Manufacturing

Highlights Geopolitical risk is trickling back into financial markets. China’s fiscal-and-credit impulse collapsed again. The Global Economic Policy Uncertainty Index is ticking back up after the sharp drop from 2020. All of our proprietary GeoRisk Indicators are elevated or rising. Geopolitical risk often rises during bull markets – the Geopolitical Risk Index can even spike without triggering a bear market or recession. Nevertheless a rise in geopolitical risk is positive for the US dollar, which happens to stand at a critical technical point. The macroeconomic backdrop for the dollar is becoming less bearish given China’s impending slowdown. President Biden’s trip to Europe and summit with Russian President Vladimir Putin will underscore a foreign policy of forming a democratic alliance to confront Russia and China, confirming the secular trend of rising geopolitical risk. Shift to a defensive tactical position. Feature Back in March 2017 we wrote a report, “Donald Trump Is Who We Thought He Was,” in which we reaffirmed our 2016 view that President Trump would succeed in steering the US in the direction of fiscal largesse and trade protectionism. Now it is time for us to do the same with President Biden. Our forecast for Biden rested on the same points: the US would pursue fiscal profligacy and mercantilist trade policy. The recognition of a consistent national policy despite extreme partisan divisions is a testament to the usefulness of macro analysis and the geopolitical method. Trump stole the Democrats’ thunder with his anti-austerity and anti-free trade message. Biden stole it back. It was the median voter in the Rust Belt who was calling the shots all along (after all, Biden would still have won the election without Arizona and Georgia). We did make some qualifications, of course. Biden would maintain a hawkish line on China and Russia but he would reject Trump’s aggressive foreign and trade policy when it came to US allies.1 Biden would restore President Obama’s policy on Iran and immigration but not Russia, where there would be no “diplomatic reset.” And Biden’s fiscal profligacy, unlike Trump’s, would come with tax hikes on corporations and the wealthy … even though they would fall far short of offsetting the new spending. This is what brings us to this week’s report: New developments are confirming this view of the Biden administration. Geopolitical Risk And Bull Markets Chart 1Global Geopolitical Risk And The Dollar In recent weeks Biden has adopted a hawkish policy on China, lowered tensions with Europe, and sought to restore President Obama’s policy of détente with Iran. The jury is still out on relations with Russia – Biden will meet with Putin on June 16 – but we do not expect a 2009-style “reset” that increases engagement. Still, it is too soon to declare a “Biden doctrine” of foreign policy because Biden has not yet faced a major foreign crisis. A major test is coming soon. Biden’s decision to double down on hawkish policy toward China will bring ramifications. His possible deal with Iran faces a range of enemies, including within Iran. His reduction in tensions with Russia is not settled yet. While the specific source and timing of his first major foreign policy crisis is impossible predict, structural tensions are rebuilding. An aggregate of our 13 market-based GeoRisk indicators suggests that global political risk is skyrocketing once again. A sharp spike in the indicator, which is happening now, usually correlates with a dollar rally (Chart 1). This indicator is mean-reverting since it measures the deviation of emerging market currencies, or developed market equity markets, from underlying macroeconomic fundamentals. The implication is positive for the dollar, although the correlation is not always positive. Looking at both the DXY’s level and its rate of change shows periods when the global risk indicator fell yet the dollar stayed strong – and vice versa. The big increase in the indicator over the past week stems mostly from Germany, South Korea, Brazil, and Australia, though all 13 of the indicators are now either elevated or rising, including the China/Taiwan indicators. Some of the increase is due to base effects. As global exports recover, currencies and equities that we monitor are staying weaker than one would expect. This causes the relevant BCA GeoRisk indicator to rise. Base effects from the weak economy in June 2020 will fall out in coming weeks. But the aggregate shows that all of the indicators are either high or rising and, on a country by country level, they are now in established uptrends even aside from base effects. Chart 2Global Policy Uncertainty Revives Meanwhile the global Economic Policy Uncertainty Index is recovering across the world after the drop in uncertainty following the COVID-19 crisis (Chart 2). Policy uncertainty is also linked to the dollar and this indicator shows that it is rising on a secular basis. The Geopolitical Risk Index, maintained by Matteo Iacoviello and a group of academics affiliated with the Policy Uncertainty Index, is also in a secular uptrend, although cyclically it has not recovered from the post-COVID drop-off. It is sensitive to traditional, war-linked geopolitical risk as reported in newspapers. By contrast our proprietary indicators are sensitive to market perceptions of any kind of risk, not just political, both domestic and international. A comparison of the Geopolitical Risk Index with the S&P 500 over the past century shows that a geopolitical crisis may occur at the beginning of a business cycle but it may not be linked with a recession or bear market. Risk can rise, even extravagantly, during economic expansions without causing major pullbacks. But a crisis event certainly can trigger a recession or bear market, particularly if it is tied to the global oil supply, as in the early 1970s, 1980s, and 1990s (Chart 3). Chart 3Secular Rise In Geopolitical Risk Soon To Reassert Itself While geopolitical risk is normally positive for the dollar, the macroeconomic backdrop is negative. The dollar’s attempt to recover earlier this year faltered. This underlying cyclical bearish dollar trend is due to global economic recovery – which will continue – and extravagant American monetary expansion and budget deficits. This is why we have preferred gold – it is a hedge against both geopolitical risk and inflation expectations. Tactically this year we have refrained from betting against the dollar except when building up some safe-haven positions like Japanese yen. Over the medium and long term we expect geopolitical risk to put a floor under the greenback. The bottom line is that the US dollar is at a critical technical crossroads where it could break out or break down. Macro factors suggest a breakdown but the recovery of global policy uncertainty and geopolitical risk suggests the opposite. We remain neutral. A final quantitative indicator of the recovery of geopolitical risk is the performance of global aerospace and defense stocks (Chart 4). Defense shares are rising in absolute and relative terms. Chart 4Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Can The WWII Peace Be Prolonged? Qualitative assessments of geopolitical risk are necessary to explain why risk is on a secular upswing – why drops in the quantitative indicators are temporary and the troughs keep getting higher. Great nations are returning to aggressive competition after a period of relative peace and prosperity. Over the past two decades Russia and China took advantage of America’s preoccupations with the Middle East, the financial crisis, and domestic partisanship in order to build up their global influence. The result is a world in which authority is contested. The current crisis is not merely about the end of the post-Cold War international order. It is much scarier than that. It is about the decay of the post-WWII international order and the return of the centuries-long struggle for global supremacy among Great Powers. The US and European political establishments fear the collapse of the WWII settlement in the face of eroding legitimacy at home and rising challenges from abroad. The 1945 peace settlement gave rise to both a Cold War and a diplomatic system, including the United Nations Security Council, for resolving differences among the great powers. It also gave rise to European integration and various institutions of American “liberal hegemony.” It is this system of managing great power struggle, and not the post-Cold War system of American domination, that lies in danger of unraveling. This is evident from the following points: American preeminence only lasted fifteen years, or at best until the 2008 Georgia war and global financial crisis. The US has been an incoherent wild card for at least 13 years now, almost as long as it was said to be the global empire. Russian antagonism with the West never really ended. In retrospect the 1990s were a hiatus rather than a conclusion of this conflict. China’s geopolitical rise has thawed the frozen conflicts in Asia from the 1940s-50s – i.e. the Chinese civil war, the Hong Kong and Taiwan Strait predicaments, the Korean conflict, Japanese pacifism, and regional battles for political influence and territory. Europe’s inward focus and difficulty projecting power have been a constant, as has its tendency to act as a constraint on America. Only now is Europe getting closer to full independence (which helped trigger Brexit). Geopolitical pressures will remain historically elevated for the foreseeable future because the underlying problem is whether great power struggle can be contained and major wars can be prevented. Specifically the question is whether the US can accommodate China’s rise – and whether China can continue to channel its domestic ambitions into productive uses (i.e. not attempts to create a Greater Chinese and then East Asian empire). The Great Recession killed off the “East Asia miracle” phase of China’s growth. Potential GDP is declining, which undermines social stability and threatens the Communist Party’s legitimacy. The renminbi is on a downtrend that began with the Xi Jinping era. The sharp rally during the COVID crisis is over, as both domestic and international pressures are rising again (Chart 5). Chart 5Biden Administration Review Of China Policy: More China Bashing While the data for China’s domestic labor protests is limited in extent, we can use it as a proxy for domestic instability in lieu of official statistics that were tellingly discontinued back in 2005. The slowdown in credit growth and the cyclical sectors of the economy suggest that domestic political risk is underrated in the lead up to the 2022 leadership rotation (Chart 6). Chart 6China's Domestic Political Risk Will Rise Chart 7Steer Clear Of Taiwan Strait The increasing focus on China’s access to key industrial and technological inputs, the tensions over the Taiwan Strait, and the formation of a Russo-Chinese bloc that is excluded from the West all suggest that the risk to global stability is grave and historic. It is reminiscent of the global power struggles of the seventeenth through early twentieth centuries. The outperformance of Taiwanese equities from 2019-20 reflects strong global demand for advanced semiconductors but the global response to this geopolitical bottleneck is to boost production at home and replace Taiwan. Therefore Taiwan’s comparative advantage will erode even as geopolitical risk rises (Chart 7). The drop in geopolitical tensions during COVID-19 is over, as highlighted above. With the US, EU, and other countries launching probes into whether the virus emerged from a laboratory leak in China – contrary to what their publics were told last year – it is likely that a period of national recriminations has begun. There is a substantial risk of nationalism, xenophobia, and jingoism emerging along with new sources of instability. An Alliance Of Democracies The Biden administration’s attempt to restore liberal hegemony across the world requires a period of alliance refurbishment with the Europeans. That is the purpose of his current trip to the UK, Belgium, and Switzerland. But diplomacy only goes so far. The structural factor that has changed is the willingness of the West to utilize government in the economic sphere, i.e. fiscal proactivity. Infrastructure spending and industrial policy, at the service of national security as well as demand-side stimulus, are the order of the day. This revolution in economic policy – a return to Big Government in the West – poses a threat to the authoritarian powers, which have benefited in recent decades by using central strategic planning to take advantage of the West’s democratic and laissez-faire governance. If the West restores a degree of central government – and central coordination via NATO and other institutions – then Beijing and Moscow will face greater pressure on their economies and fewer strategic options. About 16 American allies fall short of the 2% of GDP target for annual defense spending – ranging from Italy to Canada to Germany to Japan. However, recent trends show that defense spending did indeed increase during the Trump administration (Chart 8). Chart 8NATO Boosts Defense Spending The European Union as a whole has added $50 billion to the annual total over the past five years. A discernible rise in defense spending is taking place even in Germany (Chart 9). The same point could be made for Japan, which is significantly boosting defense spending (as a share of output) after decades of saying it would do so without following through. A major reason for the American political establishment’s rejection of President Trump was the risk he posed to the trans-Atlantic alliance. A decline in NATO and US-EU ties would dramatically undermine European security and ultimately American security. Hence Biden is adopting the Trump administration’s hawkish approach to trade with China but winding down the trade war with Europe (Chart 10). Chart 9Europe Spending More On Guns Chart 10US Ends Trade War With Europe? A multilateral deal aimed at setting a floor in global corporate taxes rates is intended to prevent the US and Europe from undercutting each other – and to ensure governments have sufficient funding to maintain social spending and reduce income inequality (Chart 11). Inequality is seen as having vitiated sociopolitical stability and trust in government in the democracies. Chart 11‘Global’ Corporate Tax Deal Shows Return Of Big Government, Attempt To Reduce Inequality In The West Risks To Biden’s Diplomacy It is possible that Biden’s attempt to restore US alliances will go nowhere over the course of his four-year term in office. The Europeans may well remain risk averse despite their initial signals of willingness to work with Biden to tackle China’s and Russia’s challenges to the western system. The Germans flatly rejected both Biden and Trump on the Nord Stream II natural gas pipeline linkage with Russia, which is virtually complete and which strengthens the foundation of Russo-German engagement (more on this below). The US’s lack of international reliability – given the potential of another partisan reversal in four years – makes it very hard for countries to make any sacrifices on behalf of US initiatives. The US’s profound domestic divisions have only slightly abated since the crises of 2020 and could easily flare up again. A major outbreak of domestic instability could distract Biden from the foreign policy game.2 However, American incapacity is a risk, not our base case, over the coming years. We expect the US economic stimulus to stabilize the country enough that the internal political crisis will be contained and the US will continue to play a global role. The “Civil War Lite” has mostly concluded, excepting one or two aftershocks, and the US is entering into a “Reconstruction Lite” era. The implication is negative for China and Russia, as they will now have to confront an America that, if not wholly unified, is at least recovering. Congress’s impending passage of the Innovation and Competition Act – notably through regular legislative order and bipartisan compromise – is case in point. The Senate has already passed this approximately $250 billion smorgasbord of industrial policy, supply chain resilience, and alliance refurbishment. It will allot around $50 billion to the domestic semiconductor industry almost immediately as well as $17 billion to DARPA, $81 billion for federal research and development through the National Science Foundation, which includes $29 billion for education in science, technology, engineering, and mathematics, and other initiatives (Table 1). Table 1Peak Polarization: US Congress Passes Bipartisan ‘Innovation And Competition Act’ To Counter China With the combination of foreign competition, the political establishment’s need to distract from domestic divisions, and the benefit of debt monetization courtesy of the Federal Reserve, the US is likely to achieve some notable successes in pushing back against China and Russia. On the diplomatic front, the US will meet with some success because the European and Asian allies do not wish to see the US embrace nationalism and isolationism. They have their own interests in deterring Russia and China. Lack Of Engagement With Russia Russian leadership has dealt with the country’s structural weaknesses by adopting aggressive foreign policy. At some point either the weaknesses or the foreign policy will create a crisis that will undermine the current regime – after all, Russia has greatly lagged the West in economic development and quality of life (Chart 12). But President Putin has been successful at improving the country’s wealth and status from its miserably low base in the 1990s and this has preserved sociopolitical stability so far. Chart 12Russia's Domestic Political Risk It is debatable whether US policy toward Russia ever really changed under President Trump, but there has certainly not been a change in strategy from Russia. Thus investors should expect US-Russia antagonism to continue after Biden’s summit with Putin even if there is an ostensible improvement. The fundamental purpose of Putin’s strategy has been to salvage the Russian empire after the Soviet collapse, ensure that all world powers recognize Russia’s veto power over major global policies and initiatives, and establish a strong strategic position for the coming decades as Russia’s demographic decline takes its toll. A key component of the strategy has been to increase economic self-sufficiency and reduce exposure to US sanctions. Since the invasion of Ukraine in 2014, Putin has rapidly increased Russia’s foreign exchange reserves so as to buffer against shocks (Chart 13). Chart 13Russia Fortified Against US Sanctions Putin has also reduced Russia’s reliance on the US dollar to about 22% (Chart 14), primarily by substituting the euro and gold. Russia will not be willing or able to purge US dollars from its system entirely but it has been able to limit America’s ability to hurt Russia by constricting access to dollars and the dollar-based global financial architecture. Russian Finance Minister Anton Siluanov highlighted this process ahead of the Biden-Putin summit by declaring that the National Wealth Fund will divest of its remaining $40 billion of its US dollar holdings. Chart 14Russia Diversifies From USD In general this year, Russia is highlighting its various advantages: its resilience against US sanctions, its ability to re-invade Ukraine, its ability to escalate its military presence in Belarus and the Black Sea, and its ability to conduct or condone cyberattacks on vital American food and fuel supplies (Chart 15). Meanwhile the US is suffering from deep political divisions at home and strategic incoherence abroad and these are only starting to be mended by domestic economic stimulus and alliance refurbishment. Chart 15Cyber Security Stocks Recover Europe’s risk-aversion when it comes to strategic confrontation with Russia, and the lack of stability in US-Russia relations, means that investors should not chase Russian currency or financial assets amid the cyclical commodity rally. Investors should also expect risk premiums to remain high in developing European economies relative to their developed counterparts. This is true despite the fact that developed market Europe’s outperformance relative to emerging Europe recently peaked and rolled over. From a technical perspective this outperformance looks to subside but geopolitical tensions can easily escalate in the near term, particularly in advance of the Russian and German elections in September (Chart 16). Chart 16Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Europe trades in line with EUR-RUB and these pair trades all correspond closely to geopolitical tensions with Russia (Chart 17). A notable exception is the UK, whose stock market looks attractive relative to eastern Europe and is much more secure from any geopolitical crisis in this region (Chart 17, bottom panel). The pound is particularly attractive against the Czech koruna, as Russo-Czech tensions have heated up in advance of October’s legislative election there (Chart 18). Chart 17Long UK Versus Eastern Europe Chart 18Long GBP Versus CZK Meanwhile Russia and China have grown closer together out of strategic necessity. Germany’s Election And Stance Toward Russia Germany’s position on Russia is now critical. The decision to complete the Nord Stream II pipeline against American wishes either means that the Biden administration can be safely ignored – since it prizes multilateralism and alliances above all things and is therefore toothless when opposed – or it means that German will aim to compensate the Americans in some other area of strategic concern. Washington is clearly attempting to rally the Germans to its side with regard to putting pressure on China over its trade practices and human rights. This could be the avenue for the US and Germany to tighten their bond despite the new milestone in German-Russia relations. The US may call on Germany to stand up for eastern Europe against Russian aggression but on that front Berlin will continue to disappoint. It has no desire to be drawn into a new Cold War given that the last one resulted in the partition of Germany. The implication is negative for China on one hand and eastern Europe on the other. Germany’s federal election on September 26 will be important because it will determine who will succeed Chancellor Angela Merkel, both in Germany and on the European and global stage. The ruling Christian Democratic Union (CDU) is hoping to ride Merkel’s coattails to another term in charge of the government. But they are likely to rule alongside the Greens, who have surged in opinion polls in recent years. The state election in Saxony-Anhalt over the weekend saw the CDU win 37% of the popular vote, better than any recent result, while Germany’s second major party, the Social Democrats, continued their decline (Table 2). The far-right Alternative for Germany won 21% of the vote, a downshift from 2016, while the Greens won 6% of the vote, a slight improvement from 2016. All parties underperformed opinion polling except the CDU (Chart 19). Table 2Saxony-Anhalt Election Results Chart 19Germany: Conservatives Outperform In Final State Election Before Federal Vote, But Face Challenges Chart 20Germany: Greens Will Outperform in 2021 Vote The implication is still not excellent for the CDU. Saxony-Anhalt is a middling German state, a CDU stronghold, and a state with a popular CDU leader. So it is not representative of the national campaign ahead of September. The latest nationwide opinion polling puts the CDU at around 25% support. They are neck-and-neck with the Greens. The country’s left- and right-leaning ideological blocs are also evenly balanced in opinion polls (Chart 20). A potential concern for the CDU is that the Free Democratic Party is ticking up in national polls, which gives them the potential to steal conservative votes. Betting markets are manifestly underrating the chance that Annalena Baerbock and the Greens take over the chancellorship (Charts 21A and 21B). We still give a subjective 35% chance that the Greens will lead the next German government without the CDU, a 30% that the Greens will lead with the CDU, and a 25% chance that the CDU retains power but forms a coalition with the Greens. A coalition government would moderate the Greens’ ambitious agenda of raising taxes on carbon emissions, wealth, the financial sector, and Big Tech. The CDU has already shifted in a pro-environmental, fiscally proactive direction. Chart 21AGerman Greens Will Recover Chart 21BGerman Greens Still Underrated No matter what the German election will support fiscal spending and European solidarity, which is positive for the euro and regional equities over the next 12 to 24 months. However, the Greens would pursue a more confrontational stance toward Russia, a petro-state whose special relations with the German establishment have impeded the transition to carbon neutrality. Latin America’s Troubles A final aspect of Biden’s agenda deserves some attention: immigration and the Mexican border. Obviously this one of the areas where Biden starkly differs from Trump, unlike on Europe and China, as mentioned above. Vice President Kamala Harris recently came back from a trip to Guatemala and Mexico that received negative media attention. Harris has been put in charge of managing the border crisis, the surge in immigrant arrivals over 2020-21, both to give her some foreign policy experience and to manage the public outcry. Despite telling immigrants explicitly “Do not come,” Harris has no power to deter the influx at a time when the US economy is fired up on historic economic stimulus and the Democratic Party has cut back on all manner of border and immigration enforcement. From a macro perspective the real story is the collapse of political and geopolitical risk in Mexico. From 2016-20 Mexico faced a protectionist onslaught from the Trump administration and then a left-wing supermajority in Congress. But these structural risks have dissipated with the USMCA trade deal and the inability of President Andrés Manuel López Obrador to follow through with anti-market reforms, as we highlighted in reports in October and April. The midterm election deprived the ruling MORENA party of its single-party majority in the Chamber of Deputies, the lower house of the legislature (Chart 22). AMLO is now politically constrained – he will not be able to revive state control over the energy and power sectors. Chart 22Mexican Midterm Election Constrained Left-Wing Populism, Political Risk Chart 23Buy Mexico (And Canada) On US Stimulus American monetary and fiscal stimulus, and the supply-chain shift away from China, also provide tailwinds for Mexico. In short, the Mexican election adds the final piece to one of our key themes stemming from the Biden administration, US populism, and US-China tensions: favor Mexico and Canada (Chart 23). A further implication is that Mexico should outperform Brazil in the equity space. Brazil is closely linked to China’s credit cycle and metals prices, which are slated to turn down as a result of Chinese policy tightening. Mexico is linked to the US economy and oil prices (Chart 24). While our trade stopped out at -5% last week we still favor the underlying view. Brazilian political risk and unsustainable debt dynamics will continue to weigh on the currency and equities until political change is cemented in the 2022 election and the new government is then forced by financial market riots into undertaking structural reforms. Chart 24Brazil's Troubles Not Truly Over - Mexico Will Outperform Elsewhere in Latin America, the rise of a militant left-wing populist to the presidency in a contested election in Peru, and the ongoing social unrest in Colombia and Chile, are less significant than the abrupt slowdown in China’s credit growth (Charts 25A and 25B). According to our COVID-19 Social Stability Index, investors should favor Mexico. Turkey, the Philippines, South Africa, Colombia, and Brazil are the most likely to see substantial social instability according to this ranking system (Table 3). Chart 25AMexico To Outperform Latin America Chart 25BChina’s Slowdown Will Hit South America Table 3Post-COVID Emerging Market Social Unrest Only Just Beginning Investment Takeaways Close long emerging markets relative to developed markets for a loss of 6.8% – this is a strategic trade that we will revisit but it faces challenges in the near term due to China’s slowdown (Chart 26). Go long Mexican equities relative to emerging markets on a strategic time frame. Our long Mexico / short Brazil trade hit the stop loss at 5% but the technical profile and investment thesis are still sound over the short and medium term. Chart 26China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets Chart 27Relative Uncertainty And Safe Havens China’s sharp fiscal-and-credit slowdown suggests that investors should reduce risk exposure, take a defensive tactical positioning, and wait for China’s policy tightening to be priced before buying risky assets. Our geopolitical method suggests the dollar will rise, while macro fundamentals are becoming less dollar-bearish due to China. We are neutral for now and will reassess for our third quarter forecast later this month. If US policy uncertainty falls relative to global uncertainty then the EUR-USD will also fall and safe-haven assets like Swiss bonds will gain a bid (Chart 27). Gold is an excellent haven amid medium-term geopolitical and inflation risks but we recommend closing our long silver trade for a gain of 4.5%. Disfavor emerging Europe relative to developed Europe, where heavy discounts can persist due to geopolitical risk premiums. We will reassess after the Russian Duma election in September. Go long GBP-CZK. Close the Euro “laggards” trade. Go long an equal-weighted basket of euros and US dollars relative to the Chinese renminbi. Short the TWD-USD on a strategic basis. Prefer South Korea to Taiwan – while the semiconductor splurge favors Taiwan, investors should diversify away from the island that lies at the epicenter of global geopolitical risk. Close long defense relative to cyber stocks for a gain of 9.8%. This was a geopolitical “back to work” trade but the cyber rebound is now significant enough to warrant closing this trade.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Trump’s policy toward Russia is an excellent example of geopolitical constraints. Despite any personal preferences in favor of closer ties with Russia, Trump and his administration ultimately reaffirmed Article 5 of NATO, authorized the sale of lethal weapons to Ukraine, and deployed US troops to Poland and the Czech Republic. 2 As just one example, given the controversial and contested US election of 2020, it is possible that a major terrorist attack could occur. Neither wing of America’s ideological fringes has a monopoly on fanaticism and violence. Meanwhile foreign powers stand to benefit from US civil strife. A truly disruptive sequence of events in the US in the coming years could lead to greater political instability in the US and a period in which global powers would be able to do what they want without having to deal with Biden’s attempt to regroup with Europe and restore some semblance of a global police force. The US would fall behind in foreign affairs, leaving power vacuums in various regions that would see new sources of political and geopolitical risk crop up. Then the US would struggle to catch up, with another set of destabilizing consequences.

Highlights In the near term, the RMB against the US dollar has ceased to be a one-way bet. Market sentiment will re-focus on economic fundamentals, which are less supportive of further RMB appreciation.  In the longer term, the RMB still has some upside potential, but the pace of its growth should be much slower than in the past 12 months. The sharp rise in the trade-weighted RMB index is starting to threaten China’s export sector and has exacerbated the tightening of domestic monetary conditions. Barring a monetary policy reset by Chinese authorities, even a small increase in the broad-RMB index would heighten the risk of a contraction in corporate profit growth in the coming 12 months. We remain risk adverse to Chinese stocks for the next 6 months. Feature Chart 1The RMB Back On A Fast Ascending Path After a brief pause in March, China’s currency versus the US dollar extended its steep upward trend began in mid-2020 (Chart 1). Chinese policymakers recently ramped up their strong-worded statements warning against speculating on the RMB. Regulators have also taken steps to stem the rise. Questions we have recently been getting from our clients about the RMB can be summarized as follows: After a 10% appreciation since its trough a year ago, does the RMB have more upside in 2021 and beyond? If the RMB continues to appreciate, what would be the impact on China’s economy and corporate sector? What can the PBoC do to slow the pace of the currency’s appreciation? One could argue that the US dollar will continue to weaken, but we see substantial headwinds to the RMB within the year. A weaker US dollar would support global stock prices outside of the US and foreign inflows have driven the recent rally in China’s onshore stocks. However, we think China’s domestic macro policy and economic conditions pose more downside risks on a cyclical basis. How Far Can The RMB Go? A continued upswing in the CNY relative to the USD can no longer be taken for granted. In the coming months, there is a strengthening case for the RMB to fall against the greenback as factors supporting a strong RMB in the past year start to abate. Economic fundamentals will no longer prop up the RMB’s rise going into 2H21. China’s growth momentum is softening due to significant tightening in the monetary environment in the second half of last year and a rapid deceleration in credit growth this year (Chart 2). Meanwhile, the massive rollouts of COVID-19 vaccines in North America and Europe have successfully reduced new infections and hospitalization rates, allowing these countries to reopen their economies. The economic growth gaps between China and the developed markets (DMs) will narrow more significantly in the coming months (Chart 3). Chart 2Chinese Economic Fundamentals Will Start To Weaken Chart 3China's Growth Gap Relative To DMs Will Narrow Chart 4Global Consumption Recovery In Services Will Likely Outpace Goods China’s large current account surplus will likely start narrowing. It has been driven by strong global demand for goods, which is unlikely to be sustained as the pent-up demand for services in DMs will outpace the consumption for goods (Chart 4). Emerging countries (EMs), many of which are China’s export competitors, lag far behind DMs and China on inoculation rates and some have resurging COVID cases (Chart 5). However, EMs will likely benefit from meaningful expansions in global vaccine production in the second half of the year.1 A catchup in vaccinations in these countries will reduce China’s export-sector advantage, reversing the RMB’s gains over other Asian currencies in the past month. Chart 5China's Asian Neighbors Have Been Hit By Resurging COVID Cases The future trend of the USD also matters to the USD/CNY exchange rate. The recent strength of the CNY vis-à-vis the dollar was the mirror image of USD weakness, which has been due to low real rates in the US and recovering economic momentum outside the US (Chart 6). However, the broad dollar index is sitting at a critical technical level that could either breakout or breakdown (Chart 7). When the Fed announces the slowing of asset purchases, which our BCA US Bond Strategy expects before the end of 2021, it could lead to higher US real yields and reverse the trend of hot money flows into China. Chart 6The Sharp Rise In The RMB In The Past Two Months Has Been Dollar-Driven Chart 7The Dollar Index: Breakout or Breakdown? Furthermore, the financial market does not seem to have priced in unstable US-China relations, which could undermine global risk appetite (Chart 8). Recent actions by US President Joe Biden – from expanding the investment ban on 59 blacklisted Chinese tech companies to calling for the US intelligence community to investigate the origins of COVID-19 – point to risks for escalating tensions between the two nations. Longer term, the RMB is at about one standard deviation below its fair value, which suggests that it still has more upside potential (Chart 9). Based on our BCA’s Foreign Exchange Strategist’s real effective exchange rate (REER) model, the RMB’s fair value mostly climbed in the past three decades, driven by higher productivity in China relative to its trading partners. However, part of the RMB’s appreciation since mid-2020 has been a catch up to its pre-trade war value and its valuation gap has rapidly narrowed. From the current valuation levels, the pace of RMB appreciation should be much slower going forward. Chart 8Geopolitical Surprises Could Spook The Market Chart 9Valuation Gap Has Rapidly Narrowed We also expect China’s real interest rates relative to the US to dwindle in the next three to five years. Demographic headwinds in China herald lower real rates while the Fed is primed to start rate liftoffs within the next two years. Bottom Line: The RMB still has some upside potential in the long run, but the pace of its appreciation should be much slower than in the past 12 months. In the near term, odds are high that economic fundamentals will not boost the RMB any further.  How Does A Stronger RMB Affect China’s Economy? Historically, a stronger RMB relative to the dollar has not had a significant impact on China’s economy. However, if the CNY appreciates considerably versus the greenback so that it pushes up the trade-weighted RMB index, then China’s corporate profits will be negatively affected (Chart 10). Chart 10Strengthening Broad-RMB Index Has Historically Led To Weaker Corporate Profit Growth... Chart 11...And Could Significantly Raise Prob Of A Earnings Contraction In 12 Months Our earnings growth recession probability model confirms our view. If all else is equal, a 3% rise in the trade-weighted RMB index from its current level would more than double the probability of a contraction in earnings growth in the coming 12 months (Chart 11, Scenario 1). On the other hand, all else will not be equal if the broad RMB index goes up by 3%. A quick increase in the RMB’s value against the currencies of its trading partners will impede China’s export growth and tighten domestic monetary conditions. Chart 12Moving Into Restrictive Territory For Chinese Exports Chart 12 shows the impact on export growth from the speed of the RMB’s appreciation; we calculate the rise in an export-weighted RMB index relative to its highs and lows in the past few years. The metric implies that the acceleration in the RMB’s value has reached levels that should be restrictive for exports. The nominal export-weighted RMB index has been significantly above the median value since 2015 and it is approaching the peak reached in that year. Clearly, the strong RMB is linked to a recent weakness in the PMI surveys on export orders. A 3% increase in the trade-weighted RMB from the current level, coupled with a drop in export growth and further deceleration in credit impulse would prop up the earnings contraction probability to more than 50% (Scenario 2 in Chart 11 above). Bottom Line: Our metrics suggest that the RMB’s recent sharp rise is starting to threaten the export sector. An additional 3% appreciation in the broad RMB index would cause a meaningful increase in the probability of a corporate earnings growth contraction in the coming 12 months. What Can The PBoC Do To Halt The RMB Rally? We break this question into two parts: the willingness and the capability of the PBoC to intervene in the currency market.  On the first aspect, the PBoC in recent years has largely refrained from draconian intervention measures in the currency market. Allowing a more market-based currency exchange rate regime is a crucial part of China’s RMB internationalization process. The PBoC seems to be mostly sticking to this long-term goal. Chart 13New FX Regime Began In 2015 Has Significantly Lowered USD Weight In The Broad-RMB Index... Importantly, the new exchange rate regime that the PBoC switched to at end-2015 has greatly weakened the link between the USD and the broad RMB trend (Chart 13). Since then China has continuously cut the weighting of the USD in the CFETS currency index basket, which has reduced the impact of dollar moves on the index. Therefore, the PBoC has mostly ignored short-term volatilities in the CNY/USD exchange rate. The central bank tends to intervene only when swings in the CNY/USD exchange rate are large enough and/or the market forms a unilateral view on the Chinese currency to drive sustained movements in the broader RMB index.  For example, the RMB value rose at a much faster rate against the USD compared with its other trading partners in the second half of 2020. However, this year, the pace of growth in the broad RMB index has caught up with that of the CNY/USD appreciation. Moreover, even when the RMB depreciated against the USD in March, the CFETS index basket kept rising and is now breaching its previous peak in April 2018 (Chart 14). As discussed in the previous section, a sharp jump in the trade-weighted RMB would be more detrimental to China’s corporate profits than an increase in the CNY/USD. Chart 14...But The Massive Appreciation In The CNY/USD Of Late Has Pushed The RMB Index To A Three-Year High Chart 15The PBoC Has Been Trying To Guide Market Expectations Lower On The RMB On the second aspect, the PBoC is unlikely to alter its monetary policy trajectory to tame the RMB’s appreciation. A looser monetary environment would encourage more asset price bubbles domestically and jeopardize policymakers’ ongoing progress in financial and property-market de-risking. If the CFETS strengthens further, Chinese authorities will probably use tools such as managing market expectations and various capital controls to mop up excess FX liquidity generated from capital inflows. In the near term, the PBoC may set a weaker fixing rate against the dollar to dampen market expectations for more RMB growth (Chart 15). An increase in the FX deposit reserve requirement ratio (RRR) rate, announced by the PBoC last week, is another example of the central bank trying to prevent a one-sided expectation by market participants. However, the previous three FX deposit RRR hikes –all taken place more than a decade ago—did little to alter the path of the CNY exchange rate; the pace of USD/CNY depreciation actually accelerated following the May 2007 RRR hike.  The two-percentage point bump in the FX deposit RRR rate will drain China’s domestic FX liquidity by about US$20 billion. Its effect on domestic FX liquidity and FX loan rates is rather limited – FX inflows to Chinese financial institutions since 2H20 were more than US$20 billion a month –more than offsetting the tightening from a RRR rate hike.  The PBoC can further loosen outward capital controls to release some pressure on the RMB’s increase. In a report from November last year we wrote that Chinese policymakers attempted to slow the pace of appreciation in the RMB through a build-up in strategic FX assets by commercial banks and other financial institutions . Since August last year, China has relaxed outbound investment regulations and increased quotas to help channel domestic money into offshore financial markets. China’s commercial banks significantly ramped up their FX assets last year (Chart 16). In Q1 this year, commercial banks enriched their FX asset holdings by US$518.5 billion, a record high in the past five years.  Bottom Line: The PBoC is willing to allow more volatility in the USD/CNY exchange rate, but a sharp jump in the RMB’s value against a basket of other currencies would warrant further policy actions. Chart 16Chinese Banks Ramped Up FX Asset Holdings Chart 17Chinese Onshore Stocks Propped Up By Foreign Investors Investment Conclusions A tightened monetary and credit environment has created headwinds for Chinese equities since early this year. However, the domestic market appears to have found support at a key technical level of late (Chart 17). The recent rebound in China’s onshore stocks on the back of a sharp CNY appreciation and accelerated foreign capital inflows, in our view, are unsustainable on a cyclical basis. Despite buoyant global economic growth, investors should consider deteriorating cyclical conditions in China when judging the appropriate allocation for Chinese equities. While policy tightening has brought multiples closer to earth than last year, the upside in Chinese stock prices will be capped by subsiding stimulus and slower profit growth ahead. As such, a decisive breakout to the upside in Chinese stock prices will require major reflationary catalysts, and it is the reason we are still risk adverse on Chinese equities (Chart 18). Meanwhile, we continue to favor onshore consumer discretionary stocks relative to the broad A-share market. A strong RMB can be a booster to domestic discretionary spending. We initiated this trade in May last year and it has largely outperformed China’s onshore broad market (Chart 19). We will close the trade when the CNY loses its strength and Chinese domestic demand starts to falter. Chart 18Cyclical Performance In Chinese Stocks Is Still Driven By Economic Fundamentals Chart 19Keep A Long CD Position, But On A Short Leash   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1The UN estimates that as many as 15 billion vaccine doses could be produced by the second half of 2021, enough to inoculate most of the world’s population. Cyclical Investment Stance Equity Sector Recommendations

Highlights The Seventh National Population Census highlights the seriousness of China’s demographic deterioration; apart from a shrinking working-age population, the nation’s fertility and birth rates have dropped meaningfully. China’s urbanization rate will likely slow in the second half of this decade. The country’s urban population growth is only slightly positive, while the rural population is declining and aging. Demand for housing will experience a structural downshift, particularly in less developed regions.  Competition for labor will become fiercer among regions and sectors, and wage growth will continue to accelerate. However, the manufacturing sector will remain competitive regardless of wage inflation, thanks to the rising quality of China’s labor force and innovation. Interest rates will structurally shift to a lower range, providing some tailwind to Chinese equities and government bonds. Feature The Seventh Population Census, conducted by the National Bureau of Statistics every 10 years, reinforced the magnitude of China’s demographic challenge. The nation’s population is not only aging but is set to start shrinking due to extremely low birth and fertility rates. The main implication is that China’s urbanization rate will slow and property market will likely encounter a structural downshift, tied to declining demand from both its working-age (age 15 to 64) and total population. Demand for housing will increasingly concentrate in top-tier cities because these metropolitan areas have more advantages attracting labor. Secondly, manufacturing will likely maintain its share of GDP, despite China’s push for consumption and growth in the service sector. Importantly, interest rates will continue to shift downward along with a decelerating potential growth; waning interest rates will create a tailwind to China’s capital market in the long term.  Highlights From The Census The Census showed three meaningful shifts in China’s demographics in the past decade:  1.  China is getting old before getting rich. China is experiencing a worse demographic transition than Japan in the early 1990s, with a lower level of per capita wealth than Japan attained when its working-age population peaked (Chart 1). Over the past ten years China’s population has only expanded by 5.4%, the lowest rate since the first census in 1953. Moreover, the country’s oldest cohort rose from 8.9% in 2010 to 13.5% and the working-age population is falling more quickly than in Japan. China’s working-age population peaked in 2010 and then fell by 6.79 percentage points in the next 10 years. In contrast, Japan’s working-age population peaked in 1992 and fell by 2.18 percentage points in the subsequent decade (Chart 1, top panel). 2.  China’s total population is set to start declining in five years. Some demographers project that China’s total population will peak in 2027,1 but a high-level Chinese official recently predicted that the country’s population will start to trend down as early as in 2025.2 The relaxation of the one-child policy in 2015 helped to lift the birthrate (births per 1,000 people) briefly in 2016, before falling sharply again in 2017. The population’s natural growth rate, calculated as birthrate minus deathrate, is rapidly approaching zero (Chart 2). Chart 1China's Working Population Falling Faster Than Japan's In 1990s Chart 2China's Population Growth Will Turn Negative In Mid-2020s The birthrate is the main determinant of the population’s natural growth rate given that China’s deathrate has been steady for decades.  If the birthrate continues to fall at the current rate, then China will undoubtedly reach a population turning point and will join nations such as Japan, Germany and South Korea, which have negative population growth.  3.  A low fertility trap. Chart 3China's Alarmingly Low Fertility Rate Is Set To Decline Even Further... China’s extremely low fertility rate3 is a major contributor to its falling birthrate.  The current 1.3 reading is less than in many developed countries, such as Japan with 1.4 and the US with 1.6, and it is far below the fertility rate of 2.1 needed to stabilize a population, according to the United Nations (Chart 3). China’s fertility rate is set to dive even further in the coming years due to structural factors such as a dwindling number of childbearing-age women linked to the one-child policy implemented in the 1980s (Chart 4). China’s high female labor participation rate and low propensity among young people to get married, and the high cost of raising children in urban areas, all are long-standing socio-economic issues hindering the Chinese from having more babies (Chart 5). Chart 4…Due To Fewer Childbearing-Age Women And… Chart 5...Structural Issues That Curb Chinese Propensity To Produce Babies Bottom Line: These structural trends will take decades to reverse. China faces a dramatic plunge in its population in the very near future if the authorities do not enact significant and immediate policy changes.   Urbanization Pace Will Slow The Census indicates that rapid urbanization continued through 2020, with the rate hitting 64% of the population, up 14 percentage points from 2010. However, the headline number in the urbanization rate understates China’s progress in industrialization, i.e. the country’s rural-to-urban transition has entered a late stage and the current pace cannot be sustained in the future. Significantly, China’s underlying demographic shifts will likely lead to a passive increase in the urbanization rate in the second half of this decade. This trend will curb rather than boost demand in urban areas.  The experience of developed countries suggests that the pace of urbanization begins to slow when the rate reaches around 70% (Chart 6). Based on China’s current level, the country should reach the 70% threshold in just six to seven years. Meanwhile, China is much more industrialized than generally perceived: the country’s industrialization rate is currently 85%, which means that 85% of jobs in China are in non-agricultural sectors (Chart 7). Chart 6Urbanization Progress Stabilizes When Reaching 70% Chart 7China Is Much More Industrialized Than Commonly Believed Furthermore, a higher urbanization reading may be the result of negative natural population growth. Given that the urbanization rate is calculated as a percentage of urban population in the total population, a decline in the absolute level of total population (the denominator) could lead to a passive increase in the numerator. Chart 8Japan Has Had A "Passive" Increase In Urbanization Since 2012 For example, Japan’s urbanization rate rose significantly during the 2000s, and maintained an upward momentum even as its total population peaked in 2010. However, its urban population growth rate dropped dramatically and turned negative in 2012 – suggesting the increase in the urbanization rate is due to a shrinking total population instead of expanding urbanities (Chart 8). The rising deathrate of the rural elderly population is another important reason for the accelerated increase in Japan's urbanization rate. China’s urban population growth is on a sharp down trend, although it is still slightly positive (Chart 9). However, the rural population has shrunk and aged, which limits future migration from rural to urban areas (Chart 10).  China’s rural population has shrunk by almost half from its peak in 1995 to 2020. The share of the rural population 50 years and older doubled in the same period. Chart 9China's Urban Population Growth Is On The Decline... Chart 10...While Rural Population Has Shrunk And Aged Thus, China’s rural-to-urban migration has slowed in the past decade (the trend turned negative last year due to the pandemic). The number of new migrant workers moving from the country to the city tumbled from 12.5 million a year to 2.5 million, and the number of younger migrants (50 years and younger) has contracted since 2017 (Chart 11). Chart 11The Number Of Young Migrant Workers Started Contracting In 2017 Bottom Line: Country-to-city migration will be smaller going forward based on a diminishing rural population, an increasing number of elders and a reduced proportion of young people in rural areas. When China’s population peaks, which is highly likely by 2025, its urbanization progress will turn passive and the aggregate population growth in urban areas may also turn negative. Aggregate Housing Demand Will Dwindle The demographic shifts described above will impact the demand for properties and accentuate regional divergences in housing demand and prices.   Historically, changes in the working-age population led residential home sales by five to six years. Home sales have fluctuated in a downward trend in the past five years along with a peak in the working-age population in 2015 (Chart 12). Moreover, the sharp deterioration in China’s birthrate means that home sales will be significantly reduced in the next 15-20 years. Chart 12Aggregate Demand For Housing Will Dwindle Along With Smaller Labor Force Chart 13Population Is An Important Driver For Urban Development The regional divergence in the demand for housing will also widen. Population, especially the labor force, is an important driver for urban development and housing (Chart 13 above). Population migration mainly occurs among 15-59-year-olds, and this cohort is also the main homeowner group. As China’s labor force increasingly flocks to developed areas, the economic development of less developed areas will face greater challenges (Chart 14). Those areas will encounter a combination of declining birthrate and outflow of labor force. This demographic shift is already evident in many two- and third-tier cities where housing prices have lagged far behind the tier-one cities (Chart 15). Chart 14Less Developed Regions Have Seen Net Population Losses In The Past Decade… Chart 15...And Softening Housing Prices Bottom Line: The drop in China’s birthrate and working-age population will lead to less demand for housing. However, China’s first-tier cities (and core metropolitan areas) will likely continue to outperform third- and fourth-tier cities in terms of labor growth, consumption and home prices. Labor Measures And Manufacturing Competitiveness Labor shortages in selected sectors and upward pressure on wages will likely intensify in the coming decade. While labor quantity will decrease, the quality of China’s labor force will remain competitive. From an aggregate economy perspective, improving labor productivity and automation can help to offset the smaller number of workers (Chart 16). Following two decades of rapid expansion in the industrial sector, China’s labor shortages began to multiply when the country’s urbanization ratio rose to between 50% and 60%. Looking at Japan and Korea, for example, a shortage in manufacturing labor emerged when the countries’ manufacturing/agricultural employment ratio climbed above one. China’s employment ratio likely have crossed this threshold in the mid-2010s, coinciding with a rollover in its working-age population and a massive jump in wage growth (Chart 17). Chart 16Improving Labor Quality To Offset Smaller Labor Quantity Chart 17Manufacturing Labor Shortage And Wage Pressure Intensified In Mid-2010s The manufacturing and service sectors will continue to compete with agriculture for labor. The wage gap between urban and rural areas is disappearing and there are signs of labor market tightness in urban settings (Chart 18).  While the demand for labor has been flat, labor supply peaked in 2013/14 and has been on the wane since that time, which has resulted in an ascending demand-to-supply ratio in China’s urban labor market (Chart 19). Chart 18Wage Gap Between Urban And Rural Areas Is Disappearing Chart 19Urban Labor Supply Can't Keep Up With Demand The bright side is that China’s labor shortage and escalating wages have not eroded the competitiveness of its manufacturing sector. Impressive labor productivity gains and progressively improving labor quality have trumped higher input costs (Chart 20). Consistent with improved productivity, China’s share of global trade continues to build regardless of higher wages, a stronger currency, and import tariffs from the US (Chart 21). The manufacturing sector has gradually climbed the value-added chain in recent years and mounting wage pressures will likely push the corporate sector, particularly in more developed coastal regions, to move further away from a labor-intensive model. Chart 20Rising Wages But Stable Unit Labor Costs Chart 21Chinese Exporters Have Maintained Their Global Market Share Despite Higher Costs The 14th Five-Year Plan outlined policymakers’ decision to maintain the share of manufacturing in GDP, which is around 30%. Labor productivity in the manufacturing sector is notably higher than in the service sector. In an environment of shrinking labor, keeping workers in a high-productivity sector may be a better way to stabilize potential growth. Bottom Line: The competition for labor between sectors will intensify. Meanwhile, manufacturing’s share of China’s economy will likely be sustained in this decade, which will help to mitigate the speed of the deceleration in China’s growth.  Implications On Policy Setting Chart 22AInterest Rates Drop With Aging Population The combination of a weak fertility/birthrate and a decline in the working-age population will weigh on consumption and investment growth, bringing deflationary headwinds to the economy. China’s interest rate regime will likely follow its Asian neighbors to downshift structurally (Chart 22). Despite moderating potential economic growth, a low interest rate environment may be positive for China’s financial asset prices.  Chart 22BInterest Rates Drop With Aging Population Chart 22CInterest Rates Drop With Aging Population Chart 23Support Ratios Are Declining Globally One could argue that a falling support ratio – measured by the number of workers relative to consumers – can lead to inflation (Chart 23). This could happen to the US where baby boomers retire but continue to spend particularly on healthcare, while production falls along with the available workers. As production falls in relation to consumption, inflation could rise. However, this is not the case in China where both production and consumption will fall. Demand from an aging population may increase pockets of inflationary pressures, such as healthcare and elderly care, but it is unlikely to fully offset weakening demand from a declining working-age population and total population. In other words, both the numerator (workers) and denominator (consumers) will be falling in China. While a weakening demographic profile is negative for economic growth, lower prices on capital will make corporate debt-servicing cheaper. Further industrial consolidation aimed at supply-side reforms will also improve corporate profitability. Cheaper capital, improving productivity and efficiency could provide tailwinds to Chinese stocks and government bonds in the long run.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1As of 2020, China’s total population is at 1411.78 million. 2"China faces an economic crisis as a population peak nears," South China Morning Post, April 18, 2021. 3The total fertility rate is based on the number of newborns by women in child-bearing years, which is ages 15-44 or 15-49 by international statistical standards.  Cyclical Investment Stance Equity Sector Recommendations

Feature Chinese stocks remain in limbo despite robust economic data in April and early May (Chart 1).  Onshore equities are pricing in policy tightening risks and a peak in the domestic economic cycle. Meanwhile, a regulatory clampdown on the tech sector continues to curb global investors’ enthusiasm towards Chinese investable stocks.  The PBoC has not changed its course of policy normalization. The falling 3-month SHIBOR since March likely reflects softening demand for interbank liquidity rather than monetary easing (Chart 2). Chart 1Stay Underweight Chinese Stocks Chart 2No Easing In Monetary Policy Fiscal policy has also been consolidating with a renewed focus on reducing local government debt load and financial risks. A delay in local government bond issuance in Q1 could potentially boost bond sales in the second half of the year. However, as we noted late last month, without a synchronized policy push for more bank loans and loosened regulations on provincial government spending, an increase in special-purpose bond issuance alone will not make a significant difference in infrastructure investment nor economic growth. We still expect China's economy, which lags the credit cycle by six to nine months, to start weakening by mid-2021 (Chart 3A & 3B). Chart 3ADomestic Economic Growth Set To Slow Chart 3BPolicy Tightening Will Weigh On Earnings Growth In 2H21   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Our BCA Li Keqiang Leading Indicator continues to fall despite a marginal improvement in the Monetary Conditions Index (MCI) component. The deceleration in both money supply and credit growth has more than offset a small uptick in the MCI (Chart 4). Furthermore, a rising RMB in trade-weighted and real terms will not help the profit outlook for China’s exporters (Chart 5). Overall, monetary conditions remain unfavorable for risk assets. This is consistent with the poor performance of Chinese stocks Chart 4Falling Credit And Money Growth More Than Offset A Minor Improvement In The MCI Chart 5Strengthening RMB Will Not Help The Profit Outlook For Chinese Exporters   A sharp jump in state-owned enterprise (SOE) defaults since late last year is due to deteriorating corporate balance sheets. The defaults have exposed the weakened fiscal positions of local governments (Chart 6 & 7). SOE bond defaults have surpassed the number of private bond defaults this year. The more restrictive policy on local government financing, together with an acceleration in SOE defaults, will weigh on spending by local governments, local government financing vehicles (LGFVs) and SOEs.  Chart 6Returns On SOE Assets Remain In Deep Contraction Chart 7SOE Bond Defaults Have Surpassed Private Bond Defaults The Politburo meeting on April 30 established new guidelines to reduce local government leverage, both on- and off-balance sheet debt. According to the new rules, local governments are strictly prohibited from obtaining “hidden debts” for new investment projects directly or through their affiliated SOEs, which include LGFVs. The directives also state that the assets of LGFVs with defaulted loans should be restructured or liquidated if companies are unable to repay their debts. In addition, financial institutions should not accept government guarantees when making decisions on lending to LGFVs or government related entities.  Moreover, stricter measures in the property market have further dampened local governments’ fiscal situations since land sales account for 53% of local government fiscal revenues. Growth in government expenditures decelerated in recent months along with slowing land auctions (Chart 8). Scaled down fiscal supports will lead to subdued infrastructure investment growth this year (Chart 9). Chart 8Fiscal Stance Has Tightened Chart 9Subdued Growth In Infrastructure Investments   In addition to policy tightening in the domestic economy, Chinese offshore stocks continue to face regulatory headwinds to root out monopolies in technology, media, and telecom (TMT) companies. The antitrust investigations and fines extending from Alibaba and Tencent to Meituan highlight China’s aim to curb platform oligopolies and monopolies. Meanwhile, Chinese tech firms listed on US exchanges are facing another regulatory threat on their accounting reporting standards, which could potentially result in their delisting from the US bourses.  Moreover, elevated valuations and a weakening in the earnings outlook will generate more downside risks for TMT stocks (Chart 10). Given that TMT stocks account for around 50% of the MSCI China Index’s market capitalization, Chinese investable stocks are disproportionally vulnerable to a selloff in TMT stocks (Chart 11). Chart 10ATMT Stocks: From Tailwind To Headwind Chart 10BTMT Stocks: From Tailwind To Headwind Chart 11MSCI China Is Highly Concentrated In TMT Stocks   China’s official PMI and the Caixin China PMI moved in opposite directions in April due to the nature of the two surveys. The Caixin PMI covers smaller, more export-oriented businesses while the NBS Manufacturing PMI includes larger, more domestically exposed companies. The divergence highlights that the domestic economy is losing speed while external demand remains robust (Chart 12). Given the dominance of domestic demand in China’s economy (investment expenditures, household spending and government spending), strong external demand will not fully offset the deceleration in domestic growth.  New orders and production subcomponents in the official PMI moderated in April from March, which indicates a slowing momentum in economic activity (Chart 13). Moreover, construction PMI fell to 57.4 from 62.3 in March, corresponding with weaker infrastructure spending and more policy tightening in the real estate sector (Chart 13, bottom panel). Chart 12Conflicting Messages From The NBS And Caixin PMIs Chart 13Slowing Momentum In China's Economic Activity   The moderating momentum in China’s economy is also reflected in April’s trade data, which showed a strengthening external sector and a slowing domestic demand. A few observations support our view: First, strong imports since early this year were partly due to robust re-exports. Solid external demand boosted processing imports, which in turn contributed to China’s overall import growth (Chart 14). Secondly, Chinese imports of commodities in volume, such as copper and steel products, have plunged recently. Chinese domestic demand for commodities will likely peak in the coming months, therefore, inventory destocking pressures and weakness in underlying consumption will threaten commodities prices (Chart 15). Finally, the strengthening of coal imports in volume terms may be related to China’s increasingly stringent environmental policies. A temporary cutback in domestic coal supply boosted the demand for imports. However, in the long run, China’s push for green energy will be bearish for Chinese coal imports (Chart 16). Chart 14Solid External Demand Boosted Processing Imports Chart 15Demand Of Commodities May Be Approaching A Cyclical Peak Chart 16China's Coal Imports Likely To Decline In The Long Run   Housing prices in tier-one cities continue to post major gains despite a slew of tightening regulations in the property sector introduced since the second half of last year (Chart 17). The Politburo meeting last month reiterated authorities’ concerns over a bubble in housing. We expect authorities to impose additional regulations to constrain both financing supply and demand in the property sector. In the meantime, the existing policies have successfully started to cool the real estate market.  Chart 17Skyrocketing Housing Prices In First-Tier Cities Chart 18Real Estate And Mortgage Loans Tumbled Under More Restrictive Borrowing Regulations Both mortgage loans and loans to real estate developers tumbled under more restrictive borrowing policies (Chart 18). Growth in home sales has also started to roll over (Chart 19). Housing completed has dropped significantly, which confirms that construction activity is decelerating. Looking forward, the reduced expansion rate of new projects due to shrinking land transfers and stricter borrowing regulations will further dampen construction activities in the second half of this year (Chart 20).   Chart 19Home Sales Growth Started To Ease Chart 20Real Estate Investments Are Set To Slow Further Table 1China Macro Data Summary Table 2China Financial Market Performance Summary​​​​​​​   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Highlights Non-US stocks have greatly underperformed US equities over the last decade, but a leadership change might be underway. As such, equity flows could be an important factor in dictating currency trends over a cyclical horizon. The narrative in favor of non-US stocks includes a recovery in profits, cheap valuations, and a secular theme that will favor capital spending in traditionally “heavy” industries. Non-US growth should also overtake the US beyond 2021, when most of the global population is vaccinated. Cyclical currencies have historically tracked the relative performance of their respective bourses. This implies a lower dollar. Higher bond yields also present a formidable headwind for the outperformance of US stocks, relative to other markets. An outperformance of non-US bourses will be particularly favorable for the AUD, NOK, SEK, and GBP. The yen will likely play catchup towards the middle of the cycle. Feature Currencies respond to broad inflows, including into bonds, equities or foreign direct investment. For most of 2020, the dominant currency flows were from fixed income investors. As most short rates are now anchored near zero, the story is morphing towards the potential winners from a recovery, especially in the equity market sphere. Non-US stocks tend to outperform the US when the dollar is falling. That said, the causality-effect link is not so clear-cut, as we penned in our Special Report last year.1 Admittedly, a lower dollar boosts the common-currency returns for US-based investors, leading to more capital deployment in offshore markets. Meanwhile, commodities tend to do well when the dollar declines, benefiting emerging market and commodity-producing countries. Financing costs for non-US corporations borrowing in dollars are also eased. Historically, profit growth has been the ultimate driver of stock prices and profitability is more contingent on productivity gains than translation effects. This suggests the starting point for gauging relative equity flows, and the potential impact on currencies, is to evaluate which countries/economies could be primed for outperformance. Relative Growth As A Starting Point One of the key drivers of relative earnings growth between two countries is relative economic performance. Chart I-1 shows that earnings-per-share in the G10 relative to the US tended to improve when growth was shifting in favor of the rest of the world. This, in turn, has been a key driver of relative equity performance. Chart I-1Relative Profits And Relative Growth What is remarkable is that this relationship has been pretty consistent across countries, including those that have huge exposures to the global economy such as Sweden, Norway, or even the United Kingdom. In general, relative economic performance has driven relative EPS growth (Chart I-2A & 2B). The reason is that these bourses still have a sizeable dependence on the domestic economy. Chart I-3 shows that for even the most export-driven economies, exposure to domestic sales is still at least 20%. Australia, a commodity country has almost 60% of sales from domestic sources. Our bias is that non-US growth will start to outperform towards the backend of this year. This will pressure the dollar lower (Chart I-4). This conviction rests on three critical pillars: Chart I-2AA Cross Country Look At Relative Profits Growth Chart I-2BA Cross Country Look At Relative Profits Growth   Chart I-3Domestic Sales Matter A Lot For Global Equity Bourses Chart I-4The Dollar Trends With ##br##Relative Growth   The rest of the world will catch up in vaccination campaigns relative to the US. This is almost a fait accompli. Canada is well behind in terms of vaccination progress compared to the US or the UK (Chart I-5). But in Quebec, where BCA is headquartered, Premier François Legault has suggested that everyone who wants a vaccine will be able to get their first dose by June 24. Relative employment growth in Canada is already picking up, and the central bank has already begun tapering asset purchases ahead of the Fed. The broader message is that the service sector has been held hostage by relatively closed economies outside the US. This will change as economies open up.   Producer prices (PPI) are picking up globally and the US is leading the pack. This will also rotate in favor of other economies. Producer prices first took off in the US as the sectors that benefited from the pandemic were those related to technology and healthcare. Norway also gained from the rebound in oil prices. Other countries should begin to catch up, as demand for goods and services broadens beyond the pandemic-related scope (Chart I-6). From a longer-term perspective, PPI usually peaks and troughs in the US ahead of other economies. Again, as we exit a recession, consumption tends to broaden from defensive goods towards more discretionary spending. Given that other economies are bigger producers of these discretionary items, this should start to shift relative pricing power towards these countries (Chart I-7). Non-US growth has been held hostage to cascading crises since the US housing market bust. In 2010, we had the euro area debt crisis. In 2011, the Fukushima disaster knocked down Japanese growth. In 2015, tight monetary policy in China led to a global manufacturing recession. In short, rest-of-world growth has not been able to catch breath for a decade. Chart I-5Many Countries Will Replicate The US and UK Vaccination Success Chart I-6Global PPIs Are ##br##Picking Up   Chart I-7US PPI Usually Leads Other Countries The silver lining is that the COVID-19 crisis has ushered in coordinated global monetary and fiscal stimulus. For the first time in a long while, non-US growth can start to outperform, according to IMF estimates (Chart I-8). Chart I-8The IMF Expects Non-US Growth To Outperform Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case when US versus non-US stocks are concerned. If we accept the premise that relative growth matters for equity allocations, then it also makes sense that relative equity performance will coincide with currency performance, due to portfolio flows. Across the G10 economies, getting the equity call right has usually been synonymous with having the appropriate currency strategy (Chart I-9). This is especially the case since equity flows have been supportive of the dollar (Chart I-10). Chart I-9ACurrencies And Equities Move Together Chart I-9BCurrencies And Equities Move Together Chart I-10Equity Flows Have Been Supportive Of The Dollar A More Quantitative Approach While relative growth is important, it is not the sole factor in determining which countries or sectors will outperform. Most investors have at least two other powerful tools that have stood the test of time in making equity allocations. These include the valuation starting point, and the historical return on capital. Valuation is the easiest place to start. Over time, non-US bourses have tended to outperform the US when the relative valuation starting point was attractive. This has been especially true around recessions, when leadership changes tend to occur. Chart I-11A, 11B, 11C, and 11D show that countries such as Japan, Mexico, and Germany should sport more attractive returns over the next decade compared to the US. The list is not comprehensive, but our previous work suggests this valuation tool works across many countries and various geographies. Chart I-11AValuation Matters For Long-Term Returns Chart I-11BValuation Matters For Long-Term Returns Chart I-11CValuation Matters For Long-Term Returns Chart I-11DValuation Matters For Long-Term Returns   Not surprisingly, the currencies that are the most undervalued in our models also have cheap equity markets. These include the Scandinavian currencies, commodity plays, the Japanese yen, and the pound. A rerating of these markets will be synonymous with a rerating in their currencies (Chart I-12). The rise in global bond yields will also prove to be a formidable headwind for US stocks. Technology constitutes 28% of the US equity market, the largest allocation within the G10. Together with defensive sectors such as health care and consumer staples, this ratio rises to 60%. As a result, the relative performance of the US equity market has been inversely correlated to bond yields (Chart I-13). Should bond yields continue to gravitate higher over the next few years, this will lead to a powerful rotation towards more cyclical bourses. The rise in yields will be particularly favorable for deep value sectors like banks (due to rising net interest margins) and commodities (due to inflation protection). Chart I-12The Dollar Remains ##br##Expensive Chart I-13US Outperformance Has Dovetailed With Lower Bond Yields Going forward, expected return on capital will be more difficult to gauge, but countries that have a history of providing superior shareholder returns are a good place to start. For example, we know that the winners of the last decade have had the largest returns on equity, as was the case for the winners during the prior decade. Given the mammoth task of performing this exercise on a cross-country basis, and across factors, we enlisted the help of our colleagues who run BCA’s Equity Analyzer platform. The EA platform provides a BCA score of 0 to 100 for all developed market stocks, according to their ranking on 30 carefully selected and curated factors. Crunching the numbers revealed a few interesting results: A long strategy based on selecting the top decile stocks according to their EA score outperformed both domestic and global indices (Chart I-14). The quality factor has been one of the better determinants of future stock market returns. The EA quality score is based on return on equity, asset growth, accruals, and margins. On this basis, the bourses with a higher concentration of quality stocks in their indices are found outside the US (Chart I-15). Using an overall blended score, which includes not only the quality factor, but also others such as value, size, and momentum, suggests investors will be rewarded by tilting away from the US. For example, 20%-30% of stocks in Scandinavian bourses make it into the top decile EA portfolio (Chart I-16). Even if one focuses solely on growth sectors such as technology and health care, non-US companies are still more attractive (Chart I-17). Chart I-14The BCA EA Platform Allows Investors To Pick Winners Chart I-15Quality Stocks Are Heavily Weighted Outside The US Chart I-16A Composite Score Ranks US Stocks Poorly Chart I-17Lots Of Attractive Growth Stocks Outside The US In a nutshell, non-US markets are attractive from a valuation standpoint and across a swathe of other metrics that have been useful in benchmarking future returns. An outperformance of non-US stocks will favor cyclical currencies, as portfolio flows gravitate to these markets. We are already selectively long a basket of Scandinavian currencies; we will be gradually accumulating other currencies such as the GBP, the CAD, and the JPY on weakness. Specifically, the yen is becoming interesting not only as portfolio insurance, but also as a play on the cyclical Japanese market. We will be covering these currencies in depth in upcoming reports. Housekeeping Three important central banks met this week. The general tone was dovish. The Bank of England kept policy roughly unchanged, but there were three important takeaways. First, the BoE suggested any pickup in UK inflation will be transitory. Second, the BoE will slow its bond purchases, as they approach the central bank’s target. And finally, growth estimates were revised upward. Our take is that the meeting was a non-event for cable in the near term and bullish longer term. The message from the Reserve Bank of Australia was bit more dovish. They kept open the possibility of additional measures on the July 6 meeting. Our bias is that the RBA is trying to fend off deflationary pressures from a strong currency. This only delays the bullish backdrop for the AUD. Next Tuesday’s budget will provide some information about additional support to the Aussie economy. The Norges bank remains on the path to hike interest rates later this year. This supports our bullish NOK thesis. We have been reluctant to establish fresh long positions as we enter a seasonally strong month for the dollar. However, our buy list is growing as we highlighted above. For now our open positions are highlighted on page 14.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, "Currencies And The Value-Versus-Growth Debate," dated July 10, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The recent data out of the US were mildly positive. The ISM Manufacturing PMI came in at 60.7 in April, well below an estimate of 65. The ISM Manufacturing New Orders Index came in at 64.3 in April, slightly below an expectation of 66.6. The trade deficit for March was -74.4B USD, in line with expectations. Personal Spending for March was 4.2% month-on-month, as expected. The dollar DXY index rose by 0.8% this week. While the PMI data for April came in on the mild side, inflationary pressures continue to build up as reflected in the robust New Orders, Backlog of Orders as well as the Prices Paid indices. That said, the Fed’s current stance is that price surges will likely be transitory. This is near-term negative for the greenback since it implies policy will not be tightened anytime soon. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The recent Euro data have been mildly positive. Unemployment rate for March was 8.1%, slightly better than the predicted 8.3%. GDP fell 1.8% year-on-year, compared to an expected 2% decrease. CPI came in at 1.6% for April year-on-year, in line with expectation. German Retail Sales for March came in at 7.7% month-on-month comfortably beating a 3% expectation. Overall euro area retail sales surged 12% year-on-year in March, comfortably outpacing consensus of a 9.4% rise. The euro was down 0.9% against USD this week. However, as the weekly vaccination increase in both the US and the UK are slowing down, it continues to rise in the euro area.  Infections are stabilizing in Germany and the Netherlands, and are on a downtrend in France and Italy. This puts a floor under the euro. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 The recent data out of Japan have been strong. The unemployment rate for March came in at 2.6%. Industrial Production for March came in at 2.2% month-on-month, versus the estimate of -2%. Tokyo Core CPI came in at -0.2%, below market consensus. Vehicles sales surged by 22.2% year-on-year in April. The Japanese yen was flat against USD this week. A lagging vaccine campaign, rising COVID-19 case count, and the state of emergency continue to drag down sentiment towards Japan. However, the yen’s real effective exchange rate is trading at one standard deviation below fair value and our intermediate-term indicator is hinting at a rebound. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The recent data out of UK have been positive. The Nationwide HPI for April was 7.1% higher than a year ago, beating an expectation of 5%. The BoE kept interest rates at 0.1% and its asset purchase target at £895bn. The pound was flat against the USD this week. The Bank of England kept policy on hold this week, but there were three important takeaways. First, the BoE sees any near-term pickup in inflation as temporary. This should keep a near-term lid on rate hike expectations and the pound. Second, the BoE will slow its bond purchases, as they approach the central bank’s target. And finally, growth estimates were revised upward, especially for 2022. This is bullish cable longer term. On the political front, a potential surprise of another Scottish independence may put some downward pressure on the currency. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The recent data out of Australia have been strong. The AIG Manufacturing Index for April came in at 61.7, higher than the prior 59.9 reading. The AIG Construction Index for April came in at 59.1, below the 61.8 print in March. The trade balance for March came in at AUD 5.6bn, below an expectation of AUD 8bn. The RBA cash rate remained at 0.1%. The Australian dollar was flat this week against the USD. The RBA provided a dovish tone at its meeting this week, extending QE until February, and kept open the possibility of additional measures on the July 6 meeting. In the near term, upbeat economic data continue to provide support for the AUD. However, the tourism industry (6% of employment) is needed to get Australia back to full employment. Our bias is that the RBA will continue to fight against an appreciating currency, until the economy reaches escape velocity. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The recent data out of New Zealand have been strong. Employment grew by 0.6% quarter-on-quarter in Q1. The Labor Cost Index for Q1 came in at 0.4% over prior quarter, and 1.6% year-on-year. The unemployment rate for Q1 declined to 4.7%, from 4.9%. Building consents increased 17.9% month-on-month in March. The New Zealand dollar was down 0.5% against USD this week. As we indicated in our report last week, the NZD is overpriced by several measures and the elevated equity market is of particular concern. The weakening GlobalDairyTrade Price Index could potentially be a harbinger of peaking agricultural prices in the coming months. This will lead the NZD to underperform other commodity currencies.  Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The recent data out of Canada have been soft. The trade balance for March came in at -1.14bn CAD versus CAD 1.42bn the previous month. Building permits rose 5.7% month-on-month in March. The CAD was flat against USD this week. Despite concerns over elevated commodity prices and a vaccination campaign that is lagging other advanced economies, recent strong employment growth and the tapering of asset purchases by the BoC should continue to boost the currency, the top performing among G10 so far this year. In the near term, Canadian exports will benefit from US fiscal stimulus, which will also provide support for the loonie. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The recent Swiss data have been strong. The KOF Leading Indicator for April came in at 134, beating the 119.5 estimate.  CPI for April came in at 0.3%. SECO Consumer Climate for Q2 came in at -18, higher than the -30 back in Q1. The Swiss franc was down 0.5% against the USD this week. The Swiss economy continues to surprise to the upside. With our intermediate-term indicator on a downward path, we remain optimistic on our long EUR/CHF position for now, despite potential upside risks to the franc given the Indian COVID-19 outbreak. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The recent data out of Norway have been strong. The unemployment rate for April came in at 4%, from 4.2% the prior month. The house price index for April came in at 12.2% year-on-year, similar to the 12.5% reading of March. Interest rate were held at 0% by the Norges Bank. The NOK was down 1.8% against the USD this week. The krone is the winning currency since the pandemic hit, suggesting some consolidation was much due. With Norwegian inflation rising sharply above the central bank’s 2% target earlier this year, the Norges Bank reiterated during its meeting on Thursday that a rate hike later this year is well in sight. Against the backdrop of the impending European recovery this summer and Norway’s own commendable vaccination progress, we continue to be long the NOK against the USD and EUR.  Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The recent Swedish data have been strong. Industrial Production for March came in at 1.1% month-on-month. Year-on-year, IP is rising by 5.7%. Industrial New Orders for March came in at 10% year-on-year. GDP in Q1 was 1.1% higher than the prior quarter, beating the estimate of 0.5%. The Swedish krona was down 1.4% against the USD this week. BCA Research’s European Investment Strategy service indicated that there is significantly more upside to Swedish stocks against both Eurozone and US equities over the remainder of the cycle. Sweden is levered to the global industrial cycle with exports representing 45% of GDP. The recovery in both Europe and across the globe should continue to benefit the krona. The tapering of asset purchases by the Riksbank later this year will also provide support to the currency in the meantime. We continue to be long SEK/USD and SEK/EUR. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights A slower money and credit growth in China will eventually generate disinflationary pressures by weighing on demand for commodities. The PBoC has shifted its inflation anchor and policy framework to target core CPI and the PPI rather than headline CPI. Beijing is scaling back its fiscal supports and cooling the property sector to tackle local government and housing sector debt issues. In the next six to nine months we favor companies and sectors that will benefit from global economic recovery rather than China’s domestic demand. We are long CSI500 relative to China’s A shares. The CSI500 has a larger exposure to the global economy and lower valuation relative to China’s broad onshore market.  Feature As a follow up to last week’s report, we look at another topic raised in recent client meetings: whether rapidly rising producer prices in China will morph into a broad-based inflationary risk and how macroeconomic policies will evolve to counter such a risk. Clients who believe that the ongoing producer price inflation is transitory cited China’s low consumer price inflation, and slowing money and credit growth, as leading indicators of budding disinflationary pressures. Advocates of sustained inflation pointed to robust recoveries and demand among advanced economies, extremely accommodative monetary conditions worldwide, massive fiscal stimulus in the US, a weak US dollar, and supply constraints. It remains to be seen what the worldwide pandemic’s impact will be on the balance between global production capacity and aggregate demand. In this report we analyze the PBoC’s inflation target and policy framework, and conclude that while China’s monetary policy has not become more hawkish, policy tightening seems to be taking place on the fiscal front. Is Inflation In China A Risk? It is debatable whether the strong rebound in GDP growth in Q4 last year and in Q1 this year has closed China’s output gap and will lead to widespread inflation. Given data distortions due to low-base effects from the previous year and uncertainty about China’s productivity and labor force growth, any calculation of the output gap will be unreliable. In addition, China’s employment statistics lack cyclicality and cannot be used to gauge inflationary pressure stemming from wage growth and unit labor costs.     Chart 1A Rollover In Credit Growth Will Weigh On Chinese Demand For Commodities Our cyclical view of inflation is therefore based on the framework that the ongoing moderation in China's money and credit growth will eventually generate disinflationary pressures by weighing on the country’s demand for and price of commodities (Chart 1).  Furthermore, behind a resilient PPI, there are suggestions that the strength in China’s economy is still bifurcated. A narrow-based uptrend in the PPI lacks the ground for sustained inflation, and is unlikely to trigger a general tightening in monetary policy.  While mounting global prices for raw materials propelled strong upstream PPI, producer prices for consumer goods and core consumer price inflation remain very subdued (Chart 2).  The inconsistency in producer prices among various industries highlight the unevenness of the economic recovery and, importantly, persistently muted household consumption (Chart 3). Chart 2A Bifurcated Economic Recovery Chart 3A Muted Recovery In Household Consumption Chart 4Weak Price Transmission From Upstream To Downstream Industries The transmission from upstream industrial PPI to the middle and downstream sectors has also been weak (Chart 4). It is evidenced in the faster growth of manufacturing output volume compared with price increases (Chart 5). This contrasts with the previous inflationary cycles, as well as mining and ferrous metals where surging prices for raw materials have way surpassed recovery in output volume (Chart 6). Given that price changes are more important to corporate profits than volume changes, Chinese middle-to-downstream industries face downward pressure on their profit margins and will likely deliver disappointing profits, despite a strong rebound in production. Chart 5China's Manufacturing Recovery: Stronger Volume Than Prices Chart 6China's Upstream Industries: Prices Surged Faster Than Production Furthermore, PMI input prices, which lead core CPI by about nine months, rolled over in April (Chart 7). While it is too soon to conclude that input prices have peaked, it is implied that upward pressure on core CPI from input prices may start to ease in 2H21. Bottom Line: So far there is no sign that elevated upstream producer prices will create sustainable inflationary pressure on consumer prices. Hence our view is that the PBoC will not respond to a rising PPI by further tightening monetary policy. Chart 7PMI Input Prices Have Rolled Over Chart 8Core CPI And PPI Have Been The PBoC's Inflation Targets Since 2015 The PBoC’s Inflation Target Since 2015, China’s monetary tightening cycles have closely correlated with a combination of the core CPI and PPI instead of headline CPI (Chart 8). The shift to targeting core CPI and PPI occurred despite the central bank’s frequent mention of headline CPI as its inflation target. The reasons for the shift are twofold. First, swings in food and fuel prices have become much larger since 2014, often dominating fluctuations in headline CPI (Chart 9).  Secondly, the price swings were often driven by supply-side factors and did not reflect changes in demand. Therefore, monetary policies could do little to mitigate inflationary or deflationary pressures. Furthermore, the PPI seems to play a greater role in the PBoC’s monetary policymaking than the headline and core CPI (Chart 10).  The tighter relationship between the de facto policy rate and the PPI is not surprising, given that China’s ex-factory price inflation reflects changes in corporate pricing, profit, and inventory cycles – all are driven by the country’s money supply and credit cycles.  Chart 9Large Swings In Food And Energy Prices Distorted Headline CPI In Recent Years Chart 10PPI Plays A Greater Role In The PBoC's Monetary Policymaking The relationship between the 7-day repo rate - the de jure policy rate - and the PPI has broken down since 2015 (Chart 11). Meanwhile, the 3-month repo rate has maintained a close relationship with the PPI (Chart 10, bottom panel). The change in the relationship is because the PBoC shifted its policy to target interest rates instead of the quantity of money supply since 2015 (Chart 12). Moreover, since 2016 the PBoC has generated monetary policy tightening measures through changes in its Macro Prudential Assessment Framework (MPA) rather than directly through interest rate hikes.  Chart 11Relationship Between The 7-Day Repo Rate And The PPI Has Broken Down Since 2015... Chart 12...Due To Monetary Policy Regime Shifted Bottom Line:  The PBoC has shifted its inflation anchor and policy framework since 2015. Core CPI and the PPI are now the main inflation targets. A Quiet Fiscal Tightening? Despite a jump in the PPI, the 3-month repo rate fell sharply in the past two months (Chart 10 on page 6, bottom panel).  It is possible that the PBoC considers escalating producer prices as transitory and, therefore, intends to keep its overall policy stance unchanged. However, the PBoC’s relaxed policy response towards inflation risk may be explained by Beijing’s quiet tightening on the fiscal front. Chart 13The Central Bank Has Made Little Interbank Liquidity Injections Lately The PBoC can hold its policy rates steady by supplying adequate liquidity to the interbank system through open market operations or by reducing the demand for liquidity. On a net basis, the PBoC has recently injected very little liquidity into the interbank system, implying that banks’ liquidity demand has likely softened (Chart 13).  This might be a sign of weakening credit origination. In a previous report we discussed how fiscal stimulus has become a more relevant driver of China’s credit origination since the onset of the 2014/15 economic downcycle. A rising 3-month SHIBOR can be the result of rapid fiscal and quasi-fiscal expansions, which occurred in Q3 last year. A flood of local government bond issuance drained liquidity from commercial banks, which boosted the banks’ needs to borrow money from the interbank system and pushed up interbank rates. Despite higher interest rates, credit growth soared in Q3 as fiscal multiplier provided an imminent and powerful reflationary force to the economy. In contrast, local government bond issuance was down sharply in the first four months of this year, compared with 2019 and 2020. Local governments sold 222.7 billion yuan of special-purpose bonds (SPBs) from January to April, a plunge from 730 billion yuan of debt sold in the same period in 2019 and 1.15 trillion yuan in 2020. The total local government bond issuance in Q1 this year has also been 36% and 44% lower than in Q1 2019 and 2020, respectively. A lack of local governments’ appetite to borrow coupled with a shortage in profitable infrastructure projects might have contributed to the sharp drop in bond issuance this year. Local government financing and spending have been under increased scrutiny this year. Following the State Council Executive Meeting in late March, in which Premier Li Keqiang pledged to reduce government leverage ratio and raise regulatory standards on infrastructure investment, Beijing suspended two high-speed rail projects that were initiated by provincial governments. Messages from Politburo’s meeting last week reinforced our view that policymakers may be scaling back fiscal support while further tightening regulations in the property sector. Both aspects have the potential to cool China’s demand for industrial metals and global industrial material prices (Chart 14 and Chart 15). Chart 14A Slowdown In Chinese Manufacturing Demand Will Have A Greater Impact On Global Industrial Material Prices Chart 15Lower Housing Demand In China Will Help To Cool Industrial Metal Prices We expect the intensity of policy tightening to reach its peak between mid-year to third-quarter 2021. It is unclear at this point whether policymakers are willing to allow local governments to significantly undershoot their SPB quota for this year. Local governments reportedly experienced a shortage in profitable investment projects towards the end of last year, and thus, parked more than 10% of proceeds from 2020 SPB issuance at the central bank. The central government may be taking a wait-and-see attitude this year, and saving more fiscal dry powder for later this year when the economic slowdown becomes more meaningful. Bottom Line: Beijing is pulling back its fiscal supports and cooling the property sector to tackle local government and housing sector debt issues. The deleveraging efforts will curb China’s demand for commodities, and may work to ease inflationary pressure on prices for raw materials. Investment Conclusions The outlook for China’s risk asset prices remains bearish, at least in the next six months. If the credit and fiscal impulse slow enough to depress corporate pricing power, inflation will not be a problem because disinflationary pressures will resurface. However, the growth of corporate profits will disappoint (Chart 16). Beijing may be saving more fiscal dry powder for later this year. Still, SPBs are only a small part of local governments’ financing source for infrastructure projects. Given the central government’s renewed focus on reducing public debt, policymakers are unlikely to unleash fiscal power to significantly boost infrastructure spending or economic growth. In the next six to nine months, we favor companies and sectors that will benefit from global economic recovery rather than China’s domestic demand. With this week's report, we initiate a long position on the CSI500 index, which has a larger exposure to the global market and lower valuation relative to China’s broad onshore market (Chart 17).  Chart 16Aggregate Corporate Profit Growth Will Slow Even Though Inflation Is No Longer An Issue Chart 17Long CSI500/Broad Market   Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Developed economies continue to transition towards a post-pandemic state. Europe has further to go, but it is lagging the US at a constant rate and is thus merely delayed – not on a different path. This ongoing transition is also reflected in the global macro data, which continues to surprise to the upside. Widespread optimism about the outlook for economic activity and earnings over the coming year has led some investors to ask whether an imminent peak in the rate of growth could be a potentially negative inflection point for richly valued risky asset prices. Using our global leading economic indicator as a guide, we find that a peak in growth momentum in and of itself is not likely to be enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). We can identify several candidates for such a shock, including the emergence of new, vaccine-resistant variants of COVID-19, the impact of higher taxes on earnings, overtightening in China, and a potentially hawkish shift in monetary policy in the developed world. But none of these risks individually appears to be likely enough to warrant reducing cyclical portfolio exposure. We continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We remain overweight global ex-US equities vs. the US, but expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials. Within a fixed-income portfolio, we recommend a modestly short duration stance, but do so primarily on a risk-adjusted basis. Feature Chart I-1Europe Is Behind The US, But On The Same Path Over the past month, developed economies have continued to transition towards a post-pandemic state. While the number of new confirmed COVID-19 cases remains relatively high on a per capita basis in the US and Europe, there continues to be significant progress on the vaccination front in all Western advanced economies. Europe continues to lag the US and the UK in terms of the share of the population that has received at least one dose of vaccine, but Chart I-1 highlights that the gap has remained constant at approximately six weeks (to the US). Panel 2 of Chart I-1 highlights that the US and UK both experienced either falling or a stable number of new cases once the number of first doses reached current European levels; Israel required significant further gains in the breadth of vaccinations before it altered COVID-19’s transmission dynamics in that country, but this appears to have occurred because of a much higher pace of spread earlier this year. The negative impact on advanced economies from reduced services activity is strongly linked to pandemic control measures (such as stay-at-home orders, curfews, forced business closures, etc). We have argued that, outside of the US, the implementation and removal of these measures is being driven by the impact of the pandemic on the medical system, rather than the sheer number of new cases and deaths. Chart I-2 highlights that, based on this framework, Europe still has further to go – current per capita hospitalizations remain much higher in France and Italy than in the US, UK, or Canada. But the nature of the disease means that hospitalizations begin to fall even if case counts remain relatively stable, and fall rapidly once new cases trend lower. Given the steady gains that European countries are making in providing first vaccine doses to their populations, it seems likely that hospitalizations there will peak sometime in the coming four to six weeks. This underscores that Europe is not on a different path than that of the US, it is simply further behind in the process (and will ultimately catch up). The transition towards a post-pandemic state is also reflected in the global macro data, which continues to positively surprise in all three major economies (Chart I-3). In Europe, the April services PMI rose back above the 50 mark, April consumer confidence surprised to the upside, and February retail sales came in better than expected (Table I-1). In the US, the March services PMI was also very strong, the labor market continued to meaningfully improve, and several measures of inflation surprised to the upside. Chart I-2Euro Area Hospitalizations Remain High, But Will Soon Decline Chart I-3The Macro Data Continues To Positively Surprise   Table I-1Services PMIs And The Labor Market Continue To Meaningfully Improve Chart I-4China's Current Contribution To Global Demand Is Strong In China, the recent tick higher in the surprise index likely reflects the recognition of some data series whose release was delayed due to the Chinese New Year, as well as significant base effects (compared with Q1 2020) in many data series recorded in year-over-year terms. On a quarter-over-quarter basis, Chinese economic activity decelerated last quarter to 0.6% from the upwardly revised 3.2% in Q4 2020 – which was below the anticipated 1.4% q/q. Still, Chinese RMB-denominated import growth closely matches (lagging) data on global exports to China (in US$ terms), with the former suggesting that China’s current contribution to global external demand remains strong (Chart I-4). This is also consistent with rising producer prices, which had fallen back into deflationary territory last year (panel 2). Peaking Growth Momentum: Should Investors Be Worried? The continued increase in the number of vaccine doses administered, positive data surprises, and bullish global growth forecasts for this year have understandably led to extremely optimistic investor sentiment. It has also naturally raised the question of “what could go wrong?”, with some investors pointing to an imminent peak in the rate of growth as a potentially negative inflection point for richly valued risky asset prices. Chart I-5 addresses this question by examining 12 episodes of waning growth momentum since 1990, defined as an identifiable peak in our global leading economic indicator. Panel 2 shows the 12-month rate of change in the relative performance of global equities versus a US$-hedged 7-10 year global Treasury index. Chart I-5Is Peaking Growth Momentum A Risk For Stocks? At first blush, the chart does support the notion that a peak in growth momentum is generally negative for risky asset prices. The subsequent 12-month relative return from stocks versus bonds following a peak in the LEI has been negative in 8 out of the 12 episodes, suggesting that the risks of an equity correction are currently quite elevated. However, there is more to the story than this simple calculation implies (Table I-2). First, two of the twelve episodes saw the global LEI peak in the context of an eventual US recession, so it is not surprising that stocks underperformed bonds in those episodes. Second, out of the six non-recessionary episodes, only two of them involved significant underperformance, in 2002 and in 2015. Table I-2Peak Growth Momentum Is An Insufficient Catalyst For Equity Underperformance US equities underperformed in the former case because of the persistently damaging impact of corporate excesses that built up during the dot-com bubble, and predominantly global ex-US equities underperformed bonds in the latter case because of a combination of the significant impact on global CAPEX from the 2014 dollar and oil price shock, as well as a major decline in global bond yields. In the four other non-recessionary examples of equity underperformance, stocks only modestly underperformed bonds, and often this occurred in the context of significant events: surprising Fed hawkishness in 1994, the Asian financial crisis in 1997, a major slowdown in China in 2013, and the combination of a domestically-driven Chinese economic slowdown coupled with the Sino/US trade war in 2017/2018. The key point for investors is that a peak in growth momentum is in and of itself not enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). What Else Could Go Wrong? There are four other plausible risks that we can identify to a bullish stance towards risky assets over the coming 6-12 months. We discuss each of these risks below. New COVID-19 Variants Chart I-6 highlights that bottom up analysts expect global earnings per share to be 12% higher than their pre-pandemic level in 12-months’ time. This expectation is driven by extraordinarily easy fiscal and monetary policy, but also the view that vaccination against COVID-19 will allow social distancing policies to end and services activity to fully recover. However, as India is clearly – and tragically – demonstrating at present, the emerging world is lagging in terms of vaccinating its population. India’s per capita case count has soared (Chart I-7), which is surprising given that the country’s COVID-19 infection rate has been significantly below that of more advanced economies over the past year. It is therefore likely that India’s case count explosion is due to new variants of the disease, and periodic outbreaks in less developed countries – as well as vaccine hesitancy in more developed economies – risks the emergence of even newer variants that may be partially or substantially vaccine-resistant. Chart I-6Earnings Expectations Already Price In A Normalization In Services Activity Chart I-7India's COVID-19 Situation Is Tragic, And Concerning   New variants of COVID-19 may prove to be less deadly, but the economic impact of the pandemic has come mainly from its potential to collapse the medical system via high rates of serious illness requiring hospitalization, not strictly from its lethality. As such, potentially new vaccine-resistant variants of the disease resulting in similar or higher rates of hospitalization pose a risk to a bullish economic outlook. Taxation Both corporate and individual tax rates are set to rise in the US over the coming 12-18 months which, at first blush, could certainly qualify as a non-recessionary event that negatively impacts earnings or raises the ERP. Corporate taxes are set to rise first as part of the American Jobs Plan, which our political strategists have argued will probably take the Biden administration most of this year to pass. The plan involves a proposed increase in the domestic corporate income tax rate to 28% from 21%, a higher minimum tax on foreign profits, and a 15% minimum tax on “book income”. In addition, as part of the American Families Plan, Biden is proposing to increase the top marginal income tax rate for households earning $400,000 or more to 39.6% (from 37%), and to substantially increase the capital gains tax rate for those earning $1 million or more from a base rate of 20% to 39.6%. The 3.8% tax on investment income that funds Obamacare would be kept in place, which would bring the total capital gain tax rate to 43.4% for that income group. Peter Berezin, BCA’s Chief Global Strategist, made two points about higher corporate taxes in a recent report.1 First, he noted that the changes would likely result in an 8% decline in forward earnings if passed as currently proposed, but that various tax credits as well as opposition to a 28% corporate tax rate from Democratic Senator Joe Manchin would likely cap the impact at 5%. Second, he argued that the behavior of 12-month forward earnings and the performance of stocks that benefitted the most from President Trump’s corporate tax cuts suggest that very little impact from these changes has been priced in. Peter argued in his report that the effect of strong economic growth will likely offset the negative impact of higher taxes on earnings, and we are inclined to agree. Chart I-8 highlights that a 5% reduction in 12-month forward earnings would reduce the equity risk premium by roughly 20-25 basis points, which would not be disastrous on its own. Still, the fact that these changes have not been priced in means that corporate tax hikes could be a more meaningful driver of lower stock prices if the impact is ultimately larger than we currently expect or if the growth outlook suddenly shifts in a negative direction. In terms of changes to individual taxes, our sense is that the proposed increase in the capital gains tax rate is more significant than the modest proposed change to the top marginal income tax rate for higher-income households. For individuals earning $1 million or more, Chart I-9 highlights that the proposed change to the capital gains rate would bring it to the highest level seen since the late 1970s. Given the rich valuation of equities, it seems inconceivable that such a change would not trigger some short-term selling of equities to lock in long-term gains at lower tax rates. Chart I-8Higher Corporate Taxes Will Only Modestly Reduce the Equity Risk Premium Chart I-9Biden's Capital Gains Tax Proposal Would Lead To Some Selling Of Stocks...   But like upcoming changes to corporate taxes, we see the potential for higher taxes on wealthy individuals as a risk to the equity market and not as a likely driver of stock prices over a cyclical time horizon. First, our political strategists see 50/50 odds that the American Families Plan will be passed this year, meaning that short-term tax avoidance selling may be postponed until 2022. In addition, Chart I-10 highlights that over the longer term, the relationship between the maximum capital gains tax rate and the ERP is weak or nonexistent. The chart highlights that the perception of a positive relationship rests entirely on the second half of the 1970s, when the maximum capital gains tax rate was between 30-40%. However, it seems clear from the chart that the stagflationary environment of that period was responsible for a high ERP, as the capital gains rate fell from 1977 to 1982 without any significant decline in risk premia. It took until the end of the 1982 recession and the beginning of the structural disinflationary period for the equity risk premium to decline, suggesting that there is effectively no relationship between the two (and therefore no reason to believe that higher capital gains taxes will lead to sustained declines in stock market multiples). Chart I-10…But The Effect Would Not Likely Last Overtightening In China Chart I-11Leading Indicators Of China's Economy Are Pointing Down, Not Up Even though Chart I-4 highlighted that Chinese import demand is currently strong, we expect China’s growth impulse to weaken in the second half of the year. Chart I-11 highlights that our leading indicator for China’s Li Keqiang index has done a good job of predicting Chinese import growth, and the indicator is now in a clear downtrend. Panel 2 presents the components of the indicator, and shows that all three are trending lower. Monetary conditions are potentially rebounding from extremely weak levels (due to past deflation and a rise in the RMB versus the US dollar and other Asian currencies), but money supply and credit measures are deteriorating. Leading indicators for China’s economy are deteriorating because Chinese policymakers have already tightened liquidity conditions in response to the country’s rebound from the pandemic and following a surge in the credit impulse. The 3-month repo rate returned to pre-pandemic levels in the second half of last year (Chart I-12), and consequently the private sector credit impulse (particularly that of corporate bond issuance) fell despite robust medium-to-long term loan growth. Chart I-12Chinese Interest Rates Have Already Returned To Pre-COVID Levels We noted in our January report that China’s credit impulse has consistently followed a 3½-year cycle since 2010, and this year has been no different. This cycle is not exogenous or mystical; it has been caused by the repeated “oversteering” of activity by Chinese policymakers who frequently oscillate between the need to fight deflation and the strong desire to curb additional private sector leveraging. Our base case view is that policymakers will not accidentally overtighten the economy, and that the credit impulse will settle somewhere between late 2019 levels and the peak rate reached in the latter half of last year. But the risk of significant oversteering cannot be ruled out, and will likely remain a downcycle risk for investors for several years to come. A Hawkish Shift In Monetary Policy In Developed Markets Last week the Bank of Canada announced that it would taper its pace of government debt purchases from 4 billion to 3 billion CAD per week. The announcement was noteworthy for many investors, as it suggested that asset purchase reductions could also be announced by the Fed and other major central banks by the end of the second or third quarter. Many investors are sensitive to the tapering question because of what transpired during the “Taper Tantrum” episode of 2013. During an appearance before Congress in late May of that year, then Chair Ben Bernanke stated that the Fed could “step down” the pace of its asset purchases in the next few FOMC meetings if economic conditions continued to improve. The result was that 10-year Treasurys fell roughly 10% in total return terms over the subsequent three-month period. While stocks rallied in response to the growth-positive implications of the move, this occurred from a much higher ERP starting point than exists today. The risk, in the minds of some investors, is that tapering today could thus lead to a correction in stock prices. There are two counterpoints to this view. First, bonds have already sold off meaningfully over the past several months in response to a significant improvement in the economic outlook, and investors already expect the Fed to raise interest rates earlier than it is publicly forecasting. It is thus difficult to see how an announcement of tapering from the Fed would significantly alter the outlook for monetary policy over the coming 6-18 months. Chart I-13Another Taper Tantrum-Like Selloff Would Necessitate Higher Expectations For R-star Second, it is notable that the “Taper Tantrum” began at yield levels at the front end of the curve that are roughly similar to what prevails today. 5-year/5-year forward bond yields stood at roughly 3% at the beginning of the “Tantrum”, compared with 2.3% today. Chart I-13 highlights how high forward bond yields would need to rise in order to generate another selloff of similar magnitude from 10-year Treasury yields (roughly 3.65%). In our view, a rise to this level over the coming year is essentially impossible without a major shift in investor expectations about the natural rate of interest. We highlighted the risk of such a shift in last month’s report,2 but for now it would likely necessitate hard evidence of little-to-no permanent damage to the labor market from the pandemic. This is not our base case view, but it will be an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Investment Conclusions As noted above, there are several identifiable risks to a bullish outlook for risky assets, but none of these risks individually appear to be likely. Given this, we continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We favor value versus growth stocks, cyclical versus defensive sectors, and small versus large cap stocks, although there is more return potential over the coming year in value versus growth than the latter two positions. We also remain short the US dollar over a cyclical time horizon. Within a global equity portfolio, we remain overweight global ex-US equities vs the US, but this position has moved against us over the past two months. Chart I-14 highlights that global ex-US equities have given back all of their October – January gains versus US equities, most of which has occurred since late-February. The chart also highlights that all of this underperformance has been driven by emerging market stocks, as euro area equity performance has been mostly stable year-to-date. Chart I-15 highlights that EM underperformance has occurred both in the broadly-defined tech sector as well as when measured in ex-tech terms. To us, this suggests that EM stocks are responding to the deterioration in leading indicators for the Chinese economy that we noted above, which implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. Chart I-14Emerging Markets Have Caused Global Ex-US Stocks To Underperform Chart I-15EM's Underperformance Has Been Broad-Based   As a final point, investors should note that we are recommending a modestly short duration stance within a fixed-income portfolio, but that we make this recommendation primarily on a risk-adjusted basis. Chart I-16 highlights that Treasury market excess returns (relative to cash) have historically been driven by whether the Fed funds rate increases by more or less than what is currently priced into the market. Over the past 12 months, the Treasury index has very substantially underperformed cash without a hawkish surprise, and the rate path that is currently implied by the OIS curve is already more hawkish than the Fed is (for now) projecting. On this basis, a neutral duration stance could be justified, but we would still prefer a modestly short duration stance due to the risk of a potential increase in investor expectations for the neutral rate of interest late this year or in early 2022. Chart I-16Policy Rate Surprises Tend To Drive The Duration Call Jonathan LaBerge, CFA Vice President The Bank Credit Analyst April 29, 2021 Next Report: May 27, 2021   II. In COVID’s Wake: Government Debt And The Path Of Interest Rates The US fiscal outlook has deteriorated substantially over the past two decades, as a consequence of the fiscal response to both the global financial crisis and the COVID-19 pandemic. US government debt-to-GDP is now nearly as high as it was at the end of the Second World War, and is projected by the US Congressional Budget Office (CBO) to explode higher over the coming 30 years. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks. We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in a scenario where investors raise their expectations for the neutral rate of interest, a possibility that we discussed in last month’s report. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, we do not expect that rising interest rates pose a risk to stocks over the coming 6-12 months. Investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. In 2001, US government debt held by the public as a share of GDP stood at 31.5%, after having fallen roughly 16 percentage points from early 1993 levels. Today, as a result of both the global financial crisis and the COVID-19 pandemic, the debt to GDP ratio has risen to a whopping 100%, and is projected to rise meaningfully higher over the coming decades. In this report we review the long-term US fiscal outlook in the wake of the pandemic, with a focus on the implications for interest rates. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks, whose fundamental performance has outstripped that of the broad equity market since the mid-1990s (reflecting pricing power that stands to be curtailed through regulation). We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report,3 i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. Debt Sustainability, And The CBO’s Baseline Projection When analyzing the US fiscal outlook, the Congressional Budget Office’s Long-Term Budget Outlook report is typically the reference point for investors. The report provides annual projections for the budget deficit and the debt-to-GDP ratio for the next three decades, as well as a breakdown of the projected deficit into its primary (i.e., non-interest) and net interest components. Charts II-1 and II-2 present the most recent baseline projections from the CBO, which clearly present a dire long-term outlook. The deficit and debt-to-GDP ratio are projected to be relatively stable over the next decade, but explode higher over the subsequent 20 years. In 2051, the CBO’s baseline projects that the budget deficit will be roughly 13% of GDP, with net interest costs accounting for approximately two-thirds of the deficit. Chart II-1The CBO’s Fiscal Outlook Is Extremely Negative Chart II-2In 2051, The CBO Projects A 13% Annual Budget Deficit In order to understand what is driving the CBO’s dire long-term budget and debt forecast, it is important to review the government debt sustainability equation shown below. The equation highlights that the change in a government’s debt-to-GDP ratio is approximately equal to 1) the primary deficit plus 2) net interest costs as a share of GDP, the latter being defined as the product of last year’s debt-to-GDP ratio and the difference between the average interest rate on the debt and the rate of GDP growth. Δ Debt-To-GDP Ratio ≈ Primary Deficit As A % Of GDP4 + (r-g)*(Prior Period Debt-To-GDP Ratio) Where: r = Average interest rate on government debt and g = Nominal GDP growth The equation highlights that expectations of a persistently rising debt-to-GDP ratio must occur either because of expectations of a persistent primary deficit, or expectations that interest rates will persistently exceed the rate of economic growth (or some combination of the two). This underscores why debt sustainability analysis often focuses on the primary budget balance, as a country’s debt-to-GDP ratio will be stable if no primary deficit exists and interest costs are at or below the prevailing rate of economic growth. Chart II-3 illustrates the source of the CBO’s projected rise in debt-to-GDP beyond 2031, by presenting the two components of the debt sustainability equation alongside the projected annual change in the debt-to-GDP ratio. The chart makes it clear that while the CBO is forecasting a sizeable primary deficit to continue, it is projected to grow at a slower pace than the debt-to-GDP ratio itself. The increasing rate at which the debt-to-GDP ratio is projected to grow in the latter years of the CBO’s forecast period is clearly driven by the interest rate component, meaning that “r” is projected to be greater than “g”. Chart II-4 presents this point directly, by highlighting that the CBO is forecasting the average interest rate on government debt to exceed that of nominal GDP growth in 2038, and to continue to exceed growth (by an increasing amount) thereafter. Chart II-3Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Chart II-4The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth   Three Adjustments To The CBO’s Baseline We make three adjustments to the CBO’s baseline in order to assess how the US fiscal outlook shifts under an interest rate path that is different than that projected by the CBO. First, we adjust the CBO’s projected budget deficit over the coming few years based on deficit forecasts from our US Political Strategy service following the passage of the American Recovery Plan act.5 Chart II-5We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path Next, we adjust the interest component of the total budget deficit based on a new path for short- and long-term interest rates that models a scenario in which the neutral rate of interest rises to, but not above, GDP growth (Chart II-5). In last month’s report we outlined a scenario in which this could feasibly occur,3 and the hypothetical path for interest rates shown in Chart II-5 thus incorporates both the negative budgetary impact of an earlier rise in interest rates and the positive budgetary impact of “r” never rising above “g”. We explicitly exclude any crowding out effect on long-term interest rates, based on the view that term premia are likely to remain muted in a world of low potential economic growth, unless a fiscal crisis appears to be imminent (see Box II-1). Box II-1 Arguing Against The CBO’s Crowding Out Assumption The CBO’s projection that interest rates will ultimately rise above the rate of economic growth rests on the view that increased government spending will absorb savings that would otherwise finance private investment (a “crowding out” effect). We agree that crowding out can occur over the course of the business cycle, especially in a scenario where increased government spending pushes output above its potential (creating a cyclical acceleration in inflation and eventually an increase in interest rates). But the CBO is assuming that high government debt-to-GDP ratios will crowd out private investment on a structural basis, and on this basis we disagree. First, Chart Box II-1 highlights that there is essentially no empirical relationship across countries between a country’s debt-to-GDP ratio and its long-term government bond yield. Japan is a clear outlier in the chart, but including Japan implies that the relationship is negative, not positive. Chart Box II-1There Is No Empirical Relationship Between Debt-To-GDP And Interest Rates In addition, given that central banks directly control interest rates at the short-end of the curve, a structural crowding out effect can only manifest itself in the form of an elevated term premium embedded in longer-term government bond yields. Our bet is that term premia are likely to stay low in a world of low falling nominal growth, as evidenced by the experience of the past decade.6 Finally, we model the impact of two changes, beginning in 2031, that would work towards reducing the primary deficit: an increase in average government revenue to 20% of GDP (its peak level reached in 2000), and a slower pace of increase on major health care program spending. Despite the fact that population aging will increase mandatory spending on social security and health care over the coming three decades, the CBO has highlighted that the majority of the increase in spending towards these programs is projected to occur due to rising health care costs per person (Chart II-6). We thus model the impact of medical care cost control by limiting the rise in net mandatory outlays on health care programs between 2021 and 2051 to roughly half of what the CBO baseline projects. This adjustment does not prevent mandatory spending on health care programs from rising, given the strong political challenges involved in limiting spending increases that are caused by an aging population. Chart II-6The US Structural Primary Balance Is Heavily Impacted By Medical Costs Charts II-7 and II-8 illustrate how these three adjustments impact the long-term US fiscal outlook. Relative to the CBO’s baseline projections, the American Recovery Plan (ARP) budget deficit forecasts from our US Political Strategy service imply that the debt-to-GDP ratio will be approximately three to four percentage points higher over the very near term, and roughly ten points higher over the long term. Chart II-7Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad… Relative to this new baseline, an increase in interest rates to, but not above, the projected rate of nominal economic growth increases the debt-to-GDP ratio by an additional ten percentage points (20 points higher versus the CBO’s baseline) in the middle of the forecast period, but it lowers the debt-to-GDP ratio over the longer run by eliminating the effect of outsized interest rates magnifying a persistent primary deficit. Still, the debt-to-GDP ratio is projected to rise to a whopping 207% of GDP by 2051 in this scenario, with a budget deficit in excess of 10% of GDP. The third adjustment shown in Charts II-7 and II-8 underscores the impact on the US fiscal outlook of actions aimed at reducing the primary deficit. Increases in government revenue and the prevention of rising health care costs per person results in the debt-to-GDP ratio that is 64 percentage points lower in 2051 than in our normalized interest rate scenario. The budget deficit in this scenario still increases to approximately 6% of GDP thirty years from today, but in this case most of the deficit is due to the net interest component rather than the primary deficit, meaning that the debt-to-GDP ratio would be increasing at a much slower rate if interest rates were no higher than the rate of economic growth. Chart II-8 highlights that net interest spending in this scenario would rise to 4.5% of GDP, which would be meaningfully higher than the prior high of roughly 3% in the late 1980s and early 1990s. Chart II-8...With Higher Taxes And Medical Cost Control Chart II-9A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays But that is far from unprecedented or necessarily consistent with a fiscal crisis. Chart II-9 also shows that Canada’s public debt charges rose to 6.5% of GDP in the early 1990s without triggering a public debt crisis. It is true that Canada subsequently embarked on a painful fiscal consolidation program in order to reduce its public debt burden, but this, in part, occurred because of a cyclically-adjusted primary deficit of approximately 3% - twice as large as that projected for the US in 2051 in our adjusted scenario shown in Charts II-7 and II-8. Revenue And Health Care Cost Reform Our third adjustment to the CBO’s long-term budget outlook involved changes to revenue and health care cost control to reduce the US’ projected primary deficit. Are these adjustments achievable? In our view, the answer is yes: As noted above, our scenario modeled these changes taking place a decade from today, which allows for policymakers and stakeholders to have a substantial amount of time to act and adjust to these changes. On the revenue front, we noted above that US government revenue has reached 20% of GDP in the past, in the year 2000. Chart II-10 highlights that while raising taxes will likely reduce US competitiveness, the US maintains a sizeable tax advantage relative to other advanced economies, and that this was true prior to the tax cuts that took place under the Trump administration. On the health care cost front, Chart II-11 highlights that US healthcare expenditure is much larger as a share of GDP than other countries, which was not the case prior to the 1980s. Chart II-12 highlights that this cost difference is entirely due to inpatient (i.e., hospital) and outpatient (i.e., drug) costs. While it is not clear what form it will take, it seems likely that future reforms by policymakers to eliminate rising health care costs per person will occur and can be achieved. Chart II-10The US Government Can Afford To Raise Revenue Chart II-11The US Spends Much More On Health Care Than Other Countries   Chart II-12The US Significantly Outspends The World On Hospital And Drug Costs The key point for investors is not whether these changes should or should not occur, but whether there are any feasible scenarios in which spiraling government debt and interest payments are avoided without the Fed purposely maintaining monetary policy at levels persistently below the rate of economic growth – and thus risking major inflationary pressure. Our analysis above highlights that there are; the question is when policymakers will choose to act and in what form. A potential tipping point may be when US government spending on net interest as a % of GDP exceeds its prior high, which occurs in 2026 in the scenario modeled in Chart II-8. In a scenario where reforms fail to materialize or where financial markets force policymakers to act, a fiscal risk premium could certainly emerge in longer-term government bond yields, which could lead the Fed to maintain lower short-term interest rates than it otherwise would. But this scenario is only likely to emerge after interest rates converge towards rates of economic growth, as US government debt will remain highly serviceable for some time if "r" remains meaningfully lower than "g". Investment Conclusions There are three potential investment implications of our research. First, the fact that rising medical costs have such a significant impact on the CBO’s projections of the primary deficit implies that fiscal reform, when it eventually occurs, will be negative for US health care stocks. Chart II-13 highlights that US health care sector earnings have outperformed broad market earnings since the mid-1990s, and that the sector has consistently delivered an above-average return on equity. This historical performance likely reflects the sector’s pricing power, which stand to be curtailed through regulatory efforts in a world where rising health care costs per person collide with fiscal belt-tightening. Interestingly, Chart II-12 highlighted that US per capita spending on medical goods is not significantly higher than in other developed markets, suggesting that the health care equipment & supplies industry may fare better over a very long term time horizon than overall health care. Second, Charts II-7 and II-8 highlighted that even if the US does raise revenue as a share of GDP and limits excessive growth in medical costs, a primary deficit will still exist and net interest outlays will still rise to elevated levels compared to what has historically been the case. We noted that Canada experienced a higher public debt burden in the 1990s and did not suffer from a fiscal crisis, but Chart II-14 highlights that the fiscal situation did weigh on the Canadian dollar, which progressively traded 10-20% below its PPP-implied fair value level over the course of the 1990s. Thus, the implication is that eventual fiscal reform in the US may be structurally negative for the US dollar, from an overvalued starting point (panels 3 and 4 of Chart II-14). Chart II-13Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Chart II-14The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative   Finally, our scenario analysis highlights that very elevated levels of government debt do not guarantee that interest rates will remain structurally low, especially over the next decade when the US primary deficit is projected to remain relatively stable. For investors focused on forecasting the direction of 10-year Treasury yields from the perspective of valuation, it should be noted that the next decade is the relevant projection period for the Fed funds rate, not what occurs to net interest outlays in the two decades that follow. Over the very long run, it is true that there may ultimately be very strong political pressure on the Fed to keep interest rates below the prevailing rate of economic growth, as policymakers in 2030 will be able to avoid a structural adjustment to the primary deficit of roughly 1.1-1.3% of GDP for every percentage point that average interest rates on government debt are below nominal GDP growth. However, we noted above that this pressure is unlikely to build before the second half of this decade even in a scenario where interest rates rise significantly over the coming few years, and it remains an open questions whether the Fed will acquiesce to this pressure given its strong potential to fuel excess private sector leveraging. Over the coming one to two years, the key conclusion is that the US fiscal outlook is not likely to prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report, i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This remains a risk to our overweight stance towards risky assets and is not our base case view. But it does highlight the importance of monitoring long-dated rate expectations over the coming year, and argues, on a risk-adjusted basis, for a below-neutral duration stance within a fixed-income portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields. The indicator remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain positive, and positive earnings surprises have risen to their strongest levels on record. Within a global equity portfolio, EM stocks have dragged down global ex-US performance, likely in response to deteriorating leading indicators for the Chinese economy. This implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. The US 10-Year Treasury yield has edged lower over the past month, after having risen to levels that were extremely technically stretched. Despite this pause, our valuation index highlights that bonds are still expensive, and that yields could move higher over the cyclical investment horizon. We expect the rise to be more modest than our valuation index would imply, but we would still recommend a modestly short duration stance within a fixed-income portfolio. Commodity prices, particularly copper, lumber, and agricultural commodities, are screaming higher. This reflects bullish cyclical conditions, but also pandemic-induced supply shortages that are likely to wane later this year. Commodity prices are technically extended and sentiment is extremely bullish for most commodities, suggesting that a breather in commodity prices is likely at some point over the coming several months. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. Our global LEI diffusion index has declined significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is lagging). Strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME:   Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see Global Investment Strategy "Taxing Woke Capital," dated April 16, 2021, available at gis.bcaresearch.com 2 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 3 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 4 Presented in this fashion, a budget deficit (surplus) is recorded with a positive (negative) sign. 5 For more information, please see US Political Strategy report “Biden’s Pittsburgh Speech And Legislative Agenda,” dated April 1, 2021, available at usp.bcaresearch.com 6 Please see “Term premia: models and some stylised facts”, by Cohen, Hördahl, and Xia, BIS Quarterly Review, September 2008.

Special Report

Highlights The Greens are likely to win control of Germany’s government in the September 26 federal elections. At least they will be very influential in the new coalition. Germany has achieved may of its long-term geopolitical goals within the EU. There is consensus on dovish monetary and fiscal policy and hawkish environmental policy. The biggest changes will come from the outside. The US and Germany have a more difficult relationship. While they both oppose Russian and Chinese aggression, Germany will resist American aggression. The Christian Democrats have a 65% chance of remaining in government which would limit the Greens’ controversial and ambitious tax agenda. The 35% chance of a left-wing coalition will frontload fiscal stimulus for the sake of recovery. The economy is looking up and a Green-led fiscal easing would supercharge the recovery. However, coalition politics will likely fail to address Germany’s poor demography, deteriorating productivity, and large excess savings. On a cyclical basis, overweight peripheral European bonds relative to bunds; EUR/USD; and Italian and Spanish stocks relative to German stocks. Feature Chart 1Germans Turn To A Young Woman And A Green Germany is set to become the first major country to be led by a green party. At very least the German election on September 26 will see an upset in which the ruling party under-performs and the Greens over-perform (Chart 1). At 30%, online betting markets are underrating the odds that Annalena Baerbock will become the first Green chancellor in 2022 – and the first elected chancellor to hail from a third party (Chart 2). The “German question” – the problem of how to unify Germany yet keep peace with the neighbors – lay at the heart of Europe for the past two centuries but today it appears substantially resolved: a peaceful and unified Germany stands at the center of a peaceful and mostly unified Europe. There are a range of risks on the horizon but this positive backdrop should be acknowledged. Chart 2Market Waking Up To Baerbock’s Bid For Chancellorship All of the likeliest scenarios for the German election will reinforce the current situation by perpetuating policies that aim for Euro Area solidarity. Even the green shift is already well underway, though a Green-led government would supercharge it. Nevertheless this year’s election is important because it heralds a leftward shift in Germany and will shape fiscal, energy, industrial, and trade policy for at least the coming four years. A left-wing sweep would generate equity market excitement in the short run – a positive fiscal surprise to supercharge the post-pandemic rebound – but over the long run it would bring greater policy uncertainty because it would cause a break with the past and possibly a structural economic shift (Chart 3). The Greens are in favor of substantial increases in taxation and regulation as well as big changes in industrial and energy policy. In the absence of a left-wing sweep, coalition politics will be a muddle and Germany’s existing policies will continue. Chart 3German Policy Uncertainty On The Rise Regardless of what happens within Germany, the geopolitical environment is increasingly dangerous. Germany will try to avoid getting drawn into the US’s great power struggles with Russia and China but it may not have a choice. Germany’s Geopolitics The difficulty of German unification stands at the center of modern European history. Because of the large and productive German-speaking population, unification in 1871 posed a security threat to the neighbors, culminating in the world wars. The peaceful German reunification after the Cold War created the potential for the EU to succeed and establish peace and prosperity on the continent. This arrangement has survived recent challenges. Germany’s relationship with the EU came under threat from the financial crisis, the Arab Spring and immigration influx, Brexit, and President Trump’s trade tariffs. But in the end these events cemented the reality that German and Europe are strengthening their bonds in the face of foreign pressures. Germany achieved what it had long sought – preeminence on the continent – by eschewing a military role, sticking to France economically, and avoiding conflict with Russia. Since Germany has achieved many of its long-sought strategic objectives it has not fallen victim to a nationalist backlash over the past ten years like the US and United Kingdom. However, Germany is not immune to populism or anti-establishment sentiment. The two main political blocs, the Christian Democrats and the Democratic Socialists, have suffered a loss of popular support in recent elections, forcing them into a grand coalition together. Anti-establishment feeling in Germany has moved the electorate to the left, in favor of the Greens. The Greens have risen inexorably over the past decade and have now seized the momentum only five months before an election (Chart 4). Yet the Greens in Germany are basically an establishment political party. They participate in 11 out of 16 state governments and currently hold the top position in Baden-Württemberg, Germany’s third most populous and productive state. From 1998-2005 they participated in government, getting their hands dirty with neoliberal structural reforms and overseas military deployments. Moreover the Greens cannot rule alone but will have to rule within a coalition, which will mediate their more controversial policies. Chart 4Greens Surge, Christian Democrats Falter Today Germany is in lock step with France and the EU by meeting three key conditions: full monetary accommodation (the German constitutional court’s challenges to the European Central Bank are ineffectual), full fiscal accommodation (Chancellor Angela Merkel agreed to joint debt issuance and loose deficit controls amid the COVID-19 crisis as well as robust green energy policies), and full security accommodation (German rearmament exists within the context of NATO and European security aspirations are undertaken in lock-step with the French). These conditions will not change in the 2021 election even assuming that the Greens take power at the head of a left-wing coalition. Bottom Line: Germany has virtually achieved its grand strategic aims of unifying and ruling Europe. No German government will challenge this situation and every German government will strive to solidify it. The greatest risks to this setup stem from abroad rather than at home. The Return Of The German Question? Germany’s geopolitical position can be summarized by Chart 5, which shows popular views toward different countries and institutions. The Germans look positively upon the EU and global institutions like the United Nations and less so NATO. They look unfavorably upon everything else. They take an unfavorable view toward Russia, but not dramatically so, which shows their lack of interest in conflict with Russia – they do not want to be the battleground or the ramparts of another major European war. They dislike the United States and China even more, and equally. Even if attitudes toward the US have improved since the 2020 election the net unfavorability is telling. Chart 5Germany More Favorable Toward Russia Than US? Since the global financial crisis, and especially Russia’s invasion of Ukraine in 2014, Germany has built up its military. This buildup is taking place under the prodding of the United States and in step with NATO allies, who are reacting to Russia’s military action to restore its sphere of influence in the former Soviet space (Chart 6). Germany’s military spending still falls short of NATO’s 2% of GDP target, however. It will not be seen as a threat to its neighbors as long as it remains integrated with France and Europe and geared toward deterring Russia. Chart 6Germany And NATO Increase Military Spending Chart 7Watch Russo-German Relations For Cracks In Europe’s Edifice Russia’s aggressiveness should continue to drive the Germans and Europeans into each other’s arms. This could change if Putin pursues diplomacy over military coercion, for then he could split Germany from eastern Europe. The possibility is clear from Russia’s and Germany’s current insistence on completing the Nord Stream 2 pipeline despite American and eastern European objections. The pipeline is set to be completed by September, right in time for the elections – in no small part because the Greens oppose it. If the US insists on halting the pipeline then a crisis will erupt with Russia that will humiliate Merkel and the Christian Democrats. But the US may refrain from doing so in the face of Russian military threats (odds are 50/50). The Russian positioning over 100,000 troops on the border with Ukraine this year – and now reportedly ordering them to return to base by May 1 – amounts to a test of Russo-German relations. Putin can easily expand the Russian footprint in Ukraine and tensions will remain elevated at least through the Russian legislative elections in September. Germans would respond to another invasion with sanctions, albeit likely watering down tougher sanctions proposed by the Americans. What would truly change the game would be a Russian conquest of all of Ukraine. This is unlikely – precisely because it would unite Germany, the Europeans, and the Americans solidly against Russia, to its economic loss as well as strategic disadvantage (Chart 7). China’s rise should also keep Germany bound up with Europe. The Germans fear China’s technological and manufacturing advancement, including Chinese involvement in digital infrastructure and networks. The Greens are critical of the way that carbon-heavy Chinese goods undercut the prices of carbon-lite German goods. Baerbock favors carbon adjustment fees, a pretty word for tariffs. However, the Germans want to maintain business with China and are not very afraid of China’s military. Hence there is a risk of a US-German split over the question of China. If Germany should consistently side with Russia and China over US objections then it risks attracting hostile attention from the US as well as from fellow Europeans, who will eventually fear that German power is becoming exorbitant by forming relations with giants outside the EU. But this is not the leading risk today. The US is courting Germany and seeking to renew the trans-Atlantic alliance. Meanwhile Germany needs US support against Russia’s military and China’s trade practices. US-German relations will improve unless the US forces Germany into an outright conflict with the autocratic powers. Bottom Line: The US and Germany have a more difficult relationship now than in the past but they share an interest in deterring Russian aggression and Chinese technological and trade ambitions. Biden’s attempt to confront these powers multilaterally is limited by Germany’s risk-aversion. Scenarios For The 2021 Election There are several realistic scenarios for the German election outcome. Our expectation that the Greens will form a government stems from a series of fundamental factors. Opinion polling has now clearly shifted in favor of our view, with the Greens gaining the momentum with only five months to go. Grouping the political parties into ideological blocs shows that the race is a dead heat. Our bet is that momentum will break in favor of the opposition Greens, which we explain below. Meanwhile the Free Democrats should perform well, stealing votes from the Christian Democrats. The right-wing Alternative für Deutschland (AfD), while not performing well, is persistent enough to poach some votes from the Christian Democrats. These are “lost” votes to the conservatives as none of the parties will join it in a coalition (Chart 8). Chart 8Germany's Median Voters Shifts To the Left The Christian Democrats bear all the signs of a stale and vulnerable government. They have been in power for 16 years and their performance in state and federal elections has eroded recently, including this year (Table 1). The public is susceptible to the powerful idea that it is time for a change. Chancellor Merkel’s approval rating is still around 60%, but in freefall, and her successful legacy is not enough to save her party, which is showing all the signs of panic: succession issues, indecision, infighting, corruption scandals. The Greens will be “tax-and-spend” lefties but the coalition matters in terms of what can actually be legislated (Table 2).1 Table 1AChristian Democrats Fall, Greens Rise, In Recent State Elections Table 1BChristian Democrats Fall, Greens Rise, In Recent State Elections Table 2Policy Platforms Of The Green Party The fact that Christian Democrats and their Bavarian sister party, the Christian Social Union, saw such a tough race for chancellor candidate is an ill omen. Moreover the party’s elites went for the safe choice of Merkel’s handpicked successor, Armin Laschet, over the more popular Markus Soeder (Chart 9), in a division that will likely haunt the party later this year. Chart 9Christian Democrats And Christian Social Union Divided Ahead Of Election Laschet has received a bounce in polls with the nomination but it will be temporary. He has not cut a major figure in any polling prior to now. Chart 10Dissatisfaction Points To Government Change He has quarreled openly with Merkel and the coalition over pandemic management. He was not her first choice of successor anyway – that was Annagret Kramp-Karrenbauer, who fell from grace due to controversy over the faintest hint of cooperation with the AfD. There is a manifest problem filling Merkel’s shoes. Even more important than coalition infighting is the fact that Germany, like the rest of the world, has suffered a historic shock to its economy and society. The pandemic and recession were then aggravated by a botched vaccine rollout. General dissatisfaction is high, another negative sign for the incumbent party (Chart 10). Of course, the election is still five months away. The vaccine will make its way around, the economy will reopen, and consumers will look up – see below for the very positive macro upturn that Germany should expect between now and the election. Voters have largely favored strict pandemic measures and Merkel will have long coattails. This Christian Democrats and Christian Social Union have ruled modern Germany for all but 15 years and have not fallen beneath 33% of the popular vote since reunification. The Greens have frequently aroused more energy in opinion polling than at the voting booth. With these points in mind, we offer the following election scenarios with our subjective probabilities: Green-Red-Red Coalition – Greens rule without Christian Democrats – 35% odds. Green-Black Coalition – Greens rule with Christian Democrats – 30% odds. Black-Green Coalition – Christian Democrats rule with Greens – 25% odds. Grand Coalition (Status Quo) – Christian Democrats rule without Greens – 10% odds. Our subjective probabilities are based on the opinion polls and online betting cited above but adjusted for the Greens’ momentum, the Christian Democrats’ internal divisions, the “time for change” factor, and the presence of a historic exogenous economic and social shock. Geopolitical surprises could occur before the election but they would most likely reinforce the Greens, since they have taken a hawkish line against Russia and China. Bottom Line: The Greens are likely to lead the next German government but at very least they will have a powerful influence. Policy Impacts Of Election Scenarios The makeup of the ruling coalition will determine the parameters of new policy. Fiscal policy will change based on the election outcome – both spending and taxes. The Greens will be “tax-and-spend” lefties but the coalition matters in terms of what can actually be legislated.2 The Greens’ idea is to “steer” the rebuilding process through environmental policy. But if the left lacks a strong majority then the Greens’ more controversial and punitive measures will not get through. Transformative policies will weigh heavily on the lower classes (Chart 11). Chart 11Ambitious Climate Policy Will Face Resistance The policy dispositions of the various chancellor candidates help to illustrate Germany’s high degree of policy consensus. Table 3 looks at the candidates based on whether they are “hawkish” (active or offensive) or “dovish” (passive or defensive) on a given policy area. What stands out is the agreement among the different candidates despite party differences. Nobody is a fiscal or monetary hawk. Only Baerbock can be classified as a hawk on trade.3 Nobody is a hawk on immigration. Nearly everyone is a hawk on fighting climate change. And attitudes are turning more skeptical of Russia and China, though not outright hawkish. Table 3Policy Consensus Among German Chancellor Candidates Germany will not abandon its green initiatives even if the Greens underperform. The current grand coalition pursued a climate package due to popular pressure even with the Greens in opposition. Germans are considerably more pro-environment even than other Europeans (Chart 12). The green shift is also happening across the world. The US is now joining the green race while China is doubling down for its own reasons. See the Appendix for current green targets and measures, which have been updated in the wake of a slew of announcements before Biden’s Earth Day climate summit on April 22-23. Chart 12Germans Care Even More About Environment Than Other Europeans Any coalition will raise spending more than taxes since it will be focused on post-COVID economic recovery. There has been a long prelude to Germany’s proactive fiscal shift – it has staying power and is not to be dismissed. A Christian Democratic coalition would try to restore fiscal discipline sooner than otherwise but there is only a 5% chance that it will have the power to do so according to the scenarios given above. The rest of Europe will be motivated to spend aggressively while EU fiscal caps are on hold in 2022, especially if the German government is taking a more dovish turn. Even more than the US and UK, Germany is turning away from the neoliberal Washington Consensus. But Germans are not experiencing any kind of US-style surge of polarization and populism. At least not yet. It may be a risk over the long run, depending on the fate of the Christian Democrats, the AfD, and various internal and external developments. Bottom Line: Germany has a national consensus that consists of dovish monetary, fiscal, trade, and immigration policies and hawkish (pro-green) environmental policy. Germany is turning less dovish on geopolitical conflicts with Russia and China. Given that a coalition government is likely, this consensus is likely to determine actual policy in the wake of this year’s election. A few things are clear regardless of the ruling coalition. First, Germany is seeking domestic demand as a new source of growth, to rebalance its economy and deepen EU integration. Second, Germany is accelerating its green energy drive. Third, Germany cannot accept being in the middle of a new cold war with Russia. Fourth, Germany has an ambivalent policy on China. Germany’s Macro Outlook Even before considering the broader fiscal picture, the outlook for German economic activity over the course of the coming 12 to 24 months was already positive. Our base case scenario for the September election, which foresees a coalition government led by the Green Party, only confirms this optimistic view. However, Germany is still facing significant long-term challenges, and, so far, there has not been a political consensus to address these structural headwinds adequately. The Greens offer some solutions but not all of their proposals are constructive and much will depend on their parliamentary strength. Peering Into The Near-Term… Germany’s economy is set to benefit from the continued recovery of the global business cycle, which is a view at the core of BCA Research’s current outlook.4 Germany remains a trading and manufacturing powerhouse, and thus, it will reap a significant dividend from the continued global manufacturing upswing. Manufacturing and trade amount to 20% and 88% of Germany’s GDP, the highest percentage of any major economy. Alternatively, according to the OECD, foreign demand for German goods accounts for nearly 30% of domestic value added, a share even greater than that for a smaller economy like Korea (Chart 13). Moreover, road vehicles, machinery and other transport equipment, as well as chemicals and related products, account for 53% of Germany’s exports. These products are all particularly sensitive to the global business cycle. They will therefore enhance the performance of the German economy over the next two years. Trade with the rest of Europe constitutes another boost to Germany’s economy going forward. Shipments to the euro area and the rest of the EU account for 34% and 23% of Germany’s exports, or 57% overall. Right now, the lagging economy of Europe is a handicap for Germany; however, Europe has more pent-up demand than the US, and the consumption of durable goods will surge once the vaccination campaign progresses further (Chart 14). This will create a significant boon for Germany, since we expect European consumption to pick up meaningfully over the coming 12 to 18 months.5 Chart 13Germany Depends On Global Trade Chart 14Europe Has More Pent-Up Demand Than The US Chart 15Vaccination Progress Domestic forces also point toward a strong Germany economy, not just foreign factors. The pace of vaccination is rapidly accelerating in Germany (Chart 15). The recent announcement of 50 million additional doses purchases for the quarter and up to 1.8 billion more doses over the next two years by the EU points to further improvements. A more broad-based vaccination effort will catalyze underlying tailwinds to consumption. German household income will also progress significantly. The Kurzarbeit program was instrumental in containing the unemployment rate during the crisis, which only peaked at 6.4% from 5% in early 2020. However, the program could not prevent a sharp decline in total hours worked of 7%, since by definition, it forced six million employees to work reduced hours (Chart 16). One of the great benefits of the program is that it prevents a rupture of the link between workers and employers. Thus, the economy suffers less frictional unemployment as activity recovers and household income does not suffer long lasting damage. Meanwhile, the German government is likely to extend the support for households and businesses as a result of the delayed use of the debt-brake. The Greens propose revising the debt brake rather than restoring it in 2022 like the conservatives pledge to do. Chart 16Kurtzarbeit Saved The Day The balance-sheet strength of German households means that they will have the wherewithal to spend these growing incomes. Residential real estate prices are rising at an 8% annual pace, which is pushing the asset-to-disposable income ratio to record highs. Meanwhile, the debt-to-assets ratio, and the level of interest rates are also very low, which means that the burden of serving existing liabilities is minimal (Chart 17). In this context, durable goods spending will accelerate, which will lift overall cyclical spending, even if German households do not spend much of the EUR120 billion in excess savings built up over the past year. As Chart 18 shows, while US durable goods spending has already overtaken its pre-COVID highs, Germany’s continues to linger near its long-term trend. Thus, as the economy re-opens this summer, and income and employment increase, the concurrent surge in consumer confidence will allow for a recovery in cyclical spending. Chart 17Strong Household Balance Sheets Chart 18Germany Too Has More Pent-up Demand Than The US Chart 19Positive Message From Many Indicators Various economic indicators are already pointing toward the coming German economic boom.Manufacturing orders are strong, and economic sentiment confidence is rising across most sectors. Meanwhile, consumer optimism is forming a trough, and new car registrations are climbing rapidly. Most positively, the stocks of finished goods have collapsed, which suggests that production will be ramped up to fulfill future demand (Chart 19). Bottom Line: The German economy is set to accelerate in the second half of the year and into 2022. As usual, Germany will enjoy a healthy dividend from robust global growth, but the expanding vaccination program, as well durable employee-employer relations, strong household balance sheets, and significant pent-up demand for durable goods will also fuel the domestic economy. Our base case scenario that fiscal policy will remain accommodative in the wake of a political shift to the left in Berlin in September will only supercharge this inevitable recovery. … And The Long-Term In contrast to the bright near-term perspective, the long-term outlook for the German economy remains poor. The policies of any new ruling coalition are unlikely to address the problems of Germany’s poor demography, deteriorating productivity, and large excess savings. There is potential for a productivity boost in the context of a global green energy and high-tech race but for now that remains a matter of speculation. The most obvious issue facing Germany is its ageing population, counterbalanced by its fertility rate of only 1.6. Over the course of the next three decades, Germany’s dependency ratio will surge to 80%, driven by an increase in the elderly dependency ratio of 20% (Chart 20). The working age population is set to decline by 18% by 2050, which will curtail potential GDP growth. The outlook for German productivity growth is also poor. Germany’s productivity growth has been in a long-term decline, falling from 5% in 1975 to less than 1% in 2019. Contrary to commonly-held ideas, from 1999 to 2007, German labor productivity growth has only matched that of France or Spain; since 2008, it has lagged behind these two nations, although it has bested Italy. One crucial reason for Germany’s uninspiring productivity performance is a lack of investment. Some of this reflects the country’s austere fiscal policy. For example, in 2019, Germany’s public investment stood at 2.4% of GDP, which compares poorly to the OECD’s average of 3.8%, or even to that of the US, where public investment stood at 3.6% of GDP. This poor statistic does not even account for the depreciation of the German public capital stock. Since the introduction of the euro, net public investment has averaged 0.03% of GDP. The biggest problem remains at the municipal level. From 2012 to 2019, federal and state level net investment averaged 0.2% of GDP, while municipal net investment subtracted 0.2% of GDP on average. Hopefully, the new government will be able to address this deficiency of the German economy. The Greens are most proactive but they will face obstacles. The bigger problem for German productivity is corporate capex. Corporate investments have been low in this country. Since the introduction of the euro, the contribution of capital intensity to productivity in Germany has equaled that of Italy and has underperformed France and Spain. As a result, the age of the German capital stock is at a record high and stands well above the US or Eurozone average (Chart 21). Chart 20Germany Has Poor Demographics Chart 21Germany's Capital Stock Is Ageing The make-up of Germany’s capex aggravates the productivity-handicap. According to a Bundesbank study, the contribution to labor productivity from information and communication technology (ICT) capital spending has averaged 0.05 percentage points annually from 2008 to 2012. On this metric, Germany lagged behind France and the US, but still bested Italy. From 2013 to 2017, the contribution of ICT investment to productivity fell to 0.02 percentage points, still below France and the US, but in line with Italy. Looking at the absolute level of ICT or knowledge-based capital (KBC) investment further highlights Germany’s challenge. In 2016, total investment in ICT equipment, software and database, R&D and intellectual property products, and other KBC assets (which include organizational capital and training) represented less than 8% of GDP. In France, the US, or Sweden, these outlays accounted for 11%, 12%, and 13% of GDP, respectively (Chart 22, top panel). This lack of investment directly hurts Germany’s capacity to innovate. The bottom panel of Chart 22 shows that, for the eight most important categories of ICT patents (accounting for 80% of total ICT patents), Germany remarkably lags behind the US, Japan, Korea, or China. Chart 22Germany Lags In ICT investment A major source of Germany’s handicap in ICT and KBC investment comes from small businesses, which have been particularly reluctant to deploy capital. A study by the OECD shows that, between 2010 and 2019, the gap of ICT tools and activities adoption between Germany’s small and large companies deteriorated relative to the OECD average (Chart 23). The lack of venture capital investing probably exacerbates these problems. In 2019, venture capital investing accounted for 0.06% of Germany’s GDP. This is below the level of venture investing in France or the UK (0.08% and 0.1% of GDP, respectively), let alone South Korea, Canada, Israel, or the US (0.16%, 0.2%, 0.4% and 0.65%, respectively). The Greens claim they will create new venture capital funds but their capability in this domain is questionable. Chart 23The Lagging ICT Capabilities Of Small German Businesses Since Germany’s productivity growth is likely to remain sub-par compared to rest of the OECD and to lag behind even that of France or the UK, the only way for Germany to protect its competitiveness will be to control costs. This means that Germany cannot allow its recent loss of competitiveness to continue much further (Chart 24). Thus, low productivity growth will limit Germany’s real wages. Chart 24Germany's Competitiveness Is Declining This wage constraint will negatively impact consumption. Beyond a pop over the coming 12 to 24 months, German consumption is likely to remain depressed, as it was in the first decade and a half of the century, following the Hartz IV labor market reforms that also hurt real wages. The Greens for their part aim to boost welfare payments, raise the minimum wage, and reduce enforcement of Hartz IV. Bottom Line: German excess savings will remain wide on a structural basis. Without a meaningful pick-up in capex, German nonfinancial businesses will remain net lenders. Meanwhile, households that were worried about their financial future in a world of low real-wage growth will also continue to save a significant share of their income. Consequently, the excess savings Germany developed since the turn of the millennia are here to stay (Chart 25). In other words, Germany will continue to sport a large current account surplus and exert a deflationary influence on Europe and the rest of the world. The policy prescribed by the various parties contesting the September election will not necessarily result in new laws that will reverse the issues of low capex and low ICT investment. The Greens will worsen the over-regulation of the economy. Barring a policy revolution that succeeds in all its aims (a tall order), we can expect more of the same for Germany – that is, a slowly declining economy. Chart 25Too Much Savings, Not Enough Investments Chart 26Germany Scores Well On Renewable Power That being said, some bright spots exist. Germany is becoming a leader in renewable energy, and it can capitalize on the broadening of this trend to enlarge its export market (Chart 26). Investment Implications Bond Markets The economic outlook for Germany and the euro area at large is consistent with the underweighting of German bunds within European fixed-income portfolios. Bunds rank among the most expensive bond markets in the world, which will make them extremely vulnerable to positive economic surprise in Europe later this year, especially if Germany’s fiscal policy loosens up further in the wake of the September election (Chart 27). Moreover, easier German fiscal policy should help European peripheral bonds, especially the inexpensive Italian BTPs that the ECB currently buys aggressively. Thus, we continue to overweight BTPs, and add Greek and Portuguese bonds to the list. Chart 27German Bunds Are Expensive Chart 28German Yields Already Embed Plenty Pessimism About Europe Relative to US Treasurys, the outlook for Bunds is more complex. On the one hand, the ECB will not tighten policy as much as the Fed later this cycle; moreover, European inflation is likely to remain below US levels this year, as well as through the business cycle. On the other hand, Bunds already embed a significantly lower real terminal rate proxy and term premium than Treasury Notes (Chart 28). Netting it all out, BCA Research Global Fixed Income Strategy service believes Bunds should outperform Treasurys this year, because they have a lower beta, which is a valuable feature in a rising yield environment.6 We will closely monitor risks around this view, because it is likely that the European economic recovery will be the catalyst for the next up leg in global yields, in which case German bunds could temporarily underperform. On a structural basis, as long as Germany’s productivity issues are not addressed by Berlin, German Bunds are likely to remain an anchor for global yields. Germany will remain awash in excess savings, which will act as a deflationary anchor, while also limiting the long-term upside for European real rates. Excess savings results in a large current account surplus; thus, Germany will continue to export its savings abroad and act as a containing factor for global yields. The Euro The medium-term outlook points to significant euro upside. Our expectation of a European and German positive growth surprise over the coming 12 months is consistent with an outperformance of the euro. The fact that investors have been moving funds out of the Eurozone and into the US at an almost constant rate for the past 10 years only lends credence to this argument (Chart 29). Our view on Germany’s fiscal policy contributes to the euro’s luster. Greater German budget deficits help European economic activity and curtail risk premia across the Eurozone. This process is doubly positive for the euro. First, lower risk premia in the periphery invite inflows into the euro area, especially since Greek, Portuguese, Italian, or Spanish yields offer better value than alternatives. Second, stronger growth and lower risk premia relieve pressure on the ECB as the sole reflator for the Eurozone. At the margin, this process should boost the extremely depressed terminal rate proxy for Europe and help EUR/USD. Robust global economic activity adds to the euro’s appeal, beyond the positive domestic forces at play in Europe. The dollar is a countercyclical currency; thus, global business cycle upswings coincide with a weak USD, which increases EUR/USD’s appeal. Nonetheless, if the boost to global activity emanates from the US, then the dollar can strengthen. This phenomenon was at play in the first quarter of 2021. However, the global growth leadership is set to move away from the US over the next 12 months, which implies that the normal inverse relationship between the dollar and global growth will reassert itself to the euro’s benefit. The European balance of payments dynamics will consolidate the attraction of the euro. Germany’s and the Eurozone’s current account surplus will remain wide, especially in comparison to the expanding twin deficit plaguing the US. Beyond the next 12 to 24 months, the lack of structural vigor of Germany’s and Europe’s economy is likely to shift the euro into a safe-haven currency, like the yen and the Swiss franc. A strong balance of payments and low interest rates (all symptoms of excess savings) are the defining features of funding currencies, and will be permanent attributes of the euro area if reforms do not address its productivity malaise. The Eurozone’s net international position is already rising and its low inflation will put a structural upward bias to the Euro’s purchasing power parity estimates (Chart 30). Those developments have all been evident in Japan and Switzerland, and will likely extinguish the euro’s pro-cyclicality as time passes. Chart 29Investors Already Underweight European Assets Chart 30Upward Bias In The Euro's Fair Value Chart 31Germany Has Not Outperformed The Rest Of The Eurozone German Equities In absolute terms, the DAX and German equities still possess ample upside over the next 12 to 24 months. BCA Research is assuming a positive stance on equities, and a high beta market like Germany stands to benefit.7 Moreover, the elevated sensitivity to global economic activity of German equities accentuate their appeal. BCA Research likes European stocks, and German ones are no exception.8 The more complex question is how to position German equities within a European stock portfolio. After massively outperforming from 2003 to 2012, German equities have moved in line with the rest of the Eurozone ever since (Chart 31). Moreover, German equities now trade at a discount on all the major valuation metrics relative to the rest of the Eurozone (Chart 31, bottom panel). The global macro forces that dictate the outlook for German equities relative to the rest of the Eurozone are currently sending conflicting messages. On the one hand, German equities normally outperform when commodity prices rally or when the euro appreciates (Chart 32). On the other hand, however, German equities also underperform when global yields rise, or following periods when Chinese excess reserves fall, such as what we are witnessing today. With this lack of clarity from global forces, the answer to Germany’s relative performance question lies within European economic dynamics. Germany is losing competitiveness relative to the rest of the Eurozone (Chart 24 page 22) which suggests that German stocks will benefit less than their peers from a stronger euro in comparison to their performance in the last decade. Moreover, German equities outperform when the German manufacturing PMI increases relative to that of the broad euro area. The gap between the German and euro area manufacturing PMI stands near record highs and is likely to narrow as the rest of the Eurozone catches up. This should have a bearing on the performance of German stocks (Chart 33). Chart 32Mixed Global Backdrop For Germany's Relative Performance Chart 33A European Economic Catch-Up Would Hurt German Equities Finally, sectoral dynamics may prove to be the ultimate arbiter. Table 4 highlights the limited difference in sectoral weightings between Germany and the rest of the Eurozone, which helps explain the stability in the relative performance over the past nine years. However, the variance is greater between Germany and specific European nations. In this approach, BCA’s negative stance on growth stocks correlates with an overweight of Germany relative to the Netherlands. Moreover, our positive outlook on financials and bond yields suggests that Germany should underperform Italian and Spanish stocks. Table 4Sectoral Breakdown Across Europe Major Bourses   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Appendix: Global Climate Policy Commitments Footnotes 1 See Matthew Karnitschnig, "German Conservatives Mired In ‘The Swamp,’" Politico, March 24, 2021, politico.eu. 2 The Greens are interested in a range of taxes, including a carbon tax, a digital services tax, and a financial transactions tax. They are also interested in industrial quotas requiring steel and car makers to sell a certain proportion of carbon-neutral steel and electric vehicles. See an excellent interview with Ms. Baerbock in Ileana Grabitz and Katharina Schuler, "I don’t have to convert the SUV driver in Prenzlauer Berg," Zeit Online, January 2, 2020, zeit.de. 3 See her comments to Zeit Online. 4 Please see BCA Research Global Investment Strategy Strategy Outlook "Second Quarter 2021 Strategy Outlook: Inflation Cometh?", dated March 26, 2021, available at gis.bcareseach.com. 5 Please see BCA Research European Investment Strategy Special Report "A Temporary Decoupling", dated April 5, 2021, available at eis.bcareseach.com. 6 Please see BCA Research Global Fixed Income Strategy Strategy Report "Harder, Better, Faster, Stronger", dated March 16, 2021, available at gfis.bcareseach.com. 7 Please see BCA Research Global Income Strategy Strategy Outlook "Second Quarter 2021 Strategy Outlook: Inflation Cometh?", dated March 26, 2021, available at gis.bcareseach.com. 8 Please see BCA Research European Income Strategy Strategy Report "Time And Attraction", dated April 12, 2021, available at eis.bcareseach.com.