Monetary

Highlights Fed: The Fed is preparing markets for a taper announcement in Q4 of this year. But we don’t see asset purchase tapering as a catalyst for higher bond yields. Rather, bond yields will move higher as the employment data continue to come in hot. Job growth will be strong enough to reach the Fed’s definition of maximum employment by the end of 2022, and the fed funds rate will rise more quickly than is implied by current market expectations. Duration: The 10-year Treasury yield will reach a range of 2% to 2.25% by the time the Fed is ready to lift rates, near the end of 2022. Strong employment data will catalyze the next significant jump in bond yields, but this may not happen until Q4 of this year. The spread of the delta COVID variant could limit the pace of hiring during the next month or two, and bond market positioning may need to turn more bullish before yields can rise. Labor Market: After July’s strong employment report, we calculate that average monthly nonfarm payroll growth of 431k is required to reach the Fed’s “maximum employment” liftoff criteria by the end of 2022. Feature Chart 1A Tapering Announcement Is Coming It’s finally time to talk about tapering. Several Fed governors and regional presidents made media appearances last week, each one presenting a timeline that sets up a tapering announcement before the end of this year. Federal Reserve Governor Christopher Waller: I think you could be ready to do an announcement by September. That depends on what the next two jobs reports do. If they come in as strong as the last one, then I think you have made the progress you need. If they don’t, then I think you are probably going to have to push things back a couple of months.1 St Louis Fed President James Bullard: I don’t think that we need to continue with these purchases now that we’ve got new risks on the horizon and possibly inflation risks on the horizon. […] What I think we should do here is start sooner and go faster and get finished by the end of the first quarter of next year. We don’t really need the purchases anymore.2 Dallas Fed President Robert Kaplan: As long as we continue to make progress in July (jobs) numbers and in August jobs numbers, I think we’d be better off to start adjusting these purchases soon. Doing so gradually, over a time frame of plus or minus about eight months, will help give ourselves as much flexibility as possible to be patient and be flexible on the fed funds rate.3 Fed Governor Lael Brainard presented the most detailed description of what it will take for the Fed to start paring its asset purchases.4 Since December, the Fed’s criteria for tapering has been “substantial further progress” toward its employment and price stability goals. In December, nonfarm payrolls were about 10 million below pre-pandemic levels (Chart 2A). In her speech, which was given prior to the release of July’s jobs report, Brainard noted that if employment grows at the same rate in Q3 as it did in Q2, then “about two-thirds of the outstanding job losses as of December 2020” would be made up by the end of 2021. That figure rose to 71% after July’s strong jobs number (Chart 2B). Chart 2AConditions For Tapering Chart 2BDefining "Substantial Further Progress" In other words, as long as employment growth stays solid – in the 500k/month range – then the Fed will be well over 50% of the way toward its maximum employment goal by the end of this year. This would certainly count as “substantial further progress”. Our expectation is that Q3 jobs growth will be strong enough for the Fed to make an official taper announcement in Q4, with the actual tapering starting in January 2022.5 There is an outside chance that the Fed will rush to start tapering earlier, but only if long-dated inflation expectations rise to well above the Fed’s target range (Chart 2A, bottom panel). As for market impact, we don’t expect the tapering announcement to move markets all that much. First, we mainly care about asset purchase tapering because it could signal that the Fed intends to move more quickly toward rate hikes (Chart 1). This is the concern that prompted the 2013 taper tantrum. This time around, however, the Fed has tied liftoff to explicit employment and inflation criteria. This forward guidance significantly weakens the signaling power of any tapering announcement. Second, surveys indicate that market participants already anticipate that tapering will start in early-2022 (Tables 1A & 1B). In other words, a Q4 taper announcement shouldn’t be that much of a shock to expectations. Table 1ASurvey Of Market Participants Expected Fed Timeline Table 1BSurvey Of Primary Dealers Expected Fed Timeline Interestingly, Fed Vice-Chair Richard Clarida did manage to shock markets with his speech last week, but only because he went further than just a discussion of tapering. Specifically, Clarida articulated his expected timeline for lifting interest rates: Chart 3Median FOMC Forecasts While, as Chair Powell indicated last week, we are clearly a ways away from considering raising interest rates and this is certainly not something on the radar screen right now, if the outlook for inflation and outlook for unemployment I summarized earlier turn out to be the actual outcomes for inflation and unemployment realized over the forecast horizon, then I believe that these three necessary conditions for raising the target range for the federal funds rate will have been met by year-end 2022.6 What are the economic forecasts that Clarida says would meet the conditions for liftoff by the end of 2022? It turns out that they are very close to the FOMC’s median projections (Chart 3). The Fed’s forecast calls for 3% core PCE inflation in 2021, falling to 2.1% in 2022 and 2023. The Fed also sees the unemployment rate falling to 4.5% by the end of this year, 3.8% by the end of 2022 and 3.5% by the end of 2023. Clarida said that he views this forecast as consistent with overall employment returning to its pre-pandemic levels by the end of 2022. We think Clarida’s expected timeline is reasonable. The Appendix at the end of this report presents different scenarios for when the Fed’s “maximum employment” liftoff condition might be met. We estimate that average monthly nonfarm payroll growth of 431k will get us to maximum employment by the end of 2022, in time for early-2023 liftoff. At least so far, monthly nonfarm payroll growth is tracking well above the 431k threshold. If we compare our (and Clarida’s) forecast to market prices, we conclude that market rate expectations are too low. The overnight index swap curve is priced for Fed liftoff in January 2023 but for not even three 25 basis point rate hikes in total by the end of 2023 (Chart 4). This seems too low if the Fed’s liftoff criteria are in fact met by the end of 2022, as is our expectation. Chart 4Rate Expectations Bottom Line: The Fed is preparing markets for a taper announcement in Q4 of this year. But we don’t see asset purchase tapering as a catalyst for higher bond yields. Rather, bond yields will move higher as the employment data continue to come in hot. Job growth will be strong enough to reach the Fed’s definition of maximum employment by the end of 2022, and the fed funds rate will rise more quickly than is implied by current market expectations. Timing The Move Higher In Yields Our expectation for a return to maximum employment by the end of 2022 implies that bond yields will be significantly higher by then. Specifically, we expect that both the 5-year/5-year forward Treasury yield and the 10-year Treasury yield will be in a range between 2% and 2.25% by the time of the first rate hike (Chart 5). The 2% to 2.25% range is consistent with survey estimates of the long-run neutral fed funds rate. But a big question remains over the timing of the next move higher in yields. Are bond yields poised to jump higher immediately? Or will they remain low for the next few months and move up only in 2022? Our sense is that the catalyst for the next significant jump in bond yields will be surprisingly strong employment data. There is widespread consensus that inflation will be close to the Fed’s target (if not higher) by the end of 2022, but recent concerns about labor supply have increased the uncertainty around employment projections. Ultimately, we think that labor supply constraints will ease and that the unemployment rate will catch up to levels implied by different labor demand indicators (Chart 6). However, this may not happen during the next month or two. Chart 5A Target For Long-Dated Yields Chart 6Labor Demand Is Strong The spread of the Delta coronavirus variant has just started to ramp up in the United States (Chart 7). The UK’s experience with the variant shows that vaccination significantly limits the number of hospitalizations and suggests that economic lockdowns can be avoided. However, it took about one month for the UK’s new case count to peak once the variant started spreading. A similar roadmap could lead to hiring delays in the US during the next month or two, at least until the new case count starts to fall and concerns abate. From a market technical perspective, we also note that bond market positioning remains significantly net short and that bond market sentiment is less bullish than is often the case at major inflection points (Chart 8). This is not the ideal technical set-up for a large immediate jump in bond yields. Chart 7Delta Is A Near-Term Risk To Hiring Chart 8Positioning & Sentiment Bottom Line: The 10-year Treasury yield will reach a range of 2% to 2.25% by the time the Fed is ready to lift rates, near the end of 2022. Strong employment data will catalyze the next significant jump in bond yields, but this may not happen until Q4 of this year. The spread of the delta COVID variant could limit the pace of hiring during the next month or two, and bond market positioning may need to turn more bullish before yields can rise. Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a more or less complete recovery of the labor force participation rate back to February 2020 levels (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 63%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +431k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth continues to print at the same level as last month, then we could anticipate a Fed rate hike by June 2022. Table A2Tracking Toward Fed Liftoff We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bloomberg.com/news/articles/2021-08-02/waller-says-strong-job-reports-may-warrant-september-taper-call?sref=Ij5V3tFi 2 https://www.stlouisfed.org/from-the-president/video-appearances/2021/bullard-washington-post-inflation-tapering 3 https://www.reuters.com/business/finance/exclusive-feds-kaplan-wants-bond-buying-taper-start-soon-be-gradual-2021-08-04/ 4 https://www.federalreserve.gov/newsevents/speech/brainard20210730a.htm 5 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021. 6 https://www.federalreserve.gov/newsevents/speech/clarida20210804a.htm Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights China’s July Politburo meeting signaled that policy is unlikely to be overtightened. The Biden administration is likely to pass a bipartisan infrastructure deal – as well as a large spending bill by Christmas. Geopolitical risk in the Middle East will rise as Iran’s new hawkish president stakes out an aggressive position. US-Iran talks just got longer and more complicated. Europe’s relatively low political risk is still a boon for regional assets. However, Russia could still deal negative surprises given its restive domestic politics. Japan will see a rise in political turmoil after the Olympic games but national policy is firmly set on the path that Shinzo Abe blazed. Stay long yen as a tactical hedge. Feature Chart 1Rising Hospitalizations Cause Near-Term Jitters, But UK Rolling Over? Our key view of 2021, that China would verge on overtightening policy but would retreat from such a mistake to preserve its economic recovery, looks to be confirmed after the Politburo’s July meeting opened the way for easier policy in the coming months. Meanwhile the Biden administration is likely to secure a bipartisan infrastructure package and push through a large expansion of the social safety net, further securing the American recovery. Growth and stimulus have peaked in both the US and China but these government actions should keep growth supported at a reasonable level and dispel disinflationary fears. This backdrop should support our pro-cyclical, reflationary trade recommendations in the second half of the year. Jitters continue over COVID-19 variants but new cases have tentatively peaked in the UK, US vaccinations are picking up, and death rates are a lot lower now than they were last year, that is, prior to widescale vaccination (Chart 1). This week we are taking a pause to address some of the very good client questions we have received in recent weeks, ranging from our key views of the year to our outstanding investment recommendations. We hope you find the answers insightful. Will Biden’s Infrastructure Bill Disappoint? Ten Republicans are now slated to join 50 Democrats in the Senate to pass a $1 trillion infrastructure bill that consists of $550 billion in new spending over a ten-year period (Table 1). The deal is not certain to pass and it is ostensibly smaller than Biden’s proposal. But Democrats still have the ability to pass a mammoth spending bill this fall. So the bipartisan bill should not be seen as a disappointment with regard to US fiscal policy or projections. The Republicans appear to have the votes for this bipartisan deal. Traditional infrastructure – including broadband internet – has large popular support, especially when not coupled with tax hikes, as is the case here. Both Biden and Trump ran on a ticket of big infra spending. However, political polarization is still at historic peaks so it is possible the deal could collapse despite the strong signs in the media that it will pass. Going forward, the sense of crisis will dissipate and Republicans will take a more oppositional stance. The Democratic Congress will pass President Joe Biden’s signature reconciliation bill this fall, another dollop of massive spending, without a single Republican vote (Chart 2). After that, fiscal policy will probably be frozen in place through at least 2025. Campaigning will begin for the 2022 midterm elections, which makes major new legislation unlikely in 2022, and congressional gridlock is the likely result of the midterm. Republicans will revert to belt tightening until they gain full control of government or a new global crisis erupts. Table 1Bipartisan Infrastructure Bill Likely To Pass Chart 2Reconciliation Bill Also Likely To Pass Chart 3Biden Cannot Spare A Single Vote In Senate Hence the legislative battle over the reconciliation bill this fall will be the biggest domestic battle of the Biden presidency. The 2021 budget reconciliation bill, based on a $3.5 trillion budget resolution agreed by Democrats in July, will incorporate parts of the American Jobs Plan that did not pass via bipartisan vote (such as $436 billion in green energy subsidies), plus a large expansion of social welfare, the American Families Plan. This bill will likely pass by Christmas but Democrats have only a one-seat margin in the Senate, which means our conviction level must be medium, or subjectively about 65%. The process will be rocky and uncertain (Chart 3). Moderate Democratic senators will ultimately vote with their party because if they do not they will effectively sink the Biden presidency and fan the flames of populist rebellion. US budget deficit projections in Chart 4 show the current status quo, plus scenarios in which we add the bipartisan infra deal, the reconciliation bill, and the reconciliation bill sans tax hikes. The only significant surprise would be if the reconciliation bill passed shorn of tax hikes, which would reduce the fiscal drag by 1% of GDP next year and in coming years. Chart 4APassing Both A Bipartisan Infrastructure Bill And A Reconciliation Bill Cannot Avoid Fiscal Cliff In 2022 … Chart 4B… The Only Major Fiscal Surprise Would Come If Tax Hikes Were Excluded From This Fall’s Reconciliation Bill Chart 5Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing There are two implications. First, government support for the economy has taken a significant step up as a result of the pandemic and election in 2020. There is no fiscal austerity, unlike in 2011-16. Second, a fiscal cliff looms in 2022 regardless of whether Biden’s reconciliation bill passes, although the private economy should continue to recover on the back of vaccines and strong consumer sentiment. This is a temporary problem given the first point. Monetary policy has a better chance of normalizing at some point if fiscal policy delivers as expected. But the Federal Reserve will still be exceedingly careful about resuming rate hikes. President Biden could well announce that he will replace Chairman Powell in the coming months, delivering a marginally dovish surprise (otherwise Biden runs the risk that Powell will be too hawkish in 2022-23). Inflation will abate in the short run but remain a risk over the long run. Essentially the outlook for US equities is still positive for H2 but clouds are forming on the horizon due to peak fiscal stimulus, tax hikes in the reconciliation bill, eventual Fed rate hikes (conceivably 2022, likely 2023), and the fact that US and Chinese growth has peaked while global growth is soon to peak as well. All of these factors point toward a transition phase in global financial markets until economies find stable growth in the post-pandemic, post-stimulus era. Investors will buy the rumor and sell the news of Biden’s multi-trillion reconciliation bill in H2. The bill is largely priced out at the moment due to China’s policy tightening (Chart 5). The next section of this report suggests that China’s policy will ease on the margin over the coming 12 months. Bottom Line: US fiscal policy is delivering, not disappointing. Congress is likely to pass a large reconciliation bill by Christmas, despite no buffer in the Senate, because Democratic Senators know that the Biden presidency hangs in the balance. China’s Khodorkovsky Moment? Many clients have asked whether China’s crackdown on private business, from tech to education, is the country’s “Khodorkovsky moment,” i.e. the point at which Beijing converts into a full, autocratic regime where private enterprise is permanently impaired because it is subject to arbitrary seizure and control of the state. The answer is yes, with caveats. Yes, China’s government is taking a more aggressive, nationalist, and illiberal stance that will permanently impair private business and investor sentiment. But no, this process did not begin overnight and will not proceed in a straight line. There is a cyclical aspect that different investors will have to approach differently. First a reminder of the original Khodorkovsky moment. After the Soviet Union’s collapse, extremely wealthy oligarchs emerged who benefited from the privatization of state assets. When President Putin began to reassert the primacy of the state, he arbitrarily imprisoned Khodorkovsky and dismantled his corporate energy empire, Yukos, giving the spoils to state-owned companies. Russia is a petro state so Putin’s control of the energy sector would be critical for government revenues and strategic resurgence, especially at the dawn of a commodity boom. Both the RUB-USD and Russian equity relative performance performed mostly in line with global crude oil prices, as befits Russia’s economy, even though there was a powerful (geo)political risk premium injected during these two decades due to Russia’s centralization of power and clash with the West (Chart 6). Investors could tactically play the rallies after Khodorkovsky but the general trend depended on the commodity cycle and the secular rise of geopolitical risk. Chart 6Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer President Xi Jinping is a strongman and hardliner, like Putin, but his mission is to prevent Communist China from collapsing like the Soviet Union, rather than to revive it from its ashes. To that end he must reassert the state while trying to sustain the country’s current high level of economic competitiveness. Since China is a complex economy, not a petro state, this requires the state-backed pursuit of science, technology, competitiveness, and productivity to avoid collapse. Therefore Beijing wants to control but not smother the tech companies. Hence there is a cyclical factor to China’s regulatory crackdown. A crackdown on President Xi Jinping’s potential rivals or powerful figures was always very likely to occur ahead of the Communist Party’s five-year personnel reshuffle in 2022, as we argued prior to tech exec Jack Ma’s disappearance. Sackings of high-level figures have happened around every five-year leadership rotation. Similarly a crackdown on the media was expected. True, the pre-party congress crackdowns are different this time around as they are targeted at the private sector, innovative businesses, tech, and social media. Nevertheless, as in the past, a policy easing phase will follow the tightening phase so as to preserve the economy and the mobilization of private capital for strategic purposes. The critical cyclical factor for global investors is China’s monetary and credit impulse. For example, the crackdown on the financial sector ahead of the national party congress in 2017 caused a global manufacturing slowdown because it tightened credit for the entire Chinese economy, reducing imports from abroad. One reason Chinese markets sold off so heavily this spring and summer, was that macroeconomic indicators began decelerating, leaving nothing for investors to sink their teeth into except communism. The latest Politburo meeting suggests that monetary, fiscal, and regulatory policy is likely to get easier, or at least stay just as easy, going forward (Table 2). Once again, the month of July has proved an inflection point in central economic policy. Financial markets can now look forward to a cyclical easing in regulation combined with easing in monetary and fiscal policy over the next 12-24 months. Table 2China’s Politburo Prepares To Ease Policy, Secure Recovery Despite all of the above, for global investors with a lengthy time horizon, the government’s crackdown points to a secular rise of Communist and Big Government interventionism into the economy, with negative ramifications for China’s private sector, economic freedoms, and attractiveness as a destination for foreign investment. The arbitrary and absolutist nature of its advances will be anathema to long-term global capital. Also, social media, unlike other tech firms, pose potential sociopolitical risks and may not boost productivity much, whereas the government wants to promote new manufacturing, materials, energy, electric vehicles, medicine, and other tradable goods. So while Beijing cannot afford to crush the tech sector, it can afford to crush some social media firms. Chart 7China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China’s equity market profile looks conspicuously like Russia’s at the time of Khodorkovsky’s arrest (Chart 7). Chinese renminbi has underperformed the dollar on a multi-year basis since Xi Jinping’s rise to power, in line with falling export prices and slowing economic growth, as a result of economic structural change and the administration’s rolling back Deng Xiaoping’s liberal reform era. We expect a cyclical rebound to occur but we do not recommend playing it. Instead we recommend other cyclical plays as China eases policy, particularly in European equities and US-linked emerging markets like Mexico. Bottom Line: The twentieth national party congress in 2022 is a critical political event that is motivating a cyclical crackdown on potential rivals to Communist Party power. Chinese equities will temporarily bounce back, especially with a better prospect for monetary and fiscal easing. But over the long run global investors should stay focused on the secular decline of China’s economic freedoms and hence productivity. What Happened To The US-Iran Deal? Our second key view for 2021 was the US strategic rotation from the Middle East and South Asia to Asia Pacific. This rotation is visible in the Biden administration’s attempt to withdraw from Iraq and Afghanistan while rejoining the 2015 nuclear deal with Iran. However, Biden here faces challenges that will become very high profile in the coming months. The Biden administration failed to rejoin the 2015 deal under the outgoing leadership of the reformist President Hassan Rouhani. This means a new and much more difficult negotiation process will now begin that could last through Biden’s term or beyond. On August 5, President Ebrahim Raisi will take office with an aggressive flourish. The US is already blaming Iran for an act of sabotage in the Persian Gulf that killed one Romanian and one Briton. Raisi will need to establish that he is not a toady, will not cower before the West. The new Israeli government of Prime Minister Naftali Bennett also needs to demonstrate that despite the fall of his hawkish predecessor Benjamin Netanyahu, Jerusalem is willing and able to uphold Israel’s red lines against Iranian nuclear weaponization and regional terrorism. Hence both Iran and its regional rivals, including Saudi Arabia, will rattle sabers and underscore their red lines. The Persian Gulf and Strait of Hormuz will be subject to threats and attacks in the coming months that could escalate dramatically, posing a risk of oil supply disruptions. Given that the Iranians ultimately do want a deal with the Americans, the pressure should be low-to-medium level and persistent, hence inflationary, as opposed to say a lengthy shutdown of the Strait of Hormuz that would cause a giant spike in prices that ultimately kills global demand. Short term, the US attempt to reduce its commitments in Iraq and Afghanistan will invite US enemies to harass or embarrass the Biden administration. The Taliban is likely to retake control of Afghanistan. The US exit will resemble Saigon in 1975. This will be a black eye for the Biden administration. But public opinion and US grand strategy will urge Biden to be rid of the war. So any delays, or a decision to retain low-key sustained troop presence, will not change the big picture of US withdrawal. Long term, Biden needs to pivot to Asia, while President Raisi is ultimately subject to the Supreme Leader Ali Khamenei, who wants to secure Iran’s domestic stability and his own eventual leadership succession. Rejoining the 2015 nuclear deal leads to sanctions relief, without requiring total abandonment of a nuclear program that could someday be weaponized, so Iran will ultimately agree. The problem will then become the regional rise of Iranian power and the balancing act that the US will have to maintain with its allies to keep Iran contained. Bottom Line: The risk to oil prices lies to the upside until a US-Iran deal comes together. The US and Iran still have a shared interest in rejoining the 2015 deal but the time frame is now delayed for months if not years. We still expect a US-Iran deal eventually but previously we had anticipated a rapid deal that would put downward pressure on oil prices in the second half of the year. What Comes After Biden’s White Flag On Nord Stream II? Our third key view for 2021 highlighted Europe’s positive geopolitical and macro backdrop. This view is correct so far, especially given that China’s policymakers are now more likely to ease policy going forward. But Russia could still upset the view. Italy has been the weak link in European integration over the past decade (excluding the UK). So the national unity coalition that has taken shape under Prime Minister Mario Draghi exemplifies the way in which political risks were overrated. Italy is now the government that has benefited the most from the overall COVID crisis in public opinion (Chart 8). The same chart shows that the German government also improved its public standing, although mostly because outgoing Chancellor Angela Merkel is exiting on a high note. Her Christian Democrat-led coalition has not seen a comparable increase in support. The Greens should outperform their opinion polling in the federal election on September 26. But the same polling suggests that the Greens will be constrained within a ruling coalition (Chart 9). The result will be larger spending without the ability to raise taxes substantially. Markets will cheer a fiscally dovish and pro-European ruling coalition. Chart 8European Political Risk Limited, But Rising, Post-COVID The chief risk to this view of low EU political risk comes from Russia. Russia is a state in long-term decline due to the remorseless fall in fertility and productivity. The result has been foreign policy aggression as President Putin attempts to fortify the country’s strategic position and frontiers ahead of an even bleaker future. Chart 9German Election Polls Point To Gridlock? Now domestic political unrest has grown after a decade of policy austerity and the COVID-19 pandemic. Elections for the Duma will be held on September 19 and will serve as the proximate cause for Russia’s next round of unrest and police repression. Foreign aggressiveness may be used to distract the population from the pandemic and poor economy. We have argued that there would not be a diplomatic reset for the US and Russia on par with the reset of 2009-11. We stand by this view but so far it is facing challenges. Putin did not re-invade Ukraine this spring and Biden did not impose tough sanctions canceling the construction of the Nord Stream II gas pipeline to Germany. Russia is tentatively cooperating on the US’s talks with Iran and withdrawal from Afghanistan. The US gave Germany and Russia a free point by condoning the NordStream II. Now the US will expect Germany to take a tough diplomatic line on Russian and Chinese aggression, while expecting Russia to give the US some goodwill in return. They may not deliver. The makeup of the new German coalition will have some impact on its foreign policy trajectory in the coming years. But the last thing that any German government wants is to be thrust into a new cold war that divides the country down the middle. Exports make up 36% of German output, and exports to the Russian and Chinese spheres account for a substantial share of total exports (Chart 10). The US administration prioritizes multilateralism above transactional benefits so the Germans will not suffer any blowback from the Americans for remaining engaged with Russia and China, at least not anytime soon. Russia, on the other hand, may feel a need to seize the moment and make strategic gains in its region, despite Biden’s diplomatic overtures. If the US wraps up its forever wars, Russia’s window of opportunity closes. So Russia may be forced to act sooner rather than later, whether in suppressing domestic dissent, intimidating or attacking its neighbors, or hacking into US digital networks. In the aftermath of the German and Russian elections, we will reassess the risk from Russia. But our strong conviction is that neither Russian nor American strategy have changed and therefore new conflicts are looming. Therefore we prefer developed market European equities and we do not recommend investors take part in the Russian equity rally. Chart 10Germany Opposes New Cold War With Russia Or China Bottom Line: German and European equities should benefit from global vaccination, Biden’s fiscal and foreign policies, and China’s marginal policy easing (Chart 11). Eastern European emerging markets and Russian assets are riskier than they appear because of latent geopolitical tensions that could explode around the time of important elections in September. Chart 11Geopolitical Tailwinds To European Equities What Comes After The Olympics In Japan? Japan is returning to an era of “revolving door” prime ministers. Prime Minister Yoshihide Suga’s sole purpose was to tie up the loose ends of the Shinzo Abe administration, namely by overseeing the Olympics. After the games end, he will struggle to retain leadership of the Liberal Democratic Party. He will be blamed for spread of Delta variant even if the Olympics were not a major factor. If he somehow retains the party’s helm, the October general election will still be an underwhelming performance by the Liberal Democrats, which will sow the seeds of his downfall within a short time (Chart 12). Suga will need to launch a new fiscal spending package, possibly as an election gimmick, and his party has the strength in the Diet to push it through quickly, which will be favorable for the economy. For the elections the problem is not the Liberal Democrats’ popularity, which is still leagues above the nearest competitor, but rather low enthusiasm and backlash over COVID. Abe’s retirement, and the eventual fall of Abe’s hand-picked deputy, does not entail the loss of Abenomics. The Bank of Japan will retain its ultra-dovish cast at least until Haruhiko Kuroda steps down in 2023. The changes that occurred in Japan from 2008-12 exemplified Japan’s existence as an “earthquake society” that undergoes drastic national changes suddenly and rapidly. The paradigm shift will not be reversed. The drivers were the Great Recession, the LDP’s brief stint in the political wilderness, the Tohoku earthquake and Fukushima nuclear crisis, and the rise of China. The BoJ became ultra-dovish and unorthodox, the LDP became more proactive both at home and abroad. The deflationary economic backdrop and Chinese nationalism are still a powerful impetus for these trends to continue – as highlighted by increasingly alarming rhetoric by Japanese officials, including now Shinzo Abe himself, regarding the Chinese military threat to Taiwan. In other words, Suga’s lack of leadership will not stand even if he somehow stays prime minister into 2022. The Liberal Democrats have several potential leaders waiting in the wings and one of these will emerge, whether Yuriko Koike, Shigeru Ishiba, or Shinjiro Koizumi, or someone else. The popular and geopolitical pressures will force the Liberal Democrats and various institutions to continue providing accommodation to the economy and bulking up the nation’s defenses. This will require the BoJ to stay easier for longer and possibly to roll out new unorthodox policies, as with yield curve control in the 2010s. Japan has some of the highest real rates in the G10 as a result of very low inflation expectations and a deeply negative output gap (Chart 13). Abenomics was bearing fruit, prior to COVID-19, so it will be justified to stay the course given that deflation has reemerged as a threat once again. Chart 12Japan: Back To Revolving Door Of Prime Ministers Chart 13Japan To Keep Fighting Deflation Post-Abe Bottom Line: The political and geopolitical backdrop for Japan is clear. The government and BoJ will have to do whatever it takes to stay the course on Abenomics even in the wake of Abe and Suga. Prime ministers will come and go in rapid succession, like in past eras of political turmoil, but the trajectory of national policy is set. We would favor JGBs relative to more high-beta government bonds like American and Canadian. Given deflation, looming Japanese political turmoil, and the secular rise in geopolitical risk, we continue to recommend holding the yen. These views conform with those of BCA’s fixed income and forex strategists. Investment Takeaways China’s policymakers are backing away from the risk of overtightening policy this year. Policy should ease on the margin going forward. Our number one key forecast for 2021 is tentatively confirmed. Base metals are still overextended but global reflation trades should be able to grind higher. The US fiscal spending orgy will continue through the end of the year via Biden’s reconciliation bill, which we expect to pass. Proactive DM fiscal policy will continue to dispel disinflationary fears. Sparks will fly in the Middle East. The US-Iran negotiations will now be long and drawn out with occasional shows of force that highlight the tail risk of war. We expect geopolitics to add a risk premium to oil prices at least until the two countries can rejoin the 2015 nuclear deal. Germany’s Green Party will surprise to the upside in elections, highlighting Europe’s low level of geopolitical risk. China policy easing is positive for European assets. Russia’s outward aggressiveness is the key risk.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Highlights The rapid spread of the COVID-19 delta variant in Asia will re-focus precious metals markets anew on the possibility of another round of lockdowns and the implications for demand, particularly in Greater China and India, which account for 33% and 12% of global physical demand for gold (Chart of the Week).1 Regulatory crackdowns across various sectors in China will continue to roil markets over coming months.  Policy uncertainty around these crackdowns is elevated in local financial markets, and could spill into global markets.  This will support the USD at the margin, which creates a headwind for gold and silver prices. Ambiguous and contradictory signaling from Fed officials following the July FOMC meeting re its $120-billion-per-month bond-buying program also adds uncertainty to precious-metals and general commodity forecasts. Despite this uncertainty, we remain bullish gold and silver.  More efficacious jabs will become available, which will support the global economic re-opening, particularly in EM economies.  In DM economies, vaccination uptake likely increases as risks become more apparent.  We continue to expect gold to trade to $2,000/oz and silver to trade to $30/oz this year. Feature Markets once again are focused on the possibility lockdowns will follow rising COVID-19 infections and deaths, as the delta variant – the most contagious variant to date – spreads through Asia and elsewhere. Chart of the WeekCOVID-19 Delta Variant Rampages Chart 2COVID-19 Infections, Deaths Rising Infection and death rates are moving higher globally (Chart 2). COVID-19 infections are still rising in 78 countries. Based on the latest 7-day-average data, the countries reporting the most new infections daily are the US, India, Indonesia, Brazil, and Iran. The countries reporting the most deaths each day are Indonesia, Brazil, Russia, India, and Mexico. Globally, more than 42% of infections were in Asia and the Middle East, where ~ 1mm new infections are reported every 4 days. We expect more efficacious jabs will become available, which will support the global economic re-opening, particularly in EM economies. In DM economies, vaccination uptake likely increases as risks become more apparent. China's Regulatory Crackdown Markets also are contending with a regulatory crackdowns across multiple sectors in China, which is part of a years-long reform process initiated by the Politburo.2 Industries ranging from internet, property, education, healthcare to capital markets will have new rules imposed on them under China's 14th Five-Year Plan as part of this process. Our colleagues in BCA's China Investment Service note the pace of regulatory tightening will not moderate in the near term, as policymakers transition from an annual planning cycle focused on setting economic growth targets to a multi-year planning horizon. "This allows policymakers to have a higher tolerance for near-term distress in exchange for long-term benefits," according to our colleagues. The overarching goal of this reform process is to introduce more social equality in the society. Of immediate import for precious metals markets is the potential for spillover effects outside China arising from the policy uncertainty that already is emanating from that market. Uncertainty boosts the USD and gold. This makes its effect uncertain. In our most recent modeling of gold prices, we have found strong two-way feedback between US and Chinese policy uncertainty.3 We also find that broad real foreign exchange rates for the USD and RMB exert a negative influence on gold prices, while higher economic uncertainty pushes gold prices higher (Chart 3). In addition, across markets – Chinese and US economic policy uncertainty – have similar effects, suggesting economic uncertainty across these markets has a similar effect as domestic uncertainty at home (Chart 4).4 Chart 3Domestic Uncertainty, Real FX Rates Strongly Affect Gold Prices... Chart 4...As Do Cross-Border Uncertainty, Real FX Rates This is yet another reason to pay close attention to PBOC and Fed policy innovations and surprises: they affect each other in similar ways within and across borders. Fed Officials Add Uncertainty Following the FOMC meeting at that end of last month, various Fed officials expressed their views of Chair Jerome Powell's post-meeting remarks, or again resumed their campaigns to begin tapering the US central bank's bond-buying program. Chair Powell's remarks reinforced the data-dependency of the Fed in directing its bond buying and monetary accommodation. He emphasized the need to see solid improvement in the jobs picture in the US before considering any lift-off of rates. As to the Fed's bond-buying program, this, too, will depend on progress on reducing unemployment in the US. Powell also reiterated the Fed views the current inflation in the US as transitory, a point that was emphasised by Fed Governor Lael Brainard two days after Powell's presser. Some very important Fed officials, most notably Fed Vice Chair Richard Clarida, are staking out an early position on what will get them to consider reducing the Fed's current accommodative policies, chiefly an "overshoot" of PCE inflation, the Fed's favored gauge, above 3%. Other Fed officials are urging strong action now: St. Louis Fed President James Bullard is adamant that tapering of the Fed's bond-buying program needed to begin in the Autumn and should be done early next year. Bullard is supported by Governor Christopher Waller. The Fed's bond-buying program is more than a year old. Beginning in July 2020, the Fed started buying $80 billion of Treasurys and $40 billion of mortgage-backed securities every month, or ~ $1.6 trillion so far. This lifted the Fed's balance sheet to ~ $8.3 trillion. Thinking about this as a commodity, that's a lot of asset supply removed from the Treasury and MBS market, which likely explains the high cost of the underlying debt instruments (i.e., their low interest rates). It is understandable why the gold market would get twitchy whenever Fed officials insist the winddown of this program must begin forthwith and be done in relatively short order. The loss of that steady stream of buying could send interest rates higher quickly, possibly raising nominal and real interest rates in the process, which, given the sensitivity of gold prices to US real rates would be bearish (Chart 5). While it is impossible to know when the tapering of the Fed's asset-purchase program will end, these occasional choruses of its imminent inauguration add to uncertainty in the US, which also depresses precious metals prices, as Chart 5 indicates. A larger issue attends this topic: economic policy uncertainty is not contained within national borders. Above, we noted there is a two-way feedback between US and China economic policy uncertainty. There also is a long-term relationship in levels of economic policy uncertainty re China and Europe, which makes sense given the trading relationship between these states. Changes in the two measures of economic policy uncertainty exhibit strong co-movement (Chart 6). Chart 5Taper Talk Makes Precious Metals Markets Twitchy Chart 6Economic Policy Uncertainty Goes Across National Borders Investment Implications The increase in COVID-19 infection and re-infection rates, and death rates, is forcing commodity markets to reevaluate demand projections and the likelihood of continued monetary accommodation globally. This ultimately affects the prospects for commodity prices. Conflicting interpretations of the state of local and the global economies increases uncertainty across markets, especially precious metals, which are exquisitely sensitive to even a hint of a change in policy. This uncertainty is compounded when top officials at systematically important central banks provide sometimes-contradictory interpretations of the state of their economies. Despite this uncertainty we remain bullish gold and silver, expecting efficacious vaccines to become more widely available, which will allow the global recovery to regain its footing. We are less sanguine about the prospects for the winding down of the massive monetary accommodation globally, particularly that of the US, where data-dependent policymakers still feel compelled to provide almost-certain policy prescriptions in an increasingly uncertain world.This is a fundamental factor driving global uncertainty. We remain long gold expecting it to trade to $2,000/oz this year, and long silver, expecting it to hit $30/oz.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish While US crude oil inventories rose 3.6mm barrels in the week ended 30 July 2021 gasoline stocks fell 5.3mm barrels, contributing to an overall decline in crude and product inventories in the US of 1.2mm barrels, according to the US EIA's latest tally (Chart 7). US crude and product stocks have been falling throughout the COVID-19 pandemic, and now stand ~ 13% below year earlier levels at 1.7 billion barrels. Crude oil stocks, at 439mm barrels, are just over 15% below year-ago levels. This reflects the decline in US domestic production, which is down 7.1% y/y and now stands at 11.2mm b/d. US refined-product demand, however, is up close to 9% over the January-July period y/y, and stands at 21.2mm b/d. Base Metals: Bullish Workers at the world's largest copper mine, Escondida in Chile, are in government-mediated talks with management that end on Saturday to see if they can avert a strike. There is a chance talks could be extended five days beyond that date, under Chilean law. The mine is majority owned by BHP. Workers at a Codelco-owned mine also voted to strike and will enter government-mediated talks as well. These potential strikes most likely explain why copper prices have been holding relatively steady as other commodities have come under pressure, as markets reassess the odds of a demand slowdown brought about by surging COVID-19 infections, which are hitting Asian markets particularly hard (Chart 8). Chart 7 Chart 8   Footnotes 1     We flagged this risk in our July 8, 2021 report entitled Assessing Risks To Our Commodity Views, which is available at ces.bcaresearch.com. 2     Please see Pricing A Tighter Regulatory Grip published on August 4, 2021 by our China Investment Strategy.  It is available at cis.bcaresearch.com. 3    We measure this using Granger-Causality tests. 4    These broad real FX rates are handy explanatory variables, in that they combine two very important factors affecting gold prices – inflation and broad FX trade-weighted indexes.  Additional modelling also suggests these broad real FX rates for the USD and RMB coupled with US real 2- and 5-year rates also provide good explanatory models for gold prices. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Last week’s market gyrations do not mark the end of China’s structural reforms. The country’s macro policy setting has shifted to allow a higher tolerance for short-term pain in exchange for long-term gain. Chinese policymakers will temporarily put the brakes on its reform agenda if policy measures threaten domestic economic stability; a spillover from the equity market rout to the currency market and private-sector investment will be a pressure point for the authorities. Messages from last week’s Politburo meeting were only marginally more positive than in April. While policymakers seem to be paying more attention to the economic slowdown, they do not appear to be in a rush to rescue the economy. We present three scenarios describing how the equity markets and policy may develop in the coming months. In all the scenarios, investors should avoid trying to catch a falling knife. Feature July was an extraordinarily difficult time for Chinese stocks and last week’s steep slide intensified as a slew of announced regulatory changes spooked market participants (Chart 1). Chart 1Chinese Stocks Had A Tough MonthWe have repeatedly outlined the risks to Chinese equities in the past month. Since the PBoC cut the reserve requirement ratio in early July, the negative impact on the financial markets from tightening industry policies has outweighed the limited positive effects from a slightly more dovish central bank policy stance.  Chart 2Chinese TMT Stock Prices Were Hammered Is now a good time to buy Chinese stocks? Multiple compressions have made Chinese equities, particularly the hard-hit technology, media & telecom (TMT) stocks in the offshore market, appear cheap compared with their global counterparts (Chart 2). In this report we present three scenarios how China’s equity market and policies will likely evolve. In our view, more than a week of stock selloffs will be needed for policymakers to halt reforms. Furthermore, even if the pace of reforms eases and policymakers start to reflate the economy, it will likely take between 6 and 12 months for stock prices to find a bottom.  In light of escalating uncertainty over China’s financial market performance, the China Investment Strategy and Global Asset Allocation services will jointly publish a Special Report on August 18. We will examine how global investors can improve the risk-reward profile of their multi-asset portfolios with exposure to Chinese assets.   Three Scenarios While the regulatory landscape is unclear, we can draw on previous experience to analyze how China’s equity market and policy directions may evolve. In the first scenario, which is our baseline case, the economy would weaken, but would not cross policymakers’ pain threshold. There would be marginal policy easing action to alleviate market anxiety and monetary policy would be slightly loosened along with polices on some non-core sectors, such as infrastructure investment. In this scenario, structural reforms could continue for another 6 to 12 months, as suggested by colleagues at the BCA Geopolitical Strategy services. Investors should resist the urge to buy on the dip. Investors would be kept on edge by a confluence of a slowing economy (even though the slowdown is measured) and heighted regulatory oversight. The market would oscillate between technical rebounds when macro policy eases and selloffs when industry regulations tighten. There are two reasons why the pace of regulatory tightening will not moderate in the near term. First, China’s economic policy has shifted from setting an annual economic growth target to multi-year planning. This allows policymakers to have a higher tolerance for near-term distress in exchange for long-term benefits. Despite a deep dive in stock prices last week, China’s bond and currency markets have been stable relative to the market gyrations in both 2015 and 2018 (Chart 3A and 3B).  Furthermore, the newly released PMIs and recent economic data show that the China’s economic activity is weakening, but the speed of softening seems to be within the policymakers’ comfort zone (Chart 4). Chart 3AChinese Bond And Currency Markets Have Been Relatively Calm Despite Equity Market Selloffs Chart 3BChinese Bond And Currency Markets Have Been Relatively Calm Despite Equity Market Selloffs Chart 4Economic Pain Has Not Crossed Policymakers' Threshold Secondly, the new rules imposed on industries - ranging from internet, property, education, healthcare to capital markets - are part of China’s long-term structural reform agenda outlined in the 14th Five-Year Plan (FYP).  As China transitions from building a "moderately prosperous society" by 2020 to becoming a "great modern socialist nation" by 2049, the country’s policy priority has shifted from a rapid accumulation of wealth to addressing income inequality and social welfare for average households.  The policy objective is not only to close regulatory loopholes and end the disorderly expansion of capital and market shares, but also assign a larger weight of social equality and responsibility to the private sector’s business practices. The pace in achieving this overarching goal will only moderate when China’s economy and financial markets show meaningful signs of stress. The second possibility would be if policymakers fail to restore investors’ confidence. Foreign and domestic investors would reassess China’s policy directions and reprice the outlook for corporate profit growth. Market selloffs would continue, like in 2015 and 2018 following policy shocks,1 equity market gyrations would spill over to the currency market through capital outflows and real economic sectors through dwindling investment (Chart 5). In this scenario, Chinese policymakers would likely abandon their reform agenda, at least temporarily, and decisively shift policy to reflate the economy (Chart 6). Chart 5Financial Market Panic Spilled Over To Other Sectors In Both 2015 and 2018... Chart 6...Triggering Decisive Reflationary Policy Responses A third scenario would be if China is challenged by the external environment, either due to a significant increase in geopolitical conflicts or a widespread resurgence of new COVID cases. Both aspects would pose sizable downside risks to China’s economic activity. The risks would force authorities to shift to an easier stance and slow the pace of domestic reforms. Chart 7It Took 6 To 12 Months (And Sizable Stimulus) For Stock Prices To Bottom Out In the second and third scenarios, the rout in the equity market would likely deepen in the near term, before prices bottom in response to a halt in regulatory crackdowns and a decisive turn to reflationary measures. As illustrated in Chart 7, in both 2015 and 2018, it took 6 to 12 months and significant stimulus for Chinese stock prices to bottom in absolute terms. Bottom Line: Our baseline scenario suggests a continuation of structural reforms. Investors should refrain from jumping into the market until there are firm signs that regulatory tightening is over and reflationary measures have started. Key Messages From The Politburo Meeting Last week’s much-anticipated Politburo meeting, chaired by President Xi Jinping, adopted a slightly more dovish tone towards macroeconomic policy than in April, but also indicated that the leadership will stick to its long-term reform agenda. The stance was mildly positive for the overall economy and financial markets. Macro policies in some non-core sectors, such as infrastructure investment, will likely ease at the margin during the rest of the year. However, the meeting’s statement warned “a more complex and challenging external environment” lies ahead, which indicates that heightened concerns over geopolitical tensions will only exacerbate regulatory oversights in data and national security.  Regarding fiscal policy in 2H21, the authorities seem to be growing more concerned about growth outlook.  The meeting mentioned that fiscal support should make “reasonable progress” later this year and early next year. The pace of local government special purpose bond (SPB) issuance will pick up in Q3 and into Q4. However, we maintain our view that without a significant rise in bank credit growth, an acceleration in SPB issuance will only provide a moderate boost to local infrastructure spending. The reference to cross-cycle policy adjustment from the meeting readout is also in line with our view that policymakers may save their fiscal ammunition for next year when the economy comes under greater downward pressure. Odds are rising that the authorities will allow a frontloading of SPBs in Q1 2022 before the National People’s Congress in March next year. The statement also notably mentioned that government officials shall “ensure the supply of commodities and stabilize prices" and called for a more rational pace in carbon reduction. We think this message implies a temporary easing of production curbs in some heavy industries, such as steel, coal, and possibly a further release of strategic reserves of industrial metals (Chart 8A and 8B). The supply-side policy shift should add downward pressure on global industrial prices in addition to the ongoing slowdown in demand from China (Chart 9). Chart 8ASome Backpaddling Likely In Decarbonization Progress Chart 8BSome Backpaddling Likely In Decarbonization Progress Chart 9Downward Pressure On Commodity Prices From China's Weakening Demand And Rising Domestic Production Meanwhile, the meeting repeated the "three stabilization” policy, which targets stabilizing land prices, housing prices and property market expectations. This sends a strong signal that policymakers are unwilling to soften the tone on restrictions in the housing market. Bottom Line: The July Politburo meeting’s messaging was only modestly more dovish than three months ago. Investment Implications Chinese offshore stocks have fallen by 26% from their February peak, compared with approximately 14% for onshore stocks. The offshore TMT stocks are approaching their long-term technical resistance, measured by the three-year moving average in prices (Chart 10). While the magnitude of last week’s stock price decline seems excessive relative to previous market selloffs, the multiple compression reflects considerable uncertainty surrounding the outlook for China’s policy direction. New antitrust regulations in China are intended to limit the monopolistic business practices of internet companies. As a result, these companies’ operational costs will rise and profit growth will decline, and their valuations will converge with those of non-TMT companies. The trailing P/E ratio in Chinese investable TMT stocks is still elevated, making the equities vulnerable to further regulatory tightening and multiple compressions (Chart 11). Chart 10Chinese TMT Stocks: On The Verge Of Breaking Below Their Technical Resistance... Chart 11...But Still Vulnerable To Further Multiple Compression     Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1On August 11, 2015, the PBOC surprised the market with three consecutive devaluations of the Chinese yuan, knocking over 3% off its value. On April 3, 2018 former US President Donald Trump unveiled plans for 25% tariffs on about $50 billion of Chinese imports. Market/Sector Recommendations Cyclical Investment Stance

Highlights Chart 1Still Close To Fair Value Treasury yields fell significantly in July, particularly at the long end of the curve. We continue to view this move as an overreaction to mediocre economic data that will be reversed this fall when labor supply constraints ease and employment surprises to the upside. It’s important to note, however, that despite the drop in long-dated yields the 5-year/5-year forward Treasury yield remains within the bounds of its 1.75% to 2.5% fair value range (Chart 1). That is, shorter-maturity Treasury yields have much more upside than long-dated yields on a 6-12 month investment horizon. We expect the next big move in bonds to be a bear-flattening of the yield curve as the market prices in a Fed rate hike cycle that we see starting near the end of 2022. Investors should position for that outcome today by keeping portfolio duration low and by entering yield curve flatteners. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 37 basis points in July, dragging year-to-date excess returns down to +172 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 89 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report looked at what different combinations of Treasury slope and corporate spreads have historically signaled about corporate bond excess returns.1 It shows that tight corporate spreads only correlate with negative excess returns once the 3-year/10-year Treasury slope is below 50 bps. Though we retain a positive view of spread product as a whole, better value can be found outside of the investment grade corporate sector. Specifically, we recommend that investors shift into high-yield corporates, municipal bonds and USD-denominated EM sovereigns and corporates. We also advise investors to favor long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2   Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 34 basis points in July, dragging year-to-date excess returns down to +433 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.2% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.6% through the first six months of the year, well below the estimate generated by our macro model. Another recent report looked at the incremental spread pick-up investors can earn by moving out of investment grade corporates and into junk.4 It concluded that the extra spread available in high-yield is worth grabbing and that B-rated bonds look particularly attractive in risk-adjusted terms.   MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 19 basis points in July, dragging year-to-date excess returns down to -64 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries widened 8 bps in July. The spread is wide compared to recent history, but it remains tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) widened 3 bps in July (panel 3), and it is now starting to look more competitive compared to other similarly risky spread sectors. The conventional 30-year MBS OAS sits at 36 bps, below the 54 bps offered by Aa-rated corporate bonds but above the 20 bps offered by Aaa-rated consumer ABS and the 34 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related Index underperformed the duration-equivalent Treasury index by 34 basis points in July, dragging year-to-date excess returns down to +57 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 149 bps in July, dragging year-to-date excess returns down to -113 bps. Foreign Agencies underperformed the Treasury benchmark by 11 bps on the month, dragging year-to-date excess returns down to +35 bps. Local Authority bonds underperformed by 19 bps in July, dragging year-to-date excess returns down to +372 bps. Domestic Agency bonds outperformed by 2 bps, bringing year-to-date excess returns up to +28 bps. Supranationals performed in line with Treasuries in July, year-to-date excess returns held flat at +26 bps. USD-denominated Emerging Market (EM) Sovereign bonds continue to offer an attractive spread pick-up versus investment grade US corporate bonds with the same credit rating and duration. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico and Russia. A recent report looked at valuation within the investment grade USD-denominated EM corporate space.6 It found that EM corporates are attractively priced relative to US corporate bonds across the entire investment grade credit spectrum. It also found that EM corporates are attractive relative to EM sovereigns within the A and Baa credit tiers. EM sovereigns have the edge in the Aa credit tier. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 37 basis points in July, dragging year-to-date excess returns down to +271 bps (before adjusting for the tax advantage). The economic and policy back-drop is favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 GO munis in the 12-17 year maturity bucket offer a 10% breakeven tax rate versus corporates with the same credit rating and duration. The breakeven tax rate for Revenue munis is just 2% (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 25% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened in July. Bond yields were down across the curve, but by much more at the long end. The 2-year/10-year slope flattened 15 bps to end the month at 105 bps. The 5-year/30-year slope steepened 1 bp to end the month at 120 bps. While we expect the recent decline in bond yields to reverse during the next 6-12 months, we do not think this reversal will coincide with a re-steepening of the 2/10 yield curve. We noted on the first page of this report that the 5-year/5-year forward Treasury yield remains close to its fair value range. Last week’s report demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.17% in one year’s time and 1.36% in five years (Chart 7). While the latter rate has 157 bps of upside if it converges all the way back to its 2018 high, this pales in comparison to the 269 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell.   TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 112 basis points in July, bringing year-to-date excess returns up to +578 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose by 9 bps and 8 bps, respectively, on the month. At 2.43%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.26%, the 5-year/5-year forward TIPS breakeven inflation rate is just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month investment horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation moderates from its extremely high level. This will lead to some modest steepening of the inflation curve (bottom panel). While the inflation curve has some room to steepen, we don’t see it returning to positive territory. An inverted inflation curve is simply more consistent with the Fed’s Average Inflation Target than a positively sloped one. This is because the Fed’s new framework calls for it to attack its inflation target from above rather than from below.  ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 2 basis points in July, dragging year-to-date excess returns down to +37 bps. Aaa-rated ABS underperformed by 3 bps on the month, dragging year-to-date excess returns down to +28 bps. Non-Aaa ABS outperformed by 4 bps, bringing year-to-date excess returns up to +88 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile, pushing the savings rate higher yet again (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum.   Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in July, bringing year-to-date excess returns up to +187 bps. Aaa Non-Agency CMBS performed in-line with Treasuries in July, keeping year-to-date excess returns steady at +82 bps. Non-Aaa Non-Agency CMBS outperformed Treasuries by 16 bps on the month, bringing year-to-date excess returns up to +539 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 28 basis points in July, dragging year-to-date excess returns down to +87 bps. The average index option-adjusted spread widened 5 bps on the month and it currently sits at 34 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of July 30TH, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of July 30TH, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 26 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 26 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of July 30TH, 2021) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 For ideas on how to increase the average spread of a US bond portfolio please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 7 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021.

Highlights Economy – The Fed remains unperturbed about inflation, even as it continues to surprise to the upside: At his latest press conference, Chair Powell repeated the mantra that the spike in inflation will prove to be temporary. The shape of the inflation expectations curve supports the Fed’s view and the key expectations boxes of our inflation checklist remain unchecked. Markets – The decline in Treasury yields indicates that investors aren’t too worried about it, either: Although inflation data have continued to surprise to the upside, investors and the broader public seem to have moved on after the release of the March and April numbers. Inflation agita is not gone for good, but it may remain dormant until the fall. Strategy – The economic and policy backdrops remain favorable for risk assets and we remain overweight equities and spread product: Stop us if you’ve heard this one before, but risk assets will continue to generate positive excess returns over Treasuries and cash unless the Delta variant disrupts activity. Feature What a difference ten weeks make. When we rolled out our checklist on May 24th, inflation was Topic A for BCA clients and Google searchers, but it has been coming up less in our meetings and the internet queries are half of what they were (Chart 1). Inflation is a critical element of bond and currency markets, however, and it can have significant implications when it diverges from market expectations. Its currently elevated level and the novelty and uncertainty of the Fed’s revised approach to it ensure that it will intermittently command the spotlight. Chart 1Oh, Never Mind Down the road, we think it has a good chance to break above a range that investors and policymakers are comfortable with, and we will review our inflation checklist every month or two to keep clients apprised of its course. We have checked the same three boxes that we did six weeks ago and the story from the charts underlying them is unchanged. Inflation remains well above 2% year-over-year and it will stay there for the foreseeable future. The Fed is nowhere close to deploying its tools to guide it back down to its stated target, however, so it presents no danger to the potent post-pandemic expansion, and households’ and businesses’ mindsets do not appear to have changed in any way that would presage a self-reinforcing dynamic that would feed an inflation spiral. If inflation isn’t going to become problematic any time soon, overheating is not a pressing risk over our twelve-month investment timeframe. If we are correct that the new Delta-powered wave of COVID infections will not strain the health care system’s capacity or spark an unsettling pickup in fatalities, we won’t need to increase our probability of a growth shortfall. From an investment strategy perspective, diminishing probabilities of too-hot and too-cold tail outcomes support continued risk-friendly positioning. The Goldilocks outcome of strong growth backed by ultra-accommodative monetary policy should allow risk assets to continue generating positive excess returns over Treasuries and cash over the next twelve months. Updating The Inflation Checklist Table 1Inflation Checklist As mentioned above, we have checked the same three boxes on our inflation checklist that we did in late May and late June (Table 1). The labor market story remains unchanged: employer demand is at all-time highs as measured by the Job Openings components of the NFIB and JOLTS surveys (Chart 2). Labor supply has not risen to meet it, however, as a range of factors, including reduced caregiver availability (for children and adults), reluctance to risk infection and generous unemployment insurance benefits, converge to limit the number of job seekers. Though record demand and limited supply would be expected to lead to much higher prices, wage growth has remained contained (Chart 3), especially in the more refined series that adjust for composition effects or include benefits (Chart 3, bottom two panels). Chart 2Help Wanted Chart 3Wage Growth Has Remained In Check Year-over-year increases in core CPI and the core PCE price index have continued to accelerate (Chart 4, solid lines). They seem to have lost their ability to shock after April, however, as inflation expectations have taken little note of them and Google “inflation” searches have come off the boil. Investors apparently accept the Fed’s contention that the base inflation readings are being distorted by price moves in spaces that have been especially impacted by the pandemic and subsequent component shortages. Though the Fed's explanation may seem awfully convenient, its read is supported by the much more modest moves in the trimmed-mean CPI and PCE indexes (Chart 4, dashed lines). Chart 4Inflation Is Not Quite As Bad As It May Seem ... We continue to check the inflation pipeline box as our Pipeline Inflation Pressure Index is still pointing steeply higher (Chart 5). With components like the CRB’s Raw Industrials Index showing no sign of letting up, pipeline pressures will not just go away. The dollar’s recovery is limiting inflation pressure from the import channel, though inflation is comparatively muted in both the euro zone (Chart 6, top panel) and China (Chart 6, bottom panel) in any event. Chart 5... But Its Got Legs Chart 6Global Pressures Are Mild For Now Chart 7Markets Are Looking Through Temporary Inflation Pressures ... Chart 8... And So Are Consumers We continue to view inflation expectations as the key to a meaningful inflection. If households, businesses and investors begin to anticipate a much higher rate of inflation over the longer term, they will change their behavior in ways that will cause their expectations to become self-fulfilling. We are therefore especially focused on the inflation expectations curve and have been relieved to see that market measures (Chart 7) and surveys (Chart 8) indicate that investors and other economic participants believe that an elevated rate of consumer price increases will not persist beyond the next year or two. As Table 2 illustrates, the inverted TIPS and CPI swaps expectations curves project a significant decline in inflation from the near term to the intermediate and long term. Table 2The Inflation Expectations Curve Is Solidly Inverted The Fed Stays The Course The FOMC meeting and Chair Powell’s subsequent press conference were thin gruel, as the committee neither made nor telegraphed any meaningful course changes. Our main takeaway from the press conference was that the Fed is in no hurry to remove monetary accommodation because it is unperturbed by the inflation data that have come out over the last several months. As for accommodation, tapering is first on the agenda, but it doesn’t look like Powell will tackle the issue at Jackson Hole later this month: “We have not reached substantial further progress yet. So we’re not there, and … we see ourselves as having some ground to cover to get there.” Following the meeting, market consensus coalesced around a November or December announcement preceding a reduction in purchases beginning in January. Powell continued to stick to his ongoing inflation story, arguing that elevated inflation prints have resulted from idiosyncratic disruptions or base effects in segments that have been particularly affected by the pandemic. “What we’re seeing is a handful of things that really account for the overshoot of inflation. … [N]ew, used and rental cars have moved up in price because of the car shortage because of the semiconductor shortage. And hotels and airfares have moved back up, but that really just is retracing the very large downward movement in prices that they had before (Chart 9). [T]hat’s a big, big part of why the inflation readings are so high. And those frankly don’t carry significant implications in the long run for inflation or for the American economy.” Chart 9Inflation Isnt So Bad On A Two-Year Basis Powell also riffed on the meaning of “transitory” in response to a reporter’s question, offering some further insight into the Fed’s inflation perspective. “[W]hat I mean by transitory is just something that doesn’t leave a permanent mark on the inflation process. I don’t mean that producers are going to take those price increases back. That’s not the idea. It’s just that they won’t go on indefinitely. So to the extent people are implementing price increases because raw materials are going up or labor costs or something’s going up, you know, the question for inflation really is, does that mean they’re going to go up the next year by the same amount?” Yet Another Great Quarter For Earnings Chart 10Following The New Script To A T Last week, with 25% of S&P 500 constituents having reported results, we noted that 2Q21 was shaping up to be the index’s fifth consecutive quarter of dramatically outsized earnings beats. Now that 60% of the S&P has reported, including all five of the mega-cap FAAMG companies, we can declare that the streak will reach five when this reporting season is complete. Once again, knockout results (Chart 10, bottom panel) have stood the long-established guide-down-a-little-before-reporting-then-beat-by-a-modest-margin pattern (Chart 10, top panel) on its head. This quarter’s beat, currently tracking to 13%, will join the previous four pandemic quarters’ beats in obliterating the 1-to-6% range that contained every single quarter from 2012 to 2019 (Chart 11). Chart 11The Monster Beats Continue The immediate upshot has been for the consensus second quarter earnings estimate to be revised higher to a level that surpasses first quarter earnings and our “easily attainable” $50 ballpark estimate (Table 3). If the Delta variant does not upend economic activity, as per our base case, we think there is scope for forward estimates to be revised higher. The current forecast has four-quarter earnings through 2Q22 ($204.70) barely rising from the current quarter’s annualized run rate ($203.84). That is unusual in a series that has a lifetime mean of 18% and rarely contracts, especially given that the economy is expanding at a gangbusters clip. Table 32Q21's Been Fixed, But The Out Quarters Still Have Scope To Rise Investment Implications Chart 12The Shelves Are Almost Bare We are undeterred by last week’s GDP disappointment, broader concerns about deceleration or overwrought talk about stagflation. 6.5% real second-quarter GDP growth came in well short of the consensus 8.4% expectation, but the number wasn’t as bad as it may have appeared to the naked eye. Real final domestic demand, which looks through inventory swings and net exports to provide a truer barometer of ongoing activity, grew at an 8.1% rate, powered by nearly 12% growth in consumption. The continued depletion of retail inventories, which must be restocked to meet ravenous consumer demand (Chart 12), pushed some growth into subsequent quarters, so growth may not have peaked in 2Q after all. As for stagflation, it simply doesn’t apply when the world’s largest economy is growing at the rate of a developing economy, three times its trend, over a year into an expansion. On balance, the new information we received last week was favorable. The Fed reiterated its resolve to keep supporting the economy with emergency levels of monetary accommodation even though the emergency has passed; S&P 500 earnings continue to shoot the lights out, forcing analysts into lifting their estimates once future quarters get closer; and consumers are spending with gusto, suggesting that excess pandemic savings and robust gains in household net worth will provide an ongoing lift to the economy well into 2022. All in all, the macroeconomic backdrop remains favorable for investors in risk assets and we continue to recommend overweighting them.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

Highlights Globalization is recovering to its pre-pandemic trajectory. But it will fail to live up to potential, as the “hyper-globalization” trends of the 1990s are long gone. China was the biggest winner of hyper-globalization. It now faces unprecedented risks in the context of hypo-globalization. Global investors woke up to China’s domestic political risks this year, which include arbitrary regulatory crackdowns on tech and private business. While Chinese officials will ease policy to soothe markets, the cyclical and structural outlook is still negative for this economy. Growth and stimulus have peaked. Political risk will stay high through the national party congress in fall 2022. US-China relations have not stabilized. India, the clearest EM alternative for global investors, is high-priced relative to China and faces troubles of its own. It is too soon to call a bottom for EM relative to DM. Feature Global investors woke up to China’s domestic political risk over the past week, as Beijing extended its regulatory crackdown to private education companies. Our GeoRisk Indicator shows Chinese political risk reaching late 2017 levels while the broad Chinese stock market continued this year’s slide against emerging market peers (Chart 1). Chart 1China: Domestic Political Risk Takes Investors By Surprise A technical bounce in Chinese tech stocks will very likely occur but we would not recommend playing it. The first of our three key views for 2021 is the confluence of internal and external headwinds for China. True, today’s regulatory blitz will pass over like previous ones and the fast money will snap up Chinese tech firms on the cheap. The Communist Party is making a show of force, not destroying its crown jewels in the tech sector. However, the negative factors weighing on China are both cyclical and structural. Until Chinese President Xi Jinping adjusts his strategy and US-China relations stabilize, investors do not have a solid foundation for putting more capital at risk in China. Globalization is in retreat and this is negative for China, the big winner of the past 40 years. Hypo-Globalization Globalization in the truest sense has expanded over millenia. It will only reverse amid civilizational disasters. But the post-Cold War era of “hyper-globalization” is long gone.1 The 2010s saw the emergence of de-globalization. In the wake of COVID-19, global trade is recovering to its post-2008 trend but it is nowhere near recovering the post-1990 trend (Chart 2). Trade exposure has even fallen within the major free trade blocs, like the EU and USMCA (Chart 3). Chart 2Hypo-Globalization Chart 3Trade Intensity Slows Even Within Trade Blocs Of course, with vaccines and stimulus, global trade will recover in the coming decade. We coined the term “hypo-globalization” to capture this predicament, in which globalization is set to rebound but not to its previous trajectory.2 We now inhabit a world that is under-globalized and under-globalizing, i.e. not as open and free as it could be. A major factor is the US-China economic divorce, which is proceeding apace. China’s latest state actions – in diplomacy, finance, and business – underscore its ongoing disengagement from the US-led global architecture. The US, for its part, is now on its third presidency with protectionist leanings. American and European fiscal stimulus are increasingly protectionist in nature, including rising climate protectionism. Bottom Line: The stimulus-fueled recovery from the global pandemic is not leading to re-globalization so much as hypo-globalization. A cyclical reboot of cross-border trade and investment is occurring but will fall short of global potential due to a darkening geopolitical backdrop. Still No Stabilization In US-China Relations Chart 4Do Nations Prefer Growth? Or Security? A giant window of opportunity is closing for China and Russia – they will look back fondly on the days when the US was bogged down in the Middle East. The US current withdrawal from “forever wars” incentivizes Beijing and Moscow to act aggressively now, whether at home or abroad. Investors tend to overrate the Chinese people’s desire for economic prosperity relative to their fear of insecurity and domination by foreign powers. China today is more desirous of strong national defense than faster economic growth (Chart 4). The rise of Chinese nationalism is pronounced since the Great Recession. President Xi Jinping confirmed this trend in his speech for the Communist Party’s first centenary on July 1, 2021. Xi was notably more concerned with foreign threats than his predecessors in 2001 and 2011 (Chart 5).3 China has arrived as a Great Power on the global stage and will resist being foisted into a subsidiary role by western nations. Chart 5Xi Jinping’s Centenary Speech Signaled Nationalist Turn Meanwhile US-China relations have not stabilized. The latest negotiations did not produce agreed upon terms for managing tensions in the relationship. A bilateral summit between Presidents Biden and Xi Jinping has not been agreed to or scheduled, though it could still come together by the end of October. Foreign Minister Wang Yi produced a set of three major demands: that the US not subvert “socialism with Chinese characteristics,” obstruct China’s development, or infringe on China’s sovereignty and territorial integrity (Table 1). The US’s opposition to China’s state-backed economic model, export controls on advanced technology, and attempts to negotiate a trade deal with the province of Taiwan all violate these demands.4 Table 1China’s Three Demands From The United States (July 2021) The removal of US support for China’s economic, development – recently confirmed by the Biden administration – will take a substantial toll on sentiment within China and among global investors. US President Joe Biden and four executive departments have explicitly warned investors not to invest in Hong Kong or in companies with ties to China’s military-industrial complex and human rights abuses. The US now formally accuses China of genocide in the Xinjiang region.5 Bottom Line: There is no stabilization in US-China relations yet. This will keep the risk premium in Chinese currency and equities elevated. The Sino-American divorce is a major driver of hypo-globalization. China’s Regulatory Crackdown President Xi Jinping’s strategy is consistent. He does not want last year’s stimulus splurge to create destabilizing asset bubbles and he wants to continue converting American antagonism into domestic power consolidation, particularly over the private economy. Now China’s sweeping “anti-trust” regulatory crackdown on tech, education, and other sectors is driving a major rethink among investors, ranging from Ark-founder Cathie Wood to perma-bulls like Stephen Roach. The driver of the latest regulatory crackdown is the administration’s reassertion of central party control. The Chinese economy’s potential growth is slowing, putting pressure on the legitimacy of single-party rule. The Communist Party is responding by trying to improve quality of life while promoting nationalism and “socialism with Chinese characteristics,” i.e. strong central government control and guidance over a market economy. Beijing is also using state power and industrial policy to attempt a great leap forward in science and technology in a bid to secure a place in the sun. Fintech, social media, and other innovative platforms have the potential to create networks of information, wealth, and power beyond the party’s control. Their rise can generate social upheaval at home and increase vulnerability to capital markets abroad. They may even divert resources from core technologies that would do more to increase China’s military-industrial capabilities. Beijing’s goal is to guide economic development, break up the concentration of power outside of the party, prevent systemic risks, and increase popular support in an era of falling income growth. Sociopolitical Risks: Social media has demonstrably exacerbated factionalism and social unrest in the United States, while silencing a sitting president. This extent of corporate power is intolerable for China. Economic And Financial Risks: Innovative fintech companies like Ant Group, via platforms like Alipay, were threatening to disrupt one of the Communist Party’s most important levers of power: the banking and financial system. The People’s Bank of China and other regulators insisted that Ant be treated more like a bank if it were to dabble in lending and wealth management. Hence the PBoC imposed capital adequacy and credit reporting requirements.6 Data Security Risks: Didi Chuxing, the ride-sharing company partly owned by Uber, whose business model it copied and elaborated on, defied authorities by attempting to conduct its initial public offering in the United States in June. The Communist Party cracked down on the company after the IPO to show who was in charge. Even more, Beijing wanted to protect its national data and prevent the US from gaining insights into its future technologies such as electric and autonomous vehicles. Foreign Policy Risks: Beijing is also preempting the American financial authorities, who will likely take action to kick Chinese companies that do not conform to common accounting and transparency standards off US stock exchanges. Better to inflict the first blow (and drive Chinese companies to Hong Kong and Shanghai for IPOs) than to allow free-wheeling capitalism to continue, giving Americans both data and leverage. Thus Beijing is continuing the “self-sufficiency” drive, divorcing itself from the US economy and capital markets, while curbing high-flying tech entrepreneurs and companies. The party’s muscle-flexing will culminate in Xi Jinping’s consolidation of power over the Politburo and Central Committee at the twentieth national party congress in fall 2022, where he is expected to take the title of “Chairman” that only Mao Zedong has held before him. The implication is that the regulatory crackdown can easily last for another six-to-12 more months. True, investors will become desensitized to the tech crackdown. But health care and medical technology are said to be in the Chinese government’s sights. So are various mergers and acquisitions. Both regulatory and political risk premia in different sectors can persist. The current administration has waged several sweeping regulatory campaigns against monopolies, corruption, pollution, overcapacity, leverage, and non-governmental organizations. The time between the initial launch of one of these campaigns and their peak intensity ranges from two to five years (Chart 6). Often, but not always, central policy campaigns have an express, three-year plan associated with them. Chart 6ABeijing Cracked Down On Monopolies, Corruption, Pollution... Chart 6B...NGOs, Overcapacity, And Leverage Chart 7China Tech: Buyer Beware The first and second year mark the peak impact. The negative profile of Chinese tech stocks relative to their global peers suggests that the current crackdown is stretched, although there is little sign of bottom formation yet (Chart 7). The crackdown began with Alibaba founder Jack Ma, and Alibaba stocks have yet to arrest their fall either in absolute terms or relative to the Hang Seng tech index. Bottom Line: A technical bounce is highly likely for Chinese stocks, especially tech, but we would not recommend playing it because of the negative structural factors. For instance, we fully expect the US to delist Chinese companies that do not meet accounting standards. The Chinese Government’s Pain Threshold? The government is not all-powerful – it faces financial and economic constraints, even if political checks and balances are missing. Beijing does not have an interest in destroying its most innovative companies and sectors. Its goal is to maintain the regime’s survival and power. China’s crackdown on private companies goes against its strategic interest of promoting innovation and therefore it cannot continue indefinitely. The hurried meeting of the China Securities Regulatory Commission with top bankers on July 28 suggests policymakers are already feeling the heat.7 In the case of Ant Group, the company ultimately paid a roughly $3 billion fine (which is 18% of its annual revenues) and was forced to restructure. Ant learned that if it wants to behave more like a bank athen it will be regulated more like a bank. Yet investors will still have to wrestle with the long-term implications of China’s arbitrary use of state power to crack down on various companies and IPOs. This is negative for entrepreneurship and innovation, regardless of the government’s intentions. Chart 8China's Pain Threshold = Property Sector Ultimately the property sector is the critical bellwether: it is a prime target of the government’s measures against speculative asset bubbles. It is also an area where authorities hope to ease the cost of living for Chinese households, whose birth rates and fertility rates are collapsing. While there is no risk of China’s entire economy crumbling because of a crackdown on ride-hailing apps or tutoring services, there is a risk of the economy crumbling if over-zealous regulators crush animal spirits in the $52 trillion property sector, as estimated by Goldman Sachs in 2019. Property is the primary store of wealth for Chinese households and businesses and falling property prices could well lead to an unsustainable rise in debt burdens, a nationwide debt-deflation spiral, and a Japanese-style liquidity trap. Judging by residential floor space started, China is rapidly approaching its overall economic pain threshold, meaning that property sector restrictions should ease, while monetary and credit policy should get easier as necessary to preserve the economic recovery (Chart 8). The economy should improve just in time for the party congress in late 2022. Bottom Line: China will be forced to maintain relatively easy monetary and fiscal policy and avoid pricking the property bubble, which should lend some support to the global recovery and emerging markets economies over the cyclical (12-month) time frame. China’s Regulation And Demographic Pressures Is the Chinese government not acting in the public interest by tamping down financial excesses, discouraging anti-competitive corporate practices, and combating social ills? Yes, there is truth to this. But arbitrary administrative controls will not increase the birth rate, corporate productivity, or potential GDP growth. First, it is true that Chinese households cite high prices for education, housing, and medicine as reasons not to have children (Chart 9). However, price caps do not attack the root causes of these problems. The lack of financial security and investment options has long fueled high house prices. The rabid desire to get ahead in life and the exam-oriented education system have long fueled high education prices. Monetary and fiscal authorities are forced to maintain an accommodative environment to maintain minimum levels of economic growth amid high indebtedness – and yet easy money policies fuel asset price inflation. In Japan, fertility rates began falling with economic development, the entrance of women in the work force, and the rise of consumer society. The fertility rate kept falling even when the country slipped into deflation. It perked up when prices started rising again! But it relapsed after the Great Recession and Fukushima nuclear crisis (Chart 10, top panel). Chart 9China: Concerns About Having Children China’s fertility rate bottomed in the 1990s and has gradually recovered despite the historic surge in property prices (Chart 10, second panel), though it is still well below the replacement rate needed to reverse China’s demographic decline in the absence of immigration. A lower cost of living and a higher quality of life will be positive for fertility but will require deeper reforms.8 Chart 10Fertility Fell In Japan Despite Falling Prices At the same time, arbitrary regulatory crackdowns that punish entrepreneurs are not likely to boost productivity. Anti-trust actions could increase competition, which would be positive for productivity, but China’s anti-trust actions are not conducted according to rule of law, or due process, so they increase uncertainty rather than providing a more stable investment environment. China’s tech crackdown is also aimed at limiting vulnerability to foreign (American) authorities. Yet disengagement with the global economy will reduce competition, innovation, and productivity in China. Bottom Line: China’s demographic decline will require larger structural changes. It will not be reversed by an arbitrary game of whack-a-mole against the prices of housing, education, and health. India And South Asia Chart 11China Will Ease Policy... Or India Will Break Out Global investors have turned to Indian equities over the course of the year and they are now reaching a major technical top relative to Chinese stocks (Chart 11). Assuming that China pulls back on its policy tightening, this relationship should revert to mean. India faces tactical geopolitical and macroeconomic headwinds that will hit her sails and slow her down. In other words, there is no great option for emerging markets at the moment. Over the long run, India benefits if China falters. Following the peak of the second COVID-19 wave in May 2021, some high frequency indicators have showed an improvement in India’s economy. However, activity levels appear weaker than of other emerging markets (Chart 12). Given the stringency levels of India’s first lockdown last spring, year-on-year growth will look faster than it really is. As the base effect wanes, underlying weak demand will become evident. Moreover India is still vulnerable to COVID-19. Only 25% of the population has received one or more vaccine shots which is lower than the global level of 28%. The result will be a larger than expected budget deficit. India refrained from administering a large dose of government spending in 2020 (Chart 13). With key state elections due from early 2022 onwards, the government could opt for larger stimulus. This could assume the form of excise duty cuts on petroleum products or an increase in revenue expenditure. These kinds of measures will not enhance India’s productivity but will add to its fiscal deficit. Chart 12Weak Post-COVID Rebound In India – And Losing Steam Chart 13India Likely To Expand Fiscal Spending Soon Such an unexpected increase in India’s fiscal deficit could be viewed adversely by markets. India’s fiscal discipline tends to be poorer than that of peers (see Chart 13 above). Meanwhile India’s north views Pakistan unfavorably and key state elections are due in this region. Consequently, Indian policy makers may be forced to adopt a far more aggressive foreign policy response to any terrorist strikes from Pakistan or territorial incursions by China over August 2021. The US withdrawal from Afghanistan poses risks for India as it has revived the Taliban’s influence. India has a long history of being targeted by Afghani terrorist groups. And its diplomatic footprint in Afghanistan has been diminishing. Earlier in July, India decided temporarily to close its consulate in Kandahar and evacuated about 50 diplomats and security personnel. As August marks the last month of formal US presence in Afghanistan, negative surprises emanating from Afghanistan should be expected. Bottom Line: Pare exposure to Indian assets on a tactical basis. Our Emerging Markets Strategy takes a more optimistic view but geopolitical changes could act as a negative catalyst in the short term. We urge clients to stay short Indian banks. Investment Takeaways US stimulus contrasts with China’s turmoil. The US Biden administration and congressional negotiators of both parties have tentatively agreed on a $1 trillion infrastructure deal over eight years. Even if this bipartisan deal falls through, Democrats alone can and will pass another $1.3-$2.5 trillion in net deficit spending by the end of the year. Stay short the renminbi. Prefer a balance of investments in the dollar and the euro, given the cross-currents of global recovery yet mounting risks to the reflation trade. A technical bounce in Chinese stocks and tech stocks is nigh. China’s policymakers are starting to respond to immediate financial pressures. However, growth has peaked and structural factors are still negative. The geopolitical outlook is still gloomy and China’s domestic political clock is a headwind for at least 12 more months. Prefer developed market equities over emerging markets (Chart 14). Emerging markets failed to outperform in the first half of the year, contrary to our expectation that the global reflation trade would lift them. China/EM will benefit when Beijing eases policy and growth rebounds. Chart 14Emerging Markets: Not Out Of The Woods Yet Stay short Indian banks and strongman EM currencies, including the Turkish lira, the Brazilian real, and the Philippine peso. The biggest driver of EM underperformance this year is the divergence between the US and China. But until China’s policy corrects, the rest of EM faces downside risks.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Dani Rodrik, The Globalization Paradox: Democracy and the Future of the World Economy (New York: Norton, 2011). 2 See my "Nationalism And Globalization After COVID-19," Investments & Wealth Monitor (Jan/Feb 2021), pp13-21, investmentsandwealth.org. 3 Our study of Xi’s speech is not limited to this quantitative, word-count analysis. A fuller comparison of his speech with that of his predecessors on the same occasion reveals that Xi was fundamentally more favorable toward Marx, less favorable toward Deng Xiaoping and the pro-market Third Plenum, utterly silent on notions of political reform or liberal reform, more harsh in his rhetoric toward the outside world, and hawkish about the mission of reunifying with Taiwan. 4 The Chinese side also insisted that the US stop revoking visas, punishing companies and institutes, treating the press as foreign agents, and detaining executives. It warned that cooperation – which the US seeks on the environment, Iran, North Korea, and other areas – cannot be achieved while the US imposes punitive measures. 5 See US Department of State, "Xinjiang Supply Chain Business Advisory," July 13, 2021, and "Risks and Considerations for Businesses Operating in Hong Kong," July 16, 2021, state.gov. 6 Top business executives are also subject to these displays of state power. For example, Alibaba founder Jack Ma caricatured China’s traditional banks as “pawn shops” and criticized regulators for stifling innovation. He is now lying low and has taken to painting! 7 See Emily Tan and Evelyn Cheng, "China will still allow IPOs in the United States, securities regulator tells brokerages," CNBC, July 28, 2021, cnbc.com. Officials are sensitive to the market blowback but the fact remains that IPOs in the US have been discouraged and arbitrary regulatory crackdowns are possible at any time. 8 Increasing social spending also requires local governments to raise more revenue but the central government had been cracking down on the major source of revenues for local government: land sales and local government financing vehicles. With the threat of punishment for local excesses and lack of revenue source, local governments have no choice but to cut social services, pushing affluent residents towards private services, while leaving the less fortunate with fewer services. As with financial regulations, the central government may backpedal from too tough regulation of local governments, but more economic and financial pain will be required to make it happen. The Geopolitics Of The Olympics The 2020 Summer Olympics are currently underway in Tokyo, even though it is 2021. The arenas are mostly empty given the global pandemic and economic slowdown. Every four years the Summer Olympics create a golden opportunity for the host nation to showcase its achievements, infrastructure, culture, and beauty. But the Olympics also have a long history of geopolitical significance: terrorist acts, war protests, social demonstrations, and boycotts. In 1906 an Irish athlete climbed a flag pole to wave the Irish flag in protest of his selection to the British team instead of the Irish one. In 1968 two African American athletes raised their fists as an act of protest against racial discrimination in the US after the assassination of Martin Luther King Jr. In 1972, the Palestinian terrorist group Black September massacred eleven Israeli Olympians in Munich, Germany. In 1980 the US led the western bloc to boycott the Moscow Olympics while the Soviet Union and its allies retaliated by boycotting the 1984 Los Angeles Olympics. In 2008, Russia used the Olympics as a convenient distraction from its invasion of Georgia, a major step in its geopolitical resurgence. So far, thankfully, the Tokyo Olympics have gone without incident. However, looking forward, geopolitics is already looming over the upcoming 2022 Winter Olympics in Beijing. How the world has changed. The 2008 Summer Olympics marked China’s global coming-of-age celebration. The breathtaking opening ceremony featured 15,000 performers and cost $100 million. The $350 million Bird’s Nest Stadium showcased to the world China’s long history, economic prowess, and various other triumphs. All of this took place while the western democratic capitalist economies grappled with what would become the worst financial and economic crisis since the Great Depression. In 2008, global elites spoke of China as a “responsible stakeholder” that was conducting a “peaceful rise” in international affairs. The world welcomed its roughly $600 billion stimulus. Now elites speak of China as primarily a threat and a competitor, a “revisionist” state challenging the liberal world order. China is blamed for a lack of transparency (if not virological malfeasance) in handling the COVID-19 pandemic. It is blamed for breaking governance promises and violating human rights in Hong Kong, for alleged genocide in Xinjiang, and for a list of other wrongdoings, including tough “Wolf Warrior” diplomacy, cyber-crime and cyber-sabotage, and revanchist maritime-territorial claims. Even aside from these accusations it is clear that China is suffering greater financial volatility as a result of its conflicting economic goals. Talk of a diplomatic or even full boycott of Beijing’s winter games is already brewing. Sponsors are also second-guessing their involvement. More than half of Canadians support boycotting the winter games. Germany is another bellwether to watch. In 2014, Germany’s president (not chancellor) boycotted the Sochi Olympics; in 2021, the EU and China are witnessing a major deterioration of relations. Parliamentarians in the UK, Italy, Sweden, Switzerland, and Norway have asked their governments to outline their official stance on the winter games. In the age of “woke capitalism,” a sponsorship boycott of the games is a possibility. This is especially true given the recent Chinese backlash against European multinational corporations for violating China’s own rules of political correctness. A boycott which includes any members of the US, Norway, Canada, Sweden, Germany, or the Netherlands would be substantial as these are the top performers in the Winter Olympics. Even if there is no boycott, there is bound to be some political protests and social demonstrations, and China will not be able to censor anything said by Western broadcasters televising the events. Athletes usually suffer backlash at home if they make critical statements about their country, but they run very little risk of a backlash for criticizing China. If anything, protests against China’s handling of human rights will be tacitly encouraged. Beijing, for its part, will likely overreact, as these days it not only controls the message at home but also attempts more actively to export censorship. This is precisely what the western governments are now trying to counteract, for their own political purposes. The bottom line is that the 2008 Beijing Olympics reflected China’s strengths in stark contrast with the failures of democratic capitalism, while the 2022 Olympics are likely to highlight the opposite: China’s weaknesses, even as the liberal democracies attempt a revival of their global leadership.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Section II: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia Section III: Geopolitical Calendar

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

Highlights Portfolio Duration: The decline in US bond yields is overdone. We anticipate that strong US employment data will catalyze a jump in bond yields this fall and that the 10-year US Treasury yield will reach a range of 2% - 2.25% by the time that the Fed is ready to lift rates, likely by the end of 2022. Maintain below-benchmark duration in bond portfolios. US Yield Curve: Investors should position for a rebound in bond yields but not a reversal of recent US Treasury curve flattening. In fact, we advocate owning 2/10 flatteners on the US Treasury curve as we see ample room for further curve flattening as Fed rate hikes approach in late-2022. ECB: The ECB’s new forward interest rate guidance has moved it that much closer to the Fed’s ultra-accommodative stance. This reinforces the defensive nature of the European bond market. Investors should overweight European bonds within global fixed income portfolios with a particular emphasis on peripheral European bond markets like Italy and Spain. Feature Chart 1Can The Bond Rally Continue? The bond rally continues to rip. The selloff that started last August when Jay Powell officially announced the Federal Reserve’s adoption of an Average Inflation Target ended on March 31st 2021. Since then, the 10-year US Treasury yield has retraced from 1.74% to 1.29% and the Bloomberg Barclays US Treasury index has clawed back 285 bps of excess return versus cash, partially offsetting the 465 bps that were lost between August 2020 and March 2021 (Chart 1). The US Bond Strategy Weekly Report from two weeks ago and last week’s Global Fixed Income Strategy Weekly Report both discuss the reasons for recent bond market strength.1 We won’t re-hash those arguments this week except to reiterate our conclusion that the decline in US bond yields is overdone. We anticipate that strong US employment data will catalyze a jump in bond yields this fall and that the 10-year US Treasury yield will reach a range of 2% - 2.25% by the time that the Fed is ready to lift rates, likely by the end of 2022. The first section of this week’s report looks at whether correlations between different asset classes have held up during the recent bond rally, with a focus on whether those relationships give us any information about the near-term direction for bond yields. The second section considers the outlook for the slope of the US Treasury curve and the third section discusses the recently released results of the European Central Bank’s strategy review. Cross-Market Correlations During The Bond Rally The bond rally has been just as intense as the prior sell-off. The US Treasury index has outperformed a position in cash by an annualized 9% since March 31st, matching the annualized losses of 9% seen between August 2020 and March 2021 (Chart 2). An important question to answer is whether this bond market performance is consistent with other asset classes. If it is, then it may suggest that the economy is experiencing a deflationary episode and that bond yields have further downside. If it isn’t, then it is more likely that the drop in bond yields will be temporary. Chart 2Bonds Versus Credit And Equities Bonds Versus Equities And Corporate Credit Chart 3Equity Sector Performance Consistent With Yields Looking first at corporate bonds, we find that – consistent with stronger Treasury performance – excess US corporate bond returns have slowed since March 31st. Baa-rated corporates have been outperforming at an annualized rate of 3% since March 31st compared to an annualized rate of 12% between August 2020 and March 2021 (Chart 2, panel 2). Equities, on the other hand, have maintained their strong performance. The S&P 500 returned an annualized 30% between August 2020 and March 2021 and has returned an even greater 42% (annualized) since the end of March (Chart 2, panel 3). Extremely tight spreads are the most likely explanation for lower corporate bond excess returns. Meanwhile, the fact that equities continue to perform well is an indication that the drop in bond yields may be overdone. Interestingly, while overall equity returns haven’t dropped in line with bond yields, the relative performance of equity sectors has been totally consistent with the movement in yields (Chart 3). Cyclical equity sectors (Industrials, Energy and Materials) have underperformed defensive equity sectors (Healthcare, Telecoms, Consumer Staples and Utilities) and Banks have underperformed the overall index. The correlation between long-maturity real Treasury yields and the relative performance of value and growth stocks has also held up, with growth stocks outperforming since the end of March (Chart 3, bottom panel). Bonds Versus Commodities Chart 4Commodities And Bonds Have Diverged We see the biggest divergence in relative performance between bond yields and commodities. Historically, the ratio between the CRB Raw Industrials commodity price index and Gold is tightly correlated with the 10-year US Treasury yield. However, the CRB/Gold ratio has increased since the end of March while bond yields have fallen (Chart 4). In our view, this is the strongest piece of evidence suggesting that bond yields have overshot to the downside. Bonds Versus Currencies Chart 5Bonds Versus Currencies Finally, we observe that the US dollar has strengthened as bond yields have dropped. This is not that unusual. There are other periods when significant declines in US bond yields have coincided with dollar strength, 2019 and 2014/15 immediately come to mind (Chart 5). The common theme of those prior episodes is that the global economy was experiencing a deflationary shock. Commodity prices also fell during those periods and Emerging Market (EM) currencies depreciated versus the dollar. However, so far this year, EM currencies have held firm versus the dollar (Chart 5, bottom panel) and commodity prices continue to rise. On balance, financial markets don’t appear to be pricing-in a deflationary economic shock. In summary, since US Treasury yields peaked on March 31st, we have observed a sector rotation within US equities, but overall stock market performance has been strong. Corporate bonds continue to outperform Treasuries, though gains are limited by tight valuations. Commodity prices have held up and while the US dollar has firmed, dollar strength has not bled into EM currency weakness. All in all, we don’t view financial market performance as consistent with a deflationary economic episode. This suggests that bond yields are an outlier within the financial landscape and that the recent drop in yields won’t persist. A Quick Word On Sentiment And Positioning Chart 6A Rebound In Yields May Require A Shift In Sentiment One possible reason why bond performance has been inconsistent with some other markets is that there had simply been too much consensus around the “bond-bearish trade”. It’s certainly true that portfolio managers have been running large net-short positions and that the MarketVane survey of bond bullish sentiment is much less bullish than it was last year (Chart 6). We suspect that we may need to see bond market positioning and sentiment get more bullish before yields move meaningfully higher. Chart 6 shows that major troughs in the 30-year US Treasury yield often occur when portfolio manager positioning is “net long” bonds and when bond bullish sentiment is significantly higher than current levels. For this reason, we don’t anticipate an immediate rebound in bond yields. Rather, we suspect that yields will remain near current levels for the next month or two before strong employment data in the fall sets off the next phase of bearish bond action.   Position For A Rebound In Bond Yields, But Don’t Expect Much Curve Steepening Chart 7The 5-Year/5-Year Yield Remains Close To Target We see bond yields re-gaining their March 2021 highs, and then some, on a 6-12 month investment horizon. However, we don’t think this rebound in yields will coincide with a significant re-steepening of the US Treasury curve. For context, the 2/10 US Treasury slope peaked at 159 bps near the end of March. It is currently 51 bps lower, at 108 bps. We can categorize periods of yield curve steepening as falling into two categories. Bull-steepening: The curve steepens as yields fall. This tends to occur when the Fed is cutting interest rates. Bear-steepening: The curve steepens as yields rise. We can identify these periods as being when the 5-year/5-year forward Treasury yield rises from low levels toward its fair value range. Since 2012, we can identify a fair value range for the 5-year/5-year forward US Treasury yield using survey estimates of the long-run neutral fed funds rate. At present, the fair value range from the New York Fed’s Survey of Primary Dealers is from 2.06% to 2.50%, with a median of 2.31%. The fair value range from the New York Fed’s Survey of Market Participants is from 1.75% to 2.50%, with a median of 2.00%. The 5-year/5-year forward US Treasury yield is currently 1.93% (Chart 7). We identify seven significant periods of 2/10 Treasury curve steepening since 2009 (Table 1). Six of those episodes were bear-steepening episodes that coincided with an increase in the 5-year/5-year yield, the other was a bull-steepening episode that coincided with Fed rate cuts in 2019/20. If we assume that our fair value ranges provide a reasonable target for how high the 5-year/5-year forward US Treasury yield can rise during the next bear-steepening move, it means that – at most – we could see an increase of 57 bps in the 5-year/5-year yield as it moves all the way up to the 2.50% top-end of our target ranges. A linear regression of changes in the 2/10 slope versus changes in the 5-year/5-year forward yield during the six bear-steepening episodes we identified suggests that a 57 bps increase in the 5-year/5-year yield would lead to 12 bps of 2/10 curve steepening (Chart 8). In fact, we can see in both Table 1 and Chart 8 that it would take about 100 bps of upside in the 5-year/5-year yield to bring the 2/10 slope back to its March highs. This is extremely unlikely. Table 1Periods Of US Treasury Curve Steepening In The Zero-Lower-Bound Era Chart 8Bear-Steepening Episodes Since 2009   In fact, if the 5-year/5-year forward Treasury yield only rises back to the middle of its fair value range – somewhere between 2% and 2.31% - then our regression suggests that the yield curve slope will probably stay close to its current level. The bottom line is that while investors should position for a rebound in bond yields by keeping portfolio duration low, they should avoid US Treasury curve steepeners. In fact, we advocate owning 2/10 flatteners on the US Treasury curve as we see ample room for further curve flattening as Fed rate hikes approach in late-2022. The ECB’s New Guidance Solidifies The Defensive Nature Of European Bonds Last week, the European Central Bank (ECB) revised its forward rate guidance in light of its recently concluded Strategy Review.2 The ECB’s new rate guidance is as follows: In support of its symmetric two per cent inflation target and in line with its monetary policy strategy, the Governing Council expects the key ECB interest rates to remain at their present or lower levels until it sees inflation reaching two per cent well ahead of the end of its projection horizon and durably for the rest of the projection horizon, and it judges that realised progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilising at two per cent over the medium term. This may also imply a transitory period in which inflation is moderately above target.3   This may sound familiar, and it should. Though not explicitly an Average Inflation Target, the ECB has moved a long way toward the Federal Reserve’s new dovish reaction function. Specifically, both the ECB and Federal Reserve now acknowledge that a temporary period of above-2% inflation will be tolerated, if not explicitly sought. Also, both central banks have linked the timing of the first rate increase to some form of outcome-based forward guidance. The Federal Reserve has explicitly said that it will not lift rates until inflation is above 2% and the economy has reached “maximum employment”. The ECB now claims that interest rates won’t rise until inflation is seen reaching 2% “well ahead of its projection horizon”, a criterion that Christine Lagarde described as having an element of outcome-based guidance.4 The ECB’s new forward guidance may not be as explicitly dovish as the Fed’s. The ECB has no “maximum employment” target and its inflation trigger for lifting rates still relies on the Governing Council’s forecasts. But for investors, the big signal is that the ECB has recognized that the risk of tightening policy prematurely is greater than the risk of remaining on hold for too long. This gives us even more confidence that there will be no ECB tightening on the horizon, and we should continue to view European bond markets as being highly defensive. This is hardly news. European bond markets performed relatively well during the bearish bond episode that lasted from August 2020 to March 2021, they have then gained less than cyclical bond markets (like US and Canada) since March (Table 2). The ECB’s new reaction function ensures that this relationship will remain place for many years to come. Table 27-10 Year Government Bond Returns (In USD, %) The new reaction function is also a boon for peripheral European bond markets (like Italy and Spain) where yields trade at a spread above German bunds. The ECB’s commitment to staying dovish will only reinforce the downward pressure on peripheral European bond spreads versus Germany (Chart 9). Chart 9Grab The Extra Spread In Spanish And Italian Bonds The bottom line is that investors should continue to overweight European bonds within global fixed income portfolios, with a particular emphasis on peripheral European bond markets like Italy and Spain. The defensive nature of European bonds will protect investors from losses during the next move higher in global yields. Italian and Spanish bond markets may not perform quite as well during the next bond bear market as they did between August 2020 and March 2021, as spreads have already compressed a lot. But ultra-accommodative ECB policy will limit the amount of spread widening that can occur, making any additional spread worth grabbing.  Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Overreaction”, dated July 13, 2021 and Global Fixed Income Strategy Weekly Report, “The Message From Falling US Bond Yields”, dated July 21, 2021. 2 The results of the Strategy Review itself are discussed in Global Fixed Income Strategy Weekly Report, “The Reflationary Backdrop Is Still In Place”, dated July 14, 2021. 3 https://www.ecb.europa.eu/press/pr/date/2021/html/ecb.mp210722~48dc3b436b.en.html 4 https://www.ecb.europa.eu/press/pressconf/2021/html/ecb.is210722~13e7f5e795.en.html Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Dear Client, We will be presenting our quarterly webcast next week, and, as a result, will not be publishing on 29 July 2021.  We will cover our major calls for the quarter and provide a look-ahead.  I look forward to the Q+A, and am hopeful you will tune in. Bob Ryan Chief Commodity & Energy Strategist   Highlights Chart Of The WeekOPEC 2.0's Hand Strengthened By Production Agreement The deal crafted by OPEC 2.0 over the weekend to add 400k b/d of oil every month from August preserves the coalition, and sends a credible signal of its ability to raise output after its 5.8mm b/d of spare capacity is returned to market next year.1 KSA and Russia will remain primi inter pares, but the position of OPEC 2.0's core producers – not just the UAE, which negotiated an immediate baseline increase – was enhanced for future negotiations. This deal explicitly recognizes they are the only ones capable of increasing output over an extended period. We assume the revised production baselines for core OPEC 2.0 effective May 2022 reflect the coalition's demand expectations from 2H22 onward. Our modeling indicates core OPEC 2.0's output will almost converge on the revised baseline production of 34.3mm b/d by 2H23, when we expect these producers to be at ~ 33.4mm b/d. Holding our demand estimates constant from last week, our revised supply expectations prompt us to move our forecast closer to our June forecast. We expect Brent to average $70/bbl in 2H21, with 2022 and 2023 averaging $74 and $80/bbl (Chart of the Week). Feature The deal concluded by OPEC 2.0 over the weekend will do more than add 400k b/d of spare capacity to the market every month beginning next month. It also does more than preserve the producer coalition's successful production-management strategy.  The big take-away from the deal is the clear message being sent by the coalition's core members – KSA, Russia, Iraq, UAE and Kuwait – that they are able to significantly increase output after their 5.8mm b/d of spare capacity has been returned to the market over the next year or so. It does so by raising the baselines of the core producers starting in May 2022, clearly indicating the capacity and willingness to raise output and keep it there (Table 1). Table 1Baseline Increases For Core OPEC 2.0 What OPEC 2.0's Deal Signals Internally, the deal is meant to recognize the investment made by the UAE in particular, which was not being accounted for in its current baseline. Externally – i.e., to competitors outside the coalition – the deal signals OPEC 2.0's successful production management strategy will continue, by raising the likelihood the coalition will remain intact. This has kept the level of supply below demand over the course of the COVID-19 pandemic (Chart 2), and is responsible for the global decline in inventories (Chart 3). Chart 2OPEC 2.0 Durability Increases Chart 3Inventories Will Remain Under Control Specifically, the massive spare capacity still to be returned to the market between now and 2H22 can be accomplished with minimal risk of a market-share war breaking out among the core OPEC 2.0 members seeking to monetize their off-the-market production before the other members of the coalition. Most importantly, the revised benchmark production levels that becomes effective May 2022 signal the coalition members with the capacity to increase production can do so. Longer-Term Forward Guidance We assume the revised production baselines for core OPEC 2.0 effective May 2022 reflect the coalition's demand expectations from 2H22 onward. Our modeling indicates core OPEC 2.0's output will approach the revised baseline reference levels of 34.3mm b/d, hitting 33.4mm b/d for crude and liquids output by 2H23 (Table 2).  Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 This implies the core group expects to be able to cover production declines within the coalition and to meet demand increases going forward. The estimates are far enough into the future to prepare ahead of time to increase production. Our estimates for core OPEC 2.0 production reflects our assumption the revised baseline levels do reflect demand expectations of the coalition. In estimating the coalition's production, we rely on historical data from the US EIA, which allows us to estimate future production using regressors we consider reliable (e.g., GDP estimates from the IMF and World Bank).  Non-OPEC 2.0 Production We use EIA historical data for non-OPEC 2.0 production as well. In last week’s balances, we substituted the EIA's estimates for non-OPEC 2.0 producers ex-US for our estimates, which resulted in lower supply numbers throughout our forecast sample.  This threw off our balances estimates in particular, as we did not balance the decrease in supply from this group using the new data set with an increase from another group. We corrected this oversight this week: We will continue to use EIA estimates for non-OPEC 2.0 ex-US countries, but will balance the decrease in oil production from this cohort with increased supply from other countries. Chart 4US Shales Are The Marginal Barrel For US oil production, we will continue to estimate it as a function of WTI price levels, the forward curve and financial variables – chiefly high-yield rates, which serve as a good proxy for borrowing costs for the marginal US shale producer, which we view as the quintessential marginal producer in the global price-taking cohort (Chart 4). Our research indicates US shale producers – like all producers, for that matter – are prioritizing shareholder interests first and foremost. This means they will focus on profitability and margins. While we have observed this tendency for some time, it appears it is gaining speed, as oil and gas producers are now considering whether they want to retain their existing exposure to their hydrocarbon assets.2   There appears to be a reluctance among resource producers generally – this is true in copper, as we have noted – to substantially increase capex. This could be the result of covid uncertainty, demand uncertainty, monetary-policy uncertainty or a real attempt to provide competitive returns. We think it is a combination of all of these, but the picture is clouded by the difficulty in separating all of these uncertainties. Income Drives Oil Demand Chart 5Income Drives Oil Demand Our demand estimates will continue to be driven by estimates of GDP from the IMF and the World Bank. We have found the level of oil consumption is highly correlated with GDP, particularly for EM states (Chart 5). Holding our demand estimates constant from last week, our revised supply expectations prompt us to move our forecast closer to our June forecast.  This week, we also will adjust our inventory calculations, which will rely less on EIA estimates of OECD stocks. In the recent past, these estimates played a sizeable role in our forecasts. From this month on, they will play a smaller part. This is why, even though our supply estimates have risen from last week, there is not a significant change to our inventory levels. Investment Implications Holding our demand estimates constant from last week, our revised supply expectations prompt us to move our forecast closer to our June forecast. We expect Brent to average $70/bbl in 2H21, with 2022 and 2023 averaging $74 and $80/bbl. We remain bullish commodities in general, given the continued tightness in these markets. We expect this to persist, as capex remains elusive in oil, gas and metals markets. This underpins our long S&P GSCI and COMT ETF commodity recommendations, and our long MSCI Global Metals & Mining Producers ETF (PICK) recommendation.   Robert P. Ryan  Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish US natural gas exports via pipeline to Mexico averaged just under 7 bcf/d in June, according to the EIA. Exports hit a record high of 7.4 bcf/d on 24 June 2021. The record high for the month was 7.4 Bcf/d on June 24. The EIA attributes the higher exports to increases in industrial and power demand, and high temperatures, which are driving air-conditioning demand south of the US border. Close to 5 bcf/d of the imported gas is used to generate power, according to the EIA. This was up close to 20% y/y. Increases in gas-pipeline infrastructure are allowing more gas to flow to Mexico from the US. Base Metals: Bullish China reportedly will be selling additional copper from its strategic stockpiles later this month, in an effort to cool the market. According to reuters.com, market participants expect China to auction 20k MT of Copper on 29 July 2021. This will bring total sales via auction to 50k MT, as the government earlier this month sold 30k MT at $10,500/MT (~ $4.76/lb). Prior to and since that first auction, copper has been trading on either side of $4.30/lb (Chart 6). Market participants expected a higher volume than the numbers being discussed as we went to press. In addition to auctioning copper, the government reportedly will auction other base metals. Precious Metals: Bullish Interest rates on 10-year inflation-linked bonds remain below -1%, as U.S. CPI inflation rises. US 10-year treasury yields have rebounded since sinking to a five-month low at the beginning of this week. The positive effect of negative real interest rates on gold is being balanced by a rising USD (Chart 7). Safe-haven demand for the greenback is being supported by uncertainty caused by COVID-19’s Delta variant. Gold prices are still volatile after the Fed’s ‘dot shock’ in mid-June.3 This volatility is reducing safe-haven demand for the yellow metal despite rising economic and policy uncertainty. Ags/Softs: Neutral Hot, dry weather is expected over most of the grain-growing regions of the US for the balance of July, which will continue to support prices, according to Farm Futures. Chart 6Copper Prices Going Down Chart 7Weaker USD Supports Gold   Footnotes 1Please see 19th "OPEC and non-OPEC Ministerial Meeting concludes" published by OPEC 18 July 2021. 2Please see "BHP said to seek an exit from its petroleum business" published by worldoil.com July 20, 2021.  3Please refer to ‘“Dot Shock” Continues To Roil Gold; Oil…Not So Much’, which we published on  July 1, 2021 for additional discussion. It is available at ces.bcaresearch.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2021 Summary of Trades Closed