Europe

Highlights Euro Area debt loads have increased significantly during the pandemic. Debt loads are not uniform. While Germany and, to a lesser extent, Spain look best, France has a less attractive total debt profile than Italy. Government debt-service ratios are not a problem for Europe. Private sector debt service ratios do not represent an imminent risk, but the French corporate sector is an important source of long-term vulnerability for the region. As a result of this indebtedness, Euro Area bond yields will not rise much and will be capped below 1.5% over this business cycle. For now, Eurozone corporate bonds remain attractive within a European fixed-income portfolio. High-yield bonds are appealing, but investors should avoid the energy sector. Feature Like the US, the Eurozone economy has witnessed a large increase in debt following the COVID-19 crisis. This debt load will have a long legacy that will impact the ability of the European Central Bank to increase interest rates over the coming years. The French corporate sector will be a particularly vulnerable pressure point. Nonetheless, in the short-term, this uptick in indebtedness will not have a major impact on European debt markets. Disparate Debt Loads… Chart 1The Eurozone's Heavy Debt Load The Eurozone's Heavy Debt Load The Eurozone's Heavy Debt Load After a period of decline in the wake of both the GFC and the European debt crisis, total nonfinancial debt rose by 29% of GDP since the COVID-19 pandemic began (Chart 1). While some of this increase reflects a declining GDP, Euro Area Households and Corporations together added EUR609 billion of debt, while governments accumulated over EUR1 trillion more to their borrowings. The aggregate European picture does not impart the more complex reality. While all countries experienced a marked rise in indebtedness, some major economies are in a much more precarious position than others. The Good Among the largest Eurozone economies, Germany sports the most favorable debt profiles and represents the smallest threat to the Eurozone. Compared with the other major Euro Area countries, Spain shows healthier trends, even if its overall debt load remains important. At 202%, Germany’s nonfinancial-debt-to-GDP ratio is still below its all-time high of 211% (Chart 2, top panel). During the crisis, household debt rose by EUR296 billion or 4% of GDP, but it still stands well below the 72% registered at the turn of the millennium. In absolute terms, nonfinancial corporate debt has increased to a record, but it remains 5% below its 2003 high (Chart 2, third panel). Despite a 9% rebound to 70% of GDP, government debt still lies nearly 12% below its 2010 summit (Chart 2, bottom panel). In Spain, total nonfinancial debt rose by 45% of GDP since the pandemic started, but remains 12% below its 2013 all-time high of 301%. However, the private sector’s borrowing is well behaved, and it has only risen to 170% of GDP, well below the 227% level recorded in 2010 (Chart 3, top panel). Both the household and corporate sectors have gone a long way toward improving their debt situation, with borrowing 23% and 33%, respectively, below their crisis peaks (Chart 3, second and third panel). Spain’s problem is government debt. The pandemic forced the public sector to borrow EUR316 billion, which pushed its debt load to 120% of GDP (Chart 3, bottom panel). Chart 2Germany Is The Best Student Germany Is The Best Student Germany Is The Best Student Chart 3Spain's Previous Efforts Have Paid Off Spain's Previous Efforts Have Paid Off Spain's Previous Efforts Have Paid Off The Bad Chart 4Italy Remains Problematic Italy Remains Problematic Italy Remains Problematic Italian debt remains a troublesome spot for the Eurozone, which sheds some light on the higher interest rate commanded by BTPs. Burdened by tepid GDP growth, Italy’s total nonfinancial debt did not decline much in the years between the European debt crisis and the onset of the pandemic. As a result, overall nonfinancial debt jumped to an all-time high of 276% of GDP in response to COVID-19 (Chart 4, top panel). Private sector nonfinancial credit is high by Italian standards, but at 120% of GDP, it is low compared with other major European or G-10 nations. Italian household debt has hit a record high of 45% of GDP, which also compares well to other countries, while corporate debt rose to 76% of GDP, which is also well below historical highs and other nations (Chart 4, second and third panels). Italy’s perennial problem remains the public sector’s debt, which stands at 156% of GDP, the highest reading among major Eurozone nations. The Ugly The major Eurozone country with the worst debt situation is France, and we expect this country to become an increasingly large hurdle on the ability of the ECB to lift rates in the future. Next week, we will devote a Special Report to the French situation. Chart 5France's Debt Binge France's Debt Binge France's Debt Binge France’s nonfinancial debt towers above 350% of GDP, and the private sector nonfinancial debt has also hit an all-time high of 240% of GDP (Chart 5, top panel). No sector is spared. French households have accumulated EUR239 billion of liabilities during the pandemic, which pushed their leverage ratio to an all-time high of nearly 70% of GDP (Chart 5, second panel). Meanwhile, after rising by 21%, nonfinancial corporate credit stands above 170% of GDP (Chart 5, third panel). Finally, at 116% of GDP, public debt may not be as high as in Italy, but it is comparable to that of Spain (Chart 5, bottom panel). Bottom Line: The Eurozone indebtedness has hit a record high, but considering this factor in isolation oversimplifies a complicated picture. Among the major economies, Germany has the cleanest balance sheet, especially in terms of its private sector. Spain continues to sport high leverage, but the private sector remains in much better shape than last decade. Italy has made little progress, but it still looks good compared with France, where both the public and private sector borrowings stand at record highs. … And Debt Servicing Costs With the exception of the French corporate sector, debt-servicing costs do not represent a great risk for Europe. Chart 6Interest Payments Are Not The Government's Problem Interest Payments Are Not The Government's Problem Interest Payments Are Not The Government's Problem When it comes to governments, the picture is particularly benign. As Chart 6 illustrates, debt-servicing costs as a percentage of GDP or tax revenues are extremely low in both France and Germany. While these two variables are higher in Italy and Spain, they remain distant from the levels recorded during the European debt crisis. Beyond their low levels, a very accommodative policy environment limits the risk created by Europe’s public debt servicing costs. The ECB has purchased EUR1.3 trillion of government bonds since April 2020, which added to its already large ownership. Moreover, BCA’s Global Fixed Income Strategy service, as well as this publication, anticipates that the ECB will roll the stock of government paper purchased under the PEPP into the PSPP. Beyond the ECB’s actions, the NGEU funds also create the embryo of fiscal risk sharing in the EU, which limits how far yields (and thus debt servicing costs) will rise in the Italy or Spain. For the private sector, the picture is more nuanced. In Germany, household debt-servicing costs are low, both historically and compared with other nations. Meanwhile, BIS data highlights that the nonfinancial corporate debt services consume a larger share of operating cash flows than at any point over the past 20 years, but they remain low by international standards (Chart 7, top panel). Meanwhile, in Spain and Italy, both the household and nonfinancial corporate sectors sport historically low debt servicing costs (Chart 7, second and third panels), which also compare well to other OECD nations. Once again, France stands out. Its household debt servicing costs are historically elevated, even if they are not particularly demanding at a global level. However, the corporate sector spends a substantial share of its cash flow on debt, both compared with its own history and internationally (Chart 7, bottom panel). Chart 7Debt Servicing Costs Across Europe Debt Servicing Costs Across Europe Debt Servicing Costs Across Europe Bottom Line: Generally, the debt-service picture in Europe does not represent a major threat for now. While risks are particularly well contained on the government front, the French corporate sector creates danger for the private sector. Investment Implications The elevated debt load in the Euro Area, especially in the corporate sector, constitutes a crucial limiting factor for interest rates in Europe over the coming business cycle. Compared with global economies, the Eurozone corporate sector sports elevated debt ratios. As Chart 8 illustrates, the Eurozone’s net debt-to-equity ratio is higher than that of the US across most sectors, and even surpasses that of Canada, another country with a heavily indebted corporate sector, for telecommunication firms and financials. The picture is even worse when looking at the net debt-to-EBITDA ratio. Except for energy and utilities, the Eurozone carries poorer numbers than both the US and Canada (Chart 9). Chart 8Debt-To-Equity Ratio Comparison A Lot Of Debt A Lot Of Debt Chart 9Net Debt-To-EBITDA Comparison A Lot Of Debt A Lot Of Debt The picture for debt service payments is even more damning. Despite the very low European corporate bond rates, Eurozone corporations generally have poorer interest rate coverage ratios than both the US and Canada (Chart 10). This indicates that, unless the subpar European profitability is resolved, significantly higher interest rates will cause significant damage to the European corporate sector. Chart 10Interest Coverage Lags In Europe A Lot Of Debt A Lot Of Debt Chart 11The French Corporate Sector And Dutch Households Will Limit The ECB A Lot Of Debt A Lot Of Debt On this front, the French corporate sector once again stands out as the most likely place for an accident. As the top panel of Chart 11 shows, French firms are positioned especially poorly, with both their debt-to-GDP and debt-servicing costs among the highest in advanced economies. Meanwhile, in the household sectors, only the Netherlands represents a potential risk (Chart 11, bottom panel). The level of corporate debt in the Eurozone and in France in particular suggests that the current level of yields in Canada may represent a cap on European long-term rates. Thus, it will be difficult for German yields to move beyond the 1% to 1.5% zone this cycle. For now, despite the elevated debt loads of the European corporate sector, we continue to overweight corporate bonds within European fixed-income portfolios. The ECB will maintain very accommodative monetary conditions for the next 24 months, at least. Moreover, the European recovery, especially in the service sector, will improve the operating cash flows of the corporate sector, and thus, increase the tolerance of the private sector for higher yields in the near terms. Finally, the strength in the Euro anticipated by BCA’s Foreign Exchange strategists will limit the upside to Eurozone inflation, and thus, to yields in the region. Nonetheless, investors should avoid certain sectors (see next section). Market Focus: How To Play Euro Area High Yield Bonds? Chart 12Valuations Are Getting Expensive Valuations Are Getting Expensive Valuations Are Getting Expensive We have argued that investors should continue to favor investment grade corporate bonds within European fixed-income portfolios over high-yield corporate bonds. Eurozone investment grade credit still offered enough value to delay a move down in quality (Chart 12). However, this value cushion is thinning and spreads are only 10 bps from their 2018 lows. BCA Research’s Global Fixed-Income strategists have recently increased their allocation to Euro Area high-yield to overweight, with a focus on the Ba-rated credit tier, while maintaining a neutral weighting in IG credit.  However, European high-yield is also becoming expensive. The yield on the overall index is a meagre 44 bps away from its lows of 2018. Moreover, the breakeven spreads of European junk bonds have only been more expensive 11% of the time since 2000 (Chart 12, bottom panel). Despite these observations, high-yield credit is not a uniform block. Caa-rated debt still offers decent value, with a breakeven spread historical percentile standing at 27%. The stretched level of valuation suggests that investors should become more selective in the high-yield space, in order to avoid the industries with the worst risk profiles. To assess the sectors most at risk of experiencing significant spread widening or default occurrences in the coming quarters, we evaluate how the 10 main high-yield industry groups, as defined by Bloomberg Barclays, perform on the following credit metrics: Risk profile The share of firms rated Caa Growth in value of debt outstanding over the past 10 years Change in net debt-to-EBITDA ratio over the past 10 years Risk Profile Chart 13Risk Profile Of HY Sectors A Lot Of Debt A Lot Of Debt We look at the duration-times-spread (DTS) ratio to determine the risk profile of each sector (Chart 13). The DTS is a simple measure that correlates closely with excess return volatility for corporate bonds. The ratio of an issue’s, or sector’s DTS, to that of the benchmark index is loosely equivalent to the beta of a stock or industry to the equity benchmark. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”); a DTS ratio below 1.0 indicates that the sector is defensive (or “low beta”). Cyclical sectors are expected to outperform (underperform) the benchmark when spreads are narrowing (widening), while the opposite is expected of defensive sectors. In Europe, only three sectors sport a high DTS. Within these cyclical sectors, energy clearly stands out as essentially being the one most at risk of underperforming during the next episode of spread widening. Meanwhile, materials, healthcare, and utilities display the lowest DTS ratios and should trade defensively relative to the high-yield benchmark index. Share of Caa-rated debt Chart 14High Share Of Caa-Rated Debt Implies Higher Risk Of Default A Lot Of Debt A Lot Of Debt The bulk of defaults happens in the Caa-rated space and below. Hence, evaluating sector risk starts by assessing the share of Caa-rated (and below) debt sported by each industry (Chart 14). Sectors bearing a larger share of low-rated debt should display higher spreads. Consumer non-cyclicals and healthcare have the highest instance of low-rated debt, 16% and 13% respectively, and yet their spreads do not adequately compensate investors for this threat. The energy sector also stands out: spreads are wide because, despite the low percentage of Caa-rated debt, this sector has amassed considerable debt and has seen a meaningful deterioration in net debt-to-EBITDA (see below). Meanwhile, utilities shine under this metric, as they have not issued debt rated Caa or lower. Debt Growth Chart 15Debt Growth Justify Spread Levels A Lot Of Debt A Lot Of Debt The speed and amount of debt accumulated during economic recoveries are other important determinants of future spread volatility, because the sectors that have rapidly levered-up are more likely to experience defaults. Chart 15 shows that, if we ignore the outlying utilities, then there is a robust positive linear relationship between this metric and spreads. Utilities, energy, and the tech sectors have added the most debt, while debt accumulation in the basic materials and health care sectors has lagged over the past 10 years. Crucially, tech and communications spreads trade below what their debt growth implies. Net Debt-To-EBITDA Chart 16Only Financials Have Improved Their Net Debt-To-EBITDA A Lot Of Debt A Lot Of Debt A rapid debt accumulation is not a concern, as long as earnings are rising more rapidly or at least at the same pace. From this case, we infer that companies are using the new debt issued efficiently, for CAPEX or to pursue projects exceeding their IRR. In this light, wide spreads are justified for the energy, consumer cyclical, and consumer non-cyclical sectors (Chart 16). Conversely, financials have seen improvement. Bottom Line: After surveying Euro area high-yield corporate sectors based on four credit metrics, it appears that the sectors most at risk are energy and consumer non-cyclical. By contrast, basic materials seem to be a good sector in which to hide.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Currency Performance A Lot Of Debt A Lot Of Debt Fixed Income Performance Government Bonds A Lot Of Debt A Lot Of Debt Corporate Bonds A Lot Of Debt A Lot Of Debt Equity Performance Major Stock Indices A Lot Of Debt A Lot Of Debt Geographic Performance A Lot Of Debt A Lot Of Debt Sector Performance A Lot Of Debt A Lot Of Debt

Highlights The US is withdrawing from the Middle East and South Asia and making a strategic pivot to Asia Pacific. The third quarter will see risks flare around Iran and the US rejoin the 2015 Iranian nuclear deal. The result is briefly negative for oil prices but the rise of Iran is a new geopolitical trend that will increase Middle Eastern risk over the long run. The geopolitical outlook is dollar bullish, while the macroeconomic outlook is getting less dollar-bearish due to China’s risk of over-tightening policy. Stay neutral USD and be wary of commodities and emerging markets in the third quarter. European political risk is bottoming. The German and French elections are at best minor risks. However, the continent is ripe for negative black swans, especially due to Russian aggression. Go tactically long global large caps and defensives. Feature Chart 1Three Key Views On Track (So Far) Three Key Views On Track (So Far) Three Key Views On Track (So Far) We chose “No Return To Normalcy” as the theme of our 2021 outlook. While the COVID-19 vaccine promised economic recovery, we argued that normalization would create complacency regarding fundamental changes that have taken place in the geopolitical environment. A contradiction between an improving macroeconomic backdrop and a foreboding geopolitical backdrop would develop in 2021 and beyond. The “reflation trade” has begun to lose steam as we go to press. However, global recovery will still be the dominant story in the second half of the year as vaccination spreads. The question for the third quarter and the rest of the year is whether reflation will continue. As a matter of forecasting, we think it will. But as a matter of investment strategy, we are taking a more defensive stance until China relaxes economic policy. In our annual outlook we highlighted three key geopolitical views: (1) China’s headwinds, both at home and abroad (2) US détente with Iran and pivot to Asia (3) Europe’s opportunity. All three trends are broadly on track and can be illustrated by looking at equity performance in the relevant regions for the year so far: Chinese stocks sold off, UAE stocks rallied, and European stocks rallied (Chart 1). However, these trends are not exclusively tied to absolute equity performance. The most important question is what happens to global growth and the US dollar as these three key views continue. Stay Neutral On The Dollar It paid off for us to maintain a neutral stance on the dollar. True, the global recovery and exorbitant US trade and budget deficits are bearish for the dollar and bullish for other currencies. But the greenback’s “counter-trend bounce” is proving more formidable than many investors expected. The fundamentals of the American economy and global position remain strong. Since the outbreak of COVID-19, the US has secured its recovery with fiscal policy, maintained rule of law amid a contested election, innovated and distributed vaccines, benefited from more flexible social restrictions, refurbished global alliances, and put pressure on its geopolitical rivals. In essence, the combined effect of President Trump’s and Biden’s policies has been to make America “great again” (Chart 2). From a geopolitical perspective, the dollar is appealing. Chart 2Trump-Biden Make America Great Again? Trump-Biden Make America Great Again? Trump-Biden Make America Great Again? In addition, the first two geopolitical views mentioned above – China’s headwinds and the US-Iran détente – imply a negative environment for China and the renminbi. The reason for the US to do a suboptimal deal with Iran, both in 2015 and 2021, is to reduce the risk of war and buy time to enable a strategic pivot to Asia Pacific. Three US presidents have been elected on the pledge to conclude the “forever wars” in the Middle East and South Asia. Biden is withdrawing US troops from Afghanistan in September. There can be little doubt Biden is committed to an Iran deal, which is supposed to free up the US’s hands (Chart 3). Meanwhile the US public and Congress are unified in their desire to better defend US interests against China’s economic and military rise. There has not yet been a stabilization of US-China policies. Biden is not likely to hold a summit with Chinese President Xi Jinping until late October at earliest – and that is a guess, not a confirmed summit. The Biden administration has completed its review of China policy and is maintaining the Trump administration’s hawkish posture, as predicted. The US and China may resume their strategic and economic dialogue at some point but it is impossible to go back to the status quo ante 2015. That was the year the US adopted a more confrontational stance toward China – a stance later supercharged by Trump’s election and trade tariffs. The hawkish consensus on China is one of the rare unifying factors in a deeply divided America. The Biden administration explicitly says the US-China relationship is now defined by “competition” instead of “engagement.”1 One exception to this neutral view on the dollar has been our decision to go long the Japanese yen and Swiss franc, which has not panned out so far. Our reasoning is that geopolitical risk will boost these currencies but otherwise the reduction of geopolitical risk will weigh on the dollar in the context of global growth recovery. So far geopolitical risk has remained subdued while the US dollar has outperformed. We are still sympathetic to these safe-haven currencies, however, as they are attractively valued as long as one expects geopolitical risks to materialize (Chart 4). Chart 3US Pivot To Asia Runs Through Iran US Pivot To Asia Runs Through Iran US Pivot To Asia Runs Through Iran Our third key view, that EU was the real winner of the US election last year, remains on track. This is marginally positive for the euro at the expense of the dollar. Given the above points, we favor an equal-weighted basket of the euro and the dollar relative to the renminbi (Chart 5). Chart 4Safe-Haven Currencies Attractive Safe-Haven Currencies Attractive Safe-Haven Currencies Attractive Chart 5Favor Euro And Dollar Over Renminbi Favor Euro And Dollar Over Renminbi Favor Euro And Dollar Over Renminbi The geopolitical outlook is dollar-bullish. The macroeconomic outlook is dollar-bearish, except that China’s economy looks to slow down. We expect China to ease policy in the second half of the year but it may come late. We remain neutral dollar in the third quarter. Wait For China To Relax Policy July 1 marks the centenary of the Communist Party of China. The main thing investors should know is that the Communist Party predates China’s capitalist phase by sixty years. The party adopted capitalism to improve the economy – it never sacrificed its political or foreign policy goals. This poses a major geopolitical problem today because the Communist Party’s consolidation of power across Greater China, symbolized by Beijing’s revocation of Hong Kong’s special status in 2019, has convinced the western democracies that China is no longer compatible with the liberal world order. China launched a 13.8% of GDP monetary-and-fiscal stimulus over 2018-20 due to the trade war and COVID-19 pandemic. So the economy is stable for the hundredth anniversary celebration. The centenary goals are largely accomplished: GDP is larger, poverty is nearly extinguished, although urban incomes are still lagging (Chart 6). General Secretary Xi Jinping will mark the occasion with a speech. The speech will contribute to his governing philosophy, Xi Jinping Thought, a synthesis of communist Mao Zedong Thought and the pro-capitalist “socialism with Chinese characteristics” pioneered by General Secretary Deng Xiaoping in the 1980s-90s. The effect is to reassert Communist Party and central government primacy after the long period of decentralization that enabled China’s rapid growth phase. It is also to endorse an inward economic turn after the four-decade export-manufacturing boom. The Xi administration’s re-centralization of policy has entailed mini-cycles of tightening and loosening control over the economy. The administration leans against the country’s tendency to gorge itself on debt and grow at any cost – until it must lean the other way for fear of triggering a destabilizing slowdown. For this reason Beijing tightened policy proactively last year, producing a sharp drop in money, credit, and fiscal expansion in 2021 that now threatens to undermine the global recovery. By our measures, any further tightening will result in undershooting the regime’s money and credit targets, i.e. overtightening, and hence threaten to drag on the global recovery (Chart 7). Chart 6China's Communist Party Centenary Goals China's Communist Party Centenary Goals China's Communist Party Centenary Goals Chart 7China Verges On Over-Tightening Policy China Verges On Over-Tightening Policy China Verges On Over-Tightening Policy Overtightening would be a policy mistake with potentially disastrous consequences. So the base case should be that the government will relax policy rather than undermine the post-COVID recovery. However, investors cannot be confident about the timing. The 2015 financial turmoil and renminbi devaluation occurred because policymakers reacted too slowly. One reason to believe policy will be eased is that after July 1 the government will turn its attention to the twentieth national party congress in 2022, the once-in-five-years rotation of the Central Committee and Politburo. The party congress begins at the local level at the beginning of next year and culminates in the fall of 2022 with the national rotation of top party leaders. Xi Jinping was originally slated to step down in 2022. So he needs to squash any last-minute push against him by opposing factions of the party. He may have himself named chairman of the Communist Party, like Mao before him. Most importantly he will put his stamp on the “seventh generation” of China’s leaders by promoting his followers into key positions. All of this suggests that the Xi administration cannot risk triggering a recession, even if its preferences remain hawkish on economic policy. Policy easing could come as early as the end of July. As a rule of thumb, we have noticed that the Politburo’s July meeting on economic policy is often an inflection point, as was the case in 2007, 2015, 2018, and 2020 (Table 1). Some observers claim the April Politburo meeting already signaled an easing in policy, although we do not see that. If July clearly signals relaxation, global investors will cheer and emerging market assets and commodities will rise. Table 1China’s Politburo Often Hits Inflection Point On Economic Policy In July Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Still we maintain a defensive posture going into the third quarter because we do not have a high level of confidence that policymakers will act preemptively. A market riot may precede and motivate the inflection point in policy. Also the negative impact of previous policy tightening will be felt in the third quarter. China plays and industrial metals are extremely vulnerable to further correction (Chart 8). Chart 8China Plays And Metals Vulnerable To Further Correction China Plays And Metals Vulnerable To Further Correction China Plays And Metals Vulnerable To Further Correction The earliest occasion for a Biden-Xi summit comes at the end of October, as mentioned. While US-China talks will occur at some level, relations will remain fundamentally unstable. While a Biden-Xi summit may improve the atmosphere and lead to a new round of strategic and economic dialogue, or Phase Two trade talks, the fact is that the US is seeking to contain China’s rise and China is seeking to break out of the strictures of the US-led world order. The global elite and mainstream media will put a lot of emphasis on the post-Trump return to diplomatic “normalcy” and summits. But this is to overemphasize style at the expense of substance. Note that the positive feelings of the Biden-Putin summit on June 16 fizzled in less than a week when Russia allegedly dropped bombs in the path of a British destroyer in the Black Sea. The US and UK were training Ukraine’s military. Britain denies any bombs were dropped but Russia says next time they will hit their target. (More on this below.) This episode is instructive for US-China relations: summitry is overrated. China is building a sphere of influence and the US no longer believes dialogue alone is the answer. Tit-for-tat punitive measures and proxy battles in China’s neighboring areas, from the Korean peninsula to the Taiwan Strait to the South and East China Seas, are the new normal. Bottom Line: Tactically, stay defensive on global risk assets, especially China plays. Strategically, maintain a constructive outlook on the cycle given the global recovery and China’s need eventually to relax monetary and fiscal policy. US-Iran Deal Likely – Then The Real Trouble Starts The US will likely rejoin the 2015 Iranian nuclear deal (Joint Comprehensive Plan of Action) by August and pull out of its longest-ever war in Afghanistan in September. The US is wrapping up its “forever wars” to meet the demands of a war-weary public. Ironically, the long-term consequence is to create power vacuums that invite new geopolitical conflicts in the context of the US’s great power struggle with China and Russia. But for now a deal with Iran – once it is settled – reduces geopolitical risk by reducing the odds of military escalation in the region. The Iran talks are more significant than the Afghanistan pullout. We are confident in a deal because Biden can rejoin the 2015 deal unilaterally – it was never approved by the US Senate as a formal treaty. The Iranians will not support any militant action so aggressive as to scupper a deal that offers them the chance of reviving their economy at a critical time in the regime’s history. Reviving the deal poses a downside risk for oil prices in the third quarter though not over the long run. It is negative in the short run because investors will have to price not only Iran’s current and future production (Chart 9) but also any resulting loss of OPEC 2.0 discipline. Brent crude is trading at $76 per barrel as we go to press, above the $65-$70 per barrel average that our Commodity & Energy Strategy service expects to see over the coming five years (Chart 10). Chart 9Iran's Oil Production Will Return Iran's Oil Production Will Return Iran's Oil Production Will Return Chart 10Brent Price Faces Short-Term Downside Risk From Iranian Crude Brent Price Faces Short-Term Downside Risk From Iranian Crude Brent Price Faces Short-Term Downside Risk From Iranian Crude The oil price ceiling is enforced by the cartel of oil producers who fear that too high of prices will incentivize US shale oil production as well as the global shift to renewable energy. The Russians have always dragged their feet over oil production cuts and are now pushing for production hikes. The government needs an oil price of around $50-55 per barrel for the budget to break even. The Saudis need higher prices to break even, at $70-75 per barrel. Moscow must coordinate various oil producers, led by the country’s powerful oligarchs and their factions, which is inherently more difficult than the Saudi position of coordinating one producer, Aramco. The Russians and Saudis have maintained cartel discipline so far in 2021, as expected, because the wounds of the market-share war last year are still raw. They retreated from that showdown in less than a month. However, a major escalation in Saudi Arabia’s strategic conflict with Iran could push the Saudis to seek greater market share at Iran’s expense, as occurred before the original Iran deal in 2014-15. Hence our view that the risk to oil prices will shift from the upside to the downside in the second half of the year if the US-Iran deal is reconstituted. Over the long run, the deal is not negative for oil prices. The deal is a tradeoff for lower geopolitical risk today but higher risk in the future. The reason is that Iran’s economic recovery will strengthen its strategic hand and generate a backlash in the region. The global oil supply and demand balance will fluctuate according to circumstances but regional conflict will inject a risk premium over time. Biden’s likely decision to rejoin the 2015 deal should be seen as a delaying tactic. It is impossible to go back to 2015, when the US had mustered a coalition of nations to pressure Iran and when Iran’s “reformist” faction stood to receive a historic boost from the opening of the country’s economy. Now the US lacks a coalition and the reformists are leaving office in disgrace, with the hardliners (“principlists”) taking full power for the foreseeable future. Iran is happy to go back to complying with a deal that consists of sanctions relief in exchange for temporary limits on its nuclear program. The 2015 deal’s restrictions on Iran’s nuclear program begin expiring in 2023 and continue to expire through 2040. Biden has no chance of negotiating a newer and more expansive deal that extends these sunset clauses while also restricting Iran’s ballistic missile program and regional militant activities. He will say that easing sanctions is premised on a broader “follow on” deal to achieve these US goals. But the broader deal is unlikely to materialize anytime soon. The Iranians will commit to future talks but they will have no intention of agreeing to a more expansive deal unless forced. The country’s leaders will never abandon their nuclear program after witnessing the invasions of non-nuclear Libya and Ukraine – in stark contrast with nuclear-armed North Korea. Moreover Biden cannot possibly reassemble the P5+1 coalition with Russia and China anytime soon. The US is directly confronting these states. They could conceivably work with the US when Iran is on the brink of obtaining nuclear weapons but not before then. They did not prevent North Korea. The Supreme Leader Ali Khamenei, the soon-to-be-inaugurated President Ebrahim Raisi, the Iranian Revolutionary Guard Corps, the Ministry of Intelligence, and other pillars of the regime are focused exclusively on strengthening the regime in advance of Khamenei’s impending succession sometime in the coming decade. The succession could easily lead to domestic unrest and a political crisis, which makes the 2020s a critical period for the Islamic Republic. With Tehran focused on a delicate succession, it is not a foregone conclusion that Iran will go on the offensive to expand its sphere of influence immediately after the US deal. But sooner or later a major new geopolitical trend will emerge: the rise of Iran. With sanctions removed, trade and investment increasing, and Chinese and Russian support, Iran will be capable of pursuing its strategic aims in the region more effectively. It will extend its influence across the “Shia Crescent,” including Iraq. The fear that this will inspire in Israel and the Gulf Arab states has already generated a slow-boiling war in the region. This war will intensify as the US will be reluctant to intervene. The purpose of the deal is to enable the war-weary US to reduce its active involvement in the region. The US foreign policy and defense establishment do not entirely see it this way – they emphasize that the US will remain engaged. But US allies in the Middle East will not be convinced. The region already has a taste for the way this works after the US’s precipitous withdrawal from Iraq in 2011, which lead to the rise of the Islamic State terrorist group. Biden will try not to be so precipitous but the writing is on the wall: the US will reduce its focus and commitment. A scramble for power in the region will begin the moment the ink dries on Biden’s signature of the JCPA. Israel and the Arab states are forming a de facto alliance – based on last year’s Abraham Accords – to prepare for Iran’s push to dominate the region. Even if Iran is not overly aggressive (a big if), Israel and the Gulf Arabs will overreact as a result of their fear of abandonment. They will also seek to hedge their bets by improving ties with the Chinese and Russians, making the Middle East the scene of a major new proxy battle in the global great power struggle. As a risk to our view: if the Biden administration changes course this summer and refuses to lift sanctions or rejoin the Iran deal – low but not zero probability – then tensions with Iran will explode almost instantaneously. The Iranians will threaten to close the Strait of Hormuz and a crisis will erupt in the third or fourth quarter. Bottom Line: The US will most likely rejoin the Iranian nuclear deal by August to avoid an immediate crisis or war. The Biden administration will wager that it can lend enough support to regional allies to keep Iran contained. This might work, as the Iranians will focus on fortifying the regime ahead of its leadership succession. However, Iran’s hardline leadership will see an opportunity in America’s withdrawal from its “forever wars.” Iran will increasingly cooperate with Russia and China. Iran’s conflict with Israel and Saudi Arabia will be extremely difficult to manage and will escalate over time, quite possibly creating a revolution or war in Iraq. The Gulf Arabs are already under immense pressure from the green energy revolution. Thus while oil prices might temporarily fall on the return of Iranian exports, they will later see upward pressure from a new wave of Middle Eastern instability. European Political Risk Has (Probably) Bottomed By contrast with all the above we have viewed Europe as a negligible source of (geo)political risk in 2021. European policy uncertainty is falling in Europe relative to these other powers and the rest of the world (Chart 11). Chart 11Europe's Relative Policy Uncertainty Bottoming Europe's Relative Policy Uncertainty Bottoming Europe's Relative Policy Uncertainty Bottoming Chart 12EU Break-Up Risk Hits Floor (Again) EU Break-Up Risk Hits Floor (Again) EU Break-Up Risk Hits Floor (Again) The risk of a break-up of the European Union has wilted and remains at historic lows (Chart 12). There is no immediate threat of any European countries emulating the UK and attempting to exit. Even Italian support for the euro has surged. Immigration flows have plummeted. European solidarity is not on the ballot in the upcoming German and French elections. Germany is choosing between the status quo and a “green revolution” that would not really be a revolution due to the constraints of coalition politics. The Greens have lost some momentum relative to their polling earlier this year but underlying trends suggest they will surprise to the upside in the September 26 vote (Charts 13A and 13B). They embrace EU solidarity, robust government spending, weariness with the Merkel regime, and concerns about climate change, Russia, China, and social justice. Chart 13AGerman Greens Will Surprise To Upside Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Chart 13BGerman Greens Will Surprise To Upside Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran We expect the Greens to surprise to the upside. But as they are forced into a coalition with the ruling Christian Democrats then they will be limited to raising spending rather raising taxes (Table 2). The market will cheer this result. Table 2German Greens’ Ambitious Tax Hike Proposals Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran If the Greens disappoint then a right-leaning government and too early fiscal tightening could become a risk – but it is a minor risk because Merkel’s hand-picked successor, the CDU Chancellor Candidate Armin Laschet, will be pro-Europe and fiscally dovish, just like the mainstream of his party under Merkel. The only limitation on this dovishness is that it would take another global shock for there to be enough votes in the Bundestag to loosen the schuldenbremse or “debt brake.” In France, President Emmanuel Macron is likely to win re-election – the populist candidate Marine Le Pen remains an underdog who is unlikely to make it through France’s two-round electoral system. In Italy, Prime Minister Mario Draghi is overseeing a national unity coalition that will dole out EU recovery funds. An election cannot be held ahead of the presidential election in January, which will be secured by the establishment parties as a major check on any future populist ruling coalition. The risk in these countries, as in Spain and elsewhere, is that neoliberal structural reform and competitiveness are falling by the wayside. Fiscal largesse is positive for securing the recovery but long-term growth potential will remain depressed (Chart 14). Chart 14European And Global Fiscal Stimulus (Updated June 2021) Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Europe remains stuck in a liquidity trap over the long run. It depends on the rest of the world for growth. This is a problem given that China’s potential growth is slowing and there is no ready substitute that will prop up global growth. Europe is increasingly ripe for negative “black swan” events. The power vacuum in the Middle East described above will lead to instability and regime failures that will threaten European security. Russia will remain aggressive, a reflection of its crumbling structural foundations. The Putin administration has not changed its strategy of building a sphere of influence in the former Soviet Union and pushing back against the West, as signaled by the threat to bomb ships that sail in Crimean waters – a unilateral expansion of Russia’s territorial waters following the Crimean invasion. The Biden administration is not seeking anything comparable to the diplomatic “reset” with Russia from 2009-11, which ended in acrimony. In other words, European political risk may be bottoming as we speak. Investment Takeaways Chart 15Limited Equity Upside From Likely US Infrastructure Bill Limited Equity Upside From Likely US Infrastructure Bill Limited Equity Upside From Likely US Infrastructure Bill US Peak Fiscal Stimulus: The Biden administration is highly likely to pass an infrastructure package through Congress, either as a bipartisan deal with Republicans or as part of the American Jobs Plan. The result is another $1-$1.5 trillion fiscal stimulus, albeit over an eight-year period, with infrastructure funding taking until 2024-25 to ramp up. Biden’s other plans probably will not pass before the 2022 midterm election, which will likely bring gridlock. Investors are well aware of these proposals and the policy setting will probably be frozen after this year. Hence there is limited remaining upside for global materials sector and US infrastructure plays (Chart 15). The extravagant US fiscal thrust of 2020-21 will turn into a huge fiscal drag in 2022 (Chart 16). The Federal Reserve, however, will remain ultra-dovish as long as labor market slack persists – regardless of who is at the helm. Chart 16US Fiscal Drag Very Large In 2022 Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Chart 17Go Long Large Caps And Defensives Go Long Large Caps And Defensives Go Long Large Caps And Defensives China’s Headwinds Persist: China may or may not ease policy in time to prevent a market riot. China plays and industrial metals are highly exposed to a correction and we recommend steering clear. US-Iran Deal Weighs On Oil Price: Tactically we are neutral on oil and oil plays. An Iran deal could depress oil prices temporarily – and potentially in a major way if the Saudis agree with the Russians on increasing production. Fundamentals are positive but depend on the OPEC 2.0 cartel. The cartel faces the risk that higher prices will incentivize both alternative oil providers and the green revolution. Europe’s Opportunity: We continue to see the euro and European stocks offering value. Given the troubles with Russia we favor developed Europe plays over emerging Europe. The German election would be a bullish catalyst for European assets but headwinds from China will prevail, which is negative for cyclical European stocks. The Russian Duma election, also in September, creates high potential for Russia to clash with the West between now and then. Tactically, go long global large caps and defensives (Chart 17).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Independent Vermont Senator Bernie Sanders recently felt it was necessary to warn against a second cold war. Sanders, a democratic socialist, is a reliable indicator of the left wing of the Democratic Party and a dissenter who puts pressure on the center-left Biden administration. His fears underscore the dominance of the new hawkish consensus. Appendix China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan – Province Of China Taiwan Territory: GeoRisk Indicator Taiwan Territory: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator

Work from home policies, originally designed as emergency measures in the early phase of the COVID-19 pandemic, are likely to be “sticky” in a post-pandemic world. This will negatively impact the labor market in central business districts, via reduced spending on services by office workers. The potential impact of working from home is often cited as an example of what is likely to be a lasting and negative effect on jobs growth, but we find that it is not likely to be a barrier to the labor market returning to the Fed’s assessment of “maximum employment.” The size of the impact depends importantly on whether employee preferences or employer plans for WFH prevail, but our sense is that the latter is more likely. A weaker pace of structures investment in response to elevated office vacancy rates will likely have an even smaller impact on growth than the effect of reduced central business district services employment. The contribution to growth from structures investment has been small over the past few decades, office building construction is a small portion of overall nonresidential structures, and there are compelling arguments that the net stock of office structures will stay flat, rather than decline. Our analysis suggests that job growth over the coming year could be even stronger than the Fed and investors expect, possibly resulting in a first rate hike by the middle of next year. This would be earlier than we currently anticipate, but it underscores that fixed-income investors should remain short duration on a 6-12 month time horizon, and that equity investors should favor value over growth positions beyond the coming 3-4 months. The outlook for US monetary policy over the next 12 to 18 months depends almost entirely on the outlook for employment. Many investors are focused on the potential for elevated inflation to force the Fed to raise interest rates earlier than it currently anticipates, but it is the progress in returning to “maximum employment” that will determine the timing of the first Fed rate hike – and potentially the speed at which interest rates rise once policy begins to tighten. In this report, we estimate the extent to which the “stickiness” of working from home (WFH) policies and practices could leave a lasting negative impact on the US labor market. We noted in last month's report that a large portion of the employment gap relative to pre-pandemic levels can be traced to the leisure & hospitality and professional and business services industries, both of which – along with retail employment – stand to be permanently impaired if the office worker footprint is much lower in a post-COVID world.1 Using employee surveys and a Monte Carlo approach, we present a range of estimates for the permanent impact of WFH policies on the unemployment rate, and separately examine the potential for lower construction of office properties to weigh on growth. We find that the impact of reduced office building construction is likely to be minimal, and that WFH policies may structurally raise the unemployment rate by 0.3 to 0.4%. While non-trivial, when compared with a pre-pandemic unemployment rate of 3.5%, WFH policies alone are not likely to cause a long-term deviation from the Fed’s maximum employment objective. Relative to the Fed’s expectations of a strong, lasting impact on the labor market from the pandemic, this suggests that job growth over the coming year could be even stronger than the Fed and investors expect, possibly resulting in a first rate hike by the middle of next year. This would be earlier than we currently anticipate, but it underscores that fixed-income investors should remain short duration on a 6-12 month time horizon, and that equity investors should favor value over growth positions beyond the coming 3-4 months (a period that may see outperformance of the latter). Quantifying The Labor Market Impact Of The New Normal For Work In a January paper, Barrero, Bloom, and Davis (“BBD”) presented evidence arguing why working from home will “stick.” The authors surveyed 22,500 working-age Americans across several survey “waves” between May and December 2020, and asked about both their preferences and their employer’s plans about working from home after the pandemic. Chart II-1 highlights that the desired amount of paid work from home days (among workers who can work from home) reported by the survey respondents is to approximately 55% of a work week, suggesting that a dramatic reduction in office presence would likely occur if post-pandemic WFH policies were set fully in accordance with worker preferences. Chart II-1Employee Preferences Imply A Dramatic Reduction In Post-COVID Office Presence July 2021 July 2021 However, Table II-1 highlights that employer plans for work from home policies are meaningfully different than those of employees. The table highlights that employers plan for employees to work from home for roughly 22% of paid days post-pandemic, which essentially translates to one day per week on average.2 BBD noted that CEOs and managers have cited the need to support innovation, employee motivation, and company culture as reasons for employees’ physical presence. Managers believe physical interactions are important for these reasons, but employees need only be on premises for about three to four days a week to achieve this. Table II-1 also shows that employers plan to allow higher-income employees more flexibility in terms of working from home, and less flexibility to employees whose earnings are between $20-50k per year. Table II-1Employer Plans, However, Imply Less Working From Home Than Employees Prefer July 2021 July 2021 Based on the survey results, BBD forecast that expenditure in major cities such as Manhattan and San Francisco will fall on the order of 5 to 10%. In order to understand the national labor market impact of work from home policies and what implications this may have on monetary policy, we scale up BBD’s calculations using a Monte Carlo approach that incorporates estimate ranges for several factors: The percent of paid days now working from home for office workers The amount of money spent per week by office workers in central business districts (“CBDs”) The number of total jobs in CBDs The percent of CBD jobs in industries likely to be negatively impacted by reduced office worker expenditure The average weekly earnings of affected CBD workers The average share of business revenue not attributable to strictly variable expenses The percent of affected jobs likely to be recovered outside of CBDs Our approach is as follows. First, we calculate the likely reduction in nationwide CBD spending from reduced office worker presence by multiplying the likely percent of paid days now permanently working from home by the number of total jobs in CBDs and the average weekly spending of office workers. This figure is then increased due to the estimated acceleration in net move outs from principal urban centers in 2020 (Chart II-2); we assume a 5% savings rate and an average annual salary of $50k for these resident workers, and assume that all of their spending occurred within CBDs. We also assume that roughly 50% of jobs connected to this spending are recovered. Chart II-2Fewer Residents Will Also Lower Spending In Central Business Districts July 2021 July 2021 Then, we calculate the gross number of jobs lost in leisure & hospitality, retail trade, and other services by multiplying this estimate of lost spending by an estimate of non-variable costs as a share of revenue for affected industries, and dividing the result by average weekly earnings of affected employees. For affected CBD employees in the administrative and waste services industry, we simply assume that the share of jobs lost matches the percent of paid days now permanently working from home. Finally, we adjust the number of jobs lost by multiplying by 1 minus an assumed “recovery” rate, given that some of the reduction in spending in CBDs will simply be shifted to areas near remote workers’ residences. We assume a slightly lower recovery rate for lost jobs in the administrative and waste services industry. Table II-2 highlights the range of outcomes for each variable used in our simulation, and Charts II-3 and II-4 present the results. The charts highlight that the distribution of outcomes based on employer WFH intensions suggest high odds that nationwide job losses in CBDs due to reduced office worker presence will not exceed 400k. Based on average employee preferences, that number rises to roughly 800-900k. Table II-2The Factors Affecting Permanent Central Business District Job Losses July 2021 July 2021 Chart II-3The Probability Distribution Of CBD Jobs Lost… July 2021 July 2021 Chart II-4…Based On Our Monte Carlo Approach July 2021 July 2021   This raises the question of whether employer plans or employee preferences for WFH arrangements will prevail. Our sense is that it will be closer to the former, given that we noted above that employer WFH plans are the least flexible for employees whose earnings are between $20-50k per year (who are presumably employees who have less ability to influence the policy of firms). Chart II-5 re-presents the projected job losses shown in Chart II-4 as a share of the February 2020 labor force, along with a probability-weighted path that assumes a 75% chance that employer WFH plans will prevail. The chart highlights that WFH arrangements would have the effect of raising the unemployment rate by approximately 0.35%. However, relative to a pre-pandemic starting point of 3.5%, this would raise the unemployment rate to a level that would still be within the Fed’s NAIRU estimates (Chart II-6). Therefore, the “stickiness” of WFH arrangements alone do not seem to be a barrier to the labor market returning to the Fed’s assessment of “maximum employment,” suggesting that the conditions for liftoff may be met earlier than currently anticipated by investors. Chart II-5CBD Job Losses Will Not Be Trivial, But They Will Not Be Enormous July 2021 July 2021 Chart II-6Sticky WFH Policies Will Not Prevent A Return To Maximum Employment Sticky WFH Policies Will Not Prevent A Return To Maximum Employment Sticky WFH Policies Will Not Prevent A Return To Maximum Employment The Impact Of Lower Office Building Construction A permanently reduced office footprint could also conceivably impact the US economy through reduced nonresidential structures investment, as builders of commercial real estate cease to construct new office towers in response to expectations of a long-lasting glut. However, several points highlight that the negative impact on growth from US office tower construction will be even smaller than the CBD employment impact of reduced office worker presence that we noted above. First, Chart II-7 highlights the overall muted impact that nonresidential building investment has had on real GDP growth by removing the contribution to growth from nonresidential structures and for overall nonresidential investment. The chart clearly highlights that the historically positive contribution to real US output from capital expenditures over the past four decades has come from investment in equipment and intellectual property products, not from structures. Chart II-8 echoes this point, by highlighting that US real investment in nonresidential structures has in fact been flat since the early-1980s, contributing positively and negatively to growth only on a cyclical basis (not on a structural basis). Chart II-7Structures Have Not Contributed Significantly To US Growth For Some Time Structures Have Not Contributed Significantly To US Growth For Some Time Structures Have Not Contributed Significantly To US Growth For Some Time Chart II-8Nonresidential Structures Investment Has Been Flat For Four Decades Nonresidential Structures Investment Has Been Flat For Four Decades Nonresidential Structures Investment Has Been Flat For Four Decades Second, Table II-3 highlights that office properties make up a small portion of investment in private nonresidential structures. In 2019, nominal investment in office structures amounted to $85 billion, compared with $630 billion in overall structures investment, meaning that office properties amounted to just 13% of structures investment. Table II-3Office Structures Investment Is A Small Share Of Total Structures Investment July 2021 July 2021 Table II-4Conceivably, Vacant Office Properties Could Be Converted To Luxury Residential Units July 2021 July 2021 Third, it is true that investment is a flow and not a stock variable, meaning that, if the net stock of office buildings were to fall as a result from WFH policies, then the US economy would see a potentially persistently negative rate of growth from nonresidential structures (which would constitute a drag on growth). But if the net stock were instead to remain flat, then gross office property investment should equal the depreciation of those structures. The second column of Table II-3 highlights that current-cost depreciation of office structures was $53 billion in 2019 (versus nominal gross investment of $85 billion). Had office property investment been ~$30 billion lower in 2019, it would have reduced nominal GDP by a mere 14 basis points (resulting in an annual growth rate of 3.84%, rather than 3.98%). Fourth, there is good reason to believe that the net stock of office properties will stay flat, as the economics of converting offices to luxury housing units (whose demand is not substantially affected by factors such as commuting) – either fully or partially into mixed-use buildings – appear to be plausible. Table II-4 highlights that the average annual asking rent for office space per square foot in Manhattan was $73.23 in Q1 2021, and that the recent median listing home price per square foot is roughly $1,400. In a frictionless world where office space could be instantly and effortlessly sold as residential property, existing prices would imply a healthy (gross) rental yield of 5.2%. Thoughts On The Future Of Office Properties Of course, reality is far from frictionless. There are several barriers that will slow office-to-residential conversion as well as construction costs, which will meaningfully lower the net value of existing office real estate in large central business districts such as Manhattan. In a recent article in the Washington Post, Roger K. Lewis, retired architect and Professor Emeritus of Architecture at the University of Maryland, College Park, detailed several of these technical barriers (which we summarize below).3 Office buildings are typically much wider than residential buildings, the latter usually being 60 to 65 feet in width in order to enable windows and natural light in living/dining rooms and bedrooms. This suggests that office-to-residential conversion might require modifying the basic structure of office buildings, including cutting open parts of roof and floor plates on upper building levels to bring natural light into habitable and interior rooms, and other costly structural modifications to address the additional plumbing and infrastructure that will be needed. Lewis noted that floor-to-floor dimensions are typically larger in office buildings, which is beneficial for office-to-residential conversion because increased room heights augments the sense of space and openness, while allowing natural light to penetrate farther into the apartment. It also allows for extra space to place needed additional building infrastructure, such as sprinkler pipes, electrical conduits, light fixtures, and air ducts. But unique apartment layouts are often needed to use available floor space effectively in an office-to-residential conversion, which will increase design costs and raise the risk that nonstandard layouts may result in unforeseen quality-of-living problems that will necessitate additional future construction to correct. Zoning regulations and building code constraints will likely add another layer of costs to office-to-housing conversions, as these rules are written for conventional buildings, meaning that special exceptions or even regulatory changes are likely to be required. So it is clear that the process of converting office space to residential property will be a costly endeavor for office tower owners, which will likely reduce the net present value of these properties relative to pre-pandemic levels. But; this process appears to be feasible and, when faced with the alternative of persistently high vacancy rates and lost revenue, our sense is that office tower owners will choose this route – thus significantly reducing the likelihood that the growth in national gross investment in office properties will fall below the rate of depreciation. In addition, the trend in suburban and CBD office property prices suggests that there are two other possible alternatives to widespread office-to-residential conversion that would also argue against a significant and long-lasting decline in office structures investment. Chart II-9 highlights that the average asking rent has already fallen significantly in most Manhattan submarkets, and Chart II-10 highlights that suburban office prices are accelerating and rising at the strongest pace relative to CBD office prices over the past two decades, possibly in response to increased demand for workspace that is closer to home for many workers who previously commuted to CBDs. Chart II-9Working From The Office Is Getting Cheaper July 2021 July 2021 Chart II-10Suburban Offices Are Getting More Expensive Suburban Offices Are Getting More Expensive Suburban Offices Are Getting More Expensive Thus, the first alternative outcome to CBD office-to-residential conversion is that an increase in suburban office construction offsets the negative impact of outright reductions in CBD office investment if residential conversions prove to be too costly or too technically challenging. The second alternative is that owners of CBD office properties “clear the market” by dramatically cutting rental rates even further, to alter the cost/benefit calculation for firms planning permissive WFH policies. We doubt that existing rents reflect the extent of vacancies in large cities such as Manhattan, so we would expect further CBD office price declines in this scenario. But if owners of centrally-located office properties face significant conversion costs and a decline in the net present value of these buildings is unavoidable and its magnitude uncertain, owners may choose to cut prices drastically as the simpler solution. Investment Conclusions Holding all else equal, the fact that owners of CBD office properties are likely to experience some permanent decline in the value of these real estate assets is not a positive development for economic activity. But these losses will be experienced by firms, investors, and ultra-high net worth individuals with strong marginal propensities to save, suggesting that the economic impact from this shock will be minimal. And as we highlighted above, a decline in the pace of gross office building investment to the depreciation rate will have a minimal impact on the overall economy. This leaves the likely impact on CBD employment as the main channel by which WFH policies are likely to affect monetary policy. As we noted above and as discussed in Section 1 of our report, the Fed is now focused entirely on the return of the labor market to maximum employment, which we interpret as an unemployment rate within the range of the Fed’s NAIRU estimates (3.5% - 4.5%) and a return to a pre-pandemic labor force participation rate. Chart II-11On A One-Year Time Horizon, Favor Value Over Growth On A One-Year Time Horizon, Favor Value Over Growth On A One-Year Time Horizon, Favor Value Over Growth Our analysis indicates that WFH policies may structurally raise the unemployment rate by 0.3 to 0.4%. While non-trivial, when compared with a pre-pandemic unemployment rate of 3.5%, this suggests that WFH policies alone are not likely to cause a long-term deviation from the Fed’s maximum employment objective. The implication is that job growth over the coming year could be even stronger than the Fed and investors expect, which could mean that the Fed may begin lifting rates by the middle of next year barring a major disruption in the ongoing transition to a post-pandemic world. This is earlier than we currently expect, but the fact that it would also be earlier than what is currently priced into the OIS curve underscores that fixed-income investors should remain short duration on a 6-12 month time horizon. In addition, as noted in Section 1 of our report, while value stocks may underperform growth stocks over the coming 3-4 months,4 rising bond yields over the coming year will ultimately favor value stocks and will likely weigh on elevated tech sector valuations. Chart II-11 highlights that the relative valuation of growth stocks remains above its pre-pandemic starting point (Chart II-11), suggesting that investors should continue to favor MSCI-benchmarked value over growth positions over a 6-12 month time horizon. Finally, as also noted in Section 1 of our report, we do not expect rising bond yields to prevent stock prices from grinding higher over the coming year, unless investor expectations for the terminal fed funds rate move sharply higher – an event that seems unlikely, although not impossible, before monetary policy actually begins to tighten. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst "June 2021," dated May 27, 2021, available at bca.bcaresearch.com 2 Readers should note that the desired share of paid work from home days post-COVID among employees is shown to be lower in Table II-1 than what is implied by Chart II-1 on a weighted-average basis. This is due to the fact that Table II-1 excludes responses from the May 2020 survey wave, because the authors did not ask about employer intensions during that wave. This underscores that the average desired number of paid days working from home declined somewhat over time, and thus argues for the value shown in Table II-1 as the best estimate for employee preferences. 3 Roger K. Lewis, “Following pandemic, converting office buildings into housing may become new ‘normal,’ Washington Post, April 3, 2021. 4 Please see US Equity Strategy "Rotate Into Growth Stocks, Be Granular In The Selection Of Cyclicals," dated June 14, 2021, available at uses.bcaresearch.com

Highlights The ongoing transition to a post-pandemic state and fiscal policy are either positive or net-neutral for risky asset prices. Fiscal thrust will turn to fiscal drag over the coming year, but the negative impact this will have on goods spending will likely be offset by a significant improvement in services spending, and thus is not likely to cause a concerning slowdown in overall economic activity. A modestly hawkish shift in the outlook for monetary policy is likely over the coming year, potentially occurring over the late summer or early fall in response to outsized jobs growth. However, such a shift is not likely to become a negative driver for risky asset prices over the coming 6-12 months, barring a major rise in market expectations for the neutral rate of interest. This may very well occur once the Fed begins to raise interest rates, but not likely before. Investors should overweight risky assets within a multi-asset portfolio, and fixed-income investors should maintain a below-benchmark duration position. We continue to favor value over growth on a 6-12 month time horizon, although growth may outperform in the near term. A bias toward value over the coming year supports an overweight stance toward global ex-US equities, and an overall pro-risk stance favors bearish US dollar bets. Feature Three factors continue to drive our global macroeconomic outlook and our cyclical investment recommendations. The first factor is our assessment of the global progress that is being made on the path to a post-pandemic state, and the return to pre-COVID economic conditions; the second is the likely contribution to growth from fiscal policy over the coming year; and the third is the outlook for monetary policy and whether or not monetary conditions will remain stimulative for both economic activity and financial markets. If the world continues to progress meaningfully on the path to a post-pandemic state, and if the impact of fiscal and monetary policy remains in line with market expectations, then we see no reason to alter our recommended investment stance. Equity market returns will be modest over the coming 6 to 12 months in this scenario given how significantly stocks have rebounded from their low last year, but we would still expect stocks to outperform bonds and would generally be pro-cyclically positioned. We present below our assessment of these three factors and their potential to deviate from consensus expectations over the coming year, to determine their likely impact on economic activity and financial markets. The Ongoing Transition To A Post-Pandemic World Chart I-1Enormous Progress Has Been Made In The Fight Against COVID-19 Enormous Progress Has Been Made In The Fight Against COVID-19 Enormous Progress Has Been Made In The Fight Against COVID-19 Chart I-1 highlights that meaningful progress continues to be made in vaccinating the world's population against COVID-19. North America and Europe continue to lead the rest of the world based on the share of people who have received at least one dose, but South America continues to make significant gains, and recent data updates highlight that Asia and Oceania are also making meaningful progress. Africa is the clear laggard in the war against SARS-COV-2 and its variants, but progress there has been delayed, at least in part, by India’s export restrictions of the Oxford-AstraZeneca/COVISHIELD vaccine. This suggests that, while Africa will continue to lag, the share of Africans provided with a first dose of vaccine will begin to rise once India resumes its exports and deliveries to African countries under the COVAX program continue. If variants of the disease were not a source of concern, Chart I-1 would highlight that the full transition to a post-pandemic economy over the next several months would be near certain. However, as evidenced by the recent decision in the UK to postpone the lifting of COVID-19 restrictions by 4 weeks due to the spreading of the Delta variant, the global economy is not entirely out of the woods yet. Encouragingly, the delay in the UK genuinely appears to be temporary. Chart I-2 highlights that while the number of confirmed UK COVID-19 cases has been rising over the past month, the uptick in hospitalizations and fatalities has so far been quite muted. Importantly, the rise in hospitalizations appears to be occurring among those who have not yet been fully vaccinated, underscoring that variants of the disease are only truly concerning if they are vaccine-resistant. The evidence so far is that the Delta variant is more transmissible and may increase the risk of hospitalization, but that two doses of COVID-19 vaccine offer high protection. Of course, vaccines only offer protection if you get them, and evidence of vaccination hesitancy in the US is thus a somewhat worrying sign. Chart I-3 shows that the daily pace of vaccinations in the US has slowed significantly from mid-April levels, resulting in a slower rise in the share of the population that has received at least one dose (second panel). On this metric, the US has recently been outpaced by Canada, and the gap between the UK and the US is now widening. Germany and France are close behind the US and may surpass it soon. Chart I-2The UK Delay In Removing Restrictions Seems Genuinely Temporary The UK Delay In Removing Restrictions Seems Genuinely Temporary The UK Delay In Removing Restrictions Seems Genuinely Temporary Chart I-3Recent Vaccination Progress In The US Has Been Underwhelming Recent Vaccination Progress In The US Has Been Underwhelming Recent Vaccination Progress In The US Has Been Underwhelming   Sadly, Chart I-4 highlights that there is a political dimension to vaccine hesitancy in the US. The chart shows that state by state vaccination rates as a share of the population are strongly predicted by the share of the popular vote for Donald Trump in the 2020 US presidential election. Admittedly, part of this relationship may also be capturing an urban/rural divide, with residents in less-dense rural areas (which typically support Republican presidential candidates) perhaps feeling a lower sense of urgency to become vaccinated against the disease. Chart I-4The US Politicization Of Vaccines Raises The Risk From COVID-19 Variants July 2021 July 2021 But given the clear politicization that has already occurred over some pandemic control measures, such as the wearing of masks, Chart I-4 makes it difficult to avoid the conclusion that the same thing has occurred for vaccines. This is unfortunate, and seemingly raises the risk that the Delta variant may spread widely in red states over the coming several months, potentially delaying economic reopening, or risking the reintroduction of pandemic control measures. However, there are two counterarguments to this concern. First, non-vaccine immunity is probably higher in red than blue states, and CDC data suggest that this effect could be large. While this figure is still preliminary and subject to change (and likely will), the CDC estimates that only 1 out of 4.3 cases of COVID-19 were reported from February 2020 to March 2021. Taken at face value, this implies that there were approximately 115 million infections during that period, compared with under 30 million reported cases. That gap accounts for 25% of the US population, and given that red states were slower to implement pandemic control measures last year and their residents often more resistant to the measures, it stands to reason that a disproportionate share of unreported cases occurred in these states. Second, as noted above, the evidence thus far suggests that the Delta variant is not vaccine resistant, at least for those who are fully vaccinated. This is significant because if Delta were to spread widely in red states over the coming several months, the resulting increase in hospitalizations would likely convince many vaccine hesitant Americans to become vaccinated out of fear and self-interest – two powerfully motivating factors. Thus, the Delta variant may become a problem for the US in the fall, but if that occurs a solution is not far from sight. And, in other developed countries where vaccine hesitancy rates appear to be lower, it would seem that a new, vaccine-resistant variant of the disease would likely be required in order to cause a major disruption in the transition to a post-pandemic state. Such a variant could emerge, but we have seen no evidence thus far that one will before vaccination rates reach levels that would slash the odds of further widespread mutation. Fiscal Policy: Passing The Baton To Services Spending Chart I-5 highlights that US fiscal policy is set to detract from growth over the coming 6-12 months, reflecting the one-off nature of some of the fiscal response to the pandemic. This is true outside of the US as well, as Chart I-6 highlights that the IMF is forecasting a two percentage point increase in the Euro Area’s cyclically-adjusted primary budget balance, representing a significant amount of fiscal drag relative to the past two decades. Chart I-5Fiscal Thrust Will Eventually Turn To Fiscal Drag In The US… July 2021 July 2021 Should investors be concerned about the impact of fiscal drag on advanced economies over the coming year? In our view, the answer is no. The reason is that much of the fiscal response in the US and Europe has been aimed at supporting income that has been lost due to a drastic reduction in services spending, which will continue to recover over the coming months as the effect of the pandemic continues to ebb. Chart I-7 underscores this point by highlighting the “gap” in US consumer goods and services spending relative to its pre-pandemic trend. The chart highlights that US goods spending is running well above what would be expected, whereas there is a sizeable gap in services spending (which accounts for approximately 70% of US personal consumption expenditures). Goods spending will likely slow as fiscal thrust turns to fiscal drag, but services spending will improve meaningfully – aided not just by a post-pandemic normalization in economic activity, but also by the sizeable amount of excess savings that US households have accumulated over the past year (Chart I-7, panel 2). Chart I-6... And In Europe ... And In Europe ... And In Europe Chart I-7But Reduced Transfers Will Only Impact Spending On Goods, Not Services But Reduced Transfers Will Only Impact Spending On Goods, Not Services But Reduced Transfers Will Only Impact Spending On Goods, Not Services While some of these savings have already been deployed to pay down debt and some may be permanently saved in anticipation of higher future taxes, the key point for investors is that the negative impact on goods spending from reduced fiscal thrust will be offset by a significant improvement in services spending, and thus is not likely to cause a concerning slowdown in overall economic activity. Monetary Policy: A Modestly Hawkish Shift Is Likely This leaves us with the question of whether or not monetary policy will become a negative driver for risky asset prices over the coming 6-12 months, which is especially relevant following last week’s FOMC meeting. The updated “dot plot” following the meeting shows that 7 of the 18 FOMC participants anticipate a rate hike in 2022, and the majority (13 members) expect at least one rate hike before the end of 2023, raising the median forecast for the Fed funds rate to 0.6% by the end of that year. Chart I-8 highlights that while 10-year Treasury yields remains mostly unchanged following the meeting, yields moved higher at the short-end and middle of the curve. Chart I-8The FOMC Meeting Resulted In Higher Short- And Mid-Term Yields The FOMC Meeting Resulted In Higher Short- And Mid-Term Yields The FOMC Meeting Resulted In Higher Short- And Mid-Term Yields Investor fears that the Fed may shift in a significantly hawkish direction at some point over the next year have been far too focused on inflation, and far too little focused on employment. It is not a coincidence that the Fed’s guidance was updated following the May jobs report, which saw a stronger pace of jobs growth relative to April. Table I-1 updates our US Bond Strategy service’s calculations showing the average monthly nonfarm payroll growth that will be required for the unemployment rate to reach 3.5-4.5% assuming a full recovery in the participation rate, which is the range of the Fed’s NAIRU estimates. May’s payroll growth number of 560k implies that the Fed’s maximum employment criterion will be met sometime between June and September next year, if monthly payroll growth continues at that pace. Table I-1Calculating The Distance To Maximum Employment July 2021 July 2021 Chart I-9Lighter Restrictions In Blue States Will Push Down The Unemployment Rate Lighter Restrictions In Blue States Will Push Down The Unemployment Rate Lighter Restrictions In Blue States Will Push Down The Unemployment Rate It is currently difficult to assess with great confidence what average payroll growth will prevail over the coming year, but we noted in last month’s report that there were compelling arguments in favor of outsized jobs growth this fall.1 In addition to those points, we note the following: Blue states have generally been slower to reopen their economies, and Chart I-9 highlights that these states have consequently been slower to return to their pre-pandemic unemployment rate. Among blue states, California and New York are the largest by population, and it is notable that both states only lifted most COVID-19 restrictions on June 15 – including the wearing of masks in most settings. This implies that services jobs are likely to grow significantly in these states over the coming few months. Both consensus private forecasts as well as the Fed’s expectation for real GDP growth imply that the output gap will be closed by Q4 of this year (Chart I-10). These expectations appear to be reasonable, given the substantial amount of excess savings that have been accumulated by US households and the fact that monetary policy remains extremely stimulative. When the output gap turned positive during the last economic cycle, the unemployment rate was approximately 4% – well within the Fed’s NAIRU range. Chart I-10 also shows that the Fed’s 7% real GDP growth forecast for this year would put the output gap above its pre-pandemic level, when the unemployment rate stood at 3.5%. In fact, it is possible that annualized Q2 real GDP growth will disappoint current consensus expectations of 10%, due to the scarcity of labor supply (scarcity that will be eased by labor day when supplemental unemployment insurance benefit programs end). Were Q2 GDP to disappoint due to supply-side limitations, it would strengthen the view that job gains will be very strong this fall ceteris paribus, as it would highlight that real output per worker cannot rise meaningfully further in the short-term and that stronger growth later in the year will necessitate very large job gains. Chart I-11 highlights that US air travel and New York City subway ridership have already returned close to 75% and 50% of their pre-pandemic levels, respectively. Based on the trend over the past three months, the chart implies that air travel will return to its pre-pandemic levels by mid-October of this year, and New York City subway ridership by June 2022. This underscores that travel-related services employment will recover significantly in the fall, and that jobs in downtown cores will rebound as office workers progressively return to work. Chart I-10Expectations For Growth This Year Suggest A Rapid Decline In The Unemployment Rate Expectations For Growth This Year Suggest A Rapid Decline In The Unemployment Rate Expectations For Growth This Year Suggest A Rapid Decline In The Unemployment Rate Chart I-11Services Employment Will Recover In The Fall Services Employment Will Recover In The Fall Services Employment Will Recover In The Fall   On the latter point, one major outstanding question affecting the outlook for monetary policy is the magnitude of the likely permanent impact of work from home policies on employment in central business districts. Fewer office workers commuting to downtown office locations suggests that some jobs in the leisure & hospitality, retail trade, professional & business services, and other services industries will never return or will be very slow to do so, arguing for a longer return to maximum employment (and the Fed’s liftoff date). We examine this question in depth in Section 2 of this month’s report, and find that the “stickiness” of work from home policies will likely cause permanent central business job losses on the order of 575k (or 0.35% of the February 2020 labor force). While this would be non-trivial, when compared with a pre-pandemic unemployment rate of 3.5%, WFH policies alone are not likely to cause a long-term deviation from the Fed’s maximum employment objective. Outsized jobs growth this fall, at a pace that quickly reduces the unemployment rate, argues for a first Fed rate hike that is even earlier than the market expects. Chart I-12 presents The Bank Credit Analyst service’s current assessment of the cumulative odds of the Fed’s liftoff date by quarter; we believe that it is likely that the Fed will have raised rates by Q3 of next year, and that a rate hike in the first half of 2022 is a possibility. These odds are slightly more aggressive than those presented by our fixed-income strategists in a recent Special Report,2 but are consistent with their view that the Fed will raise interest rates by the end of next year. Chart I-12The Bank Credit Analyst’s Assessment Of The Odds Of The First Rate Hike July 2021 July 2021 The odds presented in Chart I-12 are also more hawkish than the Fed funds rate path currently implied by the OIS curve, meaning that we expect investors to be somewhat surprised by a shifting monetary policy outlook at some point over the coming year, potentially over the next 3-6 months. Payroll growth during the late summer and early fall will be a major test for the employment outlook, and is the most likely point for a hawkish shift in the market’s view of monetary policy. Is this likely to become a negative driver for risky asset prices over the coming 6-12 months? In our view, the answer is “probably not.” While investors tend to focus heavily on the timing of the first rate hike as monetary policy begins to tighten, the reality is that it is the least relevant factor driving the fair value of 10-year Treasury yields. Investor expectations for the pace of tightening and especially for the terminal Fed funds rate are far more important, and, while it is quite possible that expectations for the neutral rate of interest will eventually rise, it seems unlikely that this will occur before the Fed actually begins to raise interest rates given that most investors accept the secular stagnation narrative and the view that “R-star” is well below trend rates of growth (we disagree).3 Chart I-13 highlights the fair value path of 10-year Treasury yields until the end of next year, assuming a 2.5% terminal Fed funds rate, no term premium, and a rate hike pace of 1% per year. The chart highlights that while government bond yields are set to move higher over the coming 6-12 months, they are likely to remain between 2-2.5%. This would drop the equity risk premium to a post-2008 low (Chart I-14), which would further reduce the attractiveness of stocks relative to bonds. But we doubt that this would be enough of a decline to cause a selloff, and it would still imply a stimulative level of interest rates for households and firms. Chart I-1310-Year Yields Will Rise Over The Coming Year, But Not Sharply 10-Year Yields Will Rise Over The Coming Year, But Not Sharply 10-Year Yields Will Rise Over The Coming Year, But Not Sharply Chart I-14Rising Yields Will Cause An Unwelcome But Contained Decline In The ERP Rising Yields Will Cause An Unwelcome But Contained Decline In The ERP Rising Yields Will Cause An Unwelcome But Contained Decline In The ERP   Investment Conclusions Among the three factors driving our global macroeconomic outlook and our cyclical investment recommendations, continued progress on the path toward a post-pandemic state and fiscal policy remain either positive or mostly neutral for risky assets. A potentially hawkish shift in the outlook for monetary policy this fall remains the chief risk, but we expect the rise in bond yields over the coming year to remain well-contained barring a sea change in investor expectations for the terminal Fed funds rate – which we believe is unlikely to occur before the Fed begins to raise interest rates. Consequently, we continue to recommend that investors should overweight risky assets within a multi-asset portfolio, and that fixed-income investors should maintain a below-benchmark duration position. We expect modest absolute returns from global equities, but even mid-single digit returns are likely to beat those from long-dated government bonds and cash positions. While value stocks may underperform growth stocks over the coming 3-4 months,4 rising bond yields over the coming year will ultimately favor value stocks and will likely weigh on elevated tech sector (and therefore growth stock) valuations (Chart I-15). Chart I-16 highlights that the attractiveness of US value versus growth is meaningfully less compelling for the S&P 500 Citigroup indexes, suggesting that investors should continue to favor MSCI-benchmarked value over growth positions over a 6-12 month time horizon.5 Chart I-15Value Is Extremely Cheap Value Is Extremely Cheap Value Is Extremely Cheap Chart I-16Value Vs. Growth: The Benchmark Matters Value Vs. Growth: The Benchmark Matters Value Vs. Growth: The Benchmark Matters   The likely outperformance of value versus growth also has implications for regional allocation within a global equity portfolio. The US is significantly overweight broadly-defined technology relative to global ex-US stocks, and financials – which are overrepresented in value indexes – have already meaningfully outperformed in the US this year compared with their global peers and are now rolling over (Chart I-17). This underscores that investors should favor ex-US stocks over the coming year, skewed in favor of DM ex-US given that China’s credit impulse continues to slow (Chart I-18). Chart I-17Favor Global Ex-US Stocks Over The Coming Year Favor Global Ex-US Stocks Over The Coming Year Favor Global Ex-US Stocks Over The Coming Year Chart I-18Concentrate Global Ex-US Exposure In Developed Markets Concentrate Global Ex-US Exposure In Developed Markets Concentrate Global Ex-US Exposure In Developed Markets   Finally, global ex-US stocks also tend to outperform when the US dollar is falling, and we would recommend that investors maintain a short dollar position on a 6-12 month time horizon despite the recent bounce in the greenback. Chart I-19 highlights that the dollar remains strongly negatively correlated with global equity returns, and that the dollar’s performance over the past year has been almost exactly in line with what one would have expected given this relationship. Thus, a bullish view toward global stocks implies both US dollar weakness and global ex-US outperformance over the coming year. Chart I-19A Bullish View Towards Global Stocks Implies A Dollar Bear Market A Bullish View Towards Global Stocks Implies A Dollar Bear Market A Bullish View Towards Global Stocks Implies A Dollar Bear Market Jonathan LaBerge, CFA Vice President The Bank Credit Analyst June 24, 2021 Next Report: July 29, 2021   II. Work From Home “Stickiness” And The Outlook For Monetary Policy Work from home policies, originally designed as emergency measures in the early phase of the COVID-19 pandemic, are likely to be “sticky” in a post-pandemic world. This will negatively impact the labor market in central business districts, via reduced spending on services by office workers. The potential impact of working from home is often cited as an example of what is likely to be a lasting and negative effect on jobs growth, but we find that it is not likely to be a barrier to the labor market returning to the Fed’s assessment of “maximum employment.” The size of the impact depends importantly on whether employee preferences or employer plans for WFH prevail, but our sense is that the latter is more likely. A weaker pace of structures investment in response to elevated office vacancy rates will likely have an even smaller impact on growth than the effect of reduced central business district services employment. The contribution to growth from structures investment has been small over the past few decades, office building construction is a small portion of overall nonresidential structures, and there are compelling arguments that the net stock of office structures will stay flat, rather than decline. Our analysis suggests that job growth over the coming year could be even stronger than the Fed and investors expect, possibly resulting in a first rate hike by the middle of next year. This would be earlier than we currently anticipate, but it underscores that fixed-income investors should remain short duration on a 6-12 month time horizon, and that equity investors should favor value over growth positions beyond the coming 3-4 months. The outlook for US monetary policy over the next 12 to 18 months depends almost entirely on the outlook for employment. Many investors are focused on the potential for elevated inflation to force the Fed to raise interest rates earlier than it currently anticipates, but it is the progress in returning to “maximum employment” that will determine the timing of the first Fed rate hike – and potentially the speed at which interest rates rise once policy begins to tighten. In this report, we estimate the extent to which the “stickiness” of working from home (WFH) policies and practices could leave a lasting negative impact on the US labor market. We noted in last month's report that a large portion of the employment gap relative to pre-pandemic levels can be traced to the leisure & hospitality and professional and business services industries, both of which – along with retail employment – stand to be permanently impaired if the office worker footprint is much lower in a post-COVID world.6 Using employee surveys and a Monte Carlo approach, we present a range of estimates for the permanent impact of WFH policies on the unemployment rate, and separately examine the potential for lower construction of office properties to weigh on growth. We find that the impact of reduced office building construction is likely to be minimal, and that WFH policies may structurally raise the unemployment rate by 0.3 to 0.4%. While non-trivial, when compared with a pre-pandemic unemployment rate of 3.5%, WFH policies alone are not likely to cause a long-term deviation from the Fed’s maximum employment objective. Relative to the Fed’s expectations of a strong, lasting impact on the labor market from the pandemic, this suggests that job growth over the coming year could be even stronger than the Fed and investors expect, possibly resulting in a first rate hike by the middle of next year. This would be earlier than we currently anticipate, but it underscores that fixed-income investors should remain short duration on a 6-12 month time horizon, and that equity investors should favor value over growth positions beyond the coming 3-4 months (a period that may see outperformance of the latter). Quantifying The Labor Market Impact Of The New Normal For Work In a January paper, Barrero, Bloom, and Davis (“BBD”) presented evidence arguing why working from home will “stick.” The authors surveyed 22,500 working-age Americans across several survey “waves” between May and December 2020, and asked about both their preferences and their employer’s plans about working from home after the pandemic. Chart II-1 highlights that the desired amount of paid work from home days (among workers who can work from home) reported by the survey respondents is to approximately 55% of a work week, suggesting that a dramatic reduction in office presence would likely occur if post-pandemic WFH policies were set fully in accordance with worker preferences. Chart II-1Employee Preferences Imply A Dramatic Reduction In Post-COVID Office Presence July 2021 July 2021 However, Table II-1 highlights that employer plans for work from home policies are meaningfully different than those of employees. The table highlights that employers plan for employees to work from home for roughly 22% of paid days post-pandemic, which essentially translates to one day per week on average.7 BBD noted that CEOs and managers have cited the need to support innovation, employee motivation, and company culture as reasons for employees’ physical presence. Managers believe physical interactions are important for these reasons, but employees need only be on premises for about three to four days a week to achieve this. Table II-1 also shows that employers plan to allow higher-income employees more flexibility in terms of working from home, and less flexibility to employees whose earnings are between $20-50k per year. Table II-1Employer Plans, However, Imply Less Working From Home Than Employees Prefer July 2021 July 2021 Based on the survey results, BBD forecast that expenditure in major cities such as Manhattan and San Francisco will fall on the order of 5 to 10%. In order to understand the national labor market impact of work from home policies and what implications this may have on monetary policy, we scale up BBD’s calculations using a Monte Carlo approach that incorporates estimate ranges for several factors: The percent of paid days now working from home for office workers The amount of money spent per week by office workers in central business districts (“CBDs”) The number of total jobs in CBDs The percent of CBD jobs in industries likely to be negatively impacted by reduced office worker expenditure The average weekly earnings of affected CBD workers The average share of business revenue not attributable to strictly variable expenses The percent of affected jobs likely to be recovered outside of CBDs Our approach is as follows. First, we calculate the likely reduction in nationwide CBD spending from reduced office worker presence by multiplying the likely percent of paid days now permanently working from home by the number of total jobs in CBDs and the average weekly spending of office workers. This figure is then increased due to the estimated acceleration in net move outs from principal urban centers in 2020 (Chart II-2); we assume a 5% savings rate and an average annual salary of $50k for these resident workers, and assume that all of their spending occurred within CBDs. We also assume that roughly 50% of jobs connected to this spending are recovered. Chart II-2Fewer Residents Will Also Lower Spending In Central Business Districts July 2021 July 2021 Then, we calculate the gross number of jobs lost in leisure & hospitality, retail trade, and other services by multiplying this estimate of lost spending by an estimate of non-variable costs as a share of revenue for affected industries, and dividing the result by average weekly earnings of affected employees. For affected CBD employees in the administrative and waste services industry, we simply assume that the share of jobs lost matches the percent of paid days now permanently working from home. Finally, we adjust the number of jobs lost by multiplying by 1 minus an assumed “recovery” rate, given that some of the reduction in spending in CBDs will simply be shifted to areas near remote workers’ residences. We assume a slightly lower recovery rate for lost jobs in the administrative and waste services industry. Table II-2 highlights the range of outcomes for each variable used in our simulation, and Charts II-3 and II-4 present the results. The charts highlight that the distribution of outcomes based on employer WFH intensions suggest high odds that nationwide job losses in CBDs due to reduced office worker presence will not exceed 400k. Based on average employee preferences, that number rises to roughly 800-900k. Table II-2The Factors Affecting Permanent Central Business District Job Losses July 2021 July 2021 Chart II-3The Probability Distribution Of CBD Jobs Lost… July 2021 July 2021 Chart II-4…Based On Our Monte Carlo Approach July 2021 July 2021   This raises the question of whether employer plans or employee preferences for WFH arrangements will prevail. Our sense is that it will be closer to the former, given that we noted above that employer WFH plans are the least flexible for employees whose earnings are between $20-50k per year (who are presumably employees who have less ability to influence the policy of firms). Chart II-5 re-presents the projected job losses shown in Chart II-4 as a share of the February 2020 labor force, along with a probability-weighted path that assumes a 75% chance that employer WFH plans will prevail. The chart highlights that WFH arrangements would have the effect of raising the unemployment rate by approximately 0.35%. However, relative to a pre-pandemic starting point of 3.5%, this would raise the unemployment rate to a level that would still be within the Fed’s NAIRU estimates (Chart II-6). Therefore, the “stickiness” of WFH arrangements alone do not seem to be a barrier to the labor market returning to the Fed’s assessment of “maximum employment,” suggesting that the conditions for liftoff may be met earlier than currently anticipated by investors. Chart II-5CBD Job Losses Will Not Be Trivial, But They Will Not Be Enormous July 2021 July 2021 Chart II-6Sticky WFH Policies Will Not Prevent A Return To Maximum Employment Sticky WFH Policies Will Not Prevent A Return To Maximum Employment Sticky WFH Policies Will Not Prevent A Return To Maximum Employment The Impact Of Lower Office Building Construction A permanently reduced office footprint could also conceivably impact the US economy through reduced nonresidential structures investment, as builders of commercial real estate cease to construct new office towers in response to expectations of a long-lasting glut. However, several points highlight that the negative impact on growth from US office tower construction will be even smaller than the CBD employment impact of reduced office worker presence that we noted above. First, Chart II-7 highlights the overall muted impact that nonresidential building investment has had on real GDP growth by removing the contribution to growth from nonresidential structures and for overall nonresidential investment. The chart clearly highlights that the historically positive contribution to real US output from capital expenditures over the past four decades has come from investment in equipment and intellectual property products, not from structures. Chart II-8 echoes this point, by highlighting that US real investment in nonresidential structures has in fact been flat since the early-1980s, contributing positively and negatively to growth only on a cyclical basis (not on a structural basis). Chart II-7Structures Have Not Contributed Significantly To US Growth For Some Time Structures Have Not Contributed Significantly To US Growth For Some Time Structures Have Not Contributed Significantly To US Growth For Some Time Chart II-8Nonresidential Structures Investment Has Been Flat For Four Decades Nonresidential Structures Investment Has Been Flat For Four Decades Nonresidential Structures Investment Has Been Flat For Four Decades Second, Table II-3 highlights that office properties make up a small portion of investment in private nonresidential structures. In 2019, nominal investment in office structures amounted to $85 billion, compared with $630 billion in overall structures investment, meaning that office properties amounted to just 13% of structures investment. Table II-3Office Structures Investment Is A Small Share Of Total Structures Investment July 2021 July 2021 Table II-4Conceivably, Vacant Office Properties Could Be Converted To Luxury Residential Units July 2021 July 2021 Third, it is true that investment is a flow and not a stock variable, meaning that, if the net stock of office buildings were to fall as a result from WFH policies, then the US economy would see a potentially persistently negative rate of growth from nonresidential structures (which would constitute a drag on growth). But if the net stock were instead to remain flat, then gross office property investment should equal the depreciation of those structures. The second column of Table II-3 highlights that current-cost depreciation of office structures was $53 billion in 2019 (versus nominal gross investment of $85 billion). Had office property investment been ~$30 billion lower in 2019, it would have reduced nominal GDP by a mere 14 basis points (resulting in an annual growth rate of 3.84%, rather than 3.98%). Fourth, there is good reason to believe that the net stock of office properties will stay flat, as the economics of converting offices to luxury housing units (whose demand is not substantially affected by factors such as commuting) – either fully or partially into mixed-use buildings – appear to be plausible. Table II-4 highlights that the average annual asking rent for office space per square foot in Manhattan was $73.23 in Q1 2021, and that the recent median listing home price per square foot is roughly $1,400. In a frictionless world where office space could be instantly and effortlessly sold as residential property, existing prices would imply a healthy (gross) rental yield of 5.2%. Thoughts On The Future Of Office Properties Of course, reality is far from frictionless. There are several barriers that will slow office-to-residential conversion as well as construction costs, which will meaningfully lower the net value of existing office real estate in large central business districts such as Manhattan. In a recent article in the Washington Post, Roger K. Lewis, retired architect and Professor Emeritus of Architecture at the University of Maryland, College Park, detailed several of these technical barriers (which we summarize below).8 Office buildings are typically much wider than residential buildings, the latter usually being 60 to 65 feet in width in order to enable windows and natural light in living/dining rooms and bedrooms. This suggests that office-to-residential conversion might require modifying the basic structure of office buildings, including cutting open parts of roof and floor plates on upper building levels to bring natural light into habitable and interior rooms, and other costly structural modifications to address the additional plumbing and infrastructure that will be needed. Lewis noted that floor-to-floor dimensions are typically larger in office buildings, which is beneficial for office-to-residential conversion because increased room heights augments the sense of space and openness, while allowing natural light to penetrate farther into the apartment. It also allows for extra space to place needed additional building infrastructure, such as sprinkler pipes, electrical conduits, light fixtures, and air ducts. But unique apartment layouts are often needed to use available floor space effectively in an office-to-residential conversion, which will increase design costs and raise the risk that nonstandard layouts may result in unforeseen quality-of-living problems that will necessitate additional future construction to correct. Zoning regulations and building code constraints will likely add another layer of costs to office-to-housing conversions, as these rules are written for conventional buildings, meaning that special exceptions or even regulatory changes are likely to be required. So it is clear that the process of converting office space to residential property will be a costly endeavor for office tower owners, which will likely reduce the net present value of these properties relative to pre-pandemic levels. But; this process appears to be feasible and, when faced with the alternative of persistently high vacancy rates and lost revenue, our sense is that office tower owners will choose this route – thus significantly reducing the likelihood that the growth in national gross investment in office properties will fall below the rate of depreciation. In addition, the trend in suburban and CBD office property prices suggests that there are two other possible alternatives to widespread office-to-residential conversion that would also argue against a significant and long-lasting decline in office structures investment. Chart II-9 highlights that the average asking rent has already fallen significantly in most Manhattan submarkets, and Chart II-10 highlights that suburban office prices are accelerating and rising at the strongest pace relative to CBD office prices over the past two decades, possibly in response to increased demand for workspace that is closer to home for many workers who previously commuted to CBDs. Chart II-9Working From The Office Is Getting Cheaper July 2021 July 2021 Chart II-10Suburban Offices Are Getting More Expensive Suburban Offices Are Getting More Expensive Suburban Offices Are Getting More Expensive Thus, the first alternative outcome to CBD office-to-residential conversion is that an increase in suburban office construction offsets the negative impact of outright reductions in CBD office investment if residential conversions prove to be too costly or too technically challenging. The second alternative is that owners of CBD office properties “clear the market” by dramatically cutting rental rates even further, to alter the cost/benefit calculation for firms planning permissive WFH policies. We doubt that existing rents reflect the extent of vacancies in large cities such as Manhattan, so we would expect further CBD office price declines in this scenario. But if owners of centrally-located office properties face significant conversion costs and a decline in the net present value of these buildings is unavoidable and its magnitude uncertain, owners may choose to cut prices drastically as the simpler solution. Investment Conclusions Holding all else equal, the fact that owners of CBD office properties are likely to experience some permanent decline in the value of these real estate assets is not a positive development for economic activity. But these losses will be experienced by firms, investors, and ultra-high net worth individuals with strong marginal propensities to save, suggesting that the economic impact from this shock will be minimal. And as we highlighted above, a decline in the pace of gross office building investment to the depreciation rate will have a minimal impact on the overall economy. This leaves the likely impact on CBD employment as the main channel by which WFH policies are likely to affect monetary policy. As we noted above and as discussed in Section 1 of our report, the Fed is now focused entirely on the return of the labor market to maximum employment, which we interpret as an unemployment rate within the range of the Fed’s NAIRU estimates (3.5% - 4.5%) and a return to a pre-pandemic labor force participation rate. Chart II-11On A One-Year Time Horizon, Favor Value Over Growth On A One-Year Time Horizon, Favor Value Over Growth On A One-Year Time Horizon, Favor Value Over Growth Our analysis indicates that WFH policies may structurally raise the unemployment rate by 0.3 to 0.4%. While non-trivial, when compared with a pre-pandemic unemployment rate of 3.5%, this suggests that WFH policies alone are not likely to cause a long-term deviation from the Fed’s maximum employment objective. The implication is that job growth over the coming year could be even stronger than the Fed and investors expect, which could mean that the Fed may begin lifting rates by the middle of next year barring a major disruption in the ongoing transition to a post-pandemic world. This is earlier than we currently expect, but the fact that it would also be earlier than what is currently priced into the OIS curve underscores that fixed-income investors should remain short duration on a 6-12 month time horizon. In addition, as noted in Section 1 of our report, while value stocks may underperform growth stocks over the coming 3-4 months,9 rising bond yields over the coming year will ultimately favor value stocks and will likely weigh on elevated tech sector valuations. Chart II-11 highlights that the relative valuation of growth stocks remains above its pre-pandemic starting point (Chart II-11), suggesting that investors should continue to favor MSCI-benchmarked value over growth positions over a 6-12 month time horizon. Finally, as also noted in Section 1 of our report, we do not expect rising bond yields to prevent stock prices from grinding higher over the coming year, unless investor expectations for the terminal fed funds rate move sharply higher – an event that seems unlikely, although not impossible, before monetary policy actually begins to tighten. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields since last August. The indicator still remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain very strong, and positive earnings surprises have risen to their highest levels on record. Within a global equity portfolio, there has been a modest tick down in global ex-US equity performance, driven by a rally in growth stocks (which may persist for a few months). EM stocks had previously dragged down global ex-US performance, and they continue to languish. A bias towards value stocks on a 1-year time horizon means that investors should still favor ex-US stocks over the coming year, skewed in favor of DM ex-US given that China’s credit impulse continues to slow. The US 10-Year Treasury yield has trended modestly lower since mid-March, after having risen to levels that were extremely technically stretched. Despite this pause, our valuation index highlights that bonds are still expensive, and we expect that yields will move higher over the cyclical investment horizon if employment growth in Q3/Q4 implies a faster return to maximum employment than currently projected by the Fed. We expect the rise to be more modest than our valuation index would imply, but we would still recommend a short duration stance within a fixed-income portfolio. The extreme rise in some commodity prices over the past several months is beginning to ease. Lumber prices have fallen close to 50% from their recent high, whereas industrial metals and agricultural prices are down roughly 5% and 17%, respectively. We had previously argued that a breather in commodity prices was likely at some point over the coming several months, and we would expect further declines as supply chains normalize, labor supply recovers, and Chinese demand for metals slows. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. Our global LEI diffusion index has declined significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). Strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst "June 2021," dated May 27, 2021, available at bca.bcaresearch.com 2 Please see US Bond Strategy/Global Fixed Income Strategy Special Report "A Central Bank Timeline For The Next Two Years," dated June 1, 2021, available at usbs.bcaresearch.com 3 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 4 Please see US Equity Strategy "Rotate Into Growth Stocks, Be Granular In The Selection Of Cyclicals," dated June 14, 2021, available at uses.bcaresearch.com 5 For a discussion of the differences in value and growth benchmarks, please see Global Asset Allocation Special Report “Value? Growth? It Really Depends!” dated September 19, 2019, available at gaa.bcaresearch.com 6 Please see The Bank Credit Analyst "June 2021," dated May 27, 2021, available at bca.bcaresearch.com 7 Readers should note that the desired share of paid work from home days post-COVID among employees is shown to be lower in Table II-1 than what is implied by Chart II-1 on a weighted-average basis. This is due to the fact that Table II-1 excludes responses from the May 2020 survey wave, because the authors did not ask about employer intensions during that wave. This underscores that the average desired number of paid days working from home declined somewhat over time, and thus argues for the value shown in Table II-1 as the best estimate for employee preferences. 8 Roger K. Lewis, “Following pandemic, converting office buildings into housing may become new ‘normal,’ Washington Post, April 3, 2021. 9 Please see US Equity Strategy "Rotate Into Growth Stocks, Be Granular In The Selection Of Cyclicals," dated June 14, 2021, available at uses.bcaresearch.com

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