Equities

Highlights China’s broad equity market performance since the PBoC cut its reserve requirement ratio (RRR) is consistent with our view. While the central bank’s policy tone remains dovish, a single reduction in the RRR rate has a limited impact on the economy. Divergent sector performance points to an ongoing pressure for structural reforms, ranging from traditional economic pillars to some of the new economy sectors. The bond market is betting on more rate cuts. While we expect more monetary policy easing later this year, the bond market may be ahead of itself and vulnerable to a near-term reassessment of policy and growth.  Stay underweight Chinese stocks until sure signs of policy easing emerge. Feature Chart 1Overexcited Bond buyers, Unimpressed Equity Investors China’s bond markets rallied in the two weeks following the PBoC’s 50bps reduction in the RRR. The A-share market, on the other hand, moved sideways until the big selloff earlier this week (Chart 1). Chinese policymakers’ continued crackdown on internet companies forced offshore Chinese equities to drop by 13% so far in July.  As we previously highlighted, a single RRR cut, at the most, represents a continuation in the central bank’s dovish policy stance.Meanwhile, China continues to push for structural reforms and shows no signs of easing industry regulations. In this week's report, we review the response of investors to the RRR cut and recent policy moves, both at the broad market and sector levels. We expect that China’s macro policy measures will eventually become more reflationary to shore up domestic demand next year. However, to change our underweight stance on Chinese stocks, we would need more evidence before concluding that policies on the macro level have eased enough and will lead to a cyclical uptrend in the country’s economy. While Chinese policymakers are unlikely to lift the existing sector regulations anytime soon, the strength in policy tightening may start to moderate in the next 12 months given that regulators’ ultimate goal is to promote domestic innovation and productivity. Chinese equities, particularly the ones in the offshore market, have underperformed global stocks for most of this year. We think a bottom in Chinese stocks’ relative performance may be near, however, we recommend investors stay the course for now.  Unimpressed Equity Investors The performance in both China’s onshore and offshore equity markets suggests market participants agree with our assessment, that a single reduction in RRR does not signal the beginning of broad-based reflationary efforts by Chinese authorities. Moreover, the divergence in sector performance continues pointing to a policy pivoting away from the traditional pillars in the economy. Charts 2A and 2B present the relative performance of Chinese investable and onshore stocks versus the emerging market (EM) and global benchmarks, both in USD and rebased to 100 on the day of the RRR cut announcement. The initial reaction to the announcement was modestly positive, with Chinese equities gaining in relative terms versus their global peers. However, the small gains disappeared less than a week after the RRR’s trim, reflecting investors’ lack of confidence in the stimulative effects from a one-off cut. Chart 2AA Lackluster Offshore Equity Market... Chart 2B...The Pickup In The Onshore Market Did Not Last Long Either Chart 3The Real-Economy Sectors In The Offshore Market Also Underperformed China’s heightened regulatory oversight on its internet companies, including the recent clampdown on private tutoring firms, has further dampened the appetite for Chinese offshore stocks, which are concentrated in internet titans. Nonetheless, the real economy sectors in the MSCI China Index also underperformed their global peers, indicating that investors’ risk-off sentiment towards Chinese stocks is widespread (Chart 3). Furthermore, divergent sector performance is consistent with our view that it is too early to call a loosening in China’s macro policy. In addition to a continued underperformance in real estate sector stocks, domestic infrastructure stocks also failed to break above their technical resistance relative to the overall domestic market and global stocks (Charts 4A and 4B). The market signals suggest that a significant ramp up in infrastructure spending in China is not imminent. Presumably, any meaningful improvement in the country’s fiscal spending would cause the earnings outlook for domestic infrastructure stocks to brighten considerably relative to the domestic market and the global average. Chart 4AProperty Stocks On A Free Fall Due To Tightened Regulations Chart 4BNo Sign Of Improvement In Infrastructure Stocks Interestingly, the BCA China Play Index, which tracks a portfolio of assets sensitive to the outlook for Chinese growth and reflation,1 has soared since the second quarter of last year. It presents nearly a mirror image of onshore Chinese infrastructure stocks (Chart 5). Such a stark contrast in the performance between the BCA China Play Index and onshore Chinese infrastructure stocks occurred in the past and we are inclined to trust the market signals from the latter rather than the former.  The Chinese Li-Keqiang Index (LKI) of industrial activity leads the BCA China Play Index by about two to three months (Chart 6). The LKI declined non-trivially in the face of a sharp reduction in credit growth and pressing structural reforms in 1H21, suggesting that risks to the China Play Index will be to the downside in the coming months. Chart 5Which One Is Sending The Right Signal? Chart 6China's Li Keqiang Index May Be Flashing Amber On the surface, the divergence between the performance in China’s blue-chip stocks and ChiNext, a NASDAQ-style subsidiary of the Shenzhen Stock Exchange, seems consistent with falling financing costs this year (Chart 7). ChiNext is tech-heavy and sensitive to changes in interest rates.  However, ChiNext’s outperformance relative to the aggregate A-share market also reflects China’s policy direction, which is a strategic push for technology self-sufficiency and a significant increase in high-tech infrastructure investment (Chart 8).   Chart 7Chinese 'High-Tech' Stocks Benefit From Lower Rates... Chart 8...But Policy Supports Have Been A Non-Trivial Factor Bottom Line: Signals from China’s equities, both in general and on a per-sector basis, suggest that investors are not betting on a meaningful easing in the country’s policy. Making Sense Of The Bond Market The RRR cut exacerbated China’s nascent bond market rally as expectations continue to climb that additional policy easing will be forthcoming. While we agree with the bond market that China’s monetary policy will eventually turn more accommodative, the timing and speed of easing may disappoint investors. The depth in the decline of sovereign bond yields in recent weeks makes the fixed-income market vulnerable to repricing in the coming months. After hitting a peak of 3.3% in November last year, China’s 10-year government bond yield has fluctuated on a downward trend. The rollover in yields coincided with a top in several key economic indicators, such as the PMI, credit impulse and the China Economic Surprise Index (ESI) (Chart 9). Falling demand for bank credit relative to liquidity supply - indicating corporates' lower propensity to invest in the real economy - further depressed bond yields (Chart 10). Chart 9Yields Fell When The Economy Peaked Chart 10Lower Propensity To Invest In Real Economy Also Helped Pushing Down Bond Yields Although the momentum in China’s economic growth has peaked, the magnitude of the decline in the 10-year bond yield has likely overstated the degree of the economic slowdown. As illustrated in Chart 9, the pace of the decline in the 10-year bond yield in the past three months was as rapid as during the height of previous economic downturns.  Those economic slowdowns involved more than a single RRR cut, including the ones that coincided with the US-China trade war in 2018 and those triggered by a prolonged deflationary cycle in 2015/16. Chart 11Is The Bond Market Ahead Of Itself? From a technical perspective, the 10-year government yield has become stretched versus the underlying trend in yields as defined by the 200-day moving average (Chart 11). The steep decline in the long-date bond yield suggests that the market has priced in more potential rate cuts as well as weaknesses in China’s economy. China’s ESI, which is a gauge of market psychology, has ticked up of late. If authorities at the Politburo meeting later this month show any reluctance in further reducing rates, then a reassessment of policy will likely push up bond yields in the coming weeks. COVID-19 remains a risk to this view, however, given China’s zero tolerance towards domestic infection cases.  Even localized outbreaks will probably cause sporadic disruptions in economic activity and dampen optimism, helping to push sovereign yields even lower. Bottom Line: We remain cautious about the sustainability of the recent bond market rally, barring large disruptions caused by the COVID-19 Delta variant. The market lacks catalysts for Chinese government bond yields to trigger significant moves in either direction. Moreover, the plummet in yields in the past few weeks makes bonds vulnerable to a price correction in the near term.   Investment Conclusions While the bond market is betting on slower economic growth and more rate cuts, the timing of further policy easing is in question and the magnitude may be smaller than the market has already priced in. Meanwhile, China’s onshore and offshore market investors remain cautious, particularly given China’s renewed focus on structural reforms.  In light of these aspects, we would not recommend that investors with a time horizon of less than three months take a long position in Chinese stocks, either in absolute terms or relative to the global benchmark. However, on a cyclical (i.e. 6-12 month) time frame, we could turn more constructive on Chinese stocks if the authorities show more willingness to respond to slowing economic activity by easing policies. Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1The assets included in the BCA China Play Index are: Chinese iron ore prices in USD; Swedish industrial equities in USD; Brazilian equities in USD; AUD/JPY; and EM high-yield bonds denominated in USD. Market/Sector Recommendations Cyclical Investment Stance

Highlights Economy – The inevitable deceleration has arrived, but the economy is still growing far faster than trend and will continue to do so through 2022: A wide range of data series shows that US growth has likely peaked but deceleration from way, way above the long-run potential growth rate to way above it is not cause for concern. Markets – Growth worries pulled equities lower for one day last week before investors rushed back in to buy the dip: Stock volatility made a brief return at the beginning of the week before the S&P 500 snapped back to resume taking aim at new highs. Fundamentals supported the reversal as earnings are on a path to blow away expectations for the fifth consecutive quarter. Strategy – Investors should stay the course by overweighting risk assets in multi-asset portfolios: As long as the spread of the Delta variant does not lead to punishing new restrictions, the economy will continue to grow at an extremely rapid clip and the strong-growth, easy-policy backdrop will continue to support equities and credit. Feature The S&P 500 had its worst one-day performance since early April last Monday, shedding 1.6% and sending the VIX above 20 for only the ninth time since it broke into the teens in March (Chart 1). We do not read too much into day-to-day moves in financial markets, but the tumult seems to have resulted from equities’ delayed reaction to investor unease about decelerating growth. It makes intuitive sense that forward-looking markets often assign greater importance to the direction of a key data series than its level. In Wayne Gretzky terms, the level is largely an indication of where conditions have been, while the direction offers more insight into where they are headed. Direction does not always trump level, however, and investors should bear in mind that the current pace of growth is extremely elevated. The Bloomberg consensus of economists is calling for 6.6% real GDP growth in 2021 and 4.2% in 2022. Those figures project a tapering, especially from quarter to quarter (Table 1), but they still represent red-hot growth for an economy with an annual long-term potential growth rate in the range of 1.75% to 2%. They also reflect a gentle tapering, with growth expected to remain comfortably above trend through 2023. Chart 1Lower Highs, Lower Lows Table 12% Is So Last Decade   We are far less concerned about deceleration from high single-digit growth than we would be about sub-trend readings. Falling below trend was the persistent fear in the aftermath of the Global Financial Crisis when economists and investors alike worried that the economy would not be able to stay above stall speed. Growth likely peaked in the second quarter, and supply bottlenecks and wavering confidence in the face of the spread of COVID-19’s Delta variant have brought the economic surprise index back down to earth (Chart 2). To take one example of a series that recently generated a negative surprise, however, we think the month-over-month decline in the ISM non-manufacturing index has less to say about the economy than its fourth straight reading in the 60s, a level it had reached just eight times in the previous 23 years (Chart 3). Chart 2The Economy Is Cooling Off, ... Chart 3... But It's Still Quite Hot   Is The Bond Market Trying To Warn Us? Chart 4Inflation Fears Have Ebbed We did not foresee the steep decline in 10-year Treasury yields that has played out since mid-June and it has led us to ask if underlying economic conditions are weaker than we perceived. Based on the available data, we do not think so. It seems like the rally in long-dated Treasuries can be attributed to an unwinding of inflation fears, concerns about slowing growth and the reversal of a Treasury sell-off that had gone too far too fast. We remain constructive on the economy, assuming vaccine-resistant COVID-19 variants do not emerge, and we still expect the 10-year Treasury yield will end the year north of 1.75%. Inflation fears have cooled considerably, with 10-year TIPS breakevens having retreated to the lower end of the Fed’s desired range, while the 5-year-on-5-year series (the 5-year breakeven five years from now) has dropped out of it (Chart 4). Though we do not expect inflation to become a problem for the economy for another couple of years, we do expect that it will re-emerge as a worry for investors once the primary impediments to labor supply disappear in September, especially if the year-over-year CPI readings continue to come in way above 2%. Our Global Fixed Income Strategy service stresses that investors should watch the mix of components driving inflation. If accelerated wage gains appear to be on their way to becoming entrenched or the rate of growth in rents inflects higher, the transitory inflation narrative might begin to weaken, leading the Fed to dial back accommodation sooner and/or faster than the bond market currently anticipates. Though we are not concerned about a widely anticipated peak in the rate of growth, a revival of COVID-19 after it seemed to have been defanged would throw a spanner into the works. A surge in new infections, even in countries like the UK and the US which have been ahead of the pack in terms of vaccinations, indicates that the Delta variant is especially transmissible. The spike in infections here (Chart 5, top panel) and abroad has apparently dampened economic optimism, helping to push Treasury and other developed world sovereign yields lower. The good news, however, is that the Delta variant does not appear to be particularly lethal (Chart 5, bottom panel) and the leading Pfizer and Moderna vaccines have acquitted themselves well against it. We are watching virus developments carefully, but we do not yet see evidence that suggests new rounds of activity restrictions are in store and we therefore expect virus variants will ultimately have little economic impact. Chart 5The Delta Variant Is More Contagious But Less Serious Aside from the pendulum shifting from too-hot concerns to too-cold concerns, much of the Treasury rally appears to have been a reaction to the speed and extent of the backup in yields. Our Global Fixed Income Strategy colleagues point out that Treasuries became quite oversold in the first quarter. The 10-year yield got as far above its 200-day moving average as it did during the taper tantrum in 2013 (Chart 6, second panel), with both real-money investors (Chart 6, third panel) and speculators (Chart 6, bottom panel) shunning duration. Speculators have trimmed their short positions but the real money has yet to capitulate, suggesting that yields may be able to hang around current levels or edge even lower before returning to a level that better aligns with underlying economic strength, robust inflation readings and the future path of the fed funds rate. Earnings Continue To Crush Expectations Every equity investor is familiar with the earnings season dance. About halfway through the quarter, companies begin to guide analysts’ expectations lower. Analysts duly adjust their estimates down a few percentage points over the ensuing ten weeks before companies begin to report. Company earnings then come in about the level initially expected midway through the quarter and – voila! – three-quarters of S&P 500 constituents beat expectations and the overall index beats by around 3%. The typical pattern looks very much like it did across 2019 (Chart 7, top panel). Chart 6The Treasury Selloff Was Overdone Chart 7Not The Same Old Song-And-Dance Beginning with the second quarter of 2020, when the most stringent lockdown measures meant to stymie the spread of the pandemic were fully in force, the picture has been very different. S&P 500 constituents have barely guided down heading into earnings before proceeding to demolish estimates by close to 20% (Chart 7, bottom panel). The established practice of companies guiding analysts to position the bar at a height they think they can comfortably clear produced a narrow and consistent dispersion of earnings beats across the 32 quarters from 2012 to 2019, with a mean of 3.7% and a standard deviation of 1.4%, all clustered within a narrow 1-to-6% range (Chart 8). Chart 8Blasting Out Of The Old Range Something else entirely has unfolded over the last four quarters, when earnings beat by an average of 19.5%, more than three times above the previous eight years’ peak and five times their mean. Even with the pandemic numbers pushing the mean higher and quadrupling the standard deviation, the four quarters’ beats have been 3.2, 2.2, 1.8 and 3.1 standard deviations above the mean, respectively. With a quarter of the S&P 500 having reported results through last Friday, the second quarter appears to be on a path to extend the blowout streak to five quarters (Chart 7, bottom panel). Investors, conditioned to the S&P 500 unfailingly beating earnings, don’t seem to be cognizant of how unusual the magnitude of the beats has been. Gigantic year-over-year earnings gains, which will peak this quarter, also seem to have obscured how low the bar has been set on a quarter-over-quarter basis. As our US Equity Sector Strategy colleagues have highlighted, year-over-year comparisons that span pandemic-distorted quarters are of limited use. To get a more relevant read, they compare 2021 results to 2019 results. (For the full year, 2021 earnings per share for the S&P 500 are projected to come in 18.2% above 2019, for 8.7% annualized growth). Table 2A Remarkably Low Bar We have been tracking quarter-over-quarter changes and were surprised to see that forward four-quarter earnings were expected to decline 2% from their first-quarter run rate ($196.52, annualized) when the reporting season began, with the second quarter declining by 8% (Table 2). Given manifold signs of economic revival, an 8% sequential contraction strikes us as highly improbable. With real GDP expected to grow by 9% on an annualized quarter-over-quarter basis, or better than 12% in nominal terms, 2% growth seems reasonable, so we see $50 as a more realistic and easily attainable ballpark estimate, which would have earnings beat by 11%. Regardless of where earnings end up, the bar has been set extremely low – the analyst consensus has not forecasted contraction in any forward four-quarter period since 1980 (Chart 9). Our takeaway is that earnings estimates have scope to move higher, taking the S&P 500 with them if multiples don’t contract, or giving valuations a chance to cool if the index moves sideways or turns lower. Chart 9An Odd Time To Call For The First Contraction In 40 Years Investment Implications Our investment strategy recommendations follow from our ongoing analysis of the business cycle, the credit cycle, the monetary policy cycle and (when applicable) the sentiment cycle. Although the consistency of our risk-friendly asset allocation recommendations may have begun to seem boring, nothing in our cycle analysis calls for a change in our views. There is no reason to expect a recession when households are sitting on $2.4 trillion of excess savings, household net worth has advanced at the fastest rate on record, retail inventories have been depleted to record-low levels and payrolls are set to continue expanding at a furious rate over the next year-plus. The credit cycle is set to continue its charmed path, as rising incomes, cash-stuffed households and businesses, and zero interest rate policy suppress borrower distress and keep lenders eager to make loans. Monetary policy may get incrementally less accommodative as asset purchases shrink, but a rate hike is more than a year away. One can make a reasonable argument that the Fed will be unable to lift the fed funds rate to a truly restrictive level in the next policy tightening cycle once it begins to hike rates, even if it’s not our base case. We are certain that monetary policy settings will remain extremely easy well beyond our one-year investment timeframe. Sentiment is generally buoyant, but it is not at extreme levels that would warrant factoring it into our strategy as a contrarian indicator. We will therefore stay the course, while monitoring pandemic developments and keeping a sharp lookout for signs that we’re wrong about inflation or growth. If we are correct that the threat from COVID-19 will remain contained, we expect that earnings revisions will ensure that the next catalyst for equities will be a positive one. The consensus expectation for a decline in the earnings run rate is simply incompatible with observed conditions on the ground. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

Dear Client, I will be on vacation next week. In lieu of our regular report, we will be sending you a Special Report written by my colleague Arthur Budaghyan, BCA Research’s Chief Emerging Markets Strategist. Arthur’s report will discuss the long-term outlook for industrial companies. He argues that the US is entering an industrial boom prompted by infrastructure stimulus and onshoring. This will benefit US industrial equities, or ones selling into the US on a multi-year horizon. I trust you will find it insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Investors keep asking whether the recent increase in US inflation is transitory. However, this is the wrong question to ask. Annualized core CPI inflation reached 10.6% in the second quarter. There is little doubt that inflation will fall from such elevated levels. The key question that investors should be asking is whether inflation will decline more or less than what the market is discounting. The widely watched 5-year/5-year forward TIPS inflation breakeven rate has sunk to 2.11%, below the Fed’s “comfort zone” of 2.3%-to-2.5%. Thus, the market already expects a substantial decline in inflation. Our sense is that US inflation will come down fast enough to allow the Fed to maintain a highly dovish policy stance, but not as fast as market expectations currently imply. As inflation surprises on the upside, long-term bond yields will rise. This should revive bank shares and other reflationary plays. The combination of a weaker US dollar, faster sequential Chinese growth, increased vaccine supplies, and favorable valuations should all help EM stocks later this year. Go long the Vanguard FTSE Emerging Markets ETF (VWO) versus the Vanguard S&P 500 ETF (VOO). The Right Question About Inflation Chart 1After A Spike In Q2, US Inflation Will Decelerate Investors remain focused on whether the recent bout of US inflation is transitory. However, this is not the correct question to be asking at the present juncture. The US core CPI rose by 10.6% at an annualized pace in Q2 relative to the first quarter (Chart 1). It is almost inevitable that inflation will come down from such high levels. The key question investors should be asking is whether inflation will decline more or less than what is already baked into market expectations. As Chart 2 shows, investors expect US inflation to come down rapidly over the next two years. The 5-year/5-year forward TIPS breakeven inflation rate – a good proxy for where investors expect inflation to be over the long haul – has sunk to 2.11% (Chart 3). This is below the Fed’s comfort zone of 2.3%-to-2.5%.1 Globally, long-term inflation expectations remain subdued (Chart 4). Chart 2Inflation Is Expected To Moderate Over The Coming Years Chart 3Inflation Expectations Have Fallen Back Below The Fed's Target Zone Chart 4Long-Term Inflation Expectations Remain Subdued       Inflation Will Fall, But… Our sense is that US inflation will come down fast enough to allow the Fed to maintain a highly dovish policy stance, but not as fast as market expectations currently imply. Broad-based inflationary pressures would make the Fed nervous. However, that is not what we are seeing. Wages have accelerated markedly in only a few relatively low-skilled sectors such as retail trade and leisure and hospitality (Chart 5). For the economy as a whole, wage growth is broadly stable (Chart 6). The expiration of extended unemployment benefits, the reopening of schools, and increased immigration should also boost labor supply in the fall. Chart 5Faster Wage Growth Has Been Confined To A Few Low-Wage Sectors Chart 6No Sign Of A Wage-Price Spiral... For Now     On the price front, more than two-thirds of the increase in the core CPI in June stemmed from pandemic-afflicted sectors (Chart 7). The price of the median item within the CPI index rose by just 2.2% year-over-year in June, somewhat below the pre-pandemic pace of inflation (Chart 8). Chart 7Most Of The Recent Increase In Inflation Is Pandemic-Related Chart 8The Median Price In The CPI Basket Is Up Only 2.2% … Not As Fast As The Market Expects While inflation will fall as pandemic effects recede, investors are overestimating how fast this will happen. US growth has undoubtedly peaked, but at a very high level. Economists surveyed by Bloomberg estimate that US GDP rose by 9.0% in Q2. Growth is expected to slow to 7.1% in Q3 and 5.1% in Q4, while averaging 4.2% in 2022 (Table 1). By any standard, these are very strong, above-trend growth rates. Table 1Growth Is Peaking, But At A Very High Level Chart 9Nearly 90% Of US Seniors Have Had At Least One Shot The current Delta-variant wave is unlikely to slow US growth by very much. Although vaccination rates among younger people are at middling levels, they are quite high for the elderly who are most at risk of serious illness. Close to 89% of Americans above the age of 65 have received at least one shot, and nearly 80% are fully vaccinated (Chart 9). The 65+ age group accounts for four-fifths of all Covid deaths in the United States. Widespread vaccination coverage for older Americans will take pressure off the hospital system, allowing the economy to remain open. Fiscal Support In The US And Abroad As we noted last week, Senate Democrats are likely to use the reconciliation process to both raise the debt ceiling and pass President Biden’s $3.5 trillion American Jobs and Families Plan. They are also likely to move forward on Biden’s proposed $600 billion in infrastructure spending, with or without Republican support. Meanwhile, much of the fiscal stimulus that has already been undertaken has yet to make its way through to the economy. US households are sitting on about $2.5 trillion in excess savings, about half of which stems from increased government transfers (Chart 10). Chart 10A Lot Of Excess Savings Chart 11Inventories Are At Low Levels   Satiating that demand has not been easy for many companies. Retail sector inventories are at record lows (Chart 11). The number of homes that have been authorized for construction but where building has yet to begin has increased by 62% since the start of the pandemic (Chart 12). By limiting production, supply-chain bottlenecks will push some spending towards the future. This will keep growth from decelerating more than it otherwise would. Outside the US, fiscal policy will remain supportive. All 27 EU countries ratified the €750 billion Next Generation fund on May 28th. The allocations from the fund for southern European countries are relatively large (Chart 13). Most of the money will be spent on public investment projects with high fiscal multipliers. Chart 12Growing Backlog Of New Home Construction Projects Chart 13EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large Chart 14Economic Growth In China Was Slow In H1 The Japanese government is contemplating sending stimulus checks to low-income citizens in advance of the general election due by October 22nd. It is an understandable move. Covid cases are rising again. As a result, the authorities have declared a state of emergency in Tokyo and barred spectators from attending the Olympic games in and around the city. Fortunately, the Japanese vaccination campaign has accelerated after a slow start. A third of the population has now received at least one shot. The government intends to vaccinate all eligible people by November.  Looking at quarter-over-quarter growth rates, Chinese growth averaged just 3.8% on an annualized basis in the first half of 2021 (Chart 14). Growth should pick up in the second half of the year thanks in part to increased fiscal spending. As of June, local governments had used only 28% of their annual bond issuance quotas, compared with 61% over the same period last year and 65% in 2019. Most of the proceeds from local government bond sales will likely flow into infrastructure projects.   Resumption Of The Dollar Bear Market Will Keep Inflation From Falling Too Far As a countercyclical currency, the US dollar usually weakens when global growth is strong (Chart 15). Short-term real interest rate differentials have moved sharply against the dollar, a trend that is unlikely to change anytime soon given the Fed’s dovish bias (Chart 16). While inflation in the US is not as sensitive to currency fluctuations as in most other countries, a weaker dollar will still lift tradeable goods prices (Chart 17). Chart 15The Dollar Is A Countercyclical Currency Chart 16Rate Differentials Are A Headwind For The Dollar Chart 17The Dollar And Inflation Structural Forces Turning More Inflationary Not only are cyclical forces likely to turn out to be less disinflationary than investors believe, but many of the structural factors that have suppressed inflation over the past 40 years are reversing direction: Chart 18Globalization Plateaued More Than A Decade Ago Globalization is in retreat: The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 18). Looking out, the ratio could even decline as more companies shift production back home in order to gain greater control over supply chains of essential goods. Baby boomers are leaving the labor force en masse. As a group, baby boomers hold more than half of US household wealth (Chart 19). They will continue to run down their wealth once they retire. However, since they will no longer be working, they will no longer contribute to national output. Continued spending against a backdrop of diminished production could be inflationary. Despite a pandemic-induced bounce, underlying productivity growth remains anemic (Chart 20). Slow productivity growth could cause aggregate supply to fall short of aggregate demand. Social stability is in peril, as exemplified by the recent dramatic increase in the US homicide rate. In the past, social instability and higher inflation have gone hand in hand (Chart 21). Perhaps most importantly, policymakers are deliberately aiming to run the economy hot. A tight labor market will eventually lift wage growth to a greater degree than what we have seen so far (Chart 22). Not only could higher wage growth push up inflation through the usual “cost-push” channel, but by boosting labor’s share of income, a tight labor market could spur aggregate demand. Chart 19Baby Boomers Have Accumulated A Lot Of Wealth Chart 20Trend Productivity Growth Has Been Disappointing Chart 21Historically, Social Unrest And Higher Inflation Move In Lock-Step     Chart 22A Tight Labor Market Eventually Bolsters Wages Investment Implications Chart 23Positive Earnings Revisions Are At High Levels The path to higher rates is lined with lower rates. The longer central banks keep interest rates below their neutral level, the more economies will overheat, and the more rates will eventually need to rise to bring inflation back down. For now, we are still in the warm-up phase to higher inflation. With long-term inflation expectations below target, central banks will be able to maintain accommodative monetary policies. This is good news for stocks, at least in the short-to-medium term. The recent wobble in equity markets has occurred despite a strong second quarter earnings season. According to the latest available data from I/B/E/S, 90% of S&P 500 companies have reported earnings above analyst expectations. Earnings have surprised on the upside by an average of 19.2%, compared to a historical average of 3.9%. Positive earnings revisions are at record high levels (Chart 23). Full year 2021 S&P 500 EPS estimates have risen 16% since the start of the year. Analysts have also raised their estimates for 2022 and 2023 (Chart 24). We continue to recommend that asset allocators favor stocks over bonds over a 12-month horizon.   Chart 24Analysts Have Been Revising Up Earnings Estimates This Year Chart 25The Gains Of Recent Winners Have Not Been Fully Mirrored In Relative Earnings Growth Chart 26Bank Shares Thrive In A Rising Yield Environment Tech stocks have outperformed the broader market over the past seven weeks. However, unlike during the pandemic, 12-month forward EPS estimates for tech have not risen in relation to other sectors (Chart 25). As long-term bond yields move back up, tech shares will underperform. In contrast, banks will benefit from higher yields (Chart 26).     Along the same lines, US stocks have outpaced other stock markets by more than one would have expected based on relative EPS trends. Notably, EM earnings have moved sideways versus the US since mid-2019. Yet, US stocks have outperformed EM by 17% over this period. Today, the forward P/E ratio for EM stands at 13.8, compared to 22.1 for the US (Chart 27). The combination of a weaker US dollar, faster sequential Chinese growth, increased vaccine supplies, and favorable valuations should all help EM stocks later this year. Go long the Vanguard FTSE Emerging Markets ETF (VWO) versus the Vanguard S&P 500 ETF (VOO).   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Chart 27Wide Valuation Gap Between US And Non-US Markets Footnotes 1 The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights The Delta variant will continue causing jitters but there is much greater evidence today than there was in early 2020 that humanity can curb the virus, both with vaccines and government stimulus. Delta jitters will reinforce the Fed’s dovishness and will, if anything, increase the odds that President Biden passes his mammoth spending package this fall. The very near term could easily see more volatility but by the end of the year the reflationary cast of global policy will have won the day. Tax hikes and rate hikes lurk beyond 2021. There is still no stabilization in US-China policy and the US and its allies have called out China for cyber aggression, signaling a new front of open competition. A cyber event is one of the leading contenders for the next negative shock to the global economy. Structural factors strongly support rising concerns among the global elite about cyber insecurity. Stick to this year’s key themes and views: long gold, long value over growth, long international stocks, long Mexico, long aerospace and defense, and short emerging market “strongmen” regimes. Feature Global equities sank and rose over the past week as investors struggled with “peak growth” in the US and China, the prospect of monetary policy normalization, and other risks on the horizon, including immediate concerns over the Delta variant of COVID-19. The rapid rebound, including for cyclicals like European stocks, suggested that investors are still buying the dip given a very supportive macro and policy backdrop (Chart 1). The BCA House View consists of accommodative policy, economic recovery, a weakening dollar, and the outperformance of cyclical risk assets. We largely agree, with the caveat that there will be “No Return To Normalcy” in the geopolitical realm. Meaning that over the medium and long term the US dollar will remain firmer than expected and cyclical economies and sectors will face headwinds.   Chart 1Equity Market Hits Wall Of Worry The pandemic will have unforeseen consequences, such as social unrest and regime failures, while China’s secular slowdown and the Great Power competition between the US and its rivals will intensify. Not only is China slowing but also President Joe Biden has been confirmed as a China hawk, coopting President Trump’s aggressive stance and courting US allies to pile the pressure on Beijing.    For most of this year the “normalcy” narrative has prevailed. Now investors are becoming fearful of the “abnormalcy” narrative. The US dollar has surprised its doubters on the basis of relative growth and interest rate differentials (Chart 2). Chart 2Dollar Remains Firm, Reflation Indicator Abates Over the next six months, the key point is that until these geopolitical risks boil over and explode, they reinforce the bullish macro view, since government spending will surge to address national challenges. The rich democracies have awoken to the threat posed by malaise at home and autocracy abroad. They have reactivated fiscal policy to rebuild their states and expand the social safety net. They are increasing investments in infrastructure, renewables, and defense. This trend is especially positive for US allied economies, global manufacturers ex-China, commodity prices, and commodity producing emerging markets, at least until the next shock erupts. We discuss the risk of a cyber shock as well as the points above in this report. Policy Responses To The Delta Variant The Delta variant began in India and has now swept the world. So far the variants respond to COVID vaccines, which are being rolled out globally. National and local political leaders will promote vaccination campaigns first – only if hospital systems are clogged will they resort to social restrictions. New infections have risen much faster than hospitalizations and deaths, although the latter are lagging indicators and will eventually follow cases (Chart 3). But financial markets will largely look past the scare, as they looked past the various waves of the original virus over the past 15 months. Today investors have greater evidence of humanity’s ability to curb the virus and can expect government spending to tide over the economy if new restrictions are necessary. New social restrictions should not be ruled out. They are not politically impossible. Public opinion in the developed countries shows that about 77% of people believe restrictions were about right or should have been tighter, while only 23% believe there should have been fewer restrictions (Chart 4). About 40% of Germans oppose the lifting of restrictions even for the vaccinated! Chart 3Delta Variant: A Limited Risk Unless Hospitals Clog Chart 4ANew Lockdowns Not Impossible Chart 4BNew Lockdowns Not Impossible Any financial or economic distress from virus variants will reinforce ultra-accommodative monetary policy. The European Central Bank adopted a symmetric inflation target of 2% as it completed its strategic review, up from a previous goal which simply aimed at inflation just under 2%. It is likely to expand rather than taper asset purchases (Chart 5). At the Fed, the balance of power between hawks and doves on the Federal Open Market Committee reflects the political and geopolitical trends of the day. In the wake of the Great Recession, the doves overwhelmed the hawks (Chart 6). The institution has fully transitioned today – it now aims to generate an inflation overshoot – and it will not jeopardize its new average inflation targeting regime by tightening policy too soon this year or next. Chart 5Central Banks Will Delay Normalization If COVID Crisis Persists Chart 6Doves Firmly In Ascendancy At Federal Reserve The Delta variant makes it more likely that governments will increase fiscal support. The European Union’s Recovery Fund has a modest impact but the EU Commission is not patrolling budget deficits anymore, in the event that new social restrictions set back the recovery. The Democratic Party will pass President Biden’s $3.5-$4.1 trillion American Jobs and Families Plan through Congress by Christmas (with a net deficit increase of $1.3-$2.5 trillion over eight years). Support rates among independents and Democrats suggest Biden will come up with the votes (Chart 7). A renewed sense of crisis will compel any straggling senators. Chart 7ADelta Variant Makes Biden Stimulus Even More Likely To Pass Chart 7BDelta Variant Makes Biden Stimulus Even More Likely To Pass Markets will cheer more government spending as they have done throughout the vast surge in budget deficits across the world, not least in the developed markets, where austerity stunted the recovery in the wake of the Great Recession (Chart 8). Beyond Delta jitters and reactive stimulus, there are clouds forming on the horizon over the medium and long term. Budget deficits will start contracting, central banks will start hiking rates, and taxes will go up (and not only in the US). Geopolitical risks that are suppressed today will erupt later. Bottom Line: The very near term could easily see more volatility but by the end of the year the reflationary cast of global economic policy will have won the day. The bigger problems come clearly into review after the ink dries on the last installment of the great Biden budget blowout. Chart 8Market Will Cheer Another Round Of Government Spending China Policy And Cyber War What might the next major negative shock be? A leading candidate is China, with its confluence of internal and external risks. China’s policymakers opened the floodgates of credit-and-fiscal stimulus to combat the global pandemic in 2020. They quickly shifted to tightening policy to prevent destabilizing asset bubbles. Now they are easing again. Stimulus and growth have both peaked. Authorities are on the verge of overtightening policy but tactical shifts in economic policy often occur in July. Right on cue the State Council ordered across-the-board cuts to bank reserve requirements on July 9. The Politburo’s July meeting on economic policy will bring an even more important policy signal. The concrete impact of the RRR cut should not be overstated. China has been lowering RRRs since late 2011 as its broad money growth has continually declined. The trend is indicative of China’s secular slowdown. A new series of RRR cuts is often attended by a global equity selloff (Chart 9). Chart 9China Blinked - But One RRR Cut Will Not Prevent A Global Selloff Our China Investment Strategy highlights that policy remains restrictive in other areas. Local governments have been told not to borrow if they have hidden debts. Moreover the crackdown on China’s tech sector also continues apace. These regulatory crackdowns are characteristic of the Xi Jinping administration and can continue for a while as it further consolidates power in advance of the twentieth National Party Congress in fall 2022. The US-China conflict is getting worse. The Biden administration took several punitive actions over the past month. It warned businesses against investing in Hong Kong and Xinjiang. It rejected a restart of the strategic and economic dialogue. While a bilateral summit between Biden and Xi Jinping is possible on October 30-31, it is not yet scheduled and would only temporarily improve relations. One of Biden’s more significant recent moves was to orchestrate a joint statement with allies condemning China for aggressive behavior in cyber space.1 A massive cyber attack should be high up on any investor’s list of “gray rhino” events (high-probability, high-impact events). The world has suffered large shocks from global terrorism, financial crisis, and pandemic. Lightning rarely strikes the same place twice. Of course, nobody knows what will cause the next upset. But a devastating cyber event has been underrated in the investment community and that is changing (Table 1). Fed Chair Powell, asked by a reporter what was the chief risk to the global financial system, said “cyber risk.” To quote in full: So you would worry about a cyber event. That's something that many, many government agencies, including the Fed and all large private businesses and all large private financial companies in particular, monitor very carefully, invest heavily in. And that's really where the risk I would say is now, rather than something that looked like the global financial crisis.2 Table 1Cyber Event Underrated In Consensus View Of Global Risks Here are six structural reasons that cyber risk will continue to escalate: Cyber space is one of the truly ungoverned spaces. The US is the preponderant power in cyber space, as elsewhere, but there is no regular order or code of conduct. The US cyber bureaucracy is decentralized and uncoordinated while its opponents are centrally commanded, aggressive, and sophisticated. Great power competition is escalating. The US is struggling with China, Russia, and Iran and all sides seek to intimidate enemies and gain allies. Cyber capabilities enhance essential tasks like spying, sabotage, and information warfare. The tech race is intensifying, with companies and governments investing heavily in innovation and industry, while US export controls exacerbate China’s frantic efforts to obtain advanced tech by any means. The pandemic boosted digital dependency across industry and commerce, creating a “perfect storm” for cyber attacks and hacking.3 The US and its allies are threatening to retaliate more actively against cyber attacks, which may initially lead to an increase in the total number of attacks. In addition, Israel will need to sabotage Iran’s nuclear program if it is not halted by diplomacy. The US is polarized and war-weary yet claiming greater commitment to its allies, a paradox that encourages foreign rivals to use cyber tools to foment US divisions; strike at regional opponents that lack US security guarantees; and test the US commitment to its allies. The current US-Russia negotiations toward a truce against cyber attacks on critical infrastructure are the sole example of a potential structural improvement. The US and Russia could conceivably lay down some rules of the road in cyber space. There may be a basis for an agreement in that already this year the US refrained from blocking the Nordstream II pipeline with Germany while Russia refrained from re-invading Ukraine. However, a Russo-American truce would not dispel the risk of a global cyber surprise. It could even increase the odds. Russia this year alone showed with the Colonial Pipeline hack and the JBS meat-packing hack that its proxies can disrupt critical US infrastructure. It would make sense to agree to a truce so that the US does not demonstrate the same capability against Russia. Even without a truce, Russia does not benefit from provoking massive US cyber attacks. The US is the world’s leading cyber power and has pledged that it will retaliate. Rather Russia will concentrate its efforts closer to home: suppressing dissent, intimidating the former Soviet Union, and testing the US’s willingness to defend its allies. It would be useful for Russia to use cyber attacks to undermine NATO unity and demonstrate that the US is reluctant to defend NATO members’ critical infrastructure. Remember the cyber strike against Estonia in 2007. Hence huge shocks could still emerge in Europe or elsewhere even if the US and Russia make a ceasefire regarding their own critical infrastructure.  The same can be said for China, Iran, and North Korea. Attacks in their neighborhood are even more likely than direct provocations against the United States now that the US is threatening graver consequences. Beijing is concentrating its cyber power on technological acquisition. But it will also try to intimidate its neighbors into neutrality and test America’s commitment to its allies. This applies to markets like Taiwan, South Korea, the Philippines, and Vietnam. Not all cyber attacks would cause a global shock but the danger of Biden’s emphasis on alliances and multilateralism is that the US will be tested and its commitments will expand. Local cyber attacks could escalate if the US believes it must prove its resolve.   Bottom Line: Cyber firms’ share prices have risen since we made our contrarian buy call back in March. True, fundamentals are poor despite the strong geopolitical tailwind. The BCA Equity Analyzer shows that valuations, debt, liquidity, and return on equity have deteriorated relative to the global large cap equity universe (Chart 10). Still, as long as liquidity is ample and geopolitical risk is high we expect cyber firms’ share prices to keep grinding upward. Chart 10Cyber Stocks: Poor Fundamentals But Geopolitics A Secular Driver Investment Takeaways We are sticking with our key themes and views: long gold; long value over growth; long DM-ex-US stocks such as FTSE100 (Chart 11) and European industrials; long US neighbors Mexico and Canada; long defense and cyber stocks; and short the assets of emerging market “strongman” regimes from China and Russia to Brazil, Turkey, and the Philippines. Taking several of our trade recommendations alongside the copper-to-gold ratio, a key measure of global reflation, there could be more near-term downside (Chart 12). Nevertheless these are strategic trades designed to bear rewards over 12 months and beyond. Mainland Chinese investors should book gains on long Chinese 10-year government bonds. We would not rule out a bigger bond rally later given China’s risks at home and abroad, but RRR cuts often lead to a selloff and the signal is that the socialist policy “put” remains in place. Book gains on long Italian / short Spanish equities. This tactical trade is now hitting the top of its range and will likely mean revert. We are still optimistic on European stocks and the euro as a whole and view the German election as a positive catalyst almost regardless of outcome. Chart 11Stay The Course: Long Value Over Growth   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Chart 12Stick To Cyclical Trades Over Near-Term Volatility   Footnotes 1     White House, “The United States, Joined by Allies and Partners, Attributes Malicious Cyber Activity and Irresponsible State Behavior to the People’s Republic of China,” July 19, 2021, whitehouse.gov. 2     “Jerome Powell: Full 2021 60 Minutes Interview Transcript,” CBS News, April 11, 2021, cbsnews.com. 3    Connor Fairman, “2020: Cybercrime’s Perfect Storm,” Council on Foreign Relations, January 20, 2021, cfr.org.

Weekly Performance Update For the week ending Thu Jul 22, 2021 The Market Monitor displays the trailing 1-quarter performance of strategies based around the BCA Score. For each region, we construct an equal-weighted, monthly rebalanced portfolio consisting of the top 3 stocks per sector and compare it with the regional benchmark. For each portfolio, we show the weekly performance of individual holdings in the Top Contributors/Detractors table. In addition, the Top Prospects table shows the holdings that currently have the highest BCA Score within the portfolio. For more details, click the region headers below to be redirected to the full historical backtest for the strategy. BCA US Portfolio Total Weekly Return BCA US Portfolio S&P500 TRI 0.37% 0.18% Top Contributors   AN:US IPG:US JLL:US DELL:US ESGR:US Weekly Return 42 bps 19 bps 12 bps 7 bps 6 bps Top Detractors   SIG:US LPX:US FLO:US MTZ:US PEG:US Weekly Return -13 bps -9 bps -8 bps -6 bps -5 bps Top Prospects   TX:US MPLX:US BRK.A:US ESGR:US ANAT:US BCA Score 97.25% 95.16% 95.13% 93.88% 91.26% BCA Canada Portfolio Total Weekly Return BCA Canada Portfolio S&P/TSX TRI -0.95% -0.42% Top Contributors   ONEX:CA RCH:CA QBR.A:CA SMU.UN:CA TCL.A:CA Weekly Return 13 bps 12 bps 6 bps 6 bps 3 bps Top Detractors   IFP:CA CS:CA CFP:CA CRON:CA CNQ:CA Weekly Return -25 bps -21 bps -15 bps -13 bps -10 bps Top Prospects   LNF:CA CS:CA IFP:CA CFP:CA ELF:CA BCA Score 98.98% 98.62% 98.50% 96.76% 93.76% BCA UK Portfolio Total Weekly Return BCA UK Portfolio FTSE 100 TRI 0.73% -0.61% Top Contributors   FDEV:GB FDM:GB HFD:GB SVST:GB GLTR:GB Weekly Return 42 bps 26 bps 12 bps 12 bps 10 bps Top Detractors   SPI:GB RMG:GB TUNE:GB CMCX:GB MNOD:GB Weekly Return -18 bps -11 bps -10 bps -9 bps -8 bps Top Prospects   SVST:GB ROSN:GB GROW:GB NLMK:GB RMG:GB BCA Score 99.11% 96.58% 95.14% 93.80% 93.56% BCA Eurozone Portfolio Total Weekly Return BCA EMU Portfolio MSCI EMU TRI 0.22% 0.25% Top Contributors   CNV:FR MONT:BE REY:IT PHA:FR ROVI:ES Weekly Return 20 bps 16 bps 10 bps 9 bps 8 bps Top Detractors   ATS:AT RWAY:IT LOUP:FR PMAG:AT SON:PT Weekly Return -12 bps -11 bps -9 bps -7 bps -7 bps Top Prospects   STR:AT TESB:BE SOLV:BE BB:FR FDJ:FR BCA Score 99.74% 97.33% 96.76% 96.66% 96.57% BCA Japan Portfolio Total Weekly Return BCA Japan Portfolio TOPIX TRI -0.77% -1.81% Top Contributors   7593:JP 8117:JP 6960:JP 6413:JP 3459:JP Weekly Return 8 bps 7 bps 6 bps 4 bps 4 bps Top Detractors   5021:JP 5020:JP 3291:JP 7994:JP 6641:JP Weekly Return -19 bps -14 bps -13 bps -12 bps -12 bps Top Prospects   4966:JP 6960:JP 9436:JP 6641:JP 8117:JP BCA Score 99.72% 99.39% 99.01% 98.49% 98.41% BCA Hong Kong Portfolio Total Weekly Return BCA Hong Kong Portfolio Hang Seng TRI -0.77% -0.97% Top Contributors   215:HK 2380:HK 316:HK 990:HK 323:HK Weekly Return 30 bps 26 bps 14 bps 12 bps 11 bps Top Detractors   220:HK 3600:HK 468:HK 856:HK 2232:HK Weekly Return -29 bps -25 bps -24 bps -22 bps -19 bps Top Prospects   1277:HK 2232:HK 857:HK 1606:HK 990:HK BCA Score 99.81% 99.47% 99.25% 98.76% 98.51% BCA Australia Portfolio Total Weekly Return BCA Australia Portfolio S&P/ASX All Ord. TRI 0.10% 0.56% Top Contributors   NEC:AU RUL:AU JLG:AU SGF:AU GRR:AU Weekly Return 22 bps 17 bps 16 bps 15 bps 12 bps Top Detractors   AGI:AU FLN:AU BLX:AU DDR:AU PSQ:AU Weekly Return -47 bps -12 bps -8 bps -8 bps -8 bps Top Prospects   GRR:AU BFG:AU PIC:AU BLX:AU SOL:AU BCA Score 99.09% 98.31% 97.86% 97.46% 97.33%