t expand by 900,000 every single month (though they may for much of the rest of this year) and a range of other variables won’t keep setting records. But deceleration from record highs will not necessarily spell the end of the rallies in risk assets. While important variables remain at elevated levels, equities and credit are likely to continue to generate excess returns. Extraordinary monetary and fiscal accommodation, combined with remarkably swift and successful action to blunt the threat of COVID-19, have carried financial markets for the last year-plus and we don’t think they’re finished yet. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the September 24, 2018 US Investment Strategy Special Report, "When Will Higher Rates Hurt Stocks?", available at usis.bcaresearch.com.

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