Financial Markets

Highlights The US has largely passed a “stress test” of its political system. Rule of law is intact. The US dollar and treasuries may fall further due to cyclical and macro developments but not due to a structural loss of confidence in US governance. The judicial system will become the key check on the Biden administration as it shifts from short-term economic relief to its longer-term agenda, especially on executive orders. The court becomes even more important as a check if the Democrats muster the votes to remove the filibuster. This is possible but not imminent. Packing the court is much harder. Major court cases only sometimes have a major impact on the stock market but key sectors can be given certainty through court verdicts after being disrupted by policy. The US dollar is bouncing on the basis of economic recovery and political stability which poses a near-term risk to cyclical sectors. Feature US government bonds continued to sell off over the past week as the economic recovery gained steam and investors rotated into cyclical equities and commodities. The US Senate passed the $1.9 trillion American Rescue Plan – a massive and likely excessive infusion of fiscal relief – sending it to the House where it will be ratified shortly and passed over to President Joe Biden for signing. Across America shops and restaurants are opening up as immunization to COVID-19 advances and hospitalizations collapse. Meanwhile the Supreme Court announced its first set of rulings under the Biden administration: it dismissed former President Trump’s last challenge to the 2020 election and ruled on other issues such as free speech. The country has tentatively passed a political “stress test.” The rule of law remains intact. On the surface these two trends stand in opposition. US treasuries have been attractive to a savings-rich world not just because of the size of the US economy but also because of the country’s 245-year tradition of good governance – the balance of freedom and stability in its government and financial markets. The share of foreign holdings of US treasuries is declining but the reason is that the Federal Reserve is increasing its share (Chart 1). Foreigners are not liquidating their holdings just yet, although it is a risk given the US’s combination of extremely easy monetary and fiscal policy and populist politics. Chart 1Foreign Holdings Of US Treasuries Foreign Holdings Of US Treasuries Foreign Holdings Of US Treasuries In this report we focus on governance in the wake of the Trump administration and COVID-19 pandemic. Is US governance eroding? If so, how will it impact the markets? How will the courts interact with the Biden administration? Should investors care about the rule of law? With a new business cycle beginning, any assurance of a basic level of US governance allows risk appetite to recover and enables investors to pursue higher-yielding cyclical assets with less inhibition. But it also suggests that US assets will remain safe havens. How Rule Of Law Matters To Investors Rule of law and the independence of the judiciary are critical aspects of good governance that make a market attractive to foreign investors and secure for domestic investors. Nowhere is this clearer than in the breakdown of global reserve currencies. The United States and its developed market allies hold pride of place (Chart 2). Nevertheless the US has lost some of its reserve status to other currencies over two decades of partisanship and repeated crises, from 9/11 through Trump’s trade war. Chart 2Rule Of Law: Bedrock For Reserve Currencies Court Rulings And The Market Court Rulings And The Market Government bond yields exhibit some degree of correlation, inversely, with rule of law: better governance implies lower yields and vice versa. As the global savings glut grew over the past few decades, investors sought to preserve capital in securities perceived to be the safest. This is apparent whether judging by a simple comparison of developed and emerging market bond yields or by the World Bank’s Worldwide Governance Indicators.1 The relationship between governance and bond yields is strongest with emerging markets but it loosely holds among developed markets like the US, as shown in Chart 3. Chart 3Bond Yields Lower Where Laws Rule Court Rulings And The Market Court Rulings And The Market It is the level of governance rather than any change matters, since bond yields have fallen for all developed markets regardless of changes in governance over the past decade. However, governments that take negative steps that harm governance attract fewer foreign purchases of their debt than those that improve governance (Chart 4). This is true of developed and emerging economies. The implication is that demand for US treasuries would have been even greater over the past decade if the US political system had remained stable like Canada’s. Chart 4Improved Rule Of Law Attracts Bond Investors Court Rulings And The Market Court Rulings And The Market Differences in developed economy governance only slightly (if at all) correlate with portfolio or direct investment flows (Charts 5 and 6). This is not surprising as governance does not translate into short-term corporate earnings growth and foreign countries invest directly in developed markets to access technology and consumer markets. By contrast, in emerging markets, better governance goes along with stronger equity demand and foreign direct investment. Chart 5Rule Of Law A Boon For Equity Flows? Court Rulings And The Market Court Rulings And The Market Chart 6Eroding Rule Of Law Discourages Direct Investment Court Rulings And The Market Court Rulings And The Market Still the global phenomenon suggests that an erosion of rule of law can shake up one’s faith in a government’s ability or willingness to make debt payments and its operating environment for private companies. Domestically focused investors have to be concerned about rule of law since its collapse would undermine political stability as well as property rights, the surety of contracts, and the redress of grievances. US Rule Of Law Post-Trump And Post-COVID The US has the world’s longest continuously running constitution and one of the highest standards of living. Other countries with similarly high standards of living have similar constitutions or even adopted theirs from the United States. At the same time US governance has deteriorated in recent years, raising the question of whether bond investors or private entrepreneurs face greater governance risk. The drop in rule of law is apparent in the World Bank’s index (Chart 7A). The turmoil of the 2020 election cycle proves beyond doubt that the US suffers from some serious governance problems. At the same time the independence of the US judiciary is rising in the ranks (Chart 7B). Looking ahead, this trend will likely continue as the judicial system managed to get through the disruptive Trump presidency and the 2020 pandemic and election with minimal damage to its independence. Chart 7AUS Rule Of Law Erosion Will Pause Court Rulings And The Market Court Rulings And The Market Chart 7BUS Judicial Independence Has Improved Court Rulings And The Market Court Rulings And The Market This is a remarkable feat as the underlying problem in the US system – political polarization – threatens to entangle the judiciary as much as any other institution. Today, with polarization subsiding yet still at a historically high level, the court’s integrity and credibility are critical to the overall maintenance of the rule of law (Chart 8). Chart 8US Polarization Set To Fall US Polarization Set To Fall US Polarization Set To Fall Chart 9Trust In Supreme Court Fairly Steady Court Rulings And The Market Court Rulings And The Market Polarization creates gridlock in Congress, which forces other branches of government to fill the vacuum and deliver solutions, thus becoming more controversial. This process has ensnared the high court from time to time as well as the central bank and other institutions.2 Over the past ten years the courts have struggled to minimize the damage from polarization. Confidence in the high court has fallen, but not catastrophically, and most voters feel about the same as ever toward the court (Chart 9). Meanwhile disapproval of Congress is stuck around 80%. The Trump era featured a range of claims about the rule of law in America that can now be assessed with some distance. The Democratic Party was not able to remove President Trump through extra-electoral means, while President Trump was not able to ride roughshod over the courts via executive order. Several of Trump’s initiatives were upheld, such as his immigration ban, while others were shot down, such as his attempt to deport the so-called “Dreamers” or add a question about citizenship on the US census. The 2020 election irregularities were not enough to sway the outcome of the electoral vote while the insurrection at the Capitol stood no chance of overthrowing the system. Supreme Court Justice John Roberts refrained from presiding over Trump’s second impeachment – differentiating it from the impeachment of a sitting president – without intervening to tell the Senate whether it could impeach a previous president. Going forward, however, the courts will act as a check on the Biden administration and therefore new controversies will arise. One of the Trump administration’s lasting legacies was to appoint three justices to the high court, creating a six-to-three conservative ideological leaning on the court. Since the Democrats won control of both the White House and Congress, the Supreme Court becomes a critical check on the administration and will thus attract opposition (Chart 10). Speculation about a conservative ideological takeover of the court has proved overrated, based on the court’s neutrality amid the election. Antagonism will inevitably increase going forward as Biden moves away from COVID relief and economic welfare to his larger legislative agenda. Yet the second reconciliation bill, which features infrastructure and green energy investments, would have to include major surprises to create anything as controversial as the dispute over the individual mandate, which imposed a tax on citizens who did not purchase health insurance.3 In other words, a major clash over legislation is more likely only when the Senate Democratic majority removes the filibuster, the rule that effectively requires 60 votes in the Senate to pass regular legislation. This can happen but it does not appear imminent. Senator Joe Manchin of West Virginia opposes removing it, keeping the Democrats at least one vote shy of repealing it, though he has recently shown some flexibility by suggesting that the Senate return to the good old days when senators had to deliver a filibuster in person (and therefore the procedural hurdle was more burdensome to maintain). Chart 10Balance Of Power In The Three Branches Court Rulings And The Market Court Rulings And The Market Thus the main arena of friction between the Biden administration and the judiciary will boil down to executive action, as with the Trump administration. Not all of this friction will be partisan but certainly ideological leanings will matter in the most important cases. While the number of Trump’s judicial appointments is often exaggerated – President Obama appointed more (Chart 11) – it is still the case that conservatives possess an improved ideological advantage due to the past few decades of appointments (Chart 12). So far Biden has faced pushback on his 100-day deportation moratorium. Chart 11Trump's Judicial Impact Overstated Court Rulings And The Market Court Rulings And The Market Chart 12Federal Courts A Bulwark For Conservatives Court Rulings And The Market Court Rulings And The Market Table 1 highlights the most investment-relevant Supreme Court cases coming due in the current session. The court will determine, among other things, whether Facebook can be treated similar to a telephone company in some respects; whether the federal government or states oversee cases brought against oil and natural and gas companies over climate change; and to what extent tech company acquisitions include patents and copyrights. The use of executive authority to reallocate funds that Congress has appropriated for different reasons, and state exemptions for Medicaid requirements, are also on the docket. Table 1Major Cases Pending At Supreme Court Court Rulings And The Market Court Rulings And The Market In addition we would identify several policy areas that are likely to become relevant to investors due to contemporary political and geopolitical concerns combined with historical precedent: National Security: The Trump administration relied heavily on the Supreme Court’s historic deference to presidents on issues involving national security and foreign policy. This tendency will likely continue, giving President Biden a freer hand in cases where he claims a national security justification, particularly in dealing with export controls vis-à-vis China. The hack into Microsoft’s Exchange email system, allegedly committed by Chinese state-backed hackers, highlights our Geopolitical Strategy view that the Biden administration will not reduce the US-China power struggle. Industrial Policy: The Supreme Court famously rebuked President Harry Truman for trying to seize control of private steel production during the Korean war (Youngstown Sheet & Tube Company v. Sawyer, 1952). Similar cases could emerge in an era in which the president is attempting to assert US government control over critical supply chains in health, tech, and defense. Immigration: The Supreme Court rebuked the Trump administration on the question of the “Dreamers,” undocumented immigrants brought to the US as children, whom the Obama administration refused to deport under an initiative called Deferred Action for Childhood Arrivals (DACA). The court said the Trump administration failed to provide adequate procedural justification for revoking the DACA program. Now the Biden administration’s executive orders loosening immigration and border controls face challenges from lower courts that could ascend the ladder. Also, following from the logic of Trump’s defeat on this issue, it is possible that the Supreme Court could overturn some of Biden’s revocations of Trump’s orders if not adequately justified. Environment: The Biden administration has pledged to phase out the fossil fuel industry over time, yet legislative majorities will be lacking and much of the activity occurs on private land free from direct federal control. The result is that Biden administration will revive regulatory expansions from the Obama era to attempt to raise the cost of carbon emissions. These actions will likely provoke court rulings. Labor: One of the Clinton presidency’s biggest legal controversies, outside the impeachment, centered on executive orders aimed at stopping businesses from hiring replacements for workers who went on strike. The Biden administration explicitly aims to have a muscular policy on labor regulation and to promote union interests and these could run afoul of the courts. Big Tech and free speech: The court has just ruled with an eight-to-one majority in favor of a free speech case on campus. The only reason Chief Justice Roberts dissented was because the case was moot. Future cases may not be moot in an era in which first amendment quarrels are heating up as Big Business, Big Tech, and mainstream media ramp up censorship of disfavored speech. The Supreme Court is likely to enforce first amendment protections robustly which could result in breaking open the digital arena for alternative platforms and services with looser standards. Bottom Line: With Democratic control over the White House and Congress, the judicial branch will become a critical source of limitations on the Biden administration’s policies. While controversial cases could possibly arise from any ambitious proposals in Biden’s second reconciliation bill, the main source of friction will center on executive orders. This is the case at least until the filibuster is removed, which is possible down the road but not imminent. Could Democrats Pack The Court? Finally there is an ongoing concern over the risk of “court packing,” i.e. partisan enlargement of the Supreme Court, under the Biden administration. During the 2020 campaign several leading Democratic Party figures suggested the party could increase the size of the high court so as to reduce the six-to-three conservative leaning. The threat was partly intended to motivate the progressive voting base and deter the Republicans from going forward with the confirmation of Supreme Court Justice Amy Coney Barrett ahead of the election. However, the possibility of court packing remains as long as polarization is extreme and the ruling party has at least 51 votes needed to repeal the filibuster in the Senate. President Biden said he was “not a fan” of court packing but one of his first acts in office was to appoint a commission of experts to study the idea of Supreme Court reform. This can be interpreted as a way of sidelining the question or as a preliminary to packing the court should it become possible later. Packing the court is politically explosive so while Democrats could remove the filibuster if and when they get the votes, they are less likely to succeed at packing the vote due to public opinion (though it cannot be ruled out over the long run). The bar to altering the filibuster is much lower than that to changing the composition of the court. History suggests that it would be a market-relevant episode if court packing were attempted. Franklin Delano Roosevelt attempted to pack the court after it ruled elements of the New Deal unconstitutional, notably a wage hike mandated by the National Industrial Recovery Act (Schechter Poultry Corp. v. United States, 1935). Roosevelt narrowly fell short of expanding the court after the Senate majority leader, a key ally, passed away unexpectedly. The S&P rallied when higher wages were struck down but there are many reasons for these developments – industrial production was rallying at the time, and when industrial production recovered later, and court packing was ruled out, the market remained low. At minimum one cannot say the case was inconsequential to the market (Chart 13). Chart 13FDR Tried To Stack The Courts FDR Tried To Stack The Courts FDR Tried To Stack The Courts In a more recent example of a Supreme Court ruling having a substantial market impact, the court ruled with a narrow five-to-four vote to uphold the legality of most of the Affordable Care Act, or Obamacare, the signature legislative effort of Obama’s presidency (National Federation of Independent Business v. Sebelius, 2012). The market reaction at that time was positive, even in the health care sector, as the result removed uncertainty. Only later, in 2015, when the major provisions of the law took effect, did the sector start to feel the negative effects (Chart 14). It is reasonable to expect that any showdown over a major piece of legislation and the courts would have a similar impact today: the market would struggle with uncertainty but rally on the verdict. Chart 14Supreme Court Ruling On Obamacare Had Market Impact Supreme Court Ruling On Obamacare Had Market Impact Supreme Court Ruling On Obamacare Had Market Impact Otherwise the Supreme Court’s ideological balance will likely be in place for a while. Justice Stephen Breyer, appointed by President Clinton, is 82 years old while Justice Clarence Thomas, appointed by President Bush, is 72 years old. The other justices are all younger than 66, meaning that conservatives would retain a five-to-four advantage even if Biden had the chance to replace both Breyer and Thomas. Bottom Line: As things stand, court packing is out of reach, more so than removing the filibuster, and therefore the current Supreme Court balance will remain an effective check on the Biden administration. Investment Takeaways The judicial system will become the major check on the Biden administration if its second reconciliation bill contains surprisingly ambitious and controversial provisions or if the Democrats ever get the votes to remove the filibuster. Otherwise the court is primarily a check on Biden’s executive orders. Climate policy is a likely area of friction given that the Biden administration will attempt to pioneer new areas of federal involvement in raising the cost of private industry when it comes to carbon emissions. At the same time the court could insist that the digital arena is a common forum where different voices must be heard, which could open the way to competitors to the tech giants. While the energy sector faces policy risks, it is favored by cyclical economic factors and will also benefit from checks and balances. Whereas the tech sector is not cyclically favored and could face some pushback from courts regarding competition (Chart 15). US rule of law is mostly intact. The selloff in the dollar and treasuries is driven by cyclical factors, not a structural loss of confidence in the rule of law or the American legal and political system. The Trump saga did not in itself trigger a collapse of the US dollar or government bonds – what did that was the Federal Reserve’s shift back to ultra-easy policy and the blowout fiscal spending stemming from the COVID-19 crisis. The US dollar is bouncing on the strong outlook for the economy as well as political stabilization. Chart 16 highlights that this is a near-term risk to cyclical sectors. Assuming the dollar resumes its cyclical weakening path it will power the next leg of outperformance for these sectors. Chart 15Courts Could Impact Energy, Tech Courts Could Impact Energy, Tech Courts Could Impact Energy, Tech Chart 16Dollar Bounce A Near-Term Risk To Cyclical Outperformance Dollar Bounce A Near-Term Risk To Cyclical Outperformance Dollar Bounce A Near-Term Risk To Cyclical Outperformance   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com     Appendix Table A1Political Risk Matrix Court Rulings And The Market Court Rulings And The Market Table A2Political Capital Index Court Rulings And The Market Court Rulings And The Market Table A3APolitical Capital: White House And Congress Court Rulings And The Market Court Rulings And The Market Table A3BPolitical Capital: Household And Business Sentiment Court Rulings And The Market Court Rulings And The Market Table A3CPolitical Capital: The Economy And Markets Court Rulings And The Market Court Rulings And The Market Table A4Biden’s Cabinet Position Appointments Court Rulings And The Market Court Rulings And The Market   Footnotes 1     The World Bank uses expert judgment and opinion polls to evaluate rule of law, defined as quality of contract enforcement, property rights, and functioning of the law and justice systems. Biases stem from the policy elite and non-governmental organizations of the western world. For instance, Hong Kong’s high rankings have all too predictably been undercut by Communist China’s power grab there.              2     Polarization escalated after Roe v. Wade and similar rulings that legalized abortion (1973), the Bush v. Gore ruling that decided the 2000 election, the NFIB v. Sebelius ruling that approved the Affordable Care Act (2012), and the Obergefell v. Hodges ruling that legalized gay marriage (2015).   3    The individual mandate is not expected to get shot down by the court this year, though it is conceivable. Even so, Biden’s second reconciliation bill would give the Democrats the chance to respond to any court ruling on health care reform. Biden’s health initiatives of automatic enrollment and government-provided insurance will be challenged but do not seem as controversial as the individual mandate in principle.       

Highlights The Senate will pass the $1.9 trillion American Rescue Plan largely as it stands. Markets will now turn to Biden’s second major reconciliation bill for FY2022 – the one with tax hikes. Democrats will go forward with tax hikes on corporations and the wealthy. But they will spend more than they tax for fear of squandering their term in power. Tax hikes threaten sectors like tech that already face headwinds from rising bond yields. The health sector is also at risk. Stick with cyclicals and value plays.  Feature Markets have seesawed as volatility spikes in the face of rapidly rising bond yields. Value stocks such as financials stand to benefit relative to growth stocks as the market comes to grips with the first hint of normal inflation expectations since 2019 (Chart 1). Underlying the trend is a sea change in US fiscal policy. Chart 1Value Stocks To Reignite On Rising Bond Yields Value Stocks To Reignite On Rising Bond Yields Value Stocks To Reignite On Rising Bond Yields The House of Representatives passed the $1.9 trillion American Rescue Plan so it will now go to the Senate for revision, back to the House for approval, and then to President Biden’s desk by around March 14. Investors will now turn to Biden’s second major legislative act prior to the 2022 midterm election cycle: the fiscal year 2022 budget reconciliation process. Before we outline the time frame and tax hikes that that process will entail, we should take a moment to review the current bill. Senate Will Pass American Rescue Plan Largely As Is The House version of the $1.9 trillion American Rescue Plan contains $1,400 household rebates, direct checks via the Internal Revenue Service, for people who make less than $75,000 per year (double those numbers for married couples). Unemployment benefits are supposed to rise from $300 to $400 per week for 73 weeks instead of 50 weeks, with an expiration on August 29 instead of March 14. Those with children or other dependents will receive additional payments. The bill also includes $75 billion for fighting COVID-19, $350 billion for state and local governments, $170 billion for schools and universities, $225 billion for small business, $38 billion for the airline industry and various other tax benefits for families and workers.1 Those who have been let go from their jobs can more easily retain their previous health insurance. Chart 2 provides a visual comparison of the American Rescue Plan with the $900 billion in fiscal relief passed at the end of 2020 prior to House passage and Senate revision. Already the Senate version excludes a hike to the minimum wage, from $7.25 to $15 per hour, as the Senate parliamentarian ruled that does not qualify under the “Byrd rule” because it does not directly impact spending or taxation.2 Vice President Kamala Harris, who is also president of the Senate, could reverse this decision but otherwise the minimum wage will have to be considered in a separate bill later. Chart 2American Rescue Plan Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The Senate could pare back other aspects of the bill – such as state and local aid, given that local government revenues are in much better shape than expected. Chart 2 highlights that the state and local aid component is much larger this time around. Still, the purpose of Senate negotiations is to secure the votes of moderate Democrats, as winning over 10 Republicans is no longer feasible, and moderate senators are not going to sink the first legislative proposal of a president of their own party. The Senate is virtually guaranteed to pass the bill, likely by March 14 when current unemployment benefits expire. The bill’s economic impact will be to speed the vaccination process and provide another infusion of cash into households and various public institutions. Families are just starting to receive the last round of benefits passed in December and they had not exhausted the 14% year-on-year increase in real income that they saw as a result of last year’s CARES Act when the Coronavirus Response and Relief Act sent incomes soaring yet again (Chart 3). Economic growth will be supercharged as economic activity normalizes, consumer confidence recovers, and the service sector revives. Chart 3Washington Lavishes Households With Dole Washington Lavishes Households With Dole Washington Lavishes Households With Dole Biden’s Second Bill Will Pass This Fall The second budget reconciliation procedure, for fiscal year 2022, will begin in mid-April. The formal deadline to adopt a budget resolution is April 15 but the average delay would put the resolution in June.3 The maximum delay would see the resolution passed in October but that is unlikely in today’s context (Diagram 1). After the resolution passes, the House and Senate must reconcile their budgets, pass the same bill, and send it to the president for his signature.  Diagram 1Timeline Of Biden Administration’s Second Budget Reconciliation, FY2022 Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The average time between Congress adopting a budget resolution and the president signing a reconciliation bill into law is 150 days, putting completion on September 15, 2021. This period could easily extend to November. In the worst-case, judging by history, Democrats could fail to conclude the process until October 2022 – but that is highly unlikely. A delay till December of this year would be a fumble, but a more realistic fumble, say if moderate Democrats must be won over due to controversial provisions. The second reconciliation bill is supposed to consist of investments over a ten-year period rather than emergency relief for the lingering pandemic and economic recovery. Biden’s proposed $2-$3 trillion green infrastructure program is the highlight but we also expect Democrats to prioritize their health care plan, which is estimated to cost $1.7-$1.9 trillion. Hence $4 trillion is a reasonable expectation for new spending but in this case the headline spending figure will be at least partially defrayed by tax hikes, unlike the first reconciliation bill (Charts 4A & 4B). If Biden raises taxes by half as much as he intends, the full price tag would be $2 trillion. Chart 4ABiden Will Spend, Then Tax Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Chart 4BBiden Will Spend, Then Tax Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The precise contours of this bill will remain unknown until Biden presents an outline in April and the House of Representatives drafts a resolution. We test six different scenarios involving different assumptions about Biden’s tax-and-spend proposals, highlighted in Table 1. Generally, we assume that Democrats will much more readily compromise tax hikes rather than spending, given that they want to err on the side of firing up the economic recovery. They are just as capable as Republicans were in 2017 of manipulating the numbers when it comes to the reconciliation requirement that the budget deficit not increase beyond a ten-year time period. Table 1Scenarios For Biden’s Second Reconciliation Bill Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The results are broken down in terms of revenue, expenditure, and net interest costs in Chart 5. The baseline is Biden’s campaign proposal. Scenario 1 assumes that Biden gets all of the spending he wants but is forced to compromise on tax hikes. Scenario 2 is more realistic as it assumes that Biden gets half of what he wants on both spending and taxes. Scenarios 3-6 examine what would happen if Biden were forced to strike out either his green infrastructure plan or his health and social security plan, depending on different revenue assumptions. In Scenarios 5 and 6 we grant Biden only half of his proposed taxes on corporations and wealthy folks, leaving other tax proposals to the side – otherwise the result would be a net tightening of fiscal conditions, which is neither intended nor politically possible. Chart 5Scenarios For Biden’s Second Reconciliation Bill Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The impact on the budget deficit in each scenario is shown in Chart 6. The greatest economic stimulus would occur under Scenario 1, which would soon become a problem for investors as it would hasten inflation and rising interest rates. Chart 6Deficit Scenarios For Biden’s Second Reconciliation Bill Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Scenario 2 is the most realistic policy scenario while being the least inflationary. By contrast, Scenario 4 is realistic but hardly less inflationary than the baseline case. In each of these scenarios it is important to bear in mind that the new government programs would be administered over a ten-year period and therefore the increase to the budget deficit would be more gradual than is the case of the American Rescue Plan, which clearly aims to be disbursed in the first few years. In the case of the Obama administration’s American Recovery and Reinvestment Act (2009) the peak in spending occurred in 2013, four years after the bill was passed (analogous to 2025 today) (Chart 7). Infrastructure and green energy projects are also expected to increase productivity and hence potential growth. Chart 7Infrastructure Spending Could Peak Four Years After Bill’s Passage, As In 2009-13 Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The Byrd rule will become even more important with Biden’s second reconciliation bill because the bill will contain a mishmash of Biden’s campaign proposals. Democrats will try to pass as much of their agenda via fast track as possible so as to meet promises ahead of the 2022 midterm election. An advantage of health care spending is that it is unlikely to be struck down by the Senate parliamentarian given that the Obama administration relied on reconciliation to pass a critical second installment to the Affordable Care Act (Obamacare). Biden’s health care plan is more popular than climate change policy, with both the general public and moderate Democrats, and it is guaranteed to pass reconciliation. Infrastructure spending faces greater challenges under reconciliation but they are not insurmountable. Infrastructure is normally handled via the traditional budget process or the Highway Trust Fund and some measures are likely to run afoul of the Byrd rule. Still, workarounds can be found.4  Hence the infrastructure plan is likely to be compromised but not prohibited due to technicalities. Even if infrastructure fails to make it into reconciliation, Biden can use the deadline to top up the exhausted Highway Trust Fund or to reauthorize the Surface Transportation Act as alternative pathways. It is not impossible to get Republican cooperation on infrastructure though the green agenda will meet resistance. The reconciliation process is nominally forbidden from increasing the budget deficit beyond ten years. Short-term spending is exempt, as is the case with the American Rescue Plan and its crisis-response measures, but the purpose of the second reconciliation bill is to invest in long-term, productivity-enhancing programs. A new government health insurance option and/or a green infrastructure buildout will take many years to implement and could increase deficits beyond the ten-year window. But Democrats, like Republicans, will be able to use accounting chicanery and gimmicks to make the budget outlook serve their purposes in passing the legislation. As long as they keep moderate members of the party on their side.   Yes, Taxes Will Go Up … But That May Not Be All Bad For Markets Why should Democrats raise taxes at all? Why not focus on stimulus without taking on the political risk of higher taxes? After all, Republicans passed tax cuts via reconciliation without offsetting them by spending cuts. Was it not the higher taxes in Obamacare that greatly fueled resistance from Republicans and their victory in the House of Representatives in 2010? First, on the level of intentions, the Democrats clearly seek to increase taxes on corporations, high-income earners, and capital gains: Both Biden and Harris said they would raise taxes on the campaign trail and in the presidential debates despite the risk to their election prospects. Biden committed only to prevent tax hikes on those making less than $400,000 per year. Harris’s weakest moment in her debate with Mike Pence was her insistence that she would raise taxes but she stuck to her guns. Both factions of the Democratic Party want to raise taxes. Traditional Democrats view tax hikes as a way of paying for a larger government role in addressing social and economic imbalances. Populists view tax hikes as a way of redistributing from the ultra-rich. While budget deficits are not a general concern, combating inequality is a theme shared across the party. Second, on the level of capability, Democrats can get at least some of the tax increases that they want: The US is not overtaxed on the whole. True, Biden’s full tax agenda would push the US back up to the top of the OECD countries in terms of the corporate tax if an “integrated” view of both firm-level taxes and taxes on dividends and capital gains (Chart 8). But this point suggests that Biden will moderate his tax plan rather than abandon it altogether. Popular opinion did not favor Trump for cutting corporate taxes. Chart 8Biden’s Corporate Tax Proposal Would Make US An Outlier Again Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The macroeconomic impact of raising taxes is manageable in the context of the extraordinary fiscal stimulus that the US is passing. There is no clear relationship between tax rates and economic growth but it is natural for the Democrats to fear that they could squander their term in power by excessive fiscal tightening. Yet the negative economic impact of raising the corporate rate is only 0.8% of GDP over the long run, and half of that if the corporate rate is raised only halfway to what Biden intends (25% instead of 28%) (Table 2), according to the conservative-leaning Tax Policy Foundation. Table 2Economic Impact Of Corporate Tax Not Dramatic Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout President Biden has the political capital early in his term to revise the Trump tax cuts according to Democratic prerogatives. His popularity will not hold up for long (Chart 9). And he only just has enough legislative power. While household sentiment is weak and economic conditions are moderate, both are set to improve as the pandemic fades and fiscal stimulus takes effect (Table 3). While tax hikes will embolden Republican opposition and the Democrats will have lost their chance to affect the tax code if Republicans win in 2022. At the moment, Republicans are divided and unpopular, so Democrats have a window of opportunity (Chart 10). Chart 9Thesis, Antithesis, Synthesis? Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Chart 10Independents Up, Republicans Down Independents Up, Republicans Down Independents Up, Republicans Down Table 3Political Capital Index Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout While Democrats could chuck all the Senate rules out the window in order to pass their spending plans without any offsets, this would anger moderates who tend to uphold Senate rules and norms. The party cannot afford to lose a single vote from their caucus in the Senate. Yet moderate Democrats are not against tax increases in principle. What they would oppose is either excessive tax hikes or a fiscal spending bonanza without any revenue offsets at all.5  It is entirely feasible to back-load tax increases so that they take effect in the latter half of the ten-year budget window, especially after the 2024 election. Treasury Secretary Janet Yellen is advising precisely this course of action and has herself argued that corporate tax hikes will go through.6 There may be some risk that Democrats go full left-wing populist and abandon any semblance of fiscal responsibility so as to supercharge the economy. So far they have agreed to maintain the Senate filibuster and scrap the minimum wage hike but this acceptance of Senate norms may not last as pressure builds. The second reconciliation bill is the last chance to fast-track major initiatives before the midterm. Vice President Harris could overrule the Senate parliamentarian across the board. This scenario is unlikely. The White House and Congress will find a balance that raises some revenue but errs on the fiscally accommodative side, as our scenarios above highlight. Investment Takeaways The market’s concern is that the Democrats will “overdo” the fiscal response and we fully share this concern. The American Rescue Plan alone will plug the output gap by almost three times more than the amount required. The coming tax hikes will not offset the wave of new spending that is coming down the pike. Democrats will partially reverse Trump’s tax cuts in the context of additional pump-priming that constitutes a net increase to the budget deficit. The net effect is inflationary.   If Congress were to pass another $2 trillion bill without any substantial revenue offsets then the market would face an even bigger inflationary jolt and an even earlier return to rate hikes by the Fed. But this scenario is unlikely. So the inflationary risk is clear but investors need not panic in the short run.  Our infrastructure trade is back on track as the reflation trade rumbles onward (Chart 11). The Democrats will get at least one more major bill passed and it will likely include at least half of Biden’s agenda, including around $2 trillion on green infrastructure. We will discuss the renewable energy portion at length in a forthcoming report. The health care sector faces headwinds from both Biden’s health policies and corporate tax hikes. The sectors that stand to benefit the most from a higher corporate tax rate are those that benefited least from Trump’s Tax Cut and Jobs Act – namely energy, industrials, materials, and financials, in that order (Chart 12A). These are also the cyclical plays that we favor in today’s accommodative policy environment. Chart 11Infrastructure Trade Back On Track Infrastructure Trade Back On Track Infrastructure Trade Back On Track   Chart 12ACyclicals Outperforming Health Care Cyclicals Outperforming Health Care Cyclicals Outperforming Health Care Chart 12BCyclicals To Outperform Tech? Cyclicals To Outperform Tech? Cyclicals To Outperform Tech? The same cyclical sectors are also trying to make headway against the tech sector, which stands to suffer from higher interest rates as well as higher taxes, including a minimum tax on book earnings, if that part of Biden’s agenda makes it through the negotiations this fall (Chart 12B).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A1BPolitical Capital: Household And Business Sentiment Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A1CPolitical Capital: The Economy And Markets Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A2Political Risk Matrix Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A3Biden’s Cabinet Position Appointments Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Footnotes 1See Jeff Drew, “House passes $1.9 trillion stimulus bill with a variety of small business relief,” and Alistair M. Nevius, “Tax provisions in the American Rescue Plan Act,” February 27, 2021, Journal of Accountancy, journalofaccountancy.com.     2See “The Budget Reconciliation Process: The Senate’s ‘Byrd Rule,’” Congressional Research Service, December 1, 2020, fas.org.            3The current delay centers on whether the Senate will confirm Biden’s appointee for director of the Office of Management and Budget, Neera Tanden, who lost support from key moderate Democrat Joe Manchin. If she does not receive a compensatory Republican vote then Biden will have to appoint someone else and the Senate will have to confirm. Thus the budget resolution could easily be delayed into May or June.       4For the difficulties, see Peter Cohn, “Democrats plan a spending blowout, but hurdles remain,” Roll Call, January 11, 2021, rollcall.com. For workarounds, see Zach Moller and Gabe Horwitz, “Reconciliation: How It Works and How to Use It to Help American Workers Recover,” Third Way, February 1, 2021, thirdway.org. 5See Alexander Bolton, “Democrats hesitant to raise taxes amid pandemic,” The Hill, February 25, 2021, thehill.com. 6See Saleha Mohsin and Christopher Condon, “Yellen Favors Higher Company Tax, Signals Capital Gains Worth a Look”, Bloomberg, February 22, 2021, Bloomberg.com  

Highlights We use a correlation-hedge approach to manage emerging market (EM) currency exposure for global investors with nine different home currencies. For USD-based investors, EM debt volatility is driven by the EM spot exchange rate vs. USD. Hedged EM debt has better absolute and risk-adjusted returns than US Treasurys. Investing in EM equities, on the other hand, makes sense only when the expected absolute return is positive on a sustained basis. During these episodes, hedging is not necessary. If USD-based investors choose to manage EM currency exposure directly, then a 12-month momentum-based dynamic hedging strategy could add value in terms of risk-adjusted returns for both EM stocks and bonds. USD-based investors could also diversify the source of funding by selling closely correlated DM currencies using an overlay of currency forwards. For non-USD-based investors, EM currency volatility is low and there is no need to fully hedge EM exposure. Domestic bonds have very low volatility, therefore these investors should avoid EM debt if their objective is to maximize risk-adjusted returns. To enhance returns, unhedged EM equities are a much better choice than EM debt. Currency overlay, in line with our long-held view on the total portfolio approach, should be managed at the total fund level. Feature How to manage EM currency exposure when investing in EM local currency debt and equities has been a frequently asked question since our reports on managing developed market (DM) currency exposure when investing in DM equities 1,2 and government bonds.3 According to the BIS Triennial Central Bank Survey, EM currency exchange markets have evolved rapidly since 2001. The daily turnover reached 1.65 trillion dollars in April 2019, which is about 25% of the global currency daily turnover.4 While it is becoming increasingly easy to trade EM currencies, compared with DM currencies it is still more costly and operationally more challenging to hedge EM currency exposure, especially the currencies with non-deliverable forwards (NDFs) that require collateral management. In this report, we identify the return and volatility drivers of EM local currency government bonds (represented by JP Morgan’s GBI-EM Global Diversified Local Currency Index) and EM equities (represented by MSCI’s EM Net Return Index). We briefly touch on a momentum-based dynamic hedging strategy to hedge EM exposure directly for USD-based investors. Our main focus is to test a correlation-hedge approach, both static and dynamic, for nine home currencies: the US dollar (USD), the euro (EUR), the Japanese yen (JPY), the British pound (GBP), the Canadian dollar (CAD), the Australian dollar (AUD), the New Zealand dollar (NZD), the Swedish krona (SEK), and the Norwegian krone (NOK). We want to determine if a USD-based investor’s return/risk profile would be improved when investing in EM assets by using unfunded overlays of DM currency forwards. Finally, we present solutions for non-USD investors, which vary based on the correlations between the home currencies and the EM currency aggregates. Part 1: The USD Perspective 1.1 EM Asset Return Drivers In general, unhedged USD returns for US investors from investing in foreign assets can be decomposed into three parts as shown in the following equation (1): (1+Rd) = (1+Rh) (1+Rc) (1+Rs) ..…..(1) Where, Rd is the unhedged return in USD. Rh is the hedged return in USD using currency forwards. Rc is the carry return resulting from the short-term rate differential between a foreign country and the US. Rs is the spot exchange rate return of a foreign currency vs. the USD (quoted as how many USD per 1 unit of foreign currency). Chart 1A and Chart 1B show the return decompositions of JP Morgan’s (JPM) EM local currency government bonds and MSCI’s EM equities based on equation (1). Chart 1AEM Local Debt USD Return Decomposition EM Local Debt USD Return Decomposition EM Local Debt USD Return Decomposition Chart 1BEM Equities USD Return Decomposition EM Equities USD Return Decomposition EM Equities USD Return Decomposition Hedging reduces both the volatility and returns for both EM local currency bonds and equities; however, the return and volatility reductions are more significant in bonds than in stocks (panel 1 in Chart 1A and Chart 1B). EM currency aggregate indexes implied from JPM and MSCI are different because of the different country compositions. The currency component has been very volatile for both indexes and has generated negative returns during the 18 years from January 2003 to January 2021 (panel 3 in Chart 1A and Chart 1B). The carry component from JPM is sharply higher than that from MSCI, which is also the result of different country compositions (panel 2, Chart 1A and Chart 1B). The carry components from both indexes have very low volatility with positive returns over the 18-year period. Many EM countries had much higher interest rates than the US, therefore a US investor had to be exposed to EM currencies to capture this carry gain. Thus, from a return-enhancing perspective, an investor should hedge only if he/she expects the EM currency spot exchange rate to depreciate more than the implied carry (panel 3, Chart 1A and Chart 1B). The answer may be different from a volatility-reducing perspective, especially for EM debt where currency volatility dominates bond volatility. We plot the return-risk profiles of EM local currency bonds and equities (hedged and unhedged) in Charts 2A, 2B and 2C to show how they behave in different environments compared to US equities, US Treasurys and hedged non-US global government bonds. Table 1 further lists the detailed statistics of all the above-mentioned assets, in addition to the spot currency and carry components implied from JPM’s EM local currency bond index and MSCI’s EM index, ranked by risk-adjusted return. The entire 18-year period (Chart 2A) is also separated into the period with steadily rising EM currencies (1/2003 – 7/2008, Chart 2B) and the period with declining EM currencies (8/2008-1/2021, Chart 2C). Chart 2AUSD Asset Return-Risk Profile For The Entire Period (1/2003-1/2021) Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Chart 2BUSD Asset Return-Risk Profile When EM Currencies Were Strong (1/2003-7/2008) Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Chart 2CUSD Asset Return-Risk Profile When EM Currencies Were Weak (8/2008-1/2021) Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Both EM debt and equities had impressive unhedged returns in the period from January 2003 to July 2008 when the EM currency index rose steadily against the USD. Even on a hedged basis, EM bonds still delivered better absolute returns (5.1%) than US Treasurys (4.3%) with lower volatility. In terms of EM equities, although hedged return of 22.8% significantly outpaced US equities (9.7%), the volatility of EM equities (16.8%) was much higher than US equities (9.8%). Interestingly, in the period with declining EM FX from August 2008 to January 2021, hedged EM equities (5.6%) significantly underperformed US equities (11.5%) with comparable volatility, but hedged EM bonds (4.2%) outperformed US Treasurys (3.6%) with comparable volatility, despite the negative carry. It is easy to make the case for EM equities: US investors should not touch EM equities unless they are convinced that EM is entering a sustainably strong absolute return period. There is no need to hedge the currency exposure because the risk reduction is relatively small. In the case of EM local currency debt, the three components of total returns in USD based on equation (1) have distinct characteristics as follows: First, the carry component generated an annualized return of 3.4% with only 0.7% volatility in the entire period, making it the best performer among all the assets in terms of risk-adjusted return, as shown in Table 1. Table 1USD Asset Return-Risk Profile In Different Time Periods Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Chart 3What Drives The Hedged Return Of EM Local Debt? What Drives The Hedged Return Of EM Local Debt? What Drives The Hedged Return Of EM Local Debt? Second, the hedged return or the EM duration return (i.e. the compensation for a US investor to take on EM interest rate and term premia risks), had a better return/risk profile than US Treasurys in terms of both absolute return and risk-adjusted return, regardless of whether the EM currency index rose or fell against the USD. From January 2003 to January 2021, hedged EM debt returned 4.5% with a volatility of 4.1%, giving a 1.1 return per unit of risk, while US Treasurys returned 3.8% with a volatility of 4.3%, resulting in a 0.9 return per unit of risk. This component is mainly driven by the direction of government bonds in the developed markets as shown in Chart 3. Third, from January 2003 to January 2021, the JPM-implied EM currency had the worst return/risk profile with an annualized loss of 1.7% and annualized volatility of 9.1% (Table 1). However, this component was also the most regime-dependent. Between January 2003 and July 2008 it registered an annualized gain of 7.0% and an annualized volatility of 6.2%, in contrast with the annualized loss of 5.2% and annualized volatility of 9.9% from August 2008 to January 2021. Historically, the EM currency as an aggregate, no matter how the aggregate is calculated, closely correlates to commodities as shown in Chart 4. This is because many EM countries are either commodity producers or have significant trading exposure to China, the dominant player influencing commodity prices as shown in Chart 5. Chart 4EM FX Largely Driven By Commodities EM FX Largely Driven By Commodities EM FX Largely Driven By Commodities Chart 5The Commodities-China Link The Commodities-China Link The Commodities-China Link It is a challenge to build a systematic EM currency model due to the complex nature of EM economies. BCA’s FX Strategy team is working on EM currency models by applying the same approach they used for their DM models. BCA’s EMS Strategy team takes a more discretionary approach to forecasting currencies. Below we will explore two options: one for investors who choose to manage an EM FX hedging program directly and another for investors who cannot manage a direct EM currency hedging program but want to improve their return-risk profile in EM assets. 1.2 Momentum-Based Dynamic Hedging Of EM Currencies Price momentum is a useful tool for dynamic hedging as shown in our previous work on DM currency exposure management. A simple rule of hedging back to the home currency when the 12-month price momentum of a foreign currency turns negative adds value for investors with several DM home currencies. Given that the USD is a strong momentum currency, it makes sense to test if a simple 12-month price momentum rule for the EM FX aggregate vs. USD adds any value. The results are encouraging as shown in Chart 6A and Chart 6B and Chart 7A and Chart 7B. Chart 6AMomentum-Based Dynamic Hedging For EM Bonds Momentum-Based Dynamic Hedging For EM Bonds Momentum-Based Dynamic Hedging For EM Bonds Chart 6BMomentum-Based Dynamic Hedging For EM Stocks Momentum-Based Dynamic Hedging For EM Stocks Momentum-Based Dynamic Hedging For EM Stocks In the case of EM local debt, dynamic hedging reduced volatility to 8.4% from an unhedged volatility of 11.7%, while only trimming return slightly compared with the unhedged index (Charts 6A, 7A). For EM equities, dynamic hedging cut volatility to 18.6% from the unhedged volatility of 21.1%, while increasing the return by 25 bps, compared to the unhedged index. (Charts 6B, 7B). Chart 7AEM Local Debt Return-Risk Profiles: Static Hedging* Vs. Dynamic Hedging** Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Chart 7BEM Equities Return-Risk Profiles: Static Hedging* Vs. Dynamic Hedging** Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach These results are directionally encouraging, but this method still requires hedging all EM currencies. The approach may operationally challenge investors who are not equipped to manage EM currency overlays. Bottom Line: Using only price momentum to hedge EM currency aggregates could improve the return-risk profile of both EM debt and equities, even though the improvements would be limited. This is encouraging for our eventual systematic approach for direct EM currency hedging. 1.3 Correlation Hedge Using DM Currencies EM FX is closely correlated with DM commodity currencies, such as the NOK, CAD, AUD, and NZD. As shown in Charts 8A and 8B, even the euro has an average correlation greater than 60% with EM currency aggregates. Only the JPY has an unstable correlation with the EM currencies of less than 25%, while the GBP also has a relative lower correlation. Chart 8AJPM-Implied EM FX* Correlation** With DM FX JPM-Implied EM FX* Correlation** With DM FX JPM-Implied EM FX* Correlation** With DM FX Chart 8BMSCI-Implied EM FX* Correlation** With DM FX MSCI-Implied EM FX* Correlation** With DM FX MSCI-Implied EM FX* Correlation** With DM FX Therefore, a USD-based investor, instead of hedging out EM currency exposure directly, should be able to eliminate part of EM currency volatility by selling lower-yielding DM currencies. This move would diversify his/her source of funding from USD to other DM currencies with high correlations with EM currencies. To test the effect on the return-risk profile, we use an unfunded overlay of 1-month DM currency forwards and rebalance monthly. To begin, we test a static correlation hedge where each of the eight DM currencies is sold individually. Then we test a dynamic correlation hedge where each one is dynamically sold based on the BCA Forex Strategy Team’s Intermediate-Term Timing Model (ITTM), which uses the same indicators described in our DM currency hedging report. To avoid subjective selection bias among the currencies, we also test an equally- weighted basket of eight currencies (AUD, NZD, JPY, GBP, EUR, CAD, NOK, and SEK) for dynamic hedging and an equally- weighted basket of five currencies (GBP, EUR, CAD, NOK, and SEK) for static hedging. The AUD, NZD, and JPY were excluded in the static hedging basket because in general, AUD and NZD had very high carries and JPY had an unstable correlation with EM currencies. The combined results are shown in Chart 9A and Chart 9B. Additionally, Table 2A and Table 2B list the return-risk profiles together with the fully hedged and unhedged EM indexes for equities and local debt. Chart 9AStatic Correlation Hedge For US Investors Static Correlation Hedge For US Investors Static Correlation Hedge For US Investors Chart 9BDynamic Correlation Hedge For US Investors Dynamic Correlation Hedge For US Investors Dynamic Correlation Hedge For US Investors Table 2AEM Debt Funding Source Diversification For USD-Based Investors (2/2003-1/2021) Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Table 2BEM Equity Funding Source Diversification For USD-Based Investors (2/2003-1/2021) Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach For US investors investing in EM local currency bonds, the best risk-adjusted return of 1.08 would come from fully hedging all the EM currencies as shown in Table 2A. Fully-hedged EM debt has the lowest volatility (4.12%), but also the lowest return (4.45%). To achieve a comparable return of unhedged EM debt (6.18%) without incurring the same high volatility (11.71%), however, a USD-based investor could either statically sell the five DM currencies or dynamically sell the eight DM currencies. The resulting risk-adjusted return of 0.8 would still be comparable to US Treasurys as shown in Table 1. US investors investing in EM equities may improve their return-risk profile by funding their positions in DM currencies. If the aim is to maximize risk-adjusted returns, then the choice would be to fund the position by selling the basket of equally weighted five DM currencies using currency forwards (i.e. using a static correlation hedge). In this way, they would achieve a comparable volatility (16.25%) as if all the EM currencies were fully hedged to USD (16.29%), while also achieving a higher return (12.29%) than when all the EM currencies were not hedged (11.71%). The return per unit of risk of 0.76 would be the highest among all the cases as shown in Table 2B and be on par with US equities as shown in Table 1. If investors prefer even higher returns without significantly higher volatility, then dynamically selling an equally weighted basket of eight currencies would achieve an annualized return of 13.03% with a higher volatility of 18.71%, resulting in a risk-adjusted return of 0.7. Bottom Line: USD-based asset allocators should use the hedged EM debt index and the unhedged EM equities index as benchmarks to measure the performance of their asset-class managers. The EM currency exposure should be managed in a currency overlay at the total fund level by either statically or dynamically selling DM currencies using a correlation hedge, depending on the return-risk preferences. Part 2: Non-USD-Perspective Six out of the eight non-USD DM currencies have strong positive correlations with EM currencies as shown in Chart 8A and Chart 8B. Therefore, non-USD investors investing in EM assets should naturally experience less spot-currency volatility (Chart 10A and Chart 10B). Consequently, they do not need to hedge EM currency exposure from a volatility perspective. But what about return enhancement? Should they consider an allocation to EM assets in place of domestic assets? If they do, would the correlation-hedge approach used by USD-based investors benefit them too? Chart 10ADM Currency Per Unit Of EM Currency DM Currency Per Unit Of EM Currency DM Currency Per Unit Of EM Currency Chart 10BDM Currency Per Unit Of EM Currency DM Currency Per Unit Of EM Currency DM Currency Per Unit Of EM Currency To find answers to those questions, we compare the return-risk profiles of domestic assets, unhedged EM assets, and correlation-hedged EM assets in Table 3A and Table 3B. For the correlation-hedged results for non-USD investors, we simply use the results for the US investors converted into the non-USD home currencies at spot exchange rates. This way, the return enhancements from the correlation-hedged EM assets compared to the unhedged EM assets would be similar for all nine currencies. Chart 3AEM-Debt* For Non USD-Based Investors Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Table 3BEM-Stocks* For Non USD-Based Investors Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach We find that non-USD investors would do better to avoid local-currency EM debt if their objective is to maximize risk-adjusted returns because domestic government bonds had unbeatably low volatility, resulting in the highest risk-adjusted returns, as shown in Table 3A. But domestic government bonds had lower returns than unhedged EM bonds for all but AUD- and NZD-based investors. To further enhance the return-risk profile, non-USD investors could follow their US counterparts by dynamically diversifying their funding sources, then converting their USD returns into their home currency at spot exchange rates (i.e. not hedging the USD exposure). GBP- and JPY-based investors would benefit the most from a dynamic correlation hedge with higher returns and lower volatility compared with the unhedged case. In the case of EM equities, other than SEK- and NZD-based investors, unhedged EM equities have higher returns on an absolute and risk-adjusted basis compared with domestic equities, with GBP-, JPY- and euro-based investors benefiting the most (Table 3B). Even though NOK-based investors increased their returns by only 1% by putting funds into unhedged EM equities, they enjoy lower volatility than in domestic equities. Unlike the case for EM debt where a static correlation hedge did not improve over an unhedged case, both static and dynamic correlation hedges improve the return/risk profiles relative to the unhedged case, and the dynamic hedge outperforms the static hedge in each country. While domestic equities underperform domestic government bonds in terms of risk-adjusted returns, EM equities outperform EM local currency debt when a dynamic correlation hedge is applied. Even in the unhedged case, EM equities are still a much better choice than EM debt (Chart 11). To evaluate how this could impact an asset allocation, we replace home equity with EM equities in a 60/40 home equity/Treasury portfolio. In this extreme exercise, six of the eight non-USD-based portfolios could generate better return/risk profiles, with only the NZD- and SEK-based portfolios worse off (Chart 12). Chart 11Risk-Adjusted Return: Stocks Minus Bonds Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Chart 12Asset Allocation Implications* Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach     Bottom Line: Non-USD-based investors should avoid EM local debt if their objective is to maximize their risk-adjusted returns. For the purposes of return enhancement, EM equities are a much better choice than EM debt for all investors with the exception of those based in New Zealand and Sweden.   Xiaoli Tang Associate Vice President xiaolit@bcaresearch.com   Footnotes 1,2Please see Global Asset Allocation Special Reports, “Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors,” dated September 29, 2017; and "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors (Part II)," dated October 13, 2017. 3 Please see Global Asset Allocation Special Reports, “Why Invest In Foreign Government Bonds?” dated March 12, 2018. 4 Please see "Triennial Central Bank Survey Foreign exchange turnover in April 2019," Bank for International Settlements, dated 16 September 2019.

Dear Client From March 18 I will be writing under a new product title, the BCA Research Counterpoint. The aim of the Counterpoint is to generate a high volume of investment opportunities that are unconnected to the business cycle and run counter to the conventional wisdom. For those of you that have followed the European Investment Strategy through the past ten years, Counterpoint will seamlessly continue the same intellectual framework of investment ‘mega-themes’, fundamental analysis, fractal analysis, and sector primacy. The difference is that the investment opportunities will encompass all geographies. To whet your appetite, early Counterpoint reports will introduce new investment mega-themes including: the compelling structural case for cryptocurrencies; why shocks such as the pandemic are inherently predictable; and the structural transformation coming to the global labour market. There will also be an upgrade of the proprietary Fractal Trading System to generate more ideas per week and to boost the win ratio towards 70 percent. As for the European Investment Strategy, it will continue in the very capable hands of my colleague and friend, Mathieu Savary. Mathieu has previously written the Foreign Exchange Service, the flagship Bank Credit Analyst, and most recently the Daily Insights. Moreover, Mathieu is French. So if anyone knows how Europe works (and doesn’t work), it is Mathieu! I do hope you read both products. Best regards Dhaval Highlights If bond yields continue their march higher, the most dangerous earthquake will happen in the global real estate market. If higher bond yields caused even a 10 percent decline in the $300 trillion global real estate market it would unleash a deflationary impulse equal to one third of world GDP This would make any preceding inflationary impulse feel like a waltz in the park. For long-term investors who can ride out near term pain, there are three important conclusions: The ultimate low in bond yields is still ahead of us. The structural bull market in stocks will continue until bond yields reach their ultimate low. Equity investors should structurally tilt towards ‘growth’ sectors that will benefit from the ultimate low in bond yields. Feature Chart of the WeekThe Real Estate Market Dwarfs The Stock Market And The Global Economy The Real Estate Market Dwarfs The Stock Market And The Global Economy The Real Estate Market Dwarfs The Stock Market And The Global Economy In the last couple of weeks, higher bond yields have caused tremors in the stock market. But if bond yields continue their march higher and stay there, the most dangerous earthquake will not happen in the stock market, it will happen in the real estate market. The $90 trillion worth of the global stock market is large, but it is chicken feed compared with the $300 trillion worth of global real estate (Chart of the Week). The big worry is that the valuation of global real estate is critically dependent on bond yields staying low. If higher bond yields caused even a 10 percent decline in global real estate values, it would amount to a $30 trillion plunge in global wealth. Such a deflationary impulse, equal to one third of world GDP, would make any preceding inflationary impulse feel like a waltz in the park. Hence, to anybody worried that we are on the road to inflation, we pose a simple question. How would the world economy cope with the massive deflationary impact on $300 trillion of global real estate?1   The Real Risk Is Real Estate Over the past decade, global real estate rents have broadly tracked nominal GDP, as they should. But real estate prices have massively outperformed rents (Chart I-2). The reason is that the valuation paid for those rents has surged by 35 percent. This ‘multiple expansion’ of real estate which has added $80 trillion to global wealth – broadly equivalent to global GDP – is entirely due to lower bond yields. Chart I-2Real Estate Prices Have Massively Outperformed Rents And GDP Real Estate Prices Have Massively Outperformed Rents And GDP Real Estate Prices Have Massively Outperformed Rents And GDP Within the global real estate market, the residential segment constitutes 80 percent by value. Commercial real estate accounts for a little over 10 percent, and agricultural and forestry real estate makes up the remainder. It follows that the most important component of the real estate boom has been a housing boom. Given that most homes are owner-occupied, the boom in house prices has boosted the wealth of the ordinary global citizen by much more than the boom in stock prices. Moreover, the 2010s housing boom was unprecedented in its penetration and regional breadth, simultaneously encompassing cities, suburbs, and rural areas across North America, Europe, Asia and Australasia. Even Germany and Japan joined in, making it the most widely participated-in housing boom in economic history. What was behind this synchronised and broad-based housing boom? The answer is the universal decline in bond yields. As the global real estate firm Savills puts it: “Real estate has increased significantly in value, spurred on by the intervention of central banks and their suppression of bond yields” In fact, as the US and China now dominate the global real estate market, the downtrend in the global rental yield has closely tracked the downtrend in the US and China long bond yields. The big danger would be if this downtrend turned into an uptrend, undermining the valuation of $300 trillion of global real estate. To repeat, even a 10 percent synchronised decline in global real estate prices would wipe out $30 trillion of global wealth equal to one third of annual GDP, and it would impact almost everybody. The ‘multiple expansion’ of real estate has added $80 trillion to global wealth, broadly equivalent to global GDP. But where is the pain point? Our answer is that if inflation fears lifted the average US and China 30-year bond yield to 3.75 percent (from 3 percent now), it would constitute the change in trend that would unleash a massive countervailing deflationary impulse from falling house prices (Chart I-3). Chart I-3Higher Bond Yields Would Unleash A Massive Deflationary Impulse From Falling House Prices Higher Bond Yields Would Unleash A Massive Deflationary Impulse From Falling House Prices Higher Bond Yields Would Unleash A Massive Deflationary Impulse From Falling House Prices Waiting For Rationality To Return To Stocks In the stock market, the August to mid-February period was a brief aberration in which stocks rallied in tandem with rising bond yields. But looking at the bigger picture, the bull market in stocks, just as for real estate, is due to lower bond yields (Chart I-4). Chart I-4The August To Mid-February Rally In Stocks Was An Aberration The August To Mid-February Rally In Stocks Was An Aberration The August To Mid-February Rally In Stocks Was An Aberration Since 2008, global stock market profits have gone nowhere. Therefore, the only reason that the stock market surged is that the valuation paid for those unchanged profits surged. Just as for real estate, the stock market’s valuation surged because bond yields collapsed (Chart I-5). Chart I-5The Bull Market In Stocks Is Entirely Due To Higher Valuations The Bull Market In Stocks Is Entirely Due To Higher Valuations The Bull Market In Stocks Is Entirely Due To Higher Valuations Taking account of this downtrend in bond yields, the post-2008 boom in valuations is rational. However, as we warned two weeks ago, the continued expansion of valuations while bond yields are backing up means that The Rational Bubble Is Turning Irrational. The point of vulnerability is in high-flying tech stocks. Since 2009, the technology sector earnings yield has always maintained a minimum 2.5 percent premium over the 10-year T-bond yield, defining the envelope of the rational bubble. But in recent weeks, this envelope has been breached, indicating that valuation is entering a new and irrational phase (Chart I-6). Chart I-6The Rational Bubble Is Turning Irrational The Rational Bubble Is Turning Irrational The Rational Bubble Is Turning Irrational For long-term investors the pressing questions are: how much higher can bond yields go, and for how long? Our answers are, much less than 1 percent, and not for long – because the deflationary impact on $300 trillion of real estate would eventually force bond yields into a very sharp reversal. The Road To Inflation Ends At Deflation Many people believe that ‘real’ assets such as real estate and stocks perform well in an inflationary scare. But this is a misunderstanding. Granted, the income generated by real assets should keep pace with nominal GDP. But the valuation paid for that income collapses, taking the price of the asset down with it. From the state of price stability, in which most developed economies now find themselves, the creation of inflation is a non-linear phenomenon. Non-linear means that policymakers’ efforts result in either nothing (witness Japan or Switzerland), or in uncontrolled inflation (witness the US in the late 1960s). In fact, can you name any economy that has shifted from price stability to a controlled inflation? If you can, please tell me in an email! When an economy phase shifts from price stability to price instability, the valuations of real assets collapse. This is because the starting valuation needed to generate a given real return during uncontrolled inflation is much lower than during price stability. When an economy phase shifts from price stability to price instability, the valuations of real assets collapse. Chart I-7 should make this crystal clear. During the low-inflation 1990s and 2000s, a starting price to earnings multiple of 15 consistently generated a prospective 10-year real return of 10 percent. But during the uncontrolled inflation of the 1970s, the same starting multiple of 15 generated a real return of zero. To generate a real return of 10 percent, the starting multiple had to sink to 7. This explains why the prices of stocks and real estate collapsed in the 1970s and why they would collapse again in a new inflationary scare. Chart I-7In An Inflation Scare, Valuations Have To Collapse To Generate An Adequate Real Return In An Inflation Scare, Valuations Have To Collapse To Generate An Adequate Real Return In An Inflation Scare, Valuations Have To Collapse To Generate An Adequate Real Return As an aside, this also explains why so-called ‘financial repression’ – whereby the central bank holds down bond yields while the government generates inflation – will not work. While it is conceivable that a government could corner its government bond market and thereby repress it, it would be near-impossible to repress the much larger asset-classes of stocks and real estate. Once these large and privately priced markets sniffed out the government’s nefarious plan, the valuation of such assets would collapse to generate the previously required real return – the result being an almighty crash in stock and real estate prices. Given that the combined value of such markets dwarfs the $90 trillion global economy, the road to inflation would end at deflation. For long-term investors who can ride out near term pain, all of this leads to three important conclusions: The ultimate low in bond yields is still ahead of us. The structural bull market in stocks will continue until bond yields reach their ultimate low. Equity investors should structurally tilt towards ‘growth’ sectors that will benefit from the ultimate low in bond yields. Fractal Trading System* In a very successful week, short MSCI Korea versus MSCI AC World achieved its 10.6 percent profit target and short tin versus lead quickly achieved its 13 percent profit target. This takes the rolling 12-month win ratio to 60 percent. Given the transition to the new product title, there are no new trades this week. We look forward to introducing the upgraded Fractal Trading System and some new trades in the BCA Counterpoint on March 18. Chart I-8MSCI Korea Vs. MSCI All-Country World MSCI Korea Vs. MSCI All-Country World MSCI Korea Vs. MSCI All-Country World * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Source: Savills Prime Index: World Cities, August 2020; and Savills: 8 things to know about global real estate value, July 2018. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights The Senate will pass the $1.9 trillion American Rescue Plan largely as it stands. Markets will now turn to Biden’s second major reconciliation bill for FY2022 – the one with tax hikes. Democrats will go forward with tax hikes on corporations and the wealthy. But they will spend more than they tax for fear of squandering their term in power. Tax hikes threaten sectors like tech that already face headwinds from rising bond yields. The health sector is also at risk. Stick with cyclicals and value plays.  Feature Markets have seesawed as volatility spikes in the face of rapidly rising bond yields. Value stocks such as financials stand to benefit relative to growth stocks as the market comes to grips with the first hint of normal inflation expectations since 2019 (Chart 1). Underlying the trend is a sea change in US fiscal policy. Chart 1Value Stocks To Reignite On Rising Bond Yields Value Stocks To Reignite On Rising Bond Yields Value Stocks To Reignite On Rising Bond Yields The House of Representatives passed the $1.9 trillion American Rescue Plan so it will now go to the Senate for revision, back to the House for approval, and then to President Biden’s desk by around March 14. Investors will now turn to Biden’s second major legislative act prior to the 2022 midterm election cycle: the fiscal year 2022 budget reconciliation process. Before we outline the time frame and tax hikes that that process will entail, we should take a moment to review the current bill. Senate Will Pass American Rescue Plan Largely As Is The House version of the $1.9 trillion American Rescue Plan contains $1,400 household rebates, direct checks via the Internal Revenue Service, for people who make less than $75,000 per year (double those numbers for married couples). Unemployment benefits are supposed to rise from $300 to $400 per week for 73 weeks instead of 50 weeks, with an expiration on August 29 instead of March 14. Those with children or other dependents will receive additional payments. The bill also includes $75 billion for fighting COVID-19, $350 billion for state and local governments, $170 billion for schools and universities, $225 billion for small business, $38 billion for the airline industry and various other tax benefits for families and workers.1 Those who have been let go from their jobs can more easily retain their previous health insurance. Chart 2 provides a visual comparison of the American Rescue Plan with the $900 billion in fiscal relief passed at the end of 2020 prior to House passage and Senate revision. Already the Senate version excludes a hike to the minimum wage, from $7.25 to $15 per hour, as the Senate parliamentarian ruled that does not qualify under the “Byrd rule” because it does not directly impact spending or taxation.2 Vice President Kamala Harris, who is also president of the Senate, could reverse this decision but otherwise the minimum wage will have to be considered in a separate bill later. Chart 2American Rescue Plan Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The Senate could pare back other aspects of the bill – such as state and local aid, given that local government revenues are in much better shape than expected. Chart 2 highlights that the state and local aid component is much larger this time around. Still, the purpose of Senate negotiations is to secure the votes of moderate Democrats, as winning over 10 Republicans is no longer feasible, and moderate senators are not going to sink the first legislative proposal of a president of their own party. The Senate is virtually guaranteed to pass the bill, likely by March 14 when current unemployment benefits expire. The bill’s economic impact will be to speed the vaccination process and provide another infusion of cash into households and various public institutions. Families are just starting to receive the last round of benefits passed in December and they had not exhausted the 14% year-on-year increase in real income that they saw as a result of last year’s CARES Act when the Coronavirus Response and Relief Act sent incomes soaring yet again (Chart 3). Economic growth will be supercharged as economic activity normalizes, consumer confidence recovers, and the service sector revives. Chart 3Washington Lavishes Households With Dole Washington Lavishes Households With Dole Washington Lavishes Households With Dole Biden’s Second Bill Will Pass This Fall The second budget reconciliation procedure, for fiscal year 2022, will begin in mid-April. The formal deadline to adopt a budget resolution is April 15 but the average delay would put the resolution in June.3 The maximum delay would see the resolution passed in October but that is unlikely in today’s context (Diagram 1). After the resolution passes, the House and Senate must reconcile their budgets, pass the same bill, and send it to the president for his signature.  Diagram 1Timeline Of Biden Administration’s Second Budget Reconciliation, FY2022 Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The average time between Congress adopting a budget resolution and the president signing a reconciliation bill into law is 150 days, putting completion on September 15, 2021. This period could easily extend to November. In the worst-case, judging by history, Democrats could fail to conclude the process until October 2022 – but that is highly unlikely. A delay till December of this year would be a fumble, but a more realistic fumble, say if moderate Democrats must be won over due to controversial provisions. The second reconciliation bill is supposed to consist of investments over a ten-year period rather than emergency relief for the lingering pandemic and economic recovery. Biden’s proposed $2-$3 trillion green infrastructure program is the highlight but we also expect Democrats to prioritize their health care plan, which is estimated to cost $1.7-$1.9 trillion. Hence $4 trillion is a reasonable expectation for new spending but in this case the headline spending figure will be at least partially defrayed by tax hikes, unlike the first reconciliation bill (Charts 4A & 4B). If Biden raises taxes by half as much as he intends, the full price tag would be $2 trillion. Chart 4ABiden Will Spend, Then Tax Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Chart 4BBiden Will Spend, Then Tax Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The precise contours of this bill will remain unknown until Biden presents an outline in April and the House of Representatives drafts a resolution. We test six different scenarios involving different assumptions about Biden’s tax-and-spend proposals, highlighted in Table 1. Generally, we assume that Democrats will much more readily compromise tax hikes rather than spending, given that they want to err on the side of firing up the economic recovery. They are just as capable as Republicans were in 2017 of manipulating the numbers when it comes to the reconciliation requirement that the budget deficit not increase beyond a ten-year time period. Table 1Scenarios For Biden’s Second Reconciliation Bill Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The results are broken down in terms of revenue, expenditure, and net interest costs in Chart 5. The baseline is Biden’s campaign proposal. Scenario 1 assumes that Biden gets all of the spending he wants but is forced to compromise on tax hikes. Scenario 2 is more realistic as it assumes that Biden gets half of what he wants on both spending and taxes. Scenarios 3-6 examine what would happen if Biden were forced to strike out either his green infrastructure plan or his health and social security plan, depending on different revenue assumptions. In Scenarios 5 and 6 we grant Biden only half of his proposed taxes on corporations and wealthy folks, leaving other tax proposals to the side – otherwise the result would be a net tightening of fiscal conditions, which is neither intended nor politically possible. Chart 5Scenarios For Biden’s Second Reconciliation Bill Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The impact on the budget deficit in each scenario is shown in Chart 6. The greatest economic stimulus would occur under Scenario 1, which would soon become a problem for investors as it would hasten inflation and rising interest rates. Chart 6Deficit Scenarios For Biden’s Second Reconciliation Bill Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Scenario 2 is the most realistic policy scenario while being the least inflationary. By contrast, Scenario 4 is realistic but hardly less inflationary than the baseline case. In each of these scenarios it is important to bear in mind that the new government programs would be administered over a ten-year period and therefore the increase to the budget deficit would be more gradual than is the case of the American Rescue Plan, which clearly aims to be disbursed in the first few years. In the case of the Obama administration’s American Recovery and Reinvestment Act (2009) the peak in spending occurred in 2013, four years after the bill was passed (analogous to 2025 today) (Chart 7). Infrastructure and green energy projects are also expected to increase productivity and hence potential growth. Chart 7Infrastructure Spending Could Peak Four Years After Bill’s Passage, As In 2009-13 Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The Byrd rule will become even more important with Biden’s second reconciliation bill because the bill will contain a mishmash of Biden’s campaign proposals. Democrats will try to pass as much of their agenda via fast track as possible so as to meet promises ahead of the 2022 midterm election. An advantage of health care spending is that it is unlikely to be struck down by the Senate parliamentarian given that the Obama administration relied on reconciliation to pass a critical second installment to the Affordable Care Act (Obamacare). Biden’s health care plan is more popular than climate change policy, with both the general public and moderate Democrats, and it is guaranteed to pass reconciliation. Infrastructure spending faces greater challenges under reconciliation but they are not insurmountable. Infrastructure is normally handled via the traditional budget process or the Highway Trust Fund and some measures are likely to run afoul of the Byrd rule. Still, workarounds can be found.4  Hence the infrastructure plan is likely to be compromised but not prohibited due to technicalities. Even if infrastructure fails to make it into reconciliation, Biden can use the deadline to top up the exhausted Highway Trust Fund or to reauthorize the Surface Transportation Act as alternative pathways. It is not impossible to get Republican cooperation on infrastructure though the green agenda will meet resistance. The reconciliation process is nominally forbidden from increasing the budget deficit beyond ten years. Short-term spending is exempt, as is the case with the American Rescue Plan and its crisis-response measures, but the purpose of the second reconciliation bill is to invest in long-term, productivity-enhancing programs. A new government health insurance option and/or a green infrastructure buildout will take many years to implement and could increase deficits beyond the ten-year window. But Democrats, like Republicans, will be able to use accounting chicanery and gimmicks to make the budget outlook serve their purposes in passing the legislation. As long as they keep moderate members of the party on their side.   Yes, Taxes Will Go Up … But That May Not Be All Bad For Markets Why should Democrats raise taxes at all? Why not focus on stimulus without taking on the political risk of higher taxes? After all, Republicans passed tax cuts via reconciliation without offsetting them by spending cuts. Was it not the higher taxes in Obamacare that greatly fueled resistance from Republicans and their victory in the House of Representatives in 2010? First, on the level of intentions, the Democrats clearly seek to increase taxes on corporations, high-income earners, and capital gains: Both Biden and Harris said they would raise taxes on the campaign trail and in the presidential debates despite the risk to their election prospects. Biden committed only to prevent tax hikes on those making less than $400,000 per year. Harris’s weakest moment in her debate with Mike Pence was her insistence that she would raise taxes but she stuck to her guns. Both factions of the Democratic Party want to raise taxes. Traditional Democrats view tax hikes as a way of paying for a larger government role in addressing social and economic imbalances. Populists view tax hikes as a way of redistributing from the ultra-rich. While budget deficits are not a general concern, combating inequality is a theme shared across the party. Second, on the level of capability, Democrats can get at least some of the tax increases that they want: The US is not overtaxed on the whole. True, Biden’s full tax agenda would push the US back up to the top of the OECD countries in terms of the corporate tax if an “integrated” view of both firm-level taxes and taxes on dividends and capital gains (Chart 8). But this point suggests that Biden will moderate his tax plan rather than abandon it altogether. Popular opinion did not favor Trump for cutting corporate taxes. Chart 8Biden’s Corporate Tax Proposal Would Make US An Outlier Again Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The macroeconomic impact of raising taxes is manageable in the context of the extraordinary fiscal stimulus that the US is passing. There is no clear relationship between tax rates and economic growth but it is natural for the Democrats to fear that they could squander their term in power by excessive fiscal tightening. Yet the negative economic impact of raising the corporate rate is only 0.8% of GDP over the long run, and half of that if the corporate rate is raised only halfway to what Biden intends (25% instead of 28%) (Table 2), according to the conservative-leaning Tax Policy Foundation. Table 2Economic Impact Of Corporate Tax Not Dramatic Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout President Biden has the political capital early in his term to revise the Trump tax cuts according to Democratic prerogatives. His popularity will not hold up for long (Chart 9). And he only just has enough legislative power. While household sentiment is weak and economic conditions are moderate, both are set to improve as the pandemic fades and fiscal stimulus takes effect (Table 3). While tax hikes will embolden Republican opposition and the Democrats will have lost their chance to affect the tax code if Republicans win in 2022. At the moment, Republicans are divided and unpopular, so Democrats have a window of opportunity (Chart 10). Chart 9Thesis, Antithesis, Synthesis? Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Chart 10Independents Up, Republicans Down Independents Up, Republicans Down Independents Up, Republicans Down Table 3Political Capital Index Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout While Democrats could chuck all the Senate rules out the window in order to pass their spending plans without any offsets, this would anger moderates who tend to uphold Senate rules and norms. The party cannot afford to lose a single vote from their caucus in the Senate. Yet moderate Democrats are not against tax increases in principle. What they would oppose is either excessive tax hikes or a fiscal spending bonanza without any revenue offsets at all.5  It is entirely feasible to back-load tax increases so that they take effect in the latter half of the ten-year budget window, especially after the 2024 election. Treasury Secretary Janet Yellen is advising precisely this course of action and has herself argued that corporate tax hikes will go through.6 There may be some risk that Democrats go full left-wing populist and abandon any semblance of fiscal responsibility so as to supercharge the economy. So far they have agreed to maintain the Senate filibuster and scrap the minimum wage hike but this acceptance of Senate norms may not last as pressure builds. The second reconciliation bill is the last chance to fast-track major initiatives before the midterm. Vice President Harris could overrule the Senate parliamentarian across the board. This scenario is unlikely. The White House and Congress will find a balance that raises some revenue but errs on the fiscally accommodative side, as our scenarios above highlight. Investment Takeaways The market’s concern is that the Democrats will “overdo” the fiscal response and we fully share this concern. The American Rescue Plan alone will plug the output gap by almost three times more than the amount required. The coming tax hikes will not offset the wave of new spending that is coming down the pike. Democrats will partially reverse Trump’s tax cuts in the context of additional pump-priming that constitutes a net increase to the budget deficit. The net effect is inflationary.   If Congress were to pass another $2 trillion bill without any substantial revenue offsets then the market would face an even bigger inflationary jolt and an even earlier return to rate hikes by the Fed. But this scenario is unlikely. So the inflationary risk is clear but investors need not panic in the short run.  Our infrastructure trade is back on track as the reflation trade rumbles onward (Chart 11). The Democrats will get at least one more major bill passed and it will likely include at least half of Biden’s agenda, including around $2 trillion on green infrastructure. We will discuss the renewable energy portion at length in a forthcoming report. The health care sector faces headwinds from both Biden’s health policies and corporate tax hikes. The sectors that stand to benefit the most from a higher corporate tax rate are those that benefited least from Trump’s Tax Cut and Jobs Act – namely energy, industrials, materials, and financials, in that order (Chart 12A). These are also the cyclical plays that we favor in today’s accommodative policy environment. Chart 11Infrastructure Trade Back On Track Infrastructure Trade Back On Track Infrastructure Trade Back On Track   Chart 12ACyclicals Outperforming Health Care Cyclicals Outperforming Health Care Cyclicals Outperforming Health Care Chart 12BCyclicals To Outperform Tech? Cyclicals To Outperform Tech? Cyclicals To Outperform Tech? The same cyclical sectors are also trying to make headway against the tech sector, which stands to suffer from higher interest rates as well as higher taxes, including a minimum tax on book earnings, if that part of Biden’s agenda makes it through the negotiations this fall (Chart 12B).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A1BPolitical Capital: Household And Business Sentiment Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A1CPolitical Capital: The Economy And Markets Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A2Political Risk Matrix Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A3Biden’s Cabinet Position Appointments Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Footnotes 1     See Jeff Drew, “House passes $1.9 trillion stimulus bill with a variety of small business relief,” and Alistair M. Nevius, “Tax provisions in the American Rescue Plan Act,” February 27, 2021, Journal of Accountancy, journalofaccountancy.com.     2     See “The Budget Reconciliation Process: The Senate’s ‘Byrd Rule,’” Congressional Research Service, December 1, 2020, fas.org.            3    The current delay centers on whether the Senate will confirm Biden’s appointee for director of the Office of Management and Budget, Neera Tanden, who lost support from key moderate Democrat Joe Manchin. If she does not receive a compensatory Republican vote then Biden will have to appoint someone else and the Senate will have to confirm. Thus the budget resolution could easily be delayed into May or June.       4    For the difficulties, see Peter Cohn, “Democrats plan a spending blowout, but hurdles remain,” Roll Call, January 11, 2021, rollcall.com. For workarounds, see Zach Moller and Gabe Horwitz, “Reconciliation: How It Works and How to Use It to Help American Workers Recover,” Third Way, February 1, 2021, thirdway.org. 5    See Alexander Bolton, “Democrats hesitant to raise taxes amid pandemic,” The Hill, February 25, 2021, thehill.com. 6    See Saleha Mohsin and Christopher Condon, “Yellen Favors Higher Company Tax, Signals Capital Gains Worth a Look”, Bloomberg, February 22, 2021, Bloomberg.com  

Highlights Portfolio Strategy The selloff in the long end of the Treasury bond market and related yield curve steepening, rising loan growth and a turnaround in bank net interest margins, all signal that a durable re-rating phase is in the offing in the beaten down financials sector. Soaring real and nominal yields on the back of a US economic reopening, sinking policy uncertainty, and the specter of a countertrend USD rally, all undermine global gold mining stocks. Downgrade to underweight. We deem there is an exploitable opportunity within the reopening theme and we reiterate our recent pair trade recommendation: long USES “Laggards” basket/short USES “Overshooters” basket (excluding the GICS1 sectors). Recent Changes Downgrade the global gold mining index to underweight, today. This move also pushes the S&P materials sector to a neutral allocation. Last week our rolling 2.5% stop was triggered and we booked gains of 17% in the deep cyclicals/defensives portfolio bent that is now on even keel. On February 10, we closed the S&P consumer staples and the S&P homebuilding high-conviction underweights for 8% and -11% returns, respectively, since the December 7 inception. On February 11, we rolled over the synthetic long SPY options structure from March expiry (long $390/$410 call spread/short $340 put) to June expiry (long $400/$420 call spread/short $340 put) netting gains of $5.41/contract or 676% since the January 12 inception. Feature While stocks swiftly gyrated last week and the selloff in Treasury bonds dominated the news flow, the corporate bond market remained as placid as ever. This eerie calmness is slightly unnerving as junk spreads, all the way out to the CCC poor-quality spectrum, have been steadily sinking. But, resurging commodities likely confirm that there is no real reason to panic as global growth remains on an upward trajectory courtesy of pent-up demand that will get unleashed in the back half of the year as the global economy reopens (Chart 1). We recently reinitiated the long “Back-To-Work” basket as the expense of our “COVID-19 Winners” basket and this trade is already up another 21.3% since the second inception on Feb 3, 2021. With regard to monetary policy that remains a key pillar of equity euphoria, the Fed has vociferously signaled that they will not be backing down from QE and their ZIRP policy. The FOMC is not even thinking about thinking about tapering asset purchases, despite a looming inflation spike in the coming months due to base effects and bottlenecks that they vehemently deem transitory. Chart 1Eerie Calm? Eerie Calm? Eerie Calm? Importantly, Charts 2 & 3 show that both the ISM’s manufacturing prices paid index and a sideways move in retail gasoline prices predict a surge in headline CPI in the April/May time frame as we first showed in a recent Special Report. Chart 2The Bond Market Is Already… The Bond Market Is Already… The Bond Market Is Already… Chart 3…Testing The Fed …Testing The Fed …Testing The Fed Tack on a plethora of anecdotes regarding shortages and price hikes in a slew of industries and an inflationary spurt is already here. In more detail, an inflationary impulse is not only evident in chip and car shortages and in container freight shipping rates, but also in dry bulk transport rates. Drilling beneath the surface of the Baltic Dry Index, and looking beyond Capesize carriers, reveals that Panamax and Handysize vessel freight rates are on a tear, probing 11-year highs and more than quadrupling since the March lows (Chart 4). These smaller ships are more nimble and rarely take voyage empty as recent container ships have been when returning to China to reload. Thus, the sizable increase in Handysize and Panamax shipping rates suggests that commodity demand is robust, especially industrial commodities. Returning to US shores, the most recent retail sales report also caused a jump in the Atlanta Fed’s GDPNow and the NY Fed’s Nowcast forecasts for Q1 near double digit real GDP growth. For calendar 2021, according to daily data from Bloomberg, economists expect US real GDP growth north of 4.9% (Chart 5). More blow out quarters are in the offing courtesy of the inoculation of the population, the reopening of the economy and persistent government largesse. Chart 4Look Beneath The Surface… Look Beneath The Surface… Look Beneath The Surface… Chart 5…And The Economic Recovery Is Gaining Steam… …And The Economic Recovery Is Gaining Steam… …And The Economic Recovery Is Gaining Steam… Crudely put, while consumers will not buy 10 coffees or eat 10 meals at a restaurant all at once when the economy fully reopens, they may choose to fly business on their next vacation and indulge on a more lavish hotel. Add on that the hospitality industry specifically has aggressively shut down capacity and an inflationary impulse is likely as consumer purse strings will loosen very quickly. Thus, trust in the Fed’s ultra-dovishness represents the biggest equity market risk in the coming months as the FOMC allows the economy to run hot and there are high odds that the bond market will continue to test the Fed’s resolve. Our sense is that the Fed will initially ignore the spike in inflation, at least until the summer, thus refraining from removing the proverbial “punch bowl”. However, if the market detects any signs of a “less dovish” Fed, especially if high inflation prints persist for whatever reason, risk premia will get repriced a lot higher (Chart 6). Chart 6…But A Lot Of Good News Is Baked In …But A Lot Of Good News Is Baked In …But A Lot Of Good News Is Baked In Staying on the topic of interest rates, we have a long-held rule of thumb that stocks cannot stomach more than 100-125bps tightening via a selloff in the 10-year US Treasury bond in a less than a year time frame basis. In other words, were the 10-year US Treasury yield to surpass and stay over 1.55% by March, 2.05% by June, and 1.75% by August, then the equity market will likely suffer a pullback, especially given the absence of a valuation cushion. In fact, last Thursday the 10-year US Treasury yield cleared the 1.6% hurdle and stocks sold off violently. In more detail, we examined data from 2009 onward, therefore only covering the QE era, which would increase the applicability of our analysis. Importantly, the 2009-2011 iterations provide the closest parallels as to what will likely take root this cycle as those instances occurred in a post recessionary environment, which is similar to today. The 2009-2011 period also best aligns with the main reason for having this rule of thumb in the first place: to gauge the risk of interest rates undermining the market by weighing on forward multiples and/or via an economic slowdown because of tightening in monetary conditions. Our analysis shows that while the exact timing and size of the stock market drawdown varies from episode to episode, it is generally consistent with a roughly 10% pullback in the S&P 500 albeit with a 1-2 month lag following the trigger in our rule1 (Chart 7). Chart 7Monitoring Our 100-125bps Rule Of Thumb Monitoring Our 100-125bps Rule Of Thumb Monitoring Our 100-125bps Rule Of Thumb Keep in mind that such a pullback is consistent with historical precedents when the Fed is actively engaged in QE, with the most recent example being last September’s/October’s 10% drawdown. Our sense is that the ongoing bond market selloff will serve as a catalyst for a continuation/acceleration of the reopening/rotation/reflation trade out of highly valued tech stocks and into more compellingly valued deep and early cyclicals. Such a transition typically proves tumultuous. This week, we update our sanguine view on an early-cyclical sector, and act on the downgrade alert to a deep cyclical sector via downgrading a safe haven commodity index to a below benchmark allocation. Financials Are On Fire Within the GICS1 universe, the most levered sector to interest rates is the S&P financials sector. Given that the bond selloff has staying power, we reiterate our overweight stance on this early-cyclical sector that we fist boosted to an above benchmark allocation on November 16, 2020. Following up from the 100-125bps bond market tightening rule of thumb, adding another layer of complexity via bringing in the yield curve (YC) is instructive. This analysis corroborates our rule of thumb and suggests that not only do 10-year US Treasury yields have more room to rise, but also so does the S&P financials sector, especially given that it is hovering at an extremely depressed level relative to the S&P 500 (Chart 8). Chart 8V-Shaped Recovery? V-Shaped Recovery? V-Shaped Recovery? Historically the yield curve peaks at a range of 150 to 250 bps. In the past 7 cycles, this range was in place with only one exception: the first leg of the double dip recession in the early 80s. This represents a stellar track record of where the YC peters out based on empirical evidence. Even in the post GFC world, the YC steepened north of 250bp (thrice) and during the early stages of that recovery. The implication is that if history at least rhymes, then the yield curve can steepen a lot more. Were it to revisit the 250bps level, the YC could nearly double from current levels (Chart 9A). Practically, given that the Fed will pin the 2-year US Treasury yield near zero with a near-term max value of roughly 50bps, this equates to a tentative early-cycle peak 10-year Treasury yield range of 2% to 3%.   Chart 9AYield Curve Can Steepen A Lot More Yield Curve Can Steepen A Lot More Yield Curve Can Steepen A Lot More Putting this in perspective, at current levels, the 10-year US Treasury yield is roughly where it stood right after Brexit in mid-2016, which was last cycle’s trough, and still deeply in overvalued territory according to BCA bond valuation model (Chart 9B). Importantly, back then, as now, yields have been late comers to the equity rally. As a reminder, during the manufacturing recession the SPX troughed on Feb 15, 2016 – the day the Royal Dutch Shell / BG Group merger closed – while interest rates bottomed in the first week of July 2016. One key driver of the positive impact of rising interest rates on relative financials share prices will be the end to the banking sector’s hemorrhaging net interest margins (Chart 10). Chart 9BBonds Remain Extremely Overvalued Bonds Remain Extremely Overvalued Bonds Remain Extremely Overvalued Chart 10NIM Turnaround Looms NIM Turnaround Looms NIM Turnaround Looms   Financial services companies represent the nervous system of every economy and a vibrant economy is synonymous with firming loan growth (bottom panel, Chart 11). Beyond the recovery in the broad non-financial corporate sector, the overheating residential housing market in particular is another vital area that is propping up the financials sector (top panel, Chart 11).  All of this suggests that relative profitability will pick up steam this year, a message that our macro-driven relative EPS models also corroborate (second panel, Chart 12). This stands in marked contrast to sell-side analysts’ profit expectations and represents an exploitable trading opportunity: the earnings hurdle is so low for financials that even a modest beat of suppressed EPS growth expectations will go a long way in breathing fresh life into this neglected early-cyclical sector (third & bottom panels, Chart 12). Tack on pent up financials sector buyback demand and a 40bps dividend yield carry versus the SPX and the profit outlook brightens further for this interest rate-sensitive sector. Chart 11Financials Rising Alongside The Economy Financials Rising Alongside The Economy Financials Rising Alongside The Economy Finally, relative valuations are bombed out on any metric used (middle, fourth & bottom panels, Chart 13). Granted, relative technicals are not as alluring as last November, however our Technical Indicator is still below overbought levels that have marked prior relative performance peaks (second panel, Chart 13). Chart 12Green Light On Earnings Green Light On Earnings Green Light On Earnings Chart 13Financials Are Cheap No Matter How You Cut It Financials Are Cheap No Matter How You Cut It Financials Are Cheap No Matter How You Cut It Adding it all up, the selloff in the long end of the Treasury bond market and the associated yield curve steepening, rising loan growth and a turnaround in bank net interest margins signal that a durable re-rating phase looms for the beaten down financials sector. Bottom Line: Continue to overweight the S&P financials sector. Are Gold Miners Losing Their Luster? Last December when we penned the 2021 high-conviction calls Strategy Report, we put global gold miners in the “also rans” section as we did not have the courage to go underweight despite our view of an economic reopening and selloff in the bond market. It is never too late. Today, we use the downgrade alert we issued on the S&P materials sector to trim the sector to neutral via downgrading the global gold mining index to a below benchmark allocation. As a reminder, in mid-January we had put the materials sector on our downgrade watch list as a way to express the move of the cyclicals/defensives portfolio bent back down to even keel. The stock-to-bond (S/B) ratio has broken out to at least a three decade high because stocks are near all-time highs and bonds are selling off violently. This represents an explosive cocktail for gold stocks and is warning that there is ample downside for relative share prices (S/B ratio shown inverted, Chart 14). Chart 14Sell Gold Miners… Sell Gold Miners… Sell Gold Miners… This is largely due to the definitive reopening of the US economy in the coming quarters (bottom panel, Chart 15). It is also evident in 5-year/5-year forward real yields that have been soaring year-to-date signaling that investors should shy away from gold miners (real yields shown inverted, middle panel, Chart 15). Even nominal yields underscore that the path of least resistance for global gold mining equities points lower, especially given that the recent bond market selloff is driven by the real (i.e. growth) not inflation component. As a reminder, gold bullion and gold miners yield next to nothing thus when real rates rise, the opportunity cost to hold gold and gold miners skyrockets and investors abandon gold miners for higher yielding assets (top panel, Chart 16). The recent fall in the share of global negative yielding bonds by over $4tn also weighs on the prospects of gold miners (bottom panel, Chart 16). Importantly, while we are not calling for the Fed to raise rates any time soon, the 12-month forward fed funds rate discounter (as backed out of the OIS curve) has jumped back to the zero line, opening a wide gap with relative share prices. This is unsustainable and our sense is that this gulf will narrow via a drop in the latter in the coming months (fed funds rate discounter shown inverted and advanced, middle panel, Chart 16). Chart 15…When The Economy Is Roaring …When The Economy Is Roaring …When The Economy Is Roaring Another source of worry for gold stocks is the USD. Historically, a rising greenback pushes gold bullion and gold equities lower and vice versa. If the US economy will rebound at a faster clip than the euro area as the Fed is explicitly taking inflation risk and is allowing the economy to run hot, then at some point the US dollar may start to flex its muscles. Granted, this will likely be a countertrend rally in the context of a USD bear market that commenced last spring, especially given the still lopsided US dollar positioning (Chart 17). Chart 16Rising Rates Are bearish Bullion Rising Rates Are bearish Bullion Rising Rates Are bearish Bullion Chart 17Mighty USA = Countertrend Rally In The USD Mighty USA = Countertrend Rally In The USD Mighty USA = Countertrend Rally In The USD In addition, US and global policy uncertainties are melting as the US/Sino trade war has been in hibernation, the US elections are behind us and a “Blue Wave” sweep is certain to deliver mega fiscal easing packages, thus exerting downward pressure on the safe haven status of gold bullion and gold mining equities (Chart 18). Finally, the global equity risk premium is in freefall as not only the Fed, but also the ECB, the BoJ, and a plethora of other CB including EM ones are doing QE effectively engineering a “risk on” asset price inflation phase (Chart 18). Nevertheless, our bearish gold mining equity thesis has to contend with oversold conditions and bombed out relative valuations. We will be closely monitoring these two risks and stand ready to act and cut losses in case value oriented buyers come out of left field (Chart 19). Chart 18Mind The Catch Down Phase Mind The Catch Down Phase Mind The Catch Down Phase Chart 19Two Risks To Monitor Two Risks To Monitor Two Risks To Monitor Netting it all out, soaring real and nominal yields on the back of a US economic reopening, sinking policy uncertainty, and the specter of a countertrend USD rally, all undermine global gold mining stocks. Bottom Line: Downgrade the global gold mining index to underweight today. This move also pushes the S&P materials sector back to the neutral zone. A Few Words On The “Back-To-Work” Trade Last year we created two baskets of stocks to capture the economic reopening theme by constructing a long/short pair trade. This year, we crystallized 21.5% in gains from that pair trade and subsequently reopened it and it is already up another 21.3% since the second inception on February 3, 2021. Two weeks ago, we took a fresh look at the economic reopening theme and pitted “Back-To-Work” laggards against leaders. First, we filtered for well-behaved cyclical industries among all the sectors and sub-sectors we cover. We define a well-behaved cyclical industry as one that trailed the SPX from February 19, 2020 to March 23, 2020; and then outpaced the broad market from March 23, 2020 to today (all computations are in relative to SPX terms). Such filtering excluded all of the defensive & cyclical industries that outperformed the market during the recession, and it also excluded those industries that were too damaged by the pandemic and could not recover above the March 23 trough level (for example, airlines) always in relative terms. Chart 20 is a stylized depiction of our analysis. In total 27 industries survived the filtering. We then computed what is the minimum percentage increase required in order for each group to recover to its February 19 level, and then calculated the difference between that required increase and the one that actually materialized. A positive value signifies that the sector climbed above its February 19 level, whereas a negative value means that the sector still has not recovered. Chart 20Stylized Depiction Of “Back-To-Work” Sectors To Buy And To Avoid… Blind Trust Blind Trust Chart 21 displays the results. Our rationale is as follows: should the economic recovery and normalization themes continue unabated as we expect, then the risk/reward trade-off of owning the “laggards” is greater than the “overshooters”: the former have ample upside potential left, whereas the latter are already discounting a lot of good news. Chart 22 plots the ratio of the two baskets against the ISM manufacturing prices paid sub-component and the 10-year US Treasury yield and supports our rationale that the “laggards” have a long runway ahead versus the “overshooters”. Chart 21…Buy The Laggards / Sell The Overshooters Blind Trust Blind Trust Chart 22Inflation Impulse Beneficiaries Inflation Impulse Beneficiaries Inflation Impulse Beneficiaries Bottom Line: We deem there is an exploitable opportunity within the reopening theme and we reiterate our recent pair trade recommendation: long USES “Laggards” basket/short USES “Overshooters” basket (excluding the GICS1 sectors). As a proxy for this trade we include tickers for the largest stock in each sub-sector (excluding GICS1). Laggards: V, BLK, HCA, MCD, HON, AXP, JPM, COP, PSX, MAR, SLB. Overshooters: EMR, BLL, LIN, NUE, UNP, HD, DHI, CAT, MS, J, TSLA, AMAT. We are aware of some minor conflicts between the “Overshooters” and the “Back-To-Work” basket and also versus our current recommendations table, but we still recommend investors stick with this pair trade.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     A quick note on the taper tantrum and the 2016 iterations. During those periods the S&P 500 actually fell at the same time as yields rose (not after the rule was triggered), so technically we should not have counted that as a valid iteration on our chart.     Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Overdose? Overdose? Size And Style Views February 24, 2021 Stay neutral cyclicals over defensives January 12, 2021  Stay neutral small over large caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, ABNB, V). January 22, 2018 Favor value over growth

Highlights Market-based geopolitical analysis is about identifying upside as well as downside risk. So far this year upside risks include vaccine efficacy, coordinated monetary and fiscal stimulus, China’s avoidance of over-tightening policy, and Europe’s stable political dynamics. Downside risks include vaccine rollout problems, excessive US stimulus, a Chinese policy mistake, and traditional geopolitical risks in the Taiwan Strait and Persian Gulf. Financial markets may see more turmoil in the near-term over rising bond yields and the dollar bounce. But the macro backdrop is still supportive for this year. We are initiating and reinitiating a handful of trades: EM currencies ex-Brazil/Turkey/Philippines, the BCA rare earth basket, DM-ex-US, and the Trans-Pacific Partnership markets, and global value plays. Feature Chart 1Bond Yield Spike Threatens Markets In Near Term Bond Yield Spike Threatens Markets In Near Term Bond Yield Spike Threatens Markets In Near Term Investors hear a lot about geopolitical risk but the implication is always “downside risk.” What about upside risks? Where are politics and geopolitics creating buying opportunities? So far this year, on the positive side, the US fiscal stimulus is overshooting, China is likely to avoid overtightening policy, and Europe’s political dynamics are positive. However, global equity markets are euphoric and much of the good news is priced in. On the negative side, the US stimulus is probably too large. The output gap will be more than closed by the Biden administration’s $1.9 trillion American Rescue Plan yet the Democrats will likely pass a second major bill later this year with a similar amount of net spending, albeit over a longer period of time and including tax hikes. The countertrend bounce in the dollar and rising government bond yields threaten the US and global equity market with a near-term correction. The global stock-to-bond ratio has gone vertical (Chart 1). Meanwhile Biden faces immediate foreign policy tests in the Taiwan Strait and Persian Gulf. These two are traditional geopolitical risks that are once again underrated by investors. The near term is likely to be difficult for investors to navigate. Sentiment is ebullient and likely to suffer some disappointments. In this report we highlight a handful of geopolitical opportunities and offer some new investment recommendations to capitalize on them. Go Long Japan And Stay Long South Korea China’s stimulus and recovery matched by global stimulus and recovery have led to an explosive rise in industrial metals and other China-sensitive assets such as Swedish stocks and the Australian dollar that go into our “China Play Index” (Chart 2). Chart 2China Plays Looking Stretched (For Now) China Plays Looking Stretched (For Now) China Plays Looking Stretched (For Now) While a near-term pullback in these assets looks likely, tight global supplies will keep prices well-bid. Moreover long-term strategic investment plans by China and the EU to accelerate the technology race and renewable energy are now being joined by American investment plans, a cornerstone of Joe Biden’s emerging national policy program. We are long silver and would buy metals on the dips. Chinese President Xi Jinping’s “new era” policies will be further entrenched at the March National People’s Congress with the fourteenth five-year plan for 2021-25 and Xi’s longer vision for 2035. These policies aim to guide the country through its economic transition from export-manufacturing to domestic demand. They fundamentally favor state-owned enterprises, which are an increasingly necessary tool for the state to control aggregate demand as potential GDP growth declines, while punishing large state-run commercial banks, which are required to serve quasi-fiscal functions and swallow the costs of the transition (Chart 3). Xi Jinping’s decision to promote “dual circulation,” which is fundamentally a turn away from Deng Xiaoping’s opening up and liberal reform to a more self-sufficient policy of import substitution and indigenous innovation, will clash with the Biden administration, which has already flagged China as the US’s “most serious competitor” and is simultaneously seeking to move its supply chains out of China for critical technological, defense, and health goods. Chart 3Xi Jinping Leans On The Banks To Save The SOEs Xi Jinping Leans On The Banks To Save The SOEs Xi Jinping Leans On The Banks To Save The SOEs Chinese political and geopolitical risks are almost entirely priced out of the market, according to our GeoRisk Indicator, leaving Chinese equities exposed to further downside (Chart 4). Hong Kong equities have traded in line with GeoRisk Indicator for China, which suggests that they also have downside as the market prices in a rising risk premium due to the US’s attempt to galvanize its allies in a great circumvention of China’s economy in the name of democracy versus autocracy. Chart 4China/HK Political Risk Priced Out Of Market China/HK Political Risk Priced Out Of Market China/HK Political Risk Priced Out Of Market China has hinted that it will curtail rare earth element exports to the US if the US goes forward with a technological blockade. Biden’s approach, however, is more defensive rather than offensive – focusing on building up domestic and allied semiconductor and supply chain capacity rather than de-sourcing China. President Trump’s restrictions can be rolled back for US designed or manufactured tech goods that are outdated or strictly commercial. Biden will draw the line against American parts going into the People’s Liberation Army. Biden has a chance in March to ease the Commerce Department’s rules implementing Trump’s strictures on Chinese software apps in US markets as a gesture of engagement. Supply constraints and shortages cannot be solved quickly in either semiconductors or rare earths. But both China and the US can circumvent export controls by importing through third parties. The problem for China is that it is easier for the US to start pulling rare earths from the ground than it is for China to make a great leap forward in semiconductor production. Given the US’s reawakening to the need for a domestic industrial policy, strategic public investments, and secure supply chains, we are reinitiating our long rare earth trade, using the BCA rare earth basket, which features producers based outside of China (Chart 5). The renminbi is starting to rolling over, having reached near to the ceiling that it touched in 2017 after Trump’s arrival. There are various factors that drive the currency and there are good macro reasons for the currency to have appreciated in 2016-17 and 2020-21 due to strong government fiscal and monetary reflation. Nevertheless the People’s Bank allowed the currency to appreciate extensively at the beginning of both Trump’s and Biden’s terms and the currency’s momentum is slowing as it nears the 2017 ceiling. We are reluctant to believe the renminbi will go higher as China will not want to overtighten domestic policy but will want to build some leverage against Biden for the forthcoming strategic and economic dialogues. For mainland-dedicated investors we recommend holding Chinese bonds but for international investors we would highlight the likelihood that the renminbi has peaked and geopolitical risk will escalate. There is no substantial change on geopolitical risk in the Taiwan Strait since we wrote about it recently. A full-scale war is a low-probability risk. Much more likely is a diplomatic crisis – a showdown between the US and China over Taiwan’s ability to export tech to the mainland and the level of American support for Taiwan – and potentially a testing of Biden’s will on the cybersecurity, economic security, or maritime security of Taiwan. While it would make sense to stay long emerging markets excluding Taiwan, there is not an attractive profile for staying long emerging markets excluding all of Greater China. Therefore investors who are forced to choose should overweight China relative to Taiwan (Chart 6). Chart 5Rare Earth Miners Outside China Can Go Higher Rare Earth Miners Outside China Can Go Higher Rare Earth Miners Outside China Can Go Higher Market forces have only begun to register the fact that Taiwan is the epicenter of geopolitical risk in the twenty-first century. The bottleneck for semiconductors and Taiwan’s role as middleman in the trade war have supported Taiwanese stocks. It will take a long time for China, the US, and Europe to develop alternative suppliers for chips. But geopolitical pressures will occasionally spike and when they do Taiwanese equities will plunge (Chart 7). Chart 6EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk South Korean geopolitical risk is also beneath the radar, though stocks have corrected recently and emerging market investors should generally favor Korea, especially over Taiwan. The first risk to Korea is that the US will apply more pressure on Seoul to join allied supply chains and exclude shipments of sensitive goods to China. The second risk is that North Korea – which Biden is deliberately ignoring in his opening speeches – will demand America’s attention through a new series of provocations that will have to be rebuked with credible threats of military force. Chart 7Markets Starting To Price Taiwan Strait Geopolitical Risk Markets Starting To Price Taiwan Strait Geopolitical Risk Markets Starting To Price Taiwan Strait Geopolitical Risk Chart 8South Korea Favored In EM But Still Faces Risks Over Chips, The North South Korea Favored In EM But Still Faces Risks Over Chips, The North South Korea Favored In EM But Still Faces Risks Over Chips, The North   Chart 9Don't Worry About Japan's Revolving Door Don't Worry About Japan's Revolving Door Don't Worry About Japan's Revolving Door The North Korean risk is usually very fleeting for financial markets. The tech risk is more serious but the Biden administration is not seeking to force South Korea to stop trading with China, at least not yet. The US would need to launch a robust, multi-year diplomatic effort to strong-arm its allies and partners into enforcing a chip and tech ban on China. Such an effort would generate a lot of light and heat – shuttle diplomacy, leaks to the press, and public disagreements and posturing. Until this starts to occur, US export controls will be a concern but not an existential threat to South Korea (Chart 8). Japan is the geopolitical winner in Asia Pacific. Japan is militarily secure, has a mutual defense treaty with the US, and stands to benefit from the recovery in global trade and growth. Japan is a beneficiary of a US-driven tech shift away from excess dependency on China and is heavily invested in Southeast Asia, which stands to pick up manufacturing share. Higher bond yields and inflation expectations will detract from growth stocks more than value stocks, and value stocks have a larger market-cap weight in European and Japanese equity markets. Japanese politics are not a significant risk despite a looming election. While Prime Minister Yoshihide Suga is unpopular and likely to revive the long tradition of a “revolving door” of short-lived prime ministers, and while the Liberal Democratic Party will lose the super-majorities it held under Shinzo Abe, nevertheless the party remains dominant and the national policy consensus is behind Abe’s platform of pro-growth reforms, coordinated dovish monetary and fiscal policy, and greater openness to trade and immigration (Chart 9). Favor EU And UK Over Russia And Eastern Europe Russian geopolitical risk appears to be rolling over according to our indicator but we disagree with the market’s assessment and expect it to escalate again soon (Chart 10). Not only will Russian social unrest continue to escalate but also the Biden administration will put greater pressure on Russia that will keep foreign investors wary. Chart 10Russia Geopolitical Risk Will Not Roll Over Russia Geopolitical Risk Will Not Roll Over Russia Geopolitical Risk Will Not Roll Over While geopolitics thus poses a risk to Russian equities – which are fairly well correlated (inversely) with our GeoRisk indicator – nevertheless they are already cheap and stand to benefit from the rise in global commodity prices and liquidity. Russia is also easing fiscal policy to try to quiet domestic unrest. The pound and the euro today are higher against the ruble than at any time since the invasion of Ukraine. It is possible that Russia will opt for outward aggressiveness amidst domestic discontent, a weak and relapsing approval rating for Vladimir Putin and his government, and the Biden administration’s avowed intention to prioritize democracy promotion, including in Ukraine and Belarus (Chart 11). The ruble will fall on US punitive actions but ultimately there is limited downside, at least as long as the commodity upcycle continues. Chart 11Ruble Can Fall But Probably Not Far Ruble Can Fall But Probably Not Far Ruble Can Fall But Probably Not Far Biden stated in his second major foreign policy speech, “we will not hesitate to raise the cost on Russia.” There are two areas where the Biden administration could surprise financial markets: pipelines and Russian bonds. Biden could suddenly adopt a hard line on the Nordstream 2 pipeline between Russia and Germany, preventing it from completion. This would require Biden to ask the Germans to put their money where their mouths are when it comes to trans-Atlantic solidarity. Biden is keen to restore relations with Germany, and is halting the withdrawal of US troops from there, but pressuring Germany on Russia is possible given that it lies in the US interest and Biden has vowed to push back against Russia’s aggressive regional actions and interference in American affairs. The US imposed sanctions on Russian “Eurobonds” under the Chemical and Biological Weapons Control and Warfare Elimination Act of 1991 (CBW Act) in the wake of Russia’s poisoning of secret agent Sergei Skripal in the UK in 2018. Non-ruble bank loans and non-ruble-denominated Russian bonds in primary markets were penalized, which at the time accounted for about 23% of Russian sovereign bonds. This left ruble-denominated sovereign bonds to be sold along with non-ruble bonds in secondary markets. The Biden administration views Russia’s poisoning of opposition leader Alexei Navalny as a similar infraction and will likely retaliate. The Defending American Security from Kremlin Aggression Act is not yet law but passed through a Senate committee vote in 2019 and proposed to halt most purchases of Russian sovereign debt and broaden sanctions on energy projects and Kremlin officials. Biden is also eager to retaliate for the large SolarWinds hack that Russia is accused of conducting throughout 2020. Cybersecurity stocks are an obvious geopolitical trade in contemporary times. Authoritarian nations have benefited from the use of cyber attacks, disinformation, and other asymmetric warfare tactics. The US has shown that it does not have the appetite to fight small wars, like over Ukraine or the South China Sea, whereas the US remains untested on the question of major wars. This incentivize incremental aggression and actions with plausible deniability like cyber. Therefore the huge run-up in cyber stocks is well-supported and will continue. The world’s growing dependency on technology during the pandemic lockdowns heightened the need for cybersecurity measures but the COVID winners are giving way to COVID losers as the pandemic subsides and normal economic activity resumes. Traditional defense stocks stand to benefit relative to cyber stocks as the secular trend of struggle among the Great Powers continues (Chart 12). Specifically a new cycle of territorial competition will revive military tensions as commodity prices rise. Chart 12Back To Work' Trade: Long Defense Versus Cyber Back To Work' Trade: Long Defense Versus Cyber Back To Work' Trade: Long Defense Versus Cyber By contrast with Russia, western Europe is a prime beneficiary of the current environment. Like Japan, Europe is an industrial, trade-surplus economy that benefits from global trade and growth. It benefits as the geopolitical middleman between the US and its rivals, China and Russia, especially as long as the Biden administration pursues consultation and multilateralism and hesitates to force the Europeans into confrontational postures against these powers. Chart 13Political Risk Still Subsiding In Continental Europe Political Risk Still Subsiding In Continental Europe Political Risk Still Subsiding In Continental Europe Meanwhile Russia and especially China need to court Europe now that the Biden administration is using diplomacy to try to galvanize a western bloc. China looks to substitute European goods for American goods and open up its market to European investors to reduce European complaints of protectionism. European domestic politics will become more interesting over the coming year, with German and French elections, but the risks are low. The rise of a centrist coalition in Italy under Mario Draghi highlights how overstated European political risk really is. In the Netherlands, Mark Rutte’s center-right party is expected to remain in power in March elections based on opinion polling, despite serious corruption scandals and COVID blowback. In Germany, Angela Merkel’s center-right party is also favored, and yet an upset would energize financial markets because it would result in a more fiscally accommodative and pro-EU policy (Chart 13). The takeaway is that there is limit to how far emerging European countries can outperform developed Europe, given the immediate geopolitical risk emanating from Russia that can spill over into eastern Europe (Chart 14). Developed European stocks are at peak levels, comparable to the period of Ukraine’s election, but Ukraine is about to heat up again as a battleground between Russia and the West, as will other peripheral states. Chart 14Favor DM Europe Over EM Europe Favor DM Europe Over EM Europe Favor DM Europe Over EM Europe Chart 15GBP: Watch For Scottish Risk Revival In May GBP: Watch For Scottish Risk Revival In May GBP: Watch For Scottish Risk Revival In May Finally, in the UK, the pound continues to surge in the wake of the settlement of a post-Brexit trade deal, notwithstanding lingering disagreements over vaccines, financial services, and other technicalities. British equities are a value play that can make up lost ground from the tumultuous Brexit years. There is potentially one more episode of instability, however, arising from the unfinished business in Scotland, where the Scottish National Party wants to convert any victory in parliamentary elections in May into a second push for a referendum on national independence. At the moment public opinion polls suggest that Prime Minister Boris Johnson’s achievement of an EU trade deal has taken the wind out of the sails of the independence movement but only the election will tell whether this political risk will continue to fall in the near term (Chart 15). Hence the pound’s rally could be curtailed in the near term but unless Scottish opinion changes direction the pound and UK domestic-oriented stocks will perform well. Short EM Strongmen Throughout the emerging world the rise of the “Misery Index” – unemployment combined with inflation – poses a persistent danger of social and political instability that will rise, not fall, in the coming years. The aftermath of the COVID crisis will be rocky once stimulus measures wane. South Africa, Turkey, and Brazil look the worst on these measures but India and Russia are also vulnerable (Chart 16). Brazilian geopolitical risk under the turbulent administration of President Jair Bolsonaro has returned to the 2015-16 peaks witnessed during the impeachment of President Dilma Rousseff amid the harsh recession of the middle of the last decade. Brazilian equities are nearing a triple bottom, which could present a buying opportunity but not before the current political crisis over fiscal policy exacts a toll on the currency and stock market (Chart 17). Chart 16EM Political Risk Will Bring Bad Surprises EM Political Risk Will Bring Bad Surprises EM Political Risk Will Bring Bad Surprises Chart 17Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Bolsonaro’s signature pension reform was an unpopular measure whose benefits were devastated by the pandemic. The return to fiscal largesse in the face of the crisis boosted Bolsonaro’s support and convinced him to abandon the pretense of austere reformer in favor of traditional Brazilian fiscal populist as the 2022 election approaches. His attempt to violate the country’s fiscal rule – a constitutional provision passed in December 2016 that imposes a 20-year cap on public spending growth – that limits budget deficits is precipitating a shakeup within the ruling coalition. Our Emerging Market Strategists believe the Central Bank of Brazil will hike interest rates to offset the inflationary impact of breaking the fiscal cap but that the hikes will likely fall short, prompting a bond selloff and renewed fears of a public debt crisis. The country’s political crisis will escalate in the lead up to elections, not unlike what occurred in the US, raising the odds of other negative political surprises. Chart 18Reinitiate Long Mexico / Short Brazil Reinitiate Long Mexico / Short Brazil Reinitiate Long Mexico / Short Brazil While Latin America as a whole is a shambles, the global cyclical upturn and shift in American policy creates investment opportunities – particularly for Mexico, at least within the region. Investors should continue to prefer Mexican equities over Brazilian given Mexico’s fundamentally more stable economic policy backdrop and its proximity to the American economy, which will be supercharged with stimulus and eager to find ways to use its new trade deal with Mexico to diversify its manufacturing suppliers away from China (Chart 18). In addition to Brazil, Turkey and the Philippines are also markets where “strongman leaders” and populism have undercut economic orthodoxy and currency stability. A basket of emerging market currencies that excludes these three witnessed a major bottom in 2014-16, when Turkish and Brazilian political instability erupted and when President Rodrigo Duterte stormed the stage in the Philippines. These three currencies look to continue underperforming given that political dynamics will worsen ahead of elections in 2022 (possibly 2023 for Turkey) (Chart 19). Chart 19Keep Shorting The Strongmen Keep Shorting The Strongmen Keep Shorting The Strongmen Investment Takeaways We closed out some “risk-on” trades at the end of January – admittedly too soon – and since then have hedged our pro-cyclical strategic portfolio with safe-haven assets, while continuing to add risk-on trades where appropriate. The Biden administration still faces one or more major foreign policy tests that can prove disruptive, particularly to Taiwanese, Chinese, Russian, and Saudi stocks. Biden’s foreign policy doctrine will be established in the crucible of experience but his preferences are known to favor diplomacy, democracy over autocracy, and to pursue alliances as a means of diversifying supply chains away from China. We will therefore look favorably upon the members of the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) and recommend investors reinitiate the long CPTPP equities basket. These countries, which include emerging markets with decent governance as well as Japan, Australia, New Zealand, and Canada all stand to benefit from the global upswing and US foreign policy (Chart 20). Chart 20Reinitiate Long Trans-Pacific Partnership Reinitiate Long Trans-Pacific Partnership Reinitiate Long Trans-Pacific Partnership Chart 21Reinitiate Long Global Value Over Growth Reinitiate Long Global Value Over Growth Reinitiate Long Global Value Over Growth The Biden administration will likely try to rejoin the CPTPP but even if it fails to do so it will privilege relations with these countries as it strives to counter China and Russia. The UK, South Korea, Thailand and others could join the CPTPP over time – though an attempt to recruit Taiwan would exacerbate the geopolitical risks highlighted above centered on Taiwan. The dollar is perking up, adding a near-term headwind to global equities, but the cyclical trend for the dollar is still down due to extreme monetary and fiscal dovishness. Tactically, go long Mexican equities over Brazilian equities. From a strategic point of view we still favor value stocks over growth stocks and recommend investors reinitiate this global trade (Chart 21). Strategically, wait to overweight UK stocks in a global portfolio until the result of the May local elections is known and the risk of Scottish independence can be reassessed. Strategically, favor developed Europe over emerging Europe stocks as a result of Russian geopolitical risks that are set to escalate. Strategically go long global defense stocks versus cyber security stocks as a geopolitical “back to work” trade for a time when economic activity resumes and resource-oriented territorial, kinetic, military risks reawaken. Strategically, favor EM currencies other than Brazil, Turkey, and the Philippines to minimize exposure to economic populism, poor macro fundamentals, and election risk. Strategically, go long the BCA Rare Earths Basket to capture persistent US-China tensions under Biden and the search for alternatives to China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   We Read (And Liked) … Supply-Side Structural Reform Supply-Side Structural Reform, a compilation of Chinese economic and policy research, discusses several aspects of Chinese economic reform as it is practiced under the Xi Jinping administration, spanning the meaning and importance of supply-side structural reform in China as well as five major tasks.1 The book consists of contributions by Chinese scholars, financial analysts, and opinion makers in 2015, so we have learned a lot since it was published, even as it sheds light on Beijing’s interpretation of reform. 2015 was a year of financial turmoil that saw a dramatic setback for China’s 2013 liberal reform blueprint. It also saw the launch of a new round of reforms under the thirteenth Five Year Plan (2016-20), which aimed to push China further down the transition from export-manufacturing to domestic and consumer-led growth. Beijing’s renewed reform push in 2017, which included a now infamous “deleveraging campaign,” ultimately led to a global slowdown in 2018-19 that was fatefully exacerbated by the trade war with the United States – only to be eclipsed by the COVID-19 pandemic in 2020. Built on fundamental economic theory and the social background of China, the book’s authors examine the impact of supply-side reform on the Chinese financial sector, industrial sector, and macroeconomic development. The comprehensive analysis covers short-term, mid-term and long-term effects. From the perspective of economic theory, there is consensus that China's supply-side structural reform framework did not forsake government support for the demand side of the economy, nor was it synonymous with traditional, liberal supply-side economics in the Western world. In contrast to Say’s Law, Reaganomics, and the UK’s Thatcherite privatization reforms, China's supply-side reform was concentrated on five tasks specific to its contemporary situation: cutting excessive industrial capacity, de-stocking, deleveraging, cutting corporate costs, and improving various structural “weaknesses.” The motives behind the new framework were to enhance the mobility and efficiency of productive factors, eliminate excess capacity, and balance effective supply with effective demand. Basically, if China cannot improve efficiencies, capital will be misallocated, corporations will operate at a loss, and the economy’s potential will worsen over the long run. The debt buildup will accelerate and productivity will suffer. Regarding implementation, the book sets forth several related policies, including deepening the reform of land use and the household registration (hukou) system, and accelerating urbanization, which are effective measures to increase the liquidity of productive factors. Others promote the transformation from a factor-driven economy to efficiency and innovation-driven economy, including improving the property rights system, transferring corporate and local government debt to the central government, and encouraging investment in human capital and in technological innovation. The book also analyzes and predicts the potential costs of reform on the economy in the short and long term. In the short run, authors generally anticipated that deleveraging and cutting excessive industrial capacity would put more pressure on the government’s fiscal budget. The rise in the unemployment rate, cases of bankruptcy, and the negative sentiment of investors would slow China’s economic growth. In the medium and long run, this structural reform was seen as necessary for a sustainable medium-speed economic growth, leading to more positive expectations for households and corporates. The improved efficiency in capital allocation would provide investors with more confidence in the Chinese economy and asset market. Authors argued that overall credit risk was still controllable in near-term, as the corresponding policies such as tax reduction and urbanization would boost private investment and consumption in the short run. These policies increased demand in the labor market and created working positions to counteract adverse impacts. Employment in industries where excessive capacity was most severe only accounted for about 3% of total urban employment in 2013. Regarding the rise in credit risk during de-capacity, the asset quality of banks had improved since the 1990s and the level of bad debt was said to be within a controllable range, given government support. Moreover, in the long run, the merger and reorganization of enterprises would increase the efficient supply and have a positive effect on economic innovation-driven transformation. We know from experience that much of the optimism about reform would confront harsh realities in the 2016-21 period. The reforms proceeded in a halting fashion as the US trade war interrupted their implementation, prompting the government to resort to traditional stimulus measures in mid-2018, only to be followed by another massive fiscal-and-credit splurge in 2020 in the face of the pandemic. Yet investors could be surprised to find that the Politburo meeting on April 17, 2020 proclaimed that China would continue to focus on supply-side structural reform even amid efforts to normalize the economy and maintain epidemic prevention and control. Leaders also pledged to maintain the supply-side reform while emphasizing demand-side management during annual Central Economic Work Conference in December 2020. In other words, Xi administration’s policy preferences remain set, and compromises forced by exogenous events will soon give way to renewed reform initiatives. This is a risk to the global reflation trade in 2021-22. There has not been a total abandonment of supply-side reform. The main idea of demand-side reform – shifts in the way China’s government stimulates the economy – is to fully tap the potential of the domestic market and call for an expansion of consumption and effective investment. Combined with the new concept of “dual circulation,” which emphasizes domestic production and supply chains (effectively import substitution), the current demand-side reforms fall in line with the supply-side goal of building a more independent and controllable supply chain and produce higher technology products. These combined efforts will provide “New China” sectors with more policy support, less regulatory constraint, and lead to better economic and financial market performance. Despite the fluctuations in domestic growth and the pressure from external demand, China will maintain the focus on reform in its long-term planning. The fundamental motivation is to enhance efficiency and innovation that is essential for China’s productivity and competitiveness in the future. Thus, investors should not become complacent over the vast wave of fiscal and credit stimulus that is peaking today as we go to press. Instead they should recognize that China’s leaders are committed to restructuring. This means that the economic upside of stimulus has a cap on it– a cap that will eventually be put in place by policymakers, if not by China’s lower capacity for debt itself. It would be a colossal policy mistake for China to overtighten monetary and fiscal policy in 2021 but any government attempts to tighten, the financial market will become vulnerable. A final thought: it is unclear whether there is potential for an improvement in China’s foreign relations contained in this conclusion. What the western world is demanding is for China to rebalance its economy, open up its markets, cut back on the pace of technological acquisition, reduce government subsidies for state-owned companies, and conform better to US and EU trade rules. There is zero chance that China will provide all of these things. But its own reform program calls for greater intellectual property protections, greater competition in non-strategic sectors (which the US and EU should be able to access under recent trade deals), and targeted stimulus for sustainable energy, where the US and EU see trade and investment opportunities. Thus there is a basis for an improvement in cooperation. What remains to be seen is how protectionist dual circulation will be in practice and how aggressively the US will pursue international enforcement of technological restrictions on China under the Biden administration. Jingnan Liu Research Associate JingnanL@bcaresearch.com Footnotes 1 Yifu L, et al. Supply-Side Structural Reform (Beijing: Democracy & Construction Publishing House, 2016). 351 pages. Appendix: GeoRisk Indicator 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 Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights The positive correlation between share prices and US bond yields – that has been in place since 1997 – is likely to turn negative. Looking ahead, stock prices will fall when US bond yields rise and will rally when Treasury yields drop. The basis is that the key macro risk to equities is shifting from low inflation/deflation to higher inflation. Global growth stocks will underperform value stocks. US equities will lag international markets. Investment strategies and frameworks that have worked over the past 24 years might require modifications. Feature From 1966 until 1997, US equity prices were negatively correlated with US Treasury yields (Chart 1, top panel). Since 1997, US share prices have been positively correlated with US government bond yields. We believe we are now in the process of a major paradigm shift in the stock-bond correlation, reverting to the pre-1997 relationship. Chart 1US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 The basis for the 1997 reversal in the stock-bond correlation was a regime shift in the global macro backdrop. Before 1997, the main risk to business cycles and share prices was inflation. From 1997 until very recently, the main risk to equity markets was deflation or very low inflation. The watershed event that triggered this global macro shift from inflation to deflation was the Asian currency devaluation of 1997. The latter followed the Chinese currency devaluations of early 1994 and the Mexican peso’s crash of early 1995 (Chart 2). All these currency devaluations allowed local producers – operating in these large manufacturing hubs – to cut their export prices in US dollar terms. The price reductions unleashed deflationary forces that spread all over the world, including the US. US import prices from emerging Asia ex-China began plummeting in 1997 (Chart 3). Chart 2EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s Chart 3Deflating Asian Export Prices Reinforced Disinflation Trends In US Deflating Asian Export Prices Reinforced Disinflation Trends In US Deflating Asian Export Prices Reinforced Disinflation Trends In US Due to this deflationary shock from EM currency devaluations and other forces (productivity gains, globalization and outsourcing, among others), the US core inflation rate dropped to 2% in 1997 (Chart 3). This marked a regime shift in global equity markets where concerns about deflation, rather than inflation, became the prime focus of investors. Consequently, share prices rallied when bond yields rose, i.e., stock investors cheered stronger growth because the latter meant diminished deflation risks and only a modest inflation pickup.   The positive relationship also prevailed in the period prior to the mid-1960s when inflation was below 2% (Chart 1). Looking ahead, the main risk to share prices, at least in the US, will be higher inflation. As investors gain confidence that US core inflation will exceed 2%, US share prices will once again exhibit a negative correlation with Treasury yields, as they did prior to 1997. Inflation Redux Odds are that US core inflation will rise well above 2%, and could potentially overshoot, over the coming 12-36 months. Chart 4US Core Inflation Lags Business Cycle By About 12 Months US Core Inflation Lags Business Cycle By About 12 Months US Core Inflation Lags Business Cycle By About 12 Months Cyclical factors driving core inflation higher in the US are as follows: 1. Core inflation lags the business cycle by about 12 months (Chart 4). A continuous economic recovery points to higher core inflation starting this spring. 2. A combination of surging money supply and a potential revival in the velocity of money heralds higher nominal GDP growth and inflation. It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing, as shown in Chart 5. In the Special Report from October 22, BCA’s Emerging Markets team discussed in depth why US money growth is currently substantially stronger than it was in the post-GFC period. Chart 5An Unprecedented US Broad Money Boom An Unprecedented US Broad Money Boom An Unprecedented US Broad Money Boom With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed (genuine public debt monetization), the only missing ingredient for inflation to transpire is a pickup in the velocity of money. Lets’ recall: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we arrive at: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend. At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation (Chart 6). Chart 6As Velocity Of Money Rises, Inflation Will Accelerate As Velocity Of Money Rises, Inflation Will Accelerate As Velocity Of Money Rises, Inflation Will Accelerate Chart 7US Goods Prices Are Rising US Goods Prices Are Rising US Goods Prices Are Rising 3. Demand-supply distortions and shortages will lead to higher prices. The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has, accordingly, produced shortages. US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia, China and Mexico are rising (Chart 7). Lockdowns will likely permanently curtail capacity in some service sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services. As a result, demand for some services will overwhelm supply and companies will take advantage of this new reality by charging considerably higher prices. Consumers will not mind paying higher prices to enjoy services that were not available to them for 18 months or so. This will lead to higher inflation expectations, which might become engrained. Critically, this could happen even if the unemployment rate is high or the output gap is large. 4. Pandemic-related fiscal stimulus in the US has amounted to 21% of GDP. We reckon this exceeds the lingering output gap that opened up in response to the economic crash last year. In short, US authorities are over-stimulating. On top of cyclical forces, there are several structural forces pointing to higher inflation: Higher concentration in US industries and the consequent reduction in competition create fertile grounds for inflation. Over the past two decades, the competitive structure of many US industries has changed: it has become oligopolistic. Due to cheap financing and weak enforcement of anti-trust regulations, large companies have acquired smaller competitors. Chart 8 shows the number of anti-trust enforcement cases has been in a secular decline and is currently very low. In the recent past, there were slightly more than 100 cases per annum while the 1970s averaged more than 400 cases per annum when the economy was much smaller and industry concentration was much lower than now. In many industries, several dominant players now have a substantial market share. Such a high concentration across many industries raises odds of collusion and price increases where conditions permit. Chart 9 demonstrates a measure of market concentration across all US industries. A higher number indicates higher industry concentration. Presently, we have the highest concentration in 50 years, which creates fertile ground for companies to raise their prices. Notably, the sharp drop in this measure of market concentration in the early 1980s was one of reasons behind the secular disinflation trend that followed. Chart 8In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US Chart 9US Industry Concentration Is At A Record High US Industry Concentration Is At A Record High US Industry Concentration Is At A Record High Chart 10US Demographic Points Towards Higher Wage Inflation US Demographic Points Towards Higher Wage Inflation US Demographic Points Towards Higher Wage Inflation   Retirement of baby boomers entails more consumption and less production and is inflationary, ceteris paribus. The US support ratio1 (shown inverted on the chart) portends that the US is transitioning from an environment of low to higher wage growth (Chart 10). This ratio is calculated as the number of workers relative to consumers. This means more consumers exist versus workers available to produce goods and services and, hence, entails higher wages. Higher employee compensation, unless supported by rapid productivity gains, will beget higher inflation.   Government policies targeting faster growth in employee compensation are conducive to higher inflation. One of the Biden administration’s key priorities is to boost wages and reduce income inequality. Unless productivity growth accelerates considerably in the coming years, odds are that labor’s share in national income will rise and companies’ profit margins will be jeopardized. Businesses will attempt to raise prices to restore their profit margins. Provided that income and spending are robust, companies might succeed in raising their prices. In the US, a (moderate) wage-inflation spiral is probable in the coming years.   De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. US import prices are already rising (Chart 7 above). If the US dollar continues to depreciate, exporters to the US will have no other choice but to raise US dollar prices to protect their profit margins. Bottom Line: The US core inflation rate will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up. The main risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite rising wages. An Invincible Fed? Many investors are relying on the Fed and other central banks to get things right. Yet, policymakers are not always infallible. We offer several reasons why putting one’s faith squarely in the Fed at present might not be the most appropriate investment strategy.   It is not unusual for central banks and other government agencies to fight previous wars. As long as the same war lingers, the Fed’s vision and strategy will remain adequate and its policies and actions will secure financial and economic stability, to the benefit of both bond and equity markets. Chart 11US Financial Markets Aggregate Volatility US Financial Markets Aggregate Volatility US Financial Markets Aggregate Volatility However, if we are experiencing a macro paradigm shift from low to higher inflation, the Fed’s strategy and actions will likely prove inadequate, begetting higher financial market volatility, i.e., instability (Chart 11). In brief, if our inflation redux thesis is correct, the Fed will fall behind the inflation curve. In such a scenario, the bond market will continue selling off and rising yields will depress equity valuations.   The Fed is excessively and singularly relying on the output gap models and the Phillips curve to forecast inflation. Yet, inflation is a complex and intricate phenomenon, and it is shaped by numerous cyclical and structural forces beyond the output gap and unemployment. Importantly, the output gap and the Phillip’s curve are theoretical models that do not have great success in real-time forecasting. If these models turn out to be wrong, policy decisions will be suboptimal. Financial markets, which up until now have put their faith in the Fed, will riot. Chart 12Inflation Could Rise And Stay High Amid High Unemployment Inflation Could Rise And Stay High Amid High Unemployment Inflation Could Rise And Stay High Amid High Unemployment Interestingly, a popular economic index in the 1970s was the Misery Index, which is calculated as the sum of the inflation rate and the unemployment rate (Chart 12, top panel). The Misery Index was extremely elevated in the 1970s because both unemployment and inflation were high (Chart 12, bottom panel). The point is that inflation can be high alongside elevated unemployment. In its recent report, BCA Research’s Global Investment Strategy service argued: “Some of the mistakes that policymakers made during the 60s and 70s were far from obvious at the time. Athanasios Orphanides, who formerly served as a member of the ECB’s Governing Council, has documented that central banks in the US and other major economies systematically overestimated the amount of slack in their economies. They also overestimated trend growth, with the result that they came to see the combination of sluggish growth and seemingly high unemployment as evidence of inadequate demand.”   Inflation is a very inert and persistent phenomenon, and it is not easy to reverse its trajectory. The Fed is now explicitly targeting higher inflation with full confidence that it can easily deal with high inflation when it transpires. We would bet that the Fed will get higher inflation this time, but that high inflation will turn out to be an unpleasant outcome for US policymakers. The basis is that US equity and credit markets are not priced for higher interest rates. By directly and indirectly super-charging equity and bond prices, the Fed has crafted excesses that are vulnerable to higher interest rates (Chart 13). Chart 13US Markets Are Priced To Perfection US Markets Are Priced To Perfection US Markets Are Priced To Perfection On the whole, the Fed is set to fall behind the inflation curve as policymakers will be late to acknowledge higher inflation and alter their policy accordingly. This will be bad news for both equity and corporate bond markets that are priced for perfection. The 1960s Roadmap For Financial Markets? There are many similarities between the US macro picture now and as it was in the late 1960s. In the late 1960s: US inflation was subdued, and interest rates were very low in the preceding two-three decades, i.e., inflation expectations were well anchored heading into the second half of the 1960s. America’s fiscal policy was extremely easy, and the budget deficit was swelling. US domestic demand was robust, and the current account deficit was widening. Chart 14FAANGM Now And Nifty-Fifty Mania In The 1960s FAANGM Now And Nifty-Fifty Mania In The 1960s FAANGM Now And Nifty-Fifty Mania In The 1960s Finally, US equities were in a long bull market and a dozen large-cap stocks (the Nifty-Fifty) was leading the rally. Notably, the decade-long profile of FAANGM2 stock prices in real terms (adjusted for inflation) resembles that of Walt Disney – one of the leaders of the Nifty-Fifty pack – in the 1960s (Chart 14). The following dynamics of financial markets in the 1960s and 1970s are noteworthy and could serve as a roadmap for the present: In the mid-1960s, US share prices initially ignored rising bond yields. However, obstinately rising Treasury yields eventually led to a major equity sell-off (bond yields are shown inverted on this panel) (Chart 15, top panel). Yet, bond yields continued ascending despite plunging share prices. Chart 151962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation 1962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation 1962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation The culprit was US core inflation surging well above 2% in 1966. This marked a paradigm shift in the relationship between equity prices and US Treasury yields. Share prices bottomed in late 1966 only after bond yields began declining. Notably, the S&P 500 fell by 22% in 1966, even though economic growth remained robust (Chart 15, middle panel). Critically, US bond yields in the period from 1966 until the early 1980s were more correlated with the core inflation rate than with the business cycle (Chart 15, middle and bottom panels). In short, sticky and persistent inflation not economic growth was the main worry for both US bond and stock markets from the mid-1960s until the early-1980s.  Presently, the US recovery will continue, and economic growth will be rather robust. However, core inflation will climb well above 2% and US Treasury yields will increase further. At some point, this will upset the equity market. Chart 16US And EM EPS Growth Expectations Are Already Very Elevated US And EM EPS Growth Expectations Are Already Very Elevated US And EM EPS Growth Expectations Are Already Very Elevated A pertinent question for stocks from a valuation standpoint is whether profit growth expectations can continue to increase enough to offset the rise in the discount factor. US equities are already pricing in a lot of earning growth: analysts’ expectations for the S&P 500’s EPS growth are 24% for 2021 and another 15% for 2022. Worth noting is that long-term EPS growth expectations have skyrocketed for both US and EM equities (Chart 16). In short, the main problem with US equities is that their valuations are expensive at a time when inflation and interest rates are set to rise. Investment Strategy The equity rally is entering a risky period. Major shakeouts are likely. Share prices will advance when US bond yields drop, and they will dip when Treasury yields ascend. As and when US share prices drop due to concerns about higher inflation, the Fed will attempt to calm investors arguing that inflation is transitory, and it knows how to deal with it. Stocks and bonds will likely rally on reassurances of this kind. However, financial markets will resume selling off if evidence from the real economy corroborates the thesis of higher inflation. The Fed will again soothe the investment community. Although equity and bond prices might firm up anew, such a rebound might not last long as investors will begin to question the appropriateness of the Fed’s policy. Chart 17No Contrarian Buy Signal For US Treasurys No Contrarian Buy Signal For US Treasurys No Contrarian Buy Signal For US Treasurys The sell-off in US Treasurys is unlikely to be over for now as traders’ sentiment on government bonds is far from a bearish extreme (Chart 17). Ultimately, to cap inflation, the Fed will have to hike interest rates more than the fixed-income market is currently pricing. This will not go down well with stock or bond markets. Higher US bond yields entail that global growth stocks will underperform global value stocks. The former is much more expensive and, hence, is more vulnerable to a rising discount rate. Global equity portfolios should underweight the US, adopt a neutral stance on EM and overweight Europe and Japan. The market-cap weight of growth stocks is the highest in the US followed by EM. European and Japanese bourses are less vulnerable to rising bond yields. The Fed falling behind the inflation curve is fundamentally bearish for the US dollar. That is why the primary trend for the dollar remains down. However, the greenback is very oversold and a rebound is likely, especially if US yields continue to rise, triggering a period of risk-off in global financial markets.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1This measure was originally shown by BCA’s Global Investment Strategy team and is calculated as the ratio of the number of workers to the number of consumers. The number of workers incorporates age-specific variation in labor force participation, unemployment, hours worked, and productivity while the number of consumers incorporates age-specific variation in needs or wants based on age-specific consumption data. 2An equally-weighted index of Facebook, Amazon, Apple, Netflix, Google (Alphabet) and Microsoft stock prices.    

Highlights The positive correlation between share prices and US bond yields – that has been in place since 1997 – is likely to turn negative. Looking ahead, stock prices will fall when US bond yields rise and will rally when Treasury yields drop. The basis is that the key macro risk to equities is shifting from low inflation/deflation to higher inflation. Global growth stocks will underperform value stocks. US equities will lag international markets. Investment strategies and frameworks that have worked over the past 24 years might require modifications. Feature From 1966 until 1997, US equity prices were negatively correlated with US Treasury yields (Chart 1, top panel). Since 1997, US share prices have been positively correlated with US government bond yields. We believe we are now in the process of a major paradigm shift in the stock-bond correlation, reverting to the pre-1997 relationship. Chart 1US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 The basis for the 1997 reversal in the stock-bond correlation was a regime shift in the global macro backdrop. Before 1997, the main risk to business cycles and share prices was inflation. From 1997 until very recently, the main risk to equity markets was deflation or very low inflation. The watershed event that triggered this global macro shift from inflation to deflation was the Asian currency devaluation of 1997. The latter followed the Chinese currency devaluations of early 1994 and the Mexican peso’s crash of early 1995 (Chart 2). All these currency devaluations allowed local producers – operating in these large manufacturing hubs – to cut their export prices in US dollar terms. The price reductions unleashed deflationary forces that spread all over the world, including the US. US import prices from emerging Asia ex-China began plummeting in 1997 (Chart 3). Chart 2EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s Chart 3Deflating Asian Export Prices Reinforced Disinflation Trends In US Deflating Asian Export Prices Reinforced Disinflation Trends In US Deflating Asian Export Prices Reinforced Disinflation Trends In US Due to this deflationary shock from EM currency devaluations and other forces (productivity gains, globalization and outsourcing, among others), the US core inflation rate dropped to 2% in 1997 (Chart 3). This marked a regime shift in global equity markets where concerns about deflation, rather than inflation, became the prime focus of investors. Consequently, share prices rallied when bond yields rose, i.e., stock investors cheered stronger growth because the latter meant diminished deflation risks and only a modest inflation pickup.   The positive relationship also prevailed in the period prior to the mid-1960s when inflation was below 2% (Chart 1). Looking ahead, the main risk to share prices, at least in the US, will be higher inflation. As investors gain confidence that US core inflation will exceed 2%, US share prices will once again exhibit a negative correlation with Treasury yields, as they did prior to 1997. Inflation Redux Odds are that US core inflation will rise well above 2%, and could potentially overshoot, over the coming 12-36 months. Chart 4US Core Inflation Lags Business Cycle By About 12 Months US Core Inflation Lags Business Cycle By About 12 Months US Core Inflation Lags Business Cycle By About 12 Months Cyclical factors driving core inflation higher in the US are as follows: 1. Core inflation lags the business cycle by about 12 months (Chart 4). A continuous economic recovery points to higher core inflation starting this spring. 2. A combination of surging money supply and a potential revival in the velocity of money heralds higher nominal GDP growth and inflation. It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing, as shown in Chart 5. In the Special Report from October 22, BCA’s Emerging Markets team discussed in depth why US money growth is currently substantially stronger than it was in the post-GFC period. Chart 5An Unprecedented US Broad Money Boom An Unprecedented US Broad Money Boom An Unprecedented US Broad Money Boom With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed (genuine public debt monetization), the only missing ingredient for inflation to transpire is a pickup in the velocity of money. Lets’ recall: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we arrive at: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend. At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation (Chart 6). Chart 6As Velocity Of Money Rises, Inflation Will Accelerate As Velocity Of Money Rises, Inflation Will Accelerate As Velocity Of Money Rises, Inflation Will Accelerate Chart 7US Goods Prices Are Rising US Goods Prices Are Rising US Goods Prices Are Rising 3. Demand-supply distortions and shortages will lead to higher prices. The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has, accordingly, produced shortages. US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia, China and Mexico are rising (Chart 7). Lockdowns will likely permanently curtail capacity in some service sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services. As a result, demand for some services will overwhelm supply and companies will take advantage of this new reality by charging considerably higher prices. Consumers will not mind paying higher prices to enjoy services that were not available to them for 18 months or so. This will lead to higher inflation expectations, which might become engrained. Critically, this could happen even if the unemployment rate is high or the output gap is large. 4. Pandemic-related fiscal stimulus in the US has amounted to 21% of GDP. We reckon this exceeds the lingering output gap that opened up in response to the economic crash last year. In short, US authorities are over-stimulating. On top of cyclical forces, there are several structural forces pointing to higher inflation: Higher concentration in US industries and the consequent reduction in competition create fertile grounds for inflation. Over the past two decades, the competitive structure of many US industries has changed: it has become oligopolistic. Due to cheap financing and weak enforcement of anti-trust regulations, large companies have acquired smaller competitors. Chart 8 shows the number of anti-trust enforcement cases has been in a secular decline and is currently very low. In the recent past, there were slightly more than 100 cases per annum while the 1970s averaged more than 400 cases per annum when the economy was much smaller and industry concentration was much lower than now. In many industries, several dominant players now have a substantial market share. Such a high concentration across many industries raises odds of collusion and price increases where conditions permit. Chart 9 demonstrates a measure of market concentration across all US industries. A higher number indicates higher industry concentration. Presently, we have the highest concentration in 50 years, which creates fertile ground for companies to raise their prices. Notably, the sharp drop in this measure of market concentration in the early 1980s was one of reasons behind the secular disinflation trend that followed. Chart 8In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US Chart 9US Industry Concentration Is At A Record High US Industry Concentration Is At A Record High US Industry Concentration Is At A Record High Chart 10US Demographic Points Towards Higher Wage Inflation US Demographic Points Towards Higher Wage Inflation US Demographic Points Towards Higher Wage Inflation   Retirement of baby boomers entails more consumption and less production and is inflationary, ceteris paribus. The US support ratio1 (shown inverted on the chart) portends that the US is transitioning from an environment of low to higher wage growth (Chart 10). This ratio is calculated as the number of workers relative to consumers. This means more consumers exist versus workers available to produce goods and services and, hence, entails higher wages. Higher employee compensation, unless supported by rapid productivity gains, will beget higher inflation.   Government policies targeting faster growth in employee compensation are conducive to higher inflation. One of the Biden administration’s key priorities is to boost wages and reduce income inequality. Unless productivity growth accelerates considerably in the coming years, odds are that labor’s share in national income will rise and companies’ profit margins will be jeopardized. Businesses will attempt to raise prices to restore their profit margins. Provided that income and spending are robust, companies might succeed in raising their prices. In the US, a (moderate) wage-inflation spiral is probable in the coming years.   De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. US import prices are already rising (Chart 7 above). If the US dollar continues to depreciate, exporters to the US will have no other choice but to raise US dollar prices to protect their profit margins. Bottom Line: The US core inflation rate will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up. The main risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite rising wages. An Invincible Fed? Many investors are relying on the Fed and other central banks to get things right. Yet, policymakers are not always infallible. We offer several reasons why putting one’s faith squarely in the Fed at present might not be the most appropriate investment strategy.   It is not unusual for central banks and other government agencies to fight previous wars. As long as the same war lingers, the Fed’s vision and strategy will remain adequate and its policies and actions will secure financial and economic stability, to the benefit of both bond and equity markets. Chart 11US Financial Markets Aggregate Volatility US Financial Markets Aggregate Volatility US Financial Markets Aggregate Volatility However, if we are experiencing a macro paradigm shift from low to higher inflation, the Fed’s strategy and actions will likely prove inadequate, begetting higher financial market volatility, i.e., instability (Chart 11). In brief, if our inflation redux thesis is correct, the Fed will fall behind the inflation curve. In such a scenario, the bond market will continue selling off and rising yields will depress equity valuations.   The Fed is excessively and singularly relying on the output gap models and the Phillips curve to forecast inflation. Yet, inflation is a complex and intricate phenomenon, and it is shaped by numerous cyclical and structural forces beyond the output gap and unemployment. Importantly, the output gap and the Phillip’s curve are theoretical models that do not have great success in real-time forecasting. If these models turn out to be wrong, policy decisions will be suboptimal. Financial markets, which up until now have put their faith in the Fed, will riot. Chart 12Inflation Could Rise And Stay High Amid High Unemployment Inflation Could Rise And Stay High Amid High Unemployment Inflation Could Rise And Stay High Amid High Unemployment Interestingly, a popular economic index in the 1970s was the Misery Index, which is calculated as the sum of the inflation rate and the unemployment rate (Chart 12, top panel). The Misery Index was extremely elevated in the 1970s because both unemployment and inflation were high (Chart 12, bottom panel). The point is that inflation can be high alongside elevated unemployment. In its recent report, BCA Research’s Global Investment Strategy service argued: “Some of the mistakes that policymakers made during the 60s and 70s were far from obvious at the time. Athanasios Orphanides, who formerly served as a member of the ECB’s Governing Council, has documented that central banks in the US and other major economies systematically overestimated the amount of slack in their economies. They also overestimated trend growth, with the result that they came to see the combination of sluggish growth and seemingly high unemployment as evidence of inadequate demand.”   Inflation is a very inert and persistent phenomenon, and it is not easy to reverse its trajectory. The Fed is now explicitly targeting higher inflation with full confidence that it can easily deal with high inflation when it transpires. We would bet that the Fed will get higher inflation this time, but that high inflation will turn out to be an unpleasant outcome for US policymakers. The basis is that US equity and credit markets are not priced for higher interest rates. By directly and indirectly super-charging equity and bond prices, the Fed has crafted excesses that are vulnerable to higher interest rates (Chart 13). Chart 13US Markets Are Priced To Perfection US Markets Are Priced To Perfection US Markets Are Priced To Perfection On the whole, the Fed is set to fall behind the inflation curve as policymakers will be late to acknowledge higher inflation and alter their policy accordingly. This will be bad news for both equity and corporate bond markets that are priced for perfection. The 1960s Roadmap For Financial Markets? There are many similarities between the US macro picture now and as it was in the late 1960s. In the late 1960s: US inflation was subdued, and interest rates were very low in the preceding two-three decades, i.e., inflation expectations were well anchored heading into the second half of the 1960s. America’s fiscal policy was extremely easy, and the budget deficit was swelling. US domestic demand was robust, and the current account deficit was widening. Chart 14FAANGM Now And Nifty-Fifty Mania In The 1960s FAANGM Now And Nifty-Fifty Mania In The 1960s FAANGM Now And Nifty-Fifty Mania In The 1960s Finally, US equities were in a long bull market and a dozen large-cap stocks (the Nifty-Fifty) was leading the rally. Notably, the decade-long profile of FAANGM2 stock prices in real terms (adjusted for inflation) resembles that of Walt Disney – one of the leaders of the Nifty-Fifty pack – in the 1960s (Chart 14). The following dynamics of financial markets in the 1960s and 1970s are noteworthy and could serve as a roadmap for the present: In the mid-1960s, US share prices initially ignored rising bond yields. However, obstinately rising Treasury yields eventually led to a major equity sell-off (bond yields are shown inverted on this panel) (Chart 15, top panel). Yet, bond yields continued ascending despite plunging share prices. Chart 151962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation 1962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation 1962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation The culprit was US core inflation surging well above 2% in 1966. This marked a paradigm shift in the relationship between equity prices and US Treasury yields. Share prices bottomed in late 1966 only after bond yields began declining. Notably, the S&P 500 fell by 22% in 1966, even though economic growth remained robust (Chart 15, middle panel). Critically, US bond yields in the period from 1966 until the early 1980s were more correlated with the core inflation rate than with the business cycle (Chart 15, middle and bottom panels). In short, sticky and persistent inflation not economic growth was the main worry for both US bond and stock markets from the mid-1960s until the early-1980s.  Presently, the US recovery will continue, and economic growth will be rather robust. However, core inflation will climb well above 2% and US Treasury yields will increase further. At some point, this will upset the equity market. Chart 16US And EM EPS Growth Expectations Are Already Very Elevated US And EM EPS Growth Expectations Are Already Very Elevated US And EM EPS Growth Expectations Are Already Very Elevated A pertinent question for stocks from a valuation standpoint is whether profit growth expectations can continue to increase enough to offset the rise in the discount factor. US equities are already pricing in a lot of earning growth: analysts’ expectations for the S&P 500’s EPS growth are 24% for 2021 and another 15% for 2022. Worth noting is that long-term EPS growth expectations have skyrocketed for both US and EM equities (Chart 16). In short, the main problem with US equities is that their valuations are expensive at a time when inflation and interest rates are set to rise. Investment Strategy The equity rally is entering a risky period. Major shakeouts are likely. Share prices will advance when US bond yields drop, and they will dip when Treasury yields ascend. As and when US share prices drop due to concerns about higher inflation, the Fed will attempt to calm investors arguing that inflation is transitory, and it knows how to deal with it. Stocks and bonds will likely rally on reassurances of this kind. However, financial markets will resume selling off if evidence from the real economy corroborates the thesis of higher inflation. The Fed will again soothe the investment community. Although equity and bond prices might firm up anew, such a rebound might not last long as investors will begin to question the appropriateness of the Fed’s policy. Chart 17No Contrarian Buy Signal For US Treasurys No Contrarian Buy Signal For US Treasurys No Contrarian Buy Signal For US Treasurys The sell-off in US Treasurys is unlikely to be over for now as traders’ sentiment on government bonds is far from a bearish extreme (Chart 17). Ultimately, to cap inflation, the Fed will have to hike interest rates more than the fixed-income market is currently pricing. This will not go down well with stock or bond markets. Higher US bond yields entail that global growth stocks will underperform global value stocks. The former is much more expensive and, hence, is more vulnerable to a rising discount rate. Global equity portfolios should underweight the US, adopt a neutral stance on EM and overweight Europe and Japan. The market-cap weight of growth stocks is the highest in the US followed by EM. European and Japanese bourses are less vulnerable to rising bond yields. The Fed falling behind the inflation curve is fundamentally bearish for the US dollar. That is why the primary trend for the dollar remains down. However, the greenback is very oversold and a rebound is likely, especially if US yields continue to rise, triggering a period of risk-off in global financial markets.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1This measure was originally shown by BCA’s Global Investment Strategy team and is calculated as the ratio of the number of workers to the number of consumers. The number of workers incorporates age-specific variation in labor force participation, unemployment, hours worked, and productivity while the number of consumers incorporates age-specific variation in needs or wants based on age-specific consumption data. 2An equally-weighted index of Facebook, Amazon, Apple, Netflix, Google (Alphabet) and Microsoft stock prices.    

Highlights The multiple paid for oil sector profits is collapsing because the market fears that the profits slump will not be short-lived. The fear is not just of a lasting hit to aviation and a slower recovery in road mobility, but an existential fear for fossil-fuelled road transportation in the post-pandemic world. Stay structurally underweight oil and gas. Within the cyclical and value segments of the equity market, overweight metals and miners versus oil and gas. Structurally underweight the stock markets of Norway and the UK which are oil and gas heavy. Structurally overweight the stock markets of Germany, Switzerland, and Denmark which have zero exposure to oil and gas or basic resources. Fractal trade: tin’s near-vertical rally is at high risk of correction. Feature Chart of the WeekOil Production Has Gone Nowhere Oil Production Has Gone Nowhere Oil Production Has Gone Nowhere The Brent crude oil price recently hit $65, not far below its pre-pandemic level of $69. Yet in the stock market, oil and gas equities remain the dogs, languishing 32 percent below their pre-pandemic price level. Relative to the market, the oil and gas sector has underperformed by 42 percent, and the underperformance has been almost a straight line down. Moreover, since last June when the crude oil price has risen by 50 percent, oil and gas equity prices have gone nowhere. This massive divergence of a surging crude oil price from slumping oil and gas equities raises the obvious question, what can explain this dichotomy? (Chart I-2 and Chart I-3) Chart I-2Oil And Gas Equities Have Slumped In Absolute Terms... Oil And Gas Equities Have Slumped In Absolute Terms... Oil And Gas Equities Have Slumped In Absolute Terms... Chart I-3...And In Relative ##br##Terms ...And In Relative Terms ...And In Relative Terms One apparent puzzle is that the oil sector’s profits have underperformed their established relationship with the crude oil price. In fact, there is no puzzle. The oil sector’s profits might appear to track the oil price, but the reality is that profits track the value of oil production, meaning the product of oil production and the oil price. Clearly though, if output is flat, then profits will appear to track the oil price.  But as it took a massive cut in oil output to support the oil price, the value of oil production and therefore, the oil sector’s profits, have significantly underperformed the oil price. Put another way, if you need to cut output to boost the commodity price it might help the commodity price, but it doesn’t much help the equity sector’s profits! (Chart I-4 and Chart I-5). Chart I-4Oil And Gas Profits Appear To Track The Oil Price Oil And Gas Profits Appear To Track The Oil Price Oil And Gas Profits Appear To Track The Oil Price Chart I-5In Reality, Oil And Gas Profits Track The Value Of Oil Output In Reality, Oil And Gas Profits Track The Value Of Oil Output In Reality, Oil And Gas Profits Track The Value Of Oil Output Will Fossil-Fuelled Road Transportation Be Driven To Extinction? We can now explain the 42 percent underperformance of oil equities, and perhaps more importantly, forecast what will happen next. When the pandemic took hold, and economic mobility ground to a halt, the oil sector’s 12-month forward profits slumped. Bear in mind that aviation accounts for 8 percent of oil consumption but, more crucially, road transportation accounts for half of all oil consumption. However, as the pandemic’s impact was expected to be short-lived, the multiple paid for those depressed 12-month forward profits rose. This partly compensated for the profit slump, but still left oil equity prices much lower. The multiple paid for oil sector profits is collapsing because the market fears that the profit slump will not be short-lived. When profits started to recover – albeit, as just discussed, by much less than the oil price rise – it should have boosted oil equity prices. The problem was that the multiple paid for those profits fell by much more than the recovery in profits, with the result that oil equities continued to underperform. Begging the question, why is the multiple paid for oil sector profits collapsing? (Chart I-6) Chart I-6Why Is The Multiple Paid For Oil Sector Profits Collapsing? Why Is The Multiple Paid For Oil Sector Profits Collapsing? Why Is The Multiple Paid For Oil Sector Profits Collapsing? The multiple paid for oil sector profits is collapsing because the market fears that the profit slump will not be short-lived. The fear is not just of a lasting hit to aviation and a slower recovery in road mobility. The fear has become existential. Governments’ plans for pandemic stimulus and recovery have put green energy at front and centre stage. Thereby the recovery has fast-tracked the ultimate nemesis of the oil industry – the extinction of fossil-fuelled road transportation. Are the fears for oil consumption justified? Yes. Aviation is not likely to reach its pre-pandemic level of oil consumption for many years, and long-haul aviation may never get there. But the much bigger threat is fossil-fuelled road transportation. From October 2021, London will extend its Ultra Low Emission Zone (ULEZ) to an 8 mile radius from the city centre.1 The effect will be to banish from London all diesel-fuelled vehicles made before 2015 as well as some older petrol-fuelled vehicles. We expect other major cities to follow London’s example. In most cases, this initiative will happen regardless of the success (or not) of electric vehicles (EVs). Combined with other green initiatives around the world, policymakers’ unashamed aim is to drive fossil-fuelled road transportation to extinction. To repeat, road transportation accounts for half of all oil consumption. The upshot is that the structural downtrend in oil consumption will persist unless the shift away from fossil-fuelled road transportation hits a brick wall, or at least a bottleneck. We do not see such a brick wall or a bottleneck in the foreseeable future. We conclude that though the sector may offer occasional countertrend tactical buying opportunities, long-term equity investors should underweight oil and gas. Structurally Prefer Metals And Miners To Oil And Gas The preceding analysis of the oil sector can be extended to other commodity equities, like the metals and miners. To reiterate, it is the total value of commodity output – the product of commodity production and the commodity price – that drives the profits of commodity equities. On this basis, the long-term prospects for the metals and miners appear somewhat brighter than for oil and gas equities (Chart I-7). Chart I-7Commodity Sector Profits Track The Value Of Commodity Output Commodity Sector Profits Track The Value Of Commodity Output Commodity Sector Profits Track The Value Of Commodity Output Looking at the production of copper, it has increased by around 25 percent over the past decade, albeit this is just in line with world real GDP. By comparison, the production of oil has gone nowhere (Chart of the Week). It is the total value of commodity output that drives the profits of commodity equities. Turning to price, relative to the 2011 high the copper price is around 15 percent lower, whereas the oil price is 50 percent lower (Chart I-8). Chart I-8The Copper Price Has Outperformed The Oil Price The Copper Price Has Outperformed The Oil Price The Copper Price Has Outperformed The Oil Price Hence, on the all-important value of output, copper has moved in a sideways channel over the past decade while oil has been in an unmistakeable structural downtrend, with lower highs and lower lows (Chart I-9). Chart I-9The Value Of Output Is Trending Sideways For Copper, But Downwards For Oil The Value Of Output Is Trending Sideways For Copper, But Downwards For Oil The Value Of Output Is Trending Sideways For Copper, But Downwards For Oil This relative trend is likely to continue as the shift from fossil-fuelled road transportation to EVs will weigh on oil demand, while supporting copper (and other metal) demand. We do not recommend an outright overweight in metals and miners given that their profits are just moving in a sideways channel. However, within the cyclical and value segments of the equity market, a good structural position is to overweight metals and miners versus oil and gas. When Oil And Gas Underperforms, So Does Norway’s OBX And The UK’s FTSE 100 Regional and country equity market performances is driven by the dominant sectors within each stock market. In relative terms, it is also driven by the sectors that are missing. If the oil and gas sector is a structural underperformer, then oil and gas heavy stock markets such as Norway and the UK will be structural underperformers too. If the oil and gas sector is a structural underperformer, it inevitably means that oil and gas heavy stock markets such as Norway and the UK will be structural underperformers too (Chart I-10 and Chart I-11). Chart I-10When Oil And Gas Underperforms, Norway's OBX Underperforms... When Oil And Gas Underperforms, Norway's OBX Underperforms... When Oil And Gas Underperforms, Norway's OBX Underperforms... Chart I-11...And The UK's FTSE 100 ##br##Underperforms ...And The UK's FTSE 100 Underperforms ...And The UK's FTSE 100 Underperforms The corollary is that stock markets which are under-exposed to the structurally underperforming sector will be at a relative advantage. This supports our structural overweighting to the stock markets of Germany, Switzerland, and Denmark, which all have zero exposure to oil and gas and basic resources. Fractal Trading System* Tin’s near-vertical rally is at high risk of correction based on fragility on all three fractal structures: 65-day, 130-day, and 260-day. A good trade is to short tin versus lead, setting a profit target and symmetrical stop-loss at 13 percent. In other trades, the underweights to China and Korea surged, but short AUD/JPY and short copper/gold reached their stop-losses. The rolling 12-month win ratio stands at 57 percent. Chart I-12Tin Vs. Lead Tin Vs. Lead Tin Vs. Lead When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1   ULEZ will be the zone inside London’s North Circular and South Circular Roads. 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